The ultimate goal of personal finance is to get yourself into a financial situation in which your investments can sustain your lifestyle. For instance, if you’re spending $50,000 per year, you should be earning over $50,000 per year in passive investments, which means that you don’t have to work anymore! Sounds like the dream, right?
Well, more and more people are achieving this at an early age and they do it by investing in dividend stocks. Now, if you’re in the dark about what a dividend is, it’s essentially a portion of a company’s earnings that it pays out to its shareholders each month. And, for you, it’s passive income that you will earn every month just by investing in a company.
Now, unless you have a lot of money invested, those dividends are probably going to shake out to just cents every month and it’s not going to be enough to cover your lifestyle. However, if you play your cards right, keep saving, and harness the power of compound interest, you can actually get to the point where you’re living off of your dividends.
And I’m going to tell you exactly how you can do that. This is how much money you need to have invested to live off of dividends.
Calculating Your Investment Target
As we get deeper into the article, we’re going to get more in-depth about the nuances of dividend investing. But, for this very first part, we’re just going to get into the most basic way to calculate how much you’ll need to live off of dividends. And the first thing to do is to calculate how much money you’re going to need to live.
Now, most people can live off of around $50,000 per year no matter where in the world they are. For example, in an interview from CNBC with 23–year-old New York City resident Elena Haskins, she said, “I definitely think you can live comfortably on a salary of $50,000, even in New York City. It’s totally doable.” And New York is, without a doubt, one of the most expensive cities in the world.
Now, of course, you need to adjust this number for whatever your lifestyle is. Do you have kids that you need to support or put through college? Are you planning to have kids? Do you just have expensive taste? Whatever it is, you need to come up with a realistic estimate of how much you need to live per year. I would even advise bumping that estimate up by 30% or so, just to be safe.
After that, you need to figure out how much you’ll need to have invested to achieve that amount of dividend income. And we do that by dividing your estimated yearly need by the dividend yield of your intended portfolio.
A dividend yield is essentially the dividend that a company pays divided by the share price. So, if a company has a yearly dividend of $1 and its shares are trading at $100, then it has a dividend yield of 1%.
Now, according to Investopedia, the average dividend yield on S&P 500 index companies that pay dividends has historically been between 2% and 5%. So, let’s cut the difference and go with 3.5% for our example
If you want to know how to make $50,000 per year off of dividends with an annual dividend yield of 3.5%, you need to divide $50,000 by 3.5%, which gives you $1,428,571. So, that’s the amount of money you’ll need to have invested to make $50,000 per year at a 3.5% dividend yield. And, yes, that sounds like a lot.
But, there are definitely ways that you can get to that number faster. You can spend less and save more each month, you can research dividend stocks and get your portfolio’s dividend yield higher than 3.5%, and, plus, this calculation hasn’t taken into account the factors of dividend reinvestment or dividend increases.
Dividend Reinvestment Plans
If you’re already familiar with the idea of compound interest, then dividend reinvestment plans (or “DRIPs”) will make a ton of sense to you. Essentially, they work the same way.
If you invest in a DRIP, you can elect to reinvest all or just a portion of the dividends you earn every year back into the stock. And that means that you’ll have more money invested in the company for the next period and you’ll be able to earn more dividends. Just like compound interest, dividend reinvestment helps your investments grow exponentially.
You know the classic example: you put in $1,000 and earn 1% interest yearly, so you earn $10 at the end of the first year. The next year, you’re earning 1% of $1,010, so you’ll make even more. And then your money grows exponentially.
The difference here is that with interest (like on a savings account), you’re going to have a fixed rate that’s not going to change. With dividends, the dividend payout is subject to change at the discretion of the company.
So, while your dividend may be $2 for one year, it could be $1 the next year, or it could be $3. It usually depends on how the company is performing. So, the amount that’s compounding in your account is variable.
You can sign up for a DRIP plan directly through the company that’s offering the stock or, alternatively, you can set up automatic reinvestment of dividends through your brokerage, which is usually free.
Going with the brokerage might be better because some brokerages will let you reinvest fractional shares, whereas the company’s DRIP plan may not. Essentially, if a company’s shares are worth $100 and you earn a $1 dividend, the brokerage will allow you to buy a fractional share for $1 and that dollar will be earning you more money.
Another very attractive aspect of dividend investing is the fact that companies tend to increase their dividends over time rather than decrease them if they can. And that means that your money is going to grow faster and faster.
Now, by this point, you might be asking why you should care so much about dividends. And it really comes down to companies’ desires to increase their dividends and their unwillingness to decrease them.
For one, a dividend increase usually signifies that a company is performing very well and wants to return some of its income to investors. Therefore, when a company announces an increase in dividend payouts, it’s a signifier of success to investors, which, in turn, leads to more investment and a boost to their stock price.
Therefore, a dividend increase is not only good for shareholders, it’s good for the companies that issue them. And that’s evidenced by the fact that dividends per share growth has outpaced inflation by 2.4% since 1940. If companies didn’t want to increase their dividends, then they would just tie dividend increases to inflation and call it a day.
On the flip side, companies really do not want to cut their dividends. That signifies that they aren’t doing well and it’s most likely going to trigger a major stock sell-off, which is only going to make that company’s problems worse.
Plus, if a company can keep paying out its same dividend even when its stock price falls, then their dividend ratio is actually going increase. If you remember the formula for dividend yield (dividend / share price), then check out this example:
A stock trading at $100 that pays a dividend of $1 has a dividend yield of 1%, right? Well, if their share price drops down to $50 and their dividend remains at $1, then their dividend yield is actually going to increase to 2%, and that actually makes the stock more attractive to some investors.
So, on the whole, companies are going to increase their dividends far more than they’re going to decrease them, and that’s why dividend increases are so helpful to building your passive income stream.
Find yourself stocks that have a long history of regularly increasing their dividends, and you’ll see your money grow increasingly quickly.
The Final Number
Alright, let’s start with a very base scenario. You’ve calculated how much you’ll need to live every year for the rest of your life and that number is $70,000.
According to an MIT study in 2020, the living wage for a family of four in the U.S. (two parents and two kids) was just under $69,000 per year. So, with that $70,000 of passive dividend income, you’ll at least be able to support yourself, your spouse, and your two kids without working.
And, as I mentioned before, the average dividend yield is about 3.5%. So, for this example, let’s use Spire Inc., a public utility company out of St. Louis, because their current dividend yield is about 3.5% as of the time of my writing this.
Here is a quick calculation of how much you would need to have invested to live off of dividends (all of the inputs will be explained below):
Spire’s current stock price is $77.70. And, let’s say, right now, you have $25,000 invested in Spire, meaning you have about 322 shares. We’re going to use Spire’s current dividend yield of 3.5%. Spire, like most companies, pays its dividends quarterly.
And, next, let’s say that you put $29,000 into Spire’s stock every year. You might think that that’s a lot of money, but considering that the average disposable income per capita today is over $50,000, it actually seems like a fairly moderate estimate.
Next, let’s say that your dividend tax rate is 15%. And the truth is that you’ll either be taxed 0%, 15%, or 20% on your dividends, depending on what tax bracket you’re in. And the tax bracket you’re in will probably change throughout your lifetime. So, I just chose 15% to split the difference.
Next, we have the expected dividend increase. And, a study from SeekingAlpha tells us that the average dividend increase percentage over the last 51 years was 5.4%, so we’re going to use 5% to be conservative.
Next is the expected annual share price increase. And, yes, dividend stocks can also go up in price, creating even more value. According to SoFi, the annual stock market return in the U.S. is 10%, but we’re going to use an especially conservative estimate of 5% because dividend stocks don’t typically show as much growth as other stocks.
And, for the holding period, we’re going to go with 20 years. As you can see, that will take you above the $2 million mark. So, if all of the conditions above prove true, you should be able to live off dividends alone.
Now, I know that was a lot of information all at once, but the basic idea is that, by investing in dividend stocks that have consistent dividend increases and steady growth and contributing a solid amount of your savings to dividend investments every year and letting those investments for long periods of time, you can get to a place where you’re living entirely off of passive dividend income.
Of course, the scenario we just went through isn’t perfect. First of all, you should have a diversified portfolio of dividend stocks to reduce risk. Don’t just invest in one single stock like Spire Inc. and think it’s going to answer all your prayers.
Second, some of the numbers that I put in there might not apply to you, like your annual contribution or initial investment or holding period. I encourage you to go on TipRanks.com and play out different scenarios on their dividend calculator.
But, the point here is that the exact amount that you’ll need to live solely off of dividends is different for everyone and getting there doesn’t happen overnight. But it is doable!
With solid budgeting, patience, a solid source of income, and some wise choices in dividend stocks, you can retire super early and live off of dividends alone and have all of your neighbors wondering where your money is coming from.
Is he protecting government secrets? Did he win a massive lawsuit? Royalties from a one-hit wonder 20 years ago? Nope! Just good old dividends.