Luis Pazos 
At Sure Dividend, we strongly support investing in high-quality dividend growth stocks, like the Dividend Aristocrats. These stocks have consistently increased their dividends for over 25 years, making them great choices for generating passive income.
Many investors aim to build enough wealth to retire comfortably without relying on the principal of their investments. For those in or nearing retirement, finding ways to create passive income is crucial. Among various methods, we find that buying high-quality dividend stocks is the most effective.
In this article, we discuss why you might want to invest for passive income, the benefits of doing so, and provide examples of excellent dividend stocks that can help you achieve this goal.
The Power of Dividends
Dividends are not just a source of income in retirement; they are also a powerful tool for wealth compounding. By reinvesting dividends, investors can grow their portfolios significantly, making it easier to achieve the goal of living off this income.
The concept of compounding is straightforward. As the portfolio balance grows each year, the dollar-based returns increase, even if the percentage return stays the same. For example, if you start with $1,000 and earn a 5% return, the returns in subsequent years will be higher as the starting balance increases.
In addition to capital gains, reinvesting dividends plays a crucial role because the earnings can be reinvested into the same or different dividend stocks, creating a virtuous cycle that significantly boosts the portfolio balance over time.
Accumulating a sufficient portfolio to live off dividends is essential. Here’s a simple example to illustrate compounding dividends over a long period, assuming a steady 3% annual yield and 4% annual capital gain, and ignoring taxes and transaction costs. The difference between reinvesting dividends and not reinvesting is significant, showing a portfolio with reinvested dividends is worth more than twice over 25 years.
Dividends and Taxes
Dividends, like most income types, are subject to taxation. The amount of tax you pay on dividends can impact your portfolio balance over time. For qualified dividends, the 2024 tax rates are favorable compared to other income forms. For example, those earning up to $47,025 in taxable income will pay zero federal taxes on their dividends. Accounting for qualified dividends’ lower tax rates makes them especially attractive for investors.
Unqualified dividends, from sources like REITs or MLPs, are taxed at ordinary income rates, so it’s beneficial to ensure your dividends meet the IRS’ criteria for being qualified, usually through common stock investments.
Dividend Investing for Passive Income
There are numerous strategies to generate passive income during retirement, such as bonds, preferred stocks, real estate investments, and dividend stocks. Among these, dividend stocks are favorable due to their potential for capital appreciation, growing income, and high yields, along with exceptional liquidity.
Certain companies consistently raise their dividends year after year, providing a way to passively increase income, combat inflation, and retire comfortably. Depending on your goals, portfolio size, and risk tolerance, strategies focusing on dividend growth, dividend safety, and yield can be incredibly effective.
Investments That Pay Dividends
Owning company stock is the primary way to generate dividends, as they are distributions of retained earnings. Other sources of fixed income, like bonds and preferred stocks, offer similar payments but aren’t classified as dividends. For those with a longer investment horizon, common stocks with dividends are generally more superior due to their growth potential.
What Is a Good Dividend Yield?
A “good” dividend yield depends on individual circumstances, such as investment time horizon, goals, and risk tolerance. Younger investors might prioritize dividend growth potential with lower current yields, while retirees might focus on higher yields and dividend safety.
The Best Stocks for Passive Income
Looking at stocks with long histories of paying and raising dividends is a great starting point. Dividend Kings, companies with over 50 years of consecutive dividend increases, are among the best for passive income.
Examples of High-Quality Dividend Stocks
- Altria (MO): A tobacco company with a 6.6% yield and a history of raising dividends for 52 years.
- Lowe’s Companies (LOW): A home improvement retailer with a 1.6% yield, raising dividends for 59 consecutive years and averaging 18% increases annually.
- 3M (MMM): A diversified industrial company with a 4% yield, raising dividends for 63 consecutive years and averaging a 10% increase annually.
How Much Would You Need to Live Off Dividends?
Determining how much you need to live off dividends involves calculating annual living expenses and achievable average portfolio yield. For example, to earn $40,000 annually, the needed portfolio size varies significantly based on yield, with higher yields requiring a smaller portfolio.
Final Thoughts on Living off Your Dividends
For generating passive income, high-quality dividend stocks with safe and potentially high yields are ideal. Altria, Lowe’s, and 3M exemplify stocks with different characteristics suitable for building a passive income portfolio. Starting with the Dividend Kings is an excellent approach to finding such stocks.
