If you want to supplement your Social Security in retirement, dividend-paying stocks are a fantastic option. By investing in companies with a history of rewarding shareholders, you can sit back and enjoy an effortless stream of cash.
The S&P 500‘s current yield is just over 1.3%, but there are plenty of solid companies with upward of a 3% dividend yield. So let’s assume you’ll need $400,000 that you can invest in dividend-paying stocks if you want to generate at least $12,000 a year, or $1,000 a month. Follow these five steps to watch the passive income start rolling in.
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1. Invest in a Roth IRA
You don’t want to split your dividend income with Uncle Sam each month. That’s why your first step to scoring $1,000 a month in dividends is to open a Roth IRA.
Because you’re paying the tax bill up front, your withdrawals are tax-free once you’re age 59 1/2 and you’ve held the account for at least five years. This advantage makes a Roth IRA a great place to hold dividend-producing investments, particularly if you’re trying to avoid owing taxes on your Social Security benefits.
2. Focus on growth early on
In your early years of investing, focus on maximizing your returns by investing in growth stocks. That may seem counterintuitive when your goal is dividend income. After all, companies in growth mode tend to reinvest extra cash back into the business rather than paying shareholders a dividend. But focusing on returns, rather than dividends, will help you get to that $400,000 minimum you’ll need to earn $1,000 a month in retirement.
If you have dividend-paying investments, maximize your returns by reinvesting your dividends until you need the income. According to Morningstar and Hartford Research data, a $10,000 investment in the S&P 500 index in 1960 would have grown to more than $627,000 as of 2020, assuming dividends weren’t reinvested. But with dividends reinvested? That $10,000 investment would have soared to more than $3.8 million.
3. Shift to dividend-paying stocks
In the decade or so before you retire, gradually shift away from high-growth stocks into dividend-paying stocks. But as long as you’re still working, keep on reinvesting those dividends. The goal here is to shift away from volatile investments as retirement approaches to preserve the wealth you’ve built.
Look to blue chip stocks, which are industry stalwarts like Johnson & Johnson (NYSE: JNJ), Microsoft (NASDAQ: MSFT), Walmart (NYSE: WMT), and Procter & Gamble (NYSE: PG). They’re stable and have a long history of increasing their dividend payments to shareholders.
Real estate investment trusts (REITs) are another reliable source of dividend income. They’re legally required to pay out 90% of their taxable income each year to shareholders as dividends.
The important thing to remember is that dividends are never guaranteed. There’s always a risk that a company will encounter tough times and reduce its dividend, or eliminate it altogether. Diversifying with a dividend mutual fund or exchange-traded fund (ETF) lessens your risk of losing dividend income.
4. Look beyond the yield
When you’re looking for investment income, you may be tempted to buy stocks with the highest dividend yield. But this is a common mistake because an unusually high dividend could be a sign of a shaky underlying business, a phenomenon known as a yield trap.
Suppose a stock trades for $100 a share and pays quarterly dividends of $0.75, giving it a 3% yield. If the company’s stock price tanks to $50 a share, its yield is now 6%. But if the stock price dropped because the company is struggling, it might not be able to sustain its dividend payment.
It’s essential to look beyond the dividend yield if you’re seeking income in retirement. Rather than investing based on yield, consider investing in Dividend Aristocrats, which have increased their dividends annually for at least 25 consecutive years, or Dividend Kings, which have at least a 50-year streak of annual increases. When a company can hike its dividends even during downturns, it’s a sign of a well-run business.
5. Quit reinvesting your dividends
Once you’ve built your nest egg and you’re ready to retire, it’s time to start enjoying those hard-earned dividends. So unenroll from any dividend reinvestment programs (DRIPs), and start collecting those payments as cash.
Though there are a handful of stocks that pay monthly dividends — most notably, Realty Income (NYSE: O), a REIT that has trademarked the nickname The Monthly Dividend Company — quarterly dividends are much more common. Make note of dividend payment dates as you plan your retirement budget.
How long will it take to save $400K?
The idea of building a nest egg of at least $400,000 may seem daunting. Of course, the earlier you start, the easier it will be. If you had invested $200 a month in the S&P 500 index starting 30 years ago, you’d have just over $400,000 today.
If you’re starting later, you’ll need to invest more or work longer. But by taking advantage of company 401(k) matches and catch-up contributions, and investing in both an employer-sponsored account and an IRA, it’s completely doable. The sacrifices you make today will pay off when you have reliable dividend income in your retirement years.
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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Robin Hartill, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft. The Motley Fool recommends Johnson & Johnson. The Motley Fool has a disclosure policy.
