Living on Dividends in Early Retirement
Dividends are a popular source of income in retirement. We rely on them for a part of our annual living expenses. Dividends provide a relatively steady stream of income regardless of the fluctuations in the stock market.
It’s worth stating that I’m not exclusively a dividend focused investor. Instead I focus on the total return of my portfolio. I’m an index fund investor with a fixed asset allocation that I use to periodically rebalance my portfolio. Right now I’m almost entirely invested in equities through mutual funds and ETFs. All of those investments pay dividends ranging from 1% to 4% per fund.
In 2015, we received a total of $28,527 in dividends from our portfolio. This is down slightly from the $29,437 we received in 2014. This drop was a little unexpected but owes to lower dividend payments from international investments due to the appreciation of the dollar and generally less favorable economic conditions overseas.
Our 2015 dividends were still significantly higher than the $22,000 dividend income we received in 2013. I’m going out on a limb by guessing that 2015 is a temporary lull in the long term growth of our dividend payments (assuming we don’t eat into the portfolio principal too much).
Here’s a pic from my Personal Capital account showing the total dividends for last year and how much each mutual fund paid (isn’t free automated investment tracking great?).
Around 75% of our investments are tied up in tax advantaged accounts. Accessing these funds requires some fancy financial footwork (namely, the Roth IRA Conversion Ladder), so we’re only spending the dividends in our taxable brokerage accounts for now.
This year we received $7,767 of dividends in our taxable accounts. That’s down roughly $1,300 from 2014’s $9,077 in dividends in our taxable accounts.
The $21,000 or so of dividends in the tax deferred accounts gets reinvested automatically.
The $7,767 of dividends from our taxable account covered about a third of our $23,802 living expenses in 2015, which goes to show just how important dividends can be to fund a successful early retirement. We didn’t spend our whole $32,400 early retirement budget in 2015, but our taxable dividends would have covered a quarter of our planned expenses for the year.
Here’s a summary of all our dividend paying investments:
These are the actual dividends we received for the investments in each asset class in 2015. To calculate the dividend yield, I divided the dividend payments by the value of the investment (as of January 8, 2016).
I have about $63,000 invested in proprietary index funds in my 457 account that don’t pay dividends. These funds automatically reinvest dividends internally without making a dividend distribution inside my 457 account. I took those account balances out of the denominator when calculating dividend yields.
I excluded about $40,000 in the kids’ 529 accounts because they are also proprietary funds that automatically reinvest dividends internally.
Taking a look at the chart, you can tell that the value tilted investments tend to pay a higher dividend yield. The US small cap asset class offered the lowest dividend yield at 1.51%, while the US REIT asset class yielded almost 4%. The overall portfolio yielded 2.44% in 2015.
For those wondering exactly what funds I invest in, take a peek at that “Representative Holdings” column in the chart. It’s not every single fund I own but it is a good reflection of what’s in my portfolio. Some of the funds are Ishares ETFs that trade for free in my Fidelity account, and might not necessarily be better than the Vanguard equivalent ETF’s (so do your due diligence on expense ratios, average bid/ask spread, average volume, and average variance from NAV).
The rest of this article is excerpted from my original article on dividends from January 2014 (with some updates), so for the twenty seven loyal readers that remember the original article verbatim, my apologies. For the other few thousand new readers, here’s what you missed two years ago:
Benefits of Dividends
In addition to being a good source of cash flow, dividends have a lot of other benefits, too.
Tax free income – If you are in the 15% tax bracket or lower, all of your qualified dividend income is tax free. For US funds, virtually all of your dividends will be qualified. For international funds, typically around half to two thirds of your dividends will be qualified dividends (with ordinary income tax being due on the non-qualified dividend income). Dividends can be a pretty sweet way to fund your retirement expenses since you could potentially enjoy a fairly high income yet pay zero federal income tax.
Psychology of automatically receiving dividends – In early retirement, you might worry excessively about selling in a down market and how to fund next month’s expenses. When markets are in the dumps, dividends can provide pain free cash in your pockets! They keep arriving (for the most part) in good markets and bad. Unless your portfolio’s yield is higher than your withdrawal rate, you’ll still have to sell some of your holdings to fund your monthly expenses, but having a large part of your expenses automatically funded by dividends can make it less painful.
