You’ll find plenty of YouTube videos with self-proclaimed personal finance experts, without any professional credentials, telling you it’s possible to live off dividends in retirement. Some even maintain that you can retire early and payouts to shareholders will keep you in your desired lifestyle for decades.
It’s a nice idea, and in some cases might be viable, but for most retirees, dividend income alone won’t be enough.
“While it’s certainly possible to live off dividends alone, whether it’s realistic depends entirely on a retiree’s desired lifestyle and the total size of their portfolio,” says Zack Swad, president and wealth manager at Swad Wealth Management in Santa Rosa, California.
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“If someone has accumulated enough assets to generate sufficient income to cover their spending needs through dividends alone, it can work,” he adds. “But that’s a high bar for most people.”
Here are some things to keep in mind if you are planning to use dividends to offset part or most of your living expenses in retirement:
— Dividend investing for early retirement.
— Risks of relying on dividends alone.
— Is there a safe or yield target?
— Why dividends alone aren’t always enough.
Dividend Investing for Early Retirement
Investors who hope to retire earlier than their full Social Security retirement age face some steep challenges. While the idea sounds appealing, the reality is usually complicated and involves more than just picking some high-yield stocks to make a plan work.
Early retirement dividend investing is a popular concept, especially within the Financial Independence, Retire Early (FIRE) movement. But it’s not as easy as it often seems, says Tyler Abney, lead financial planner at Tidemark Financial Partners in San Diego.
He notes that building a portfolio large enough to generate sufficient dividend income decades before traditional retirement age typically requires very high savings rates, disciplined investing and careful lifestyle planning.
“Additionally, early retirees need to consider sequence of returns risk, inflation, and the potential for changing tax policies or dividend cuts,” Abney says.
In most cases, a more practical path involves a diversified investment strategy that includes dividends but isn’t entirely reliant on them.
“A flexible plan, with guidance from a financial advisor, can better support long-term financial independence,” Abney says.
Risks of Relying on Dividends Alone
Companies like Procter & Gamble Co. (ticker: PG), Coca-Cola Co. (KO) and Johnson & Johnson (JNJ) are among the ranks of Dividend Kings, or those with a track record of raising dividends for 50 years or more.
Given the inevitable ups and downs of economic cycles and market volatility, that’s an impressive achievement across any half-century span.
Although these companies have shown long-term resilience and stability, they typically don’t have the fast price growth to stay ahead of inflation over the long haul. Growth stocks can complement dividend payers by boosting total return potential.
“Think of your dividend portfolio like a pyramid,” says Marcel Miu, founder of Simplify Wealth Planning in Austin, Texas. “The base and middle should be reliable dividend growers, which can be accomplished by holding diversified dividend ETFs, and the top should include higher-growth stocks for inflation protection,” he says, adding that retirement investors should also keep one to two years of living expenses in cash to avoid selling during downturns.
Is There a Safe or Yield Target?
Higher-yielding stocks may offer more income per dollar invested, but total return depends on dividend sustainability and price performance.
Investors need to be cautious about simply seeking yield, as regular income depends on dividend stability, earnings strength and a company’s long-term growth.
Michelle Petrowski, founder of Being in Abundance in Anthem, Arizona, cautions that there’s no one-size-fits-all formula for generating dividend income. “But generally, a sustainable dividend yield target seems to fall between 3% and 5%,” she says.
If a portfolio yields less than 3%, investors following the 4% withdrawal rule will likely need to tap into principal or find other income sources. That’s especially true if their after-tax, inflation-adjusted income needs exceed what that yield can support.
“Yields higher than 5% often come with more volatility or risk, and may not be as safe as they look on the surface,” Petrowski says. “So we need to be cautious when chasing yields, because higher dividend stocks, like some REITs or energy companies, may look really attractive on the surface, but many times they come with business risks, payout inconsistencies or even sector concentration,” she adds.
For those reasons, Petrowski adds, investors need to research and understand what they own and why, what their risk tolerance and risk capacity are, and have a strategy that determines both buy and sell points for their positions on an ongoing basis.
“This isn’t a one-and-done exercise,” she says.
Why Dividends Alone Aren’t Always Enough
Dividend income has some special considerations.
“A common misconception is that reinvested dividends aren’t taxed, but they are, regardless of whether they’re spent or not,” says Swad. “Also, dividends are never guaranteed. They can be reduced or eliminated, especially during economic downturns. That’s why it’s so important to have a flexible spending plan.”
When it comes to early retirement or FIRE strategies, he adds, flexibility is critical.
An investor who hopes to live off dividends alone should be prepared to cut spending or go back to work if that income is reduced, Swad says.
“In my experience, most clients today prioritize living their most fulfilled lives in retirement, which often means doing more, traveling more and helping family,” he says. “That often requires tapping into principal in a sustainable way, rather than limiting themselves to portfolio income alone.”
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How to Live Off Dividends in Retirement — or Not originally appeared on usnews.com