How to Live Off Dividends: A Brief Guide

This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.

No matter how much you love your job, having another regular stream of money coming into your bank account is almost certainly an attractive prospect. While it might sound like wishful thinking, it’s not as impossible as it seems if you know how to live off dividends. 

To break down how this is possible, we’ll run through what dividends are, how to make an investment strategy to work toward living off them and the risks you may encounter.

How dividends work

Before we get over excited about the possibility of early retirement, let’s explain what we mean when we talk about how to live off dividends. Dividends are a payout companies give to their shareholders and they’re usually paid every quarter (but payments may be irregular or even a one-off thing). Dividends typically come in cash form but they’re sometimes paid as more shares.

Stocks are the most common example of a dividend-paying asset. Many established companies go down this route to distribute their profits.

Then, there are index funds, which consist of multiple dividend-paying companies. These can take one of two possible forms: 

• Exchange-traded funds (ETFs), which are traded live on the stock market and not actively managed

• Mutual funds, which are actively managed and aren’t traded live on the market

A slightly different example is real estate investment trusts (REITs), which are funds that contain real estate projects. Unlike the other funds mentioned, REITs must distribute 90% or more of taxable income as dividends to their shareholders.

If you invest in a couple of dividend-paying stocks, you’re probably not looking at earning more than a few dollars each year in dividends. But once you scale up, the possibility of living off dividends becomes a possible reality. Let’s look at how to do it.

Create an investment strategy for how to live off dividends

Something as incredible as financial independence doesn't just happen by accident. You need to formulate a plan and know how to execute it the right way.

Work out how much you’ll need

Before you can begin to decide which types of investments to make, you need to figure out how much you need to live off dividends.

Start by working out how much your living expenses amount to each month. However, since different assets pay dividends at different times in the year, it’s simplest to use your monthly estimate to figure out your annual cost of living. Try not to be overly optimistic — unless you run your personal finances like a well-oiled machine, you’re probably going to need some margin for error.

Let’s look at an example. If you spend around $3,000 per month, you’d need $36,000 per year in dividend yields. Investing $100,000 in stocks offering a 3% annual yield would only give you $3,000 a year in dividend income — but $1.2 million in stocks would give you $36,000 of annual income. 

This might sound like a lot of money, but even if you can’t pull together enough to live off dividends entirely, you probably can supplement your annual income through dividends.

Also, remember to account for dividend growth over time. As your stocks (hopefully) increase in value, the percentage yield will also increase. 

Plus, you may have additional income sources you can rely on — for example, those who are already retirees receive social security checks from the government. 

Decide on your investment strategy

Everyone has different preferences for investing, especially regarding the risk you’re willing to take to secure high returns. Some stocks or funds might offer greater dividend yields but that doesn’t mean the companies offering them are running sustainable business practices. Are you willing to take the risk or would you prefer to be conservative?

You also need to consider if you want to double down on a small number of companies by purchasing large quantities of a few dividend stocks, or if you want to aim for diversification by either investing in a dividend fund or a wide selection of stocks.

Something else you may want to consider is reinvesting your dividends (as long as you’re not relying on the income to cover your expenses). This can help you to build up funds through compounding. For instance, if you earn a 3% yield on $10,000 one year, that would give you $300 of dividend income. If you reinvest that, you’d earn 3% on $10,300 the next year — that’s $309 in dividend income. Over time, this can really add up, especially if you’re investing larger quantities. 

If you’re unsure on the approach you want to take, it may be a good idea to talk to a financial advisor — especially if dividends are likely to be an important part of your retirement planning. 

Choose your investments

Once you’ve decided on your investment strategy, you can begin to choose the investments you’ll make. How do you want to divide up your portfolio and how can you achieve the dividend payout you’re looking for?

The average dividend yield in the U.S. is 1.29%, although yields within the S&P 500 hover between 2% and 5%. For a broader idea of what’s possible, look at the companies included in the S&P 500 Dividend Aristocrats for a breakdown of the country’s biggest and most consistent dividend-paying corporations. There can be wide variations.

However, when choosing your investments, it’s advisable to look beyond the dividend yield. Is the company sustainable? The dividend payout ratio can help you figure out the proportion of net income paid to shareholders. 

If this number is too high, you may want to stay away. Between 35% and 55% is generally seen as a good ratio, while a higher number suggests a company is pursuing a short-term strategy and could be at risk of running low on funds in the future.

If you don’t feel comfortable analyzing the health of companies in this way, opting for a dividend index might be a safer option.

Consider taxes

As if it wasn’t difficult enough to figure out all of the above, you’ll also need to think about the types of taxes you might owe, which can eat into your dividend profits. 

If you’re investing in a 401(k), IRA or a brokerage account, you may have to pay income tax or capital gains tax on your dividend earnings.

Fortunately, you can avoid this problem by using an account that only taxes pre-tax dollars, like a Roth 401(k) or Roth IRA.

Again, it’s a good idea to speak to a professional if you’re unsure about the best option for you.

The risks of dividends

Done right, dividend yields can be a great way to give you an additional income stream that’s somewhat easier to predict than returns from other investments, such as growth stocks. 

Although we’ve discussed how to live off dividends as if you’re guaranteed a good outcome if you follow certain steps, the truth is that dividend investing is like any type of investing in one crucial way: It involves risk and volatility. 

A company may decide to change its dividend yield at any given moment. Even if your yield remains the same, the stock price could change — which could affect how much you’d receive in dividend payments. 

There’s no way to remove these risks completely but you can reduce your risk exposure by putting some of your money into other asset classes to ensure you have a diversified investment portfolio. For instance, you could invest some money into bonds, which don’t pay dividends but tend to involve lower risk than the stock market (especially if you choose government bonds).

Freedom could await you

Dividends can be a fantastic way to create passive income if you want a relatively straightforward and predictable way to boost how much you have coming in each month. However, even if you know how to live off dividends, there’s no guarantee the dividends will last forever, so don’t neglect other investment types completely.

Yet, financial planning isn’t just about increasing your income. To reach financial independence, you need to manage your debt along the way. If you need help with your credit card debt, consider the Tally†credit card repayment app. The app combines your higher-interest credit card debt into one lower-interest line of credit. It also automates your payments to avoid any pesky late or missed payment fees.

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