How to Live Off Dividends in Retirement

It is never too early to begin planning your retirement. Early planning can help you create streams of income that effectively supplement your Social Security benefits without necessarily creating or increasing your tax burden. In 2013, dividends from solid preferred stocks easily yield 6 percent or more. If interest rates rise in future years, dividend rates will follow and provide a larger income stream. A Roth individual retirement account can be instrumental in structuring your retirement income.

Wealth Accumulation

If you assemble a portfolio of high-dividend stocks yielding 6 percent, you will gross $6,000 of income for each $100,000 of stock you own. This is where early planning can prove crucial. It may take quite a while to acquire sufficient wealth to create the necessary dividend income, but an early start will increase your chances to accumulate your portfolio at a comfortable rate. You need not concentrate on dividends during the wealth accumulation stage, as you can wait to buy dividend-paying stocks once you retire. A financial advisor can provide important input as you decide how to invest for the long term.

Stock Dividends

Preferred shares pay higher dividends that common stock. They have stable prices and corporations must pay all preferred dividends before paying any dividends on common stock. If you purchase cumulative preferred stock, the corporation must repay any missed dividends before resuming common stock dividends. While common stocks pay lower dividends, they do afford the possibility of dividend growth and capital gains. Dividend growth is necessary to counteract the impact of inflation, which cuts the dividend's real value. If you select stocks that pay “qualified” dividends -- the issuer pays income tax on earnings and the stock is easily available in the United States -- you may reduce or avoid a tax liability on qualified dividends (IRS Publication 550 specifies the details).

Depletion

When a common stock pays a dividend, the drain on earnings that pay for the dividend causes the stock to lose value -- the price drops by an amount equal to the dividend. Preferred share prices are based solely on yield and thus do not experience the same drop -- they behave more like bonds. A $100,000 portfolio that pays $4,000 in common dividends would deplete in value to $96,000. Unless sheltered in a Roth IRA, the dividend income may be taxable, depending on several factors. You get basically the same result by selling stocks worth $4,000. The difference is that you can sell shares with a capital loss or a small capital gain. This may lower or eliminate your tax liability, and assuming you’ve held the sold stock for over a year, you’ll benefit from a tax break for long-term capital gains. With either strategy, you can offset depletion if you achieve a minimum portfolio growth equal to the depletion loss.

The 4 Percent Rule

In 1994, financial planner William P. Bengen created the "4 percent rule." The rule is simple: withdraw 4 percent from your nest egg in the first year, and in subsequent years withdraw 4 percent plus the inflation rate. His conclusion was that this scenario would provide 30 years of income. You can adapt this to your dividend portfolio by excluding stocks paying less than 4 percent in dividends. Alternatively, you can supplement a dividend yield under 4 percent by selling off some of your holdings. You can extend the life of the portfolio by choosing stocks with dividends that grow at a rate that exceeds the inflation rate. You cannot expect dividend growth from preferred stock, so if you choose to implement this type of strategy, you will have to rely on common stock dividends. As noted, common stock growth may offset portfolio depletion.

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About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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