Automatic Income

by Matthew Paulson

  I personally use a Vanguard brokerage account for my dividend‑stock portfolio. While their research tools aren’t as good as some other brokerages, they offer fantastic customer service and charge very low fees. I personally receive a few dozen free trades each year and only pay $2.00 per trade after that because I qualify for Vanguard’s Voyager Select service. I also have other accounts with Vanguard and prefer to keep our various accounts at one provider. TD Ameritrade is also a very good all‑around brokerage. I use them for the self‑directed portion of my 401K plan and a small investment club that I am a part of.

  Asset Location Matters

  If you have different types of investments interspersed between an IRA, a 401k plan, and a taxable brokerage account, make sure to put your investments that receive the poorest tax treatment inside your tax‑advantaged accounts in order to minimize your tax burden. This means you always should put tax‑free investments, like municipal bonds, inside of your taxable brokerage account. You should put assets that are taxed as ordinary income, such as REITs, BDCs, corporate bonds and some preferred stocks inside your IRA, 401k, or other tax‑advantaged accounts whenever possible. Dividend stocks can either be placed in your tax‑advantaged or taxable brokerage account, depending on what other assets you may want to place in your tax‑advantaged investment accounts.

  Wrap‑up

  As we learned from the example at the beginning of this chapter, taxes can dramatically alter how much of your investment income you actually get to keep. If you were in the top tax bracket, the difference between a tax‑free municipal bond and a real‑estate investment trust would be 43.4% (39.6% in ­ordinary income taxes and 3.8% net investment income tax). When reviewing different investments, always compare the after‑tax dividend yield that you will receive from each investment and determine which of your investment accounts is the best location to hold each investment.

  CHAPTER SIX

  How to Build a Dividend Stock Portfolio

  You now have an understanding of how dividend stocks work, why they are attractive investments, how to evaluate individual dividend stocks, what tools you can use to research dividend stocks, and the tax implications of owning different types of dividend stocks. The only two things left that we need to learn are how to actually create a portfolio of dividend stocks and live during retirement off of the income your portfolio generates up to and during retirement.

  What Should a Dividend Portfolio Look Like?

  Over time, you should work to build a diversified portfolio of 15–25 dividend stocks in different industries. You will probably own several blue‑chip stocks, a couple of real‑estate investment trusts (REITs), a master limited partnership (MLP), and some preferred stock or a preferred‑stock fund inside of your portfolio. My portfolio consists of 23 S&P 500 companies, two master limited partnerships, three real‑estate investment trusts, one preferred stock ETF, and two closed‑end municipal‑bond funds.

  Your portfolio should target a blended dividend yield of 4% to 5% in order to generate attractive dividend payments without taking on too much risk. If you own a typical mix of dividend stocks, your portfolio’s beta should be around 0.8, meaning that it is only 80% as volatile as the broader market indexes. You should target a 10% total annual return between capital gains and the dividend payments you receive. Your portfolio’s dividend payments should grow by an average of 5% to 8% each year so that the amount of income your portfolio generates increases every year.

  I hesitate to discuss specific companies that are frequently included in dividend portfolios, primarily because the future growth prospects of any given company can change over time. For example, Pitney Bowes (PBI) was part of the S&P Dividend Aristocrats list, meaning they had raised their dividend for more than 25 years in a row. In 2013, the company was forced to cut their dividend by more than 50% after years of facing steadily shrinking demand for its shipping and mailing products. If you had read that Pitney Bowes had a long track record of dividend growth and was included in many dividend portfolios in a book written five years earlier, you might not know about that company’s fall from grace and add it to your portfolio without doing enough research. If you would like ideas for companies that you may want to include in your portfolio of dividend stocks, consider subscribing to the Morningstar Dividend Investor newsletter, subscribing to the SureDividend newsletter, or using any of the other research tools outlined earlier in this book.

  Should You Include Other Investments in Your Income Portfolio?

  Ultimately, what we’re trying to accomplish by buying dividend‑growth stocks is to create an income stream that we can live off of during retirement. Dividend stocks are by far my favorite income‑generating investment because they offer both near‑term income and long‑term capital gains, but they’re not the only income‑generating investments you might want to consider. Like any other asset class, dividend stocks can come in and out of favor depending on how other income investments are performing and what mood the market happens to be in. In order to create diversification among the asset classes you own, you may also consider buying municipal bonds if you are in a high tax bracket, buying a rental house or a duplex depending on what your local real estate market looks like, or loaning money to other people through peer‑to‑peer lending websites like Lending Club and Prosper.

  In addition to my portfolio of dividend stocks, I personally own shares of two closed‑end municipal bond funds that have very attractive tax‑equivalent yields. I have invested in a couple of local private‑equity deals that throw off income each year. I also had previously invested in consumer notes through Lending Club, which are taxed as ordinary income. I divested my portfolio of Lending Club notes when I found myself in the 39.6% tax bracket and the after‑tax yield I was receiving was no longer competitive. Finally, I own a piece of rental real estate that generates positive cash flow each month.

