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Dividends are great tools for investors

Dividends are payments made by publicly traded companies to their shareholders. They’re typically used to communicate strength about the company’s financial position. Steady dividends — even low ones – often signal a company’s positive projection of its long-term outlook.

Many dividends are paid in cash. For investors with 401(k)s or IRAs, dividends are often automatically reinvested and, through the power of compounding, offer a powerful tool to grow a nest egg.

For straight-up equity investors, those cash payouts fuel dividend income — where passively generated payouts cover your living expenses.

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How much you’ll need

How much you’ll need exactly depends on your income, spending habits and living expenses. Which means the answer is highly personal.

But once you know how much you’ll need to live, here’s a simple formula to apply that to sort out how much you need in total.

Desired Dividend Income / Dividend Yield (%) = Estimated Portfolio $ needed

Let’s consider a desired dividend income of $37,522, which was the real median single-person income in the U.S. in 2021 according to data from the St. Louis Federal Reserve.

Next, consider what you can reasonably expect from dividend yields. It’s fair to plan on yield rates between 1% and 6%.

Using our formula mentioned above, here’s how yields translate to required portfolio size:

  • 2% yields require a portfolio of $1,876,100
  • 3% yields require a portfolio of $1,250,733
  • 4% yields require a portfolio of $938,050
  • 5% yields require a portfolio of $750,440
  • 6% yields require a portfolio of $625,367.

Yet as we’ll see, these numbers need further refinement thanks (or really, no thanks) to taxes.

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Weighing the risks of this approach

There are three potential consequences that should be considered before you commit fully to this income strategy.

Taxes. Dividend payments from a taxable brokerage account, or traditional 401(k) and IRA accounts, are considered taxable income.

Downside risk. Dividends aren’t a slam dunk. High-yield dividends may not be sustainable and a company too focused on returning profit to investors could lose out on growth later. And sometimes without warning, today’s higher dividends tank.

If you plan to pay your bills with dividends, you’ll need to feel the risk is both reasonable and worth it.

Too-tight budget. If you think you can manage expenses at a median dividend income, then planning is everything. High inflation, rising interest rates and global turmoil can do a number on your portfolio: You’ll need a strong stomach and stronger strategy.

As housing is a foundational cost, start there. Should you move? For the first time, median asking rents crossed the $2,000 threshold in May, according to Redfin. The numbers now range nationally from $1,453 in San Antonio, Texas to more than $4,000 in the New York metropolitan area.

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High yield = high risk?

Handled carefully, the pursuit of steady, sustainable dividend income can be a winning play.

For older Americans, living off dividend income could make sense, especially if it delays taking a Social Security benefit. The longer you wait, the more money you’ll get when you collect.

Yet as with anything investment related, risk never goes away. History is littered with companies whose high yields indicated looming weakness.

And when in trouble, companies often ditch the dividends first. So in crafting a strategy, it helps to remember this truism: Powerful dividends and portfolio diversification make for a great combination.

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Chris Clark Freelance Contributor

Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.

Disclaimer

The content provided on Moneywise is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter.