For many people, portfolio income is the path to achieving financial independence. Funds accumulated during one’s working years can be used to construct an investment portfolio that generates revenue during retirement.
Here is a guide to creating a portfolio that focuses on generating a steady income.
Definition of Portfolio Income Income can be conveniently categorized into three primary types:
- Earned income –constitutes the earnings from labor and encompasses salaries, wages, commissions, bonuses, and gratuities.
- Passive income -pertains to revenue deemed “unearned,” originating from diverse sources, including royalties from creative works, rental payments from properties, earnings from affiliate marketing, and returns from limited partnerships where the investor holds ownership without active participation in operations.
- Investment income-The income obtained from investments, such as stocks and bonds, is known as investment income. Mutual funds, exchange-traded funds (ETFs), and real estate are known as portfolio income. This type of income includes capital gains, dividends, and interest earned from savings accounts, money market accounts, certificates of deposit (CDs), or bonds.
Portfolio Income vs. Passive Income
Passive income denotes regular earnings that do not necessitate active engagement. Sources comprise royalties, pensions, rental earnings, or involvement in a business venture where the investor isn’t actively involved. Portfolio income comes from receiving dividends from stocks, mutual funds, ETFs, or REITs (real estate investment trusts). It also takes the form of interest, such as that yielded by bonds or as capital gains.
How to start generating portfolio income
Initiating portfolio income involves purchasing dividend-paying stocks, a significant portion dispensing dividends quarterly. Should the dividend income not be immediately required for daily expenses, and with the company’s permission, reinvesting dividends to obtain additional shares could be considered through a dividend reinvestment plan (DRIP).
Notably, like all stocks, dividend-paying stocks carry the inherent risk of potential share price depreciation or a reduction in dividend disbursements. Evaluating the dividend yield is crucial in conjunction with examining the dividend amount per share. This entails dividing the current annual dividend per share by the current share price.
Another strategy is investing in dividend-focused exchange-traded funds (ETFs) or mutual funds. These pooled investments encompass an array of securities such as stocks, bonds, REITs, and alternative investments.
While some ETFs and mutual funds are actively managed, others track indices like the S&P 500. Money market mutual funds primarily comprise short-term Treasuries like T-bills, certificates of deposit (CDs), and repurchase agreements (repos). The yields of these funds fluctuate alongside interest rates. Shares of mutual funds, termed net asset values (NAVs), can be bought or sold once daily at market close. Conversely, ETF shares are tradable throughout the trading day.
Bond funds concentrate on specific bond types or bond indices. They are affected by shifts in interest rates; as rates rise, bond fund share values drop, and vice versa. Bonds are issued by governments, companies, and agencies to raise funds, comprising a face value, interest rate, and maturity date. The interest rate corresponds to the risk level, and bond interest is frequently paid semi-annually.
Treasurys, emanating from the U.S. Treasury, carry minimal risk. Corporate bond risk is appraised by agencies like Moody’s, Standard & Poor’s, and Fitch based on the issuer’s ability to meet interest payments and repay principal.
- Capital gains through profitable investment sales offer an additional revenue stream. For instance, if 100 shares of a stock were purchased at $30 each and sold a year later for $50 per share, the capital gains amount to $2,000.
- Real estate, whether residential or commercial and held within the investment portfolio can generate rental income. Yet, one must factor in maintenance costs and property taxes.
Investing in a REIT can mitigate these concerns. A REIT comprising similar properties or mortgages is tradable akin to stocks and is required to distribute 90% of taxable income as dividends. REITs contribute to diversified income portfolios due to their limited correlation with stocks.
Illustration of Portfolio Income
Let’s consider a hypothetical investor named Rob. A 45-year-old married man with two college-bound children, Rob possesses $50,000 for investment and several objectives:
- Short-term: Offset college tuition costs for his children.
- Immediate: Support a home improvement project.
- Long-term: Plan for retirement income generation.
Rob’s approach to building his income portfolio involves five steps:
- Allocating some savings to a certificate of deposit (CD). A credit union offers an annual percentage yield (APY) of 5.25% with a minimum deposit of $500 and a one-year term—a $10,000 deposit yields $525 in a year.
- Assuming a degree of risk by investing in a high-dividend individual stock, like Devon Energy (DVN), with a 10% annual dividend yield. Acquiring 200 shares at $50 each, Rob gains $1,000 annually.
- Exploring high-yield ETFs, Rob selects the Vanguard International High Dividend Yield ETF (VYMI) with a 4.6% yield. By purchasing 161 shares at approximately $62 per share, he garners around $566.72 annually.
- Investing in a dividend-issuing REIT like Sun Communities (SUI) boasts a 3.1% yield. A $10,000 investment yields $310 per year.
- Committing $10,000 to an asset allocation fund such as the Invesco Balanced Multi-Asset Allocation ETF (PSMB), which allocates 45-75% to equity ETFs and 25-55% to fixed-income ETFs. With a 3.04% yield, Rob’s investment yields $304 annually.
Rob’s portfolio income from these five investments amounts to $2,705.72, representing a 5.4% yield on his $50,000 investment.
Amplifying Portfolio Income
One technique to elevate portfolio income is writing call options on held shares. A call option permits the buyer to acquire a set quantity of shares at a specific price until a designated future date. If the market price surpasses the strike price, the option is usually exercised, generating both capital gain and the option premium for the seller.
Taxation of Portfolio Income
Portfolio income enjoys favorable taxation due to lower rates applied to dividends and capital gains than earned income. These revenues are also not subject to Social Security or Medicare deductions. The tax on capital gains is contingent on the duration of investment, with short-term gains taxed at the regular income tax rate and long-term gains subject to rates ranging from 0% to 20% based on various factors. Portfolio losses can be leveraged to offset capital gains.
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