  Should I Just Buy a Dividend Mutual Fund?

  It can be a lot of work to research individual companies and build a portfolio of 15–25 dividend stocks and you may be tempted to just buy a dividend‑growth mutual fund instead. There have been some decent attempts to create dividend funds and ETFs, but they have several downsides that any dividend investor should be aware of.

  First, dividend mutual funds tend to have unimpressive yields. Mutual funds have to own a large number of companies in order to remain fully invested in the market. For example, Vanguard’s Dividend Growth Fund (VDIGX) has more than $30 billion in assets and is the largest dividend‑growth mutual fund in the world. If that fund were to target a few target select dividend‑growth stocks, it would literally have to buy entire companies to invest its’ shareholder’ ‘money. Because ETFs and mutual funds have to own so many companies, they end up having to invest in many companies that pay low yields and have unimpressive dividend growth. VDIGX currently pays a yield of just 1.91%, which is actually a lower yield than offered by an S&P 500 index fund.

  Dividend mutual funds and ETFs tend to have relatively high expense ratios relative to the low‑cost index funds that are now available through Vanguard, Fidelity, and other providers. Expense ratios eat away at the dividend income you receive. For example, the SPDR S&P Dividend ETF (SDY) and the ProShares S&P 500 Dividend Aristocrats ETF each have an expense ratio of 0.35% per year. While that number may seem insignificant, NOBL currently pays a dividend yield of just 2.06%. If you were to own the 52 companies that make up the S&P Dividend Aristocrats Index in your brokerage account at the same weighting at NOBL, you would earn a 2.41% dividend yield because you are not paying the 0.35% expense ratio to the fund’s managers. By paying the 0.35% expense ratio, you would be giving up 14.5% of the dividends you would otherwise receive to ProShares in management fees.

  When you invest in a dividend mutual fund or ETF, you have no control over what companies are included in your portfolio and which are not. You are stuck with the basket of stocks selected by the fund’s managers or by the index that the fund tracks. You are unable t
o model the portfolios outlined by Morningstar Dividend Investor, SureDividend, or any other dividend advisory service because those portfolios are not modeled by any existing ETF or mutual fund. While you might select a dividend ETF or mutual fund that has a lot of solid companies that meet the criteria outlined in chapter three, there may be just as many low‑yield or low‑growth companies in the fund that drag down your portfolio’s overall yield and capacity for dividend growth.

  The main reason you might consider owning a dividend mutual fund or ETF is diversification, but it turns out that you can get most of the benefits of diversification by owning one or two dozen individual stocks. According to Keith Brown and Frank Reilley, authors of Investment Analysis and Portfolio Management, a series of studies for randomly selected stocks show that you can get “about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.” These studies do assume that you own an equally weighted portfolio, meaning that you own an equal dollar amount of each stock in your portfolio.

  For your personal IRA and your taxable brokerage account, I would choose investing in individual dividend stocks over choosing a dividend mutual fund or ETF, any day of the week. There are two scenarios where it may be a good idea to invest in a dividend ETF or mutual fund. First, if you’re investing through a 401K or other retirement plan that only allows you to buy ­mutual funds, you may choose to invest in a dividend mutual fund to get many of the benefits of dividend growth while operating within the constraints of your retirement account.

  The only other scenario where you might consider choosing a dividend mutual fund is if you aren’t interested or willing to do the research to select individual dividend stocks yourself and want a much more hands‑off approach. In this case, you might be willing to pay a management fee and accept a lower dividend yield than you could get otherwise in order to get the benefits of dividend‑growth investing without having to learn about investing and researching individual stocks yourself. Since you’re reading a book about dividend investing, I suspect that’s not the case in your situation.

  Should I Reinvest My Dividends?

  Many brokers offer dividend reinvestment programs (DRIPs) which allow you to automatically purchase additional shares of a stock with dividend payments that you receive without having to pay a trade fee. Most major discount brokers offer DRIPs including TradeKing, TD Ameritrade, Scotttrade, E*TRADE, Firsttrade, and Vanguard. If your brokerage offers a DRIP, you will be given the option whether or not to automatically reinvest the dividend payments that you receive. I generally recommend reinvesting your dividends because your money is immediately put back to work to generate additional dividend income and capital gains for you over the long term.

  Before you retire and begin to live off your dividend payments, the only other time you might not want to reinvest your dividends is when a stock is particularly overvalued and is no longer attractive for additional purchases. In this case, take your dividend payment as cash and reinvest the funds into dividend stock that is more attractive at the time. You are still reinvesting your dividends, but you are reinvesting the funds in a different company. If a dividend payment doesn’t amount to much and you would have to pay a large percentage of the dividend payment as a trade fee, hold on to the money until you have additional funds to invest and would be paying less than 1% of your transaction as a trade fee.

  When Should I Sell a Dividend Stock?

