How will you fund your retirement years? For many, this question resides in the back of your mind from the time you enter the workforce. Others don’t pay retirement funds a second thought until it’s almost time to retire.
Wherever you are on the spectrum, it’s a good idea to understand ways to finance your retirement years, so you can make informed decisions when you’re ready. One of the options for funding retirement is dividend income.
What Are Dividends?
Dividends are the rewards that companies pay to investors for their investment. Usually, the company will pay dividends with cash bonuses, but sometimes they dole out shares of stock or other property.
Companies make dividend payments at a set frequency, like quarterly, monthly, or annually. They can also issue special dividends to individuals following a strong business performance.
Usually, companies pay dividends from their net profits, so payments generally occur when a company has a surplus. However, some companies pride themselves on paying regular dividends, so they may issue payments even if they didn’t make as much.
Larger companies with a good track record of profits pay the best dividends. Shareholders usually see steady growth from regular dividend payments. Newer companies and start-ups generally don’t offer regular dividends because of the natural ups and downs of getting started.
Why Paying Dividends is Important to a Company
Dividends reward shareholders and encourage trust in a company. Shareholders appreciate the payments because they are passive income that snowballs. Dividend payments are usually tax-free, too.
Paying dividends is important because it impacts a company’s stock price. When dividends are paid regularly or at a high rate due to strong profits, company stock prices may rise. Conversely, when a company’s dividends decrease, their stock prices may fall.
Types of Dividends
There are three main types of dividends. Most dividends are common and paid on the company’s common stock. The other two are different because they are irregular.
Companies pay special dividends to all common stock shareholders, but the payments are infrequent. They only occur when a company has accumulated excess profits that they don’t need to use immediately.
A different type of dividend is a preferred dividend that a company pays for a particular stock that acts more like a bond. Payments are fixed and paid only to people who hold the preferred stock.
Understanding the Dividend Payment Schedule
Like everything related to stocks and finance, set schedules and timelines dictate which shareholders receive dividend payments. The dates rely on specific actions occurring in chronological order.
The dividend payment process begins with the announcement date, also known as the declaration date. Company management announces the dividends once the board of directors approves them.
Every payment has an ex-dividend date, or ex-date, that establishes the cut-off for eligibility. Anybody who purchases stock on or after the ex-date is not eligible for the dividend payment. Before the ex-date, stock prices may rise by the amount of the dividend. The prices then fall by that same amount on the ex-date.
The record date is a cut-off established by a company to determine who is eligible to receive a dividend. This date is important because shareholders trade so often that it can be challenging to keep track. Usually, you need to purchase the stock at least two business days before the record date to be eligible to receive a dividend payment.
The payment date, also known as the payable date, is the date the company pays its shareholders. Companies tend to set payment dates for a few weeks after the ex-date.
How to Find the Best Dividend Stocks for You
When it comes to investing, you want to be more like the tortoise than the hare. Dividends are a long-term game where your wealth snowballs over the years. The goal purchase stock in companies that pay dividends so you can reinvest those payments to accumulate more wealth.
Sounds easy, right? Many factors can affect dividend payments and cause your net worth to take a hit. There’s a fair amount of guesswork involved, but try to look for stable companies with certain markers.
Consistency is Key
It may be tempting to grab up stocks when they pay out exceptional dividends, but what happens if those payments result in a company going under? Instead, you should seek out companies with consistent profits and steady growth. Remember, this isn’t a race. It is more of a steady crawl.
- Look for companies that have long-term earnings growth expectations between 5% and 15%.
- Watch for companies with steady cash flow because that’s what pays the dividends. If they demonstrate consistent growth, they’re more likely to continue paying out.
- Bet on established companies with long-term increases in their dividends. Look for companies whose dividends have increased for at least five years running.
Evaluate the Company’s Debt-to-Equity Ratio
Avoid companies that are bogged down by debt. Look at a company’s debt-to-equity ratio to assess their overall financial health. You should pass over companies with ratios higher than two and focus on those with ratios less than one.
It doesn’t matter how well-known or established they are, if the debt-to-equity ratio is high, move on. When a company has debt, they need to use their profits to pay it down at some point, which translates to a loss of dividends down the line.
Consider the Industry
Before going all-in on a company with a longstanding record of profits and stable dividend payouts, be sure to account for industry trends. A prime example is the fuel industry. For years, oil companies delivered, but then oil and gas integrated, and the price of oil fell. Look at the big picture before buying into an industry.
Can You Live Off Dividends?
If you employ a solid strategy and invest wisely, it is possible to live off your stock dividends. However, it takes time and patience. While dividends are considered passive income, it takes some effort to build a portfolio that’s profitable enough to live off of the dividends.
There are two ways to approach living off dividends. Only you can decide which way to go and whether you have the time and patience to make it work.
Dividends as Your Sole Income
You can invest and build enough regular yield to live solely off your dividends. It’s an interesting idea that’s gained traction in recent years. The general idea is to create a stock portfolio that is so sound it produces regular, predictable payments.
Supplementing Your Income with Dividends
Second, you can use dividends to supplement other retirement income, like Social Security and pension. Building a portfolio that provides a steady flow of funds in addition to your set retirement income ensures that you can live the life you desire.
Retirement and the Four Percent Rule
Understanding the four percent rule will help you make decisions about your portfolio. The four percent rule is a guideline for how much retirees should withdraw from their retirement account each year. It’s a way to ensure a steady income stream while maintaining a sufficient balance to fund the rest of your life.
The four percent rule primarily relies on withdrawals from investments and dividends, so building a diverse portfolio is crucial. One of the most important factors in determining your rate is life expectancy because the longer you live, the more income you need.
Developed in the 1990s by a financial advisor, William Bengen, the four percent rule emerged from a long-term study. Bengen reviewed returns from a fifty-year period (1926 through 1976) to account for rises and falls in the market. This longitudinal study included massive falls from the Great Depression.
Bengen found that no retirement portfolio with a four percent annual withdrawal ran out in less than 33 years. The four percent rule even survived the Great Depression and the downturn in the 1970s. Consequently, this approach is safe but very conservative and may result in leftover funds for some people.
The four percent rule does not work for some retirees. If somebody holds more high-risk investments than index funds and bonds, it may be necessary to draw less than four percent at the beginning of retirement. By choosing high-risk investments, more conservative withdrawals can help you survive market downturns.
How to Start Your Portfolio
Since dividends are a long-term project, you should start immediately, if you haven’t already. A solid, consistent portfolio will not appear overnight, or even in a year. It takes several years to acquire the financial footing you desire from dividends.
Assess Your Financial Situation
Start by making a list of your current assets, liabilities, and income. By mapping out your present situation, you can determine how much money you’d like to make off dividends and how much you have to invest.
Choosing Your First Stocks
Once you know how much money you have to invest in stocks, you can look at the options. Seek out companies that consistently pay dividends. Another marker of a good investment is a company that shows consistent growth. Companies that managed to do both for several years are usually good starting points.
Be wary of companies with high-dividend yields. They could be a moneymaker for you, but it’s more likely that the company is in trouble. In some cases, savvy investors can turn profits on these situations, but if you’re just getting started, it’s better to play it safe.
Spreading Your Wealth
Once you dip your toe into investing, you’ll probably hear about diversification. There is a degree of risk involved in investing in stocks; that’s where diversification comes into play. By investing in a variety of stocks, you decrease your risk.
It’s not difficult to diversify your portfolio. Continue looking for sound investments. Try to pair a variety of companies with different growth and yield patterns. For example, choose a slow-growth, high-yielding company with a low-yield company that has an opportunity for fast growth.
Signs You Need to Make Changes
Dividends are passive income, but you still need to keep tabs on your status. There is always risk involved with stocks, but there are a few things you can monitor to help avoid major losses.
Typical Drops vs. Significant Drops
There is an ebb and flow to stock pricing, but significant drops may mean trouble for your dividends. If you notice a continuous or dramatic decline, you may want to consider moving to a different stock. A good rule of thumb is to look elsewhere if stock prices drop more than 15% from recent highs.
Keep an Eye on Dilution
One of the causes of drastic drops in stock prices occurs when shares are diluted. Dilution is the result of companies issuing new stocks, which in turn decreases the ownership percentage of current stockholders. Obviously, existing shareholders are not generally excited about splitting profits with new investors.
Why would a company upset their shareholders? Companies often issue new shares when they need more money. Selling more stocks builds capital, but it also divides the profits among more people and causes stock prices to fall.
Watch for Problems in the Company or Industry
New leadership, scandals in management, and major events that impact an entire industry can cause stock prices to fall. Depending on the severity of the issue, prices could rebound promptly. It’s essential to keep an eye on your stocks for these situations.
Consider the example of Twenty-First Century Fox, Inc. after the sexual harassment scandals involving former Fox News Host Bill O’Reilly and former Fox News Chairman Roger Ailes. Despite the scandals, FOX stock dipped minimally then rose again after the company announced the departures of both men.
Skip Out on Stagnate Stocks
Monitor your stocks at regular intervals to identify stagnate stocks. While it’s a good idea to have some slow-growing stocks, you need to see some level of growth. You don’t need to see growth every quarter, but several consecutive quarters with no increase could signal trouble.
Hiring a Professional to Handle Your Portfolio
Are you feeling just a little overwhelmed by all of this information? That’s okay, dividends and stocks are complicated with many variables to consider. Thankfully, there are professionals committed to managing wealth and planning financial futures for people.
What is a Financial Advisor?
Financial advisors, or planners, are well-versed in wealth management and retirement savings. They can help you create a comprehensive plan to live your best life in retirement. Financial planners handle more than just stocks and dividends. They can guide you through financial difficulties and help you find insurance policies.
How to Decide if You Need a Financial Advisor
Even if you understand all there is to know about stocks and dividends, there are other issues to consider before deciding to handle your own portfolio. Think about your situation realistically to evaluate your aptitude and desire to manage your financial portfolio.
- How do you want to spend your time? Decide if you have free time to commit to your financial planning.
- What is your experience with financial instruments? There are many ways to manage a portfolio, and they all have different perks. If you’re not comfortable with the technology, you may miss out on opportunities.
- Do you enjoy reading about financial topics? You probably won’t be as diligent about keeping up with your portfolio and the latest trends if you don’t find wealth management enjoyable.
How to Choose a Financial Advisor
Choosing a financial planner is not something to take lightly. You want to make sure that a person is right for you and what you hope to accomplish. It’s okay to ask a lot of questions and interview multiple people. Good financial planners will answer your questions honestly.
Before hiring a financial advisor, you want to ask direct questions to understand what you’re getting with them. Understand that many advisors handle accounts virtually, so you may not have in-person meetings. You still need to ask the questions to avoid a bad situation that costs you money.
- Have you worked with people like me? It sounds silly, but this question is critical, especially if you are a part of a smaller niche, like a divorcee or a widow.
- Ask about fees and commission rates. You need to know what you’re getting into, including how the advisor wants to be compensated.
- Inquire about all the services the planner offers. You may want to choose somebody who can handle more than one thing for you.
- Identify how the advisor prefers to communicate. Will meetings be in-person, over the phone, or via email? You need to know how you’ll be updated about your portfolio as well.
Signs You Need a New Financial Advisor
Like every profession, there are bad financial advisors. Dishonesty and incompetence can cost you a lot of money if you aren’t careful about who you hire. Watch for warning signs that you need to replace your financial planner.
- Replace a financial advisor who buys and sells more than necessary. They are probably doing so to build a higher commission for themselves.
- Be wary of planners who suggest expensive investments when lower-cost choices would be better for your circumstances.
- Skip the sketchy plans. When an advisor suggests questionable financial plans with holes and vague blueprints, you should run the other way.
- Cut ties when a financial planner doesn’t communicate with you. Your advisor should respond to calls and emails in a timely manner.
Are You Ready to Retire?
The ultimate question for any working individual is when they are in an excellent position to retire. Even if you love your job and plan to continue as long as possible, it’s essential to know when you’re financially stable enough to retire.
