For most investors, a safe and sound retirement is priority number one. The bulk of many people's assets go into accounts dedicated to that purpose. However, living off your investments once you finally retire can be as challenging as saving for a comfortable retirement.

Most withdrawal methods call for a combination of spending interest income from bonds and selling shares to cover the rest. Personal finance's famous four-percent rule thrives on this fact. The four-percent rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that will allow funds to last many years. What if there was another way to get four percent or more from your portfolio each year without selling shares and reducing the principal?

One way to enhance your retirement income is to invest in dividend-paying stocks, mutual funds, and exchange traded funds (ETFs). Over time, the cash flow generated by those dividend payments can supplement your Social Security and pension income. Perhaps, it can even provide all the money you need to maintain your preretirement lifestyle. It is possible to live off dividends if you do a little planning.

Key Takeaways

  • Retirement income planning can be tricky and uncertain.
  • Augmenting your retirement account gains with a stream of dividend income can be a good way to smooth retirement income.
  • Identifying the right mix of dividend-paying stocks with dividend growth potential is vital.
  • Investors and retirees alike should not forgo growth altogether in favor of yield.
  • Small investors can use ETFs to build diversified portfolios of dividend growth and high-dividend-yield stocks.

It's All About Dividend Growth

Stock dividends tend to grow over time, unlike the interest from bonds. That's one of the main reasons why stocks should be a part of every investor's portfolio. Furthermore, dividend growth has historically outpaced inflation. For those investors with a long timeline, this fact can be used to create a portfolio that is strictly for dividend-income living.

A smart strategy for people who are still saving for retirement is to use those dividends to buy more shares of stock in firms. That way, they will receive even more dividends and be able to buy even more shares.

For example, assume you bought 1,000 shares of a stock that traded for $100, for a total investment of $100,000. The stock has a 3% dividend yield, so you received $3 per share over the past year, which is $3,000 in dividends. You then take the dividends and buy more stock, so your total investment is $103,000. Assume the stock price doesn't move much, but the company increases its dividend by 6% a year. In the second year, you will get a dividend yield of 3.18% on $103,000 for a dividend of about $3,275. However, that is a yield on cost of about 3.28%.

This dividend reinvestment strategy continues to increase the yield on cost over time. After ten years, the hypothetical portfolio from the previous paragraph will produce around $7,108 in dividends. After 20 years, you will receive more than $24,289 a year in dividends.

What If You Are Already Retired?

Compounding of dividend income is very advantageous if you have a long time horizon, but what about if you are near retirement? For these investors, dividend growth plus a little higher yield could do the trick.

First, retired investors looking to live off their dividends may want to ratchet up their yield. High yielding stocks and securities, such as master limited partnerships, REITs, and preferred shares, generally do not generate much in the way of distributions growth. On the other hand, investing in them increases your current portfolio yield. That'll go a long way toward helping to pay today's bills without selling off securities.

Dividends paid in a Roth IRA are not subject to income tax.

Nonetheless, retired investors shouldn't shy away from classic dividend growth stocks like Procter & Gamble (PG). These stocks will increase dividend income at or above the inflation rate and help power income into the future. By adding these types of firms to a portfolio, investors sacrifice some current yield for a larger payout down the line.

While an investor with a small portfolio may have trouble living off dividends completely, the rising and steady payments still help reduce principal withdrawals.

Dividend ETFs

It can be hard to find the right stocks for dividends. Furthermore, achieving sufficient diversification is even more challenging for small investors. Fortunately, some ETFs deploy dividend strategies for you. Dividend growth ETFs focus on stocks that are likely to grow their dividends in the future. If you are looking for current income, high-dividend-yield ETFs are a better choice.

The Bottom Line

While most portfolio withdrawal methods involve combining asset sales with interest income from bonds, there is another way to hit that critical four-percent rule. By investing in quality dividend stocks with rising payouts, both young and old investors can benefit from the stocks' compounding, and historically inflation-beating, distribution growth. All it takes is a little planning, and then investors can live off their dividend payment streams.