  Dividend‑growth investing is a long‑term play and is very much a “buy and hold” strategy. As long as your stocks remain attractive and continue to grow their dividend, you should hold on to them. If a company’s dividend gets cut or if there is a very strong possibility of it being cut, you should cut bait and move the money into a more attractive stock. You can determine when a dividend payment becomes unsustainable by regularly tracking your companies’ dividend payout ratio (DPR). If any of your stocks DPR rises above 90% (with the exception of REITs and utilities), you should closely monitor them and do additional research to determine if the company’s dividend is likely to get cut.

  You might also consider selling a stock if you can trade it for a similar company with a better yield, better growth prospects, or a more sustainable dividend. For example, the Morningstar Dividend Investor Dividend Select Portfolio sold shares of AT&T last summer and used the funds to buy shares of Verizon. Both companies offered similar yields, but AT&T’s dividend growth had significantly slowed down and Verizon offered much better long‑term earnings‑growth potential.

  Planning Your Retirement Income Stream

  When you are nearing retirement and want to begin living off Social Security, your investment portfolio, and other secondary income sources, your first step is to take stock of each ­potential source of monthly income from your family. If you live in the United States, you will probably receive some income in the form of Social Security. You should calculate how much income your portfolio of dividend stocks will generate each year by multiplying your portfolio value by its blended dividend yield. Also calculate any additional income that you have from other investments, such as rental real‑estate or a 401K plan. Total the income you will receive from these various sources and compare that number to what your average monthly living expenses are to see if you are ready to retire.

  If these sources together don’t cover your living expenses, you may consider taking a low‑stress part‑time job to fill the gap. This doesn’t mean you have to be a greeter at Wal‑Mart and you may actually enjoy pursuing a new career path on a part‑time basis during your retirement years. There are also great health benefits to staying active and continuing to work part‑time during your retirement years that you should take into consideration.

  Once you have taken stock of the various income sources available to you in retirement, you then need to identify which sources you will want to withdraw from first. This decision will primarily be driven by taxes and the optimal age to start receiving Social Security. It can be advantageous to hold off on taking Social Security if you are generally healthy and relying on other income sources to delay Social Security. Because of the amount of money involved, it may be worth your time to talk to a Social Security consultant to determine the ideal age for you to begin taking Social Security.

  Generally speaking, you should avoid taking money out of retirement accounts until you need the money or are required to take minimum distributions from a retirement account. For any traditional IRA or 401K accounts you have, you will be required to begin taking minimum distributions beginning at age 70 ½. Required minimum distribution rules do not apply to Roth 401Ks or Roth IRAs. You can learn more about required minimum distributions on the IRS website at https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions.

  Living Off Dividend Payments

  When it becomes time to start relying on your dividend investments to pay for your living expenses during your retirement years, you simply need to stop reinvesting your dividend payments and let them collect in your brokerage account. At the end of each month or each quarter, initiate a bank transfer to withdraw the dividend payments you have received and transfer them to your primary bank account and use the funds as you would with any other kind of income.

  Remember that you will owe tax on any dividend payments that you receive from companies held in a taxable brokerage account. If you are not in the top tax bracket, you should set aside 15% of the dividend payments you receive for taxes at the end of the year. If you are in the top tax bracket, you should set aside 23.8% of the dividend payments you receive for taxes at the end of the year. In order to minimize any burden from capital gains tax, try to avoid selling any appreciated stocks in your portfolio if at all possible.

  Wrap‑Up

  A lot of ground has been covered in Automatic Income. You have learned the basics of how dividend payments work. You now know why dividend stocks are incredibly attractive investments. You have learned about blue chips, REITs, MLPs, roya
lty trusts, and other types of dividend stocks. You have studied how to research and evaluate dividend stocks. You now know about different resources that we can use to identify high‑quality companies to invest in. You have learned about the tax implications of different types of dividend investments. You now know how to build a portfolio of dividend‑paying stock and live off that portfolio during retirement.

  The next step is for you to start taking action. Open a brokerage account with a discount brokerage firm if you don’t already have one. Make a small deposit and purchase your first shares of a dividend‑paying stock to see how the process works. Watch as your first few dividend payments come in. Continue learning by reading the resources mentioned in Appendix One and soak in every bit of information you can about dividend investing. Begin doing some of your own research on individual dividend‑paying stocks. Develop a savings plan so that you can grow your portfolio of dividend stocks each month and put that plan into action.

  As you begin to create and grow your portfolio of dividend stocks, the payments you receive may seem small and inconsequential at first, but remember that they will compound over time. If you were to buy 100 shares of a company today that pays a 4% dividend and that dividend grows by 8% each year at the cost of $10,000, you would have an income stream of $1,184.05 after 10 years if you reinvest your dividends and pay a 15% capital‑gains rate. After 20 years, that number would grow to $3,504.91. After 30 years, you would be earning $10,374.94 in dividends per year on your original investment of $10,000. That’s the power of dividend investing in action. Now, it’s your turn.