Signs You’re Financially Ready to Retire
There’s an emotional component involved in the decision to retire, but if you’re not financially stable, it’s not a viable option. You need to evaluate your financial health to determine your retirement readiness.
- Take time to track your expenses and determine your life expectancy to estimate how much income you’ll need each year.
- List your projected income from Social Security, pension, and other sources (like rental income from properties you own).
- Figure out how much you can withdraw from retirement savings to supplement your income.
- Factor in how much you’ll owe in taxes each year.
- Account for healthcare because long-term care can put a significant dent in your savings.
Reasons You’re Not Ready to Retire
Aside from emotional readiness, there are plenty of reasons to keep working. Even if you don’t love your job, you can’t afford to retire if any of these situations apply to you.
Behind in Your Bills
If you can’t manage to cover your monthly expenses with a paycheck, how will you pay them on a reduced income? You can’t rely on getting part-time work either.
Bogged Down by Debt
Pay down debt before you head into retirement because it will drain you after retirement. Just like being behind in monthly bills, retiring with mounds of debt can cripple you long-term.
Poor Planning
If you take nothing else from this, understand that you need a solid financial plan for a successful retirement. Failing to plan monthly finances and long-term plans, including health and travel, leave you vulnerable.
There will inevitably be some variables that blindside you, but with a proper plan, you can rebound and handle them. Without a viable financial strategy, you could end up in dire straits during your retirement years. Don’t forget to factor in inflation!
What About Early Retirement?
Technically, early retirement applies to anybody who retires before age 62. In recent years, there’s been an influx of people retiring in their 30s and 40s because of sound financial planning. Part of early retirement involves dividend income from a solid, diverse stock portfolio.
Make no mistake about it, retiring early takes time and discipline. Not only do you need to plan and save, but you also need to account for more years than a typical retirement. Essentially, you would need to save 25 to 30 times more for an early retirement.
The Emergence of FIRE
FIRE is a recent concept that stands for financial independence, retire early. There are currently three different categories, FIRE, leanFIRE, and fatFIRE, representing the estimated annual spending for early retirees.
- FIRE is a person who retires with an income in line with the average typical household.
- To qualify as leanFIRE, a person needs to save 25 times their annual expenses and spend less than an average household.
- FatFIRE people spend more than the average person and can afford to do so because they accumulated enough wealth to support their lifestyle.
Tips to Retire Early
People who retire early share several common denominators regardless of how much they make while working. It starts with defining what early retirement looks like for you. Your ideas about how and where you want to live will impact your opportunity to retire early.
Assess Your Situation
Like any person contemplating retirement, you need to evaluate your financial situation. Detail your net worth and annual spending to arrive at your target number. The target number is the amount of money you need to live without a regular paycheck.
Live on Less
Living beneath your means while you’re saving for an early retirement is the best way to build your savings. Housing, transportation, and food can drain your income faster than you realize, so they are the first places you should look to save.
Maximize Retirement Accounts
Optimizing your retirement savings, like a 401(k) and IRA, give you tax advantages, including pre-tax contributions and deductions. However, you won’t be able to access some funds without penalties until you reach a certain age. Still, retirement accounts help early retirees by providing long-term solutions.
Pay Off Your Mortgage
Housing costs dig into your annual income, even when you retire. If you pay off your home before retiring, that’s less money you have to factor into your expenses each year.
Reinvest and Diversify
Once you pay off debt, including your mortgage, and max out your retirement accounts, it’s time to invest any leftover income. Passive income is a key component in early retirement. Dividend income is beneficial at any stage of the game, but for people seeking to retire early, it’s a necessity.
Building a diverse portfolio that generates enough dividend income to cover your monthly expenses helps you establish financial freedom. Many early retirees suggest low-cost index funds to diversify your portfolio while minimizing your risk.
It’s Time to Retire
Dividends are an excellent source of passive income to support you through the retirement years. There will be ups and downs, there’s no way to avoid the volatility of stocks when you invest. Be prepared to handle the rises and falls in prices as you expand your portfolio.
Whether you’re approaching retirement or planning ahead, understanding how dividend income works will help you build a solid portfolio. Now that you know what to look for and what to avoid, you are ready to take on the world of dividends!