Long term growth of dividends – The dividends paid by the stocks and funds you own will increase as the underlying companies grow their profits over time. The growth in dividends will keep inflation at bay. Dividends can grow faster than the rate of inflation, thereby providing a real increase in your standard of living.
Emergency funds – If you hit a bump in the road and need an extra source of cash before you reach financial independence, you can consider your dividends as a source of emergency funds. At a 2% yield, a “modest” portfolio of $100,000 can produce $2,000 of dividend income per year. I was lucky to never need the extra cash while working, but when my job suddenly ended and I decided to retire, it felt great to know I had an instant source of about $8,000 per year with a few clicks.
Dividend focused portfolios
If you want to become a dividend investor, you could copy my asset allocation and get a 2.44% yield without trying very hard.
Or if you want to be a hot shot investor, you can try to hand pick the “best” dividend stocks out there and craft a portfolio that pays 3-4% or more. I’m not particularly good at picking stocks so I wouldn’t personally choose this route.
I like easy solutions that don’t take a lot of work. Vanguard has a few excellent offerings that are dirt cheap (which is a good thing when you are shopping for an investment).
The Vanguard High Dividend Yield Fund is available in mutual fund or ETF format (ticker: VHDYX or VYM respectively). The ETF version (VYM) has a nice low expense ratio of 0.10% (which is great!). This fund invests in stocks that consistently pay higher than average yields today. The fund yields about 3.4% currently.
You can sacrifice a bit of yield today in exchange for higher dividend growth in the future with two different Vanguard funds. The Vanguard Dividend Appreciation Index Fund (ticker: VDADX for mutual fund or VIG for ETF) is the better choice since it has a low 0.10% expense ratio and a current yield around 2.3%. The other option, the Vanguard Dividend Growth Fund (ticker: VDIGX) comes with a higher expense ratio (0.29%) and a 2% yield.
Another great way to put together a dividend focused portfolio is by purchasing a basket of solid dividend paying stocks through Motif Infesting (full review here). For $9.95, you can buy a slate of up to 30 stocks. You can choose your own 30 stocks based on your own dividend screens. For example, you can set a filter that shows only those stocks with yield over 4% with a history of stable and growing dividends. Or you can pick from one of Motif Investing’s many pre-selected “motifs” (basket of stocks) centered around high dividend yield or dividend growth. Buying motifs is slightly more complicated than buying a dividend mutual fund, however you can skip the 0.10% to 0.29% expense ratios by owning the stocks directly. That means a 3% yield after expenses would become 3.1% to 3.29% without the expenses. Definitely worth checking out Motif Investing if you want to maximize your yield.
Dividend yields can be a great way to generate cash to fund an early retirement. I personally don’t put too much emphasis on dividends in my own portfolio, since I’m expecting long term appreciation of my investments to keep me flush with cash as I continue to enjoy my early retirement. But a 2-3% dividend yield can fund the majority of your budgeted retirement expenses if you don’t exceed a 4% annual withdrawal rate from your portfolio.
I came of age and started buying my first investments during the roaring 1990’s tech bubble when everyone was making easy double digit returns and no one cared about a few percent yield. The focus was all growth growth growth, and sometimes profit profit profit was ignored. After the tech bubble burst and double digit losses replaced double digit gains, the dividend investors sat back and smiled since their dividend focused portfolios sailed through the crash relatively unscathed.
A decade later, the old high growth tech bellwethers like Apple, Microsoft, and Intel have become somewhat boring dividend payers (yes, Apple is boring).
Some companies are good at consistently earning money but still don’t pay any dividends at all. Warren Buffett’s Berkshire Hathaway is one of those companies. Mr. Buffett thinks it more efficient to reinvest all the corporate earnings from Berkshire’s holdings instead of giving part of the earnings to shareholders in the form of dividends. Berkshire Hathaway’s impressive track record of outperforming the S&P 500 by 4-5% annually for a few decades means Mr. Buffett knows what he’s doing.
I mention Berkshire Hathaway’s solid investment performance to highlight a company you would completely miss if you were strictly a dividend investor.
Dividend focused strategies can pay off, but so can investment strategies that are spread across many asset classes.
What is your take on the dividend investment strategy? Do you manage your portfolio with a focus on generating current dividends growing your dividend stream in the future? Or do you rely on the overall growth of your investment portfolio?