Income Investing Guide: How to Invest for Steady Cash Flow
There are many ways you can invest depending on your goals. Some people invest to grow their money quickly and accept a higher risk of losing money in the short term.
Others may be at a different point in their investing journey. They need reliable income from their investments. These people generally can’t afford to lose a large percentage of their assets.
Income investing is the name of this more conservative form of investing. It focuses on earning a reliable income from your investments.
What is Income Investing?
Income investing is exactly what it sounds like. It’s investing with the goal of earning income from your assets.
Different types of investments work in different ways. Stocks with high growth potential may have been a good fit early in your investing journey. These stocks may not provide consistent growth or income, though.
These types of assets normally aren’t what most income investors gravitate toward. When you rely on your investment income to live in retirement, you want safer options.
Safer investments still have downside risk, but it isn’t nearly as great. They’re generally stable and, in most cases, provide income in different forms.
Types of Income
When you’re investing for income, you have many different ways you can earn that income.
When you invest in a company by buying stock, you’re a partial owner of the company. One way companies reward their shareholders is through dividend payments.
Dividends are direct payments to the shareholders. They are typically paid from the profits of a company.
Corporations don’t have to offer their shareholders dividends. If they already give out dividends, they can lower them or cancel them if they wish.
Of dividend-paying stocks, a group of companies may try to provide reliable dividends year after year. In some cases, these companies pride themselves on increasing their dividends each year.
One way to gauge the value of the dividend a company offers is a formula called dividend yield. Divide the total dividends paid per share by the share price. This gives you a percentage of the share price the company pays in dividends.
You can use the dividend yield to compare the income from these investments to other options.
You can earn interest income from many different sources. Essentially, interest is a payment for lending your money to someone else.
You can earn interest payments from keeping money in savings accounts, certificates of deposit, by investing in corporate bonds or other interest-paying investments.
When you choose these types of assets, you’re generally told up front what the interest rate will be.
Some investments, such as putting money in a high yield savings account, have an interest rate that can change over time. Others have set interest rates for the term of the investment.
The interest rate you’re paid normally varies based on the risk of the asset.
Since savings accounts are FDIC-insured, their interest rates are usually low.
However, risky corporate bonds may have very high interest rates due to the possibility of the company defaulting.
Real estate investments can offer rental income, another type of reliable income for income investors.
Investing in real estate is more time consuming than investing in stocks or bonds. It can be more rewarding, too.
Many people consider real estate investments -- and being a landlord -- to be passive income.
The reality is:
This is rarely the case, but it is possible if you outsource all of the management of the rental properties you own.
Who is Income Investing a Good Fit For?
Income investing is a good fit for people that can’t afford or don’t want to see drastic decreases in their total assets.
No type of investing can guarantee no losses.
Income investing is considered one of the most conservative types of investing.
You’ll typically receive much lower returns than with other types of investing. This can be well worth it.
Those that have already accumulated a sufficient nest egg don’t need to take on extra risk. Instead, they want to ensure their money doesn’t run out prematurely.
Income investing is also popular among those that are risk-averse. These people are willing to accept lower returns and invest more to reach their goals to avoid the downside risk of riskier investments.
Types of Investments Commonly Used in Income Investing
Depending on your preferences, you could use several types of investments to reach your income investing goals.
There are plenty of asset classes to choose from and financial services companies can help you invest in them.
Savings accounts, certificates of deposit and money market accounts are all relatively safe assets.
They normally offer low interest rates, though. (Online banks are a common exception.)
Bonds come in several varieties. You may hear them referred to as fixed income investments. They generally pay you interest throughout the bond's life or maturity.
Here are the major categories and their characteristics.
U.S. Treasuries are bonds issued by the federal government. The federal government is seen as offering one of the lowest risks of default possible.
For this reason, U.S. treasuries usually have relatively low interest rates compared to other types of bonds.
U.S. savings bonds
U.S. savings bonds are a special type of bond sold at a discount.
It doesn’t pay interest over the life of the bond. Instead, the savings bond slowly increases in value. Eventually, it reaches its maturity value printed on the bond.
These bonds cannot be sold to others. They can only be redeemed through the U.S. government.
Mortgage-backed securities are an investment that pools several similar mortgages together before selling them to investors.
These securities provide income based on the mortgage interest rates.
To provide that income, the mortgages that underlie the securities must continue paying as agreed.
If the mortgages default, there is the risk you may not receive your payments as scheduled.
Corporate bonds are debts issued by companies rather than governments.
These bonds come in a wide variety of options. Terms vary depending on the needs of the company selling them.
Corporate bonds are usually rated with riskier bonds paying higher interest rates than safer bonds.
Corporate bonds often have higher interest rates than government bonds.
Treasury inflation-protected securities (TIPS)
Treasure inflation-protected securities are a type of bond designed to keep up with inflation.
These bonds do not provide any return in excess of inflation, though. For this reason, these securities may be a good fit if you’re worried about future inflation prospects.
Municipal bonds are a type of bond sold by state or local governments.
These bonds are normally viewed as riskier than U.S. bonds.
However, these bonds are federal income tax-exempt. They may be state income tax-exempt, depending on the state.
International bonds are bonds issued by other countries or companies not based in the United States.
These may be riskier depending on the issuing entity. If they are viewed as higher risk, they may pay higher interest rates.
It’s essential to understand the currency tied to an international bond.
If a bond pays out in a foreign currency, you also have a risk tied to the value of that currency.
Another option to earn income is owning dividend-paying stocks. Dividend-paying stocks can be fairly safe or extremely risky depending on the company you invest in.
Dividend yield can be used to estimate the amount of income you could receive from a company. Dividends can be changed at any time, though.
In addition to earning dividend income, your investment could grow or decrease in value based on the company’s performance and other factors.
For the sake of diversification, you could purchase mutual funds focused on long-term investing in dividend-paying stocks.
Income-focused mutual funds and exchange-traded funds (ETFs)
You may want access to dividend-paying stocks or other income-based investments. Even so, you may not want to investigate individual options. Consider these alternatives.
Income-focused mutual funds or ETFs may still provide the income you need. They’re professionally managed by a portfolio manager. These investments hold several individual investments, which can help you achieve a diversified portfolio.
A diversified income investment portfolio helps you avoid being as negatively impacted if one of your income investments fails or declines in value.
These investments come with expense ratios. Make sure you shop for a low-cost option. Also verify the cost is worth the benefits the investment provides.
Investing in real estate used to be straightforward. Today, you have more options than ever to invest in real estate.
Rental real estate is another favorite type of investment for income investors. By owning and renting out a property, you receive income in the form of rent checks.
The goal is to cash flow the rental property. This means the rent you receive covers all of your costs and provides a profit.
Some people buy rental properties early in life. Then, they pay off the mortgages before they retire.
By doing this, you could have significant income-producing assets in retirement.
The same concept applies if you can pay cash for rental properties without using a mortgage.
Real estate investment trusts (REITs)
Real estate investment trusts usually own real estate to produce income or capital appreciation.
The trust may own a single property or several properties depending on its goals.
Then, individuals can invest in the trust. This allocates them a portion of the returns from the underlying real estate assets.
These properties may be apartment complexes, commercial space or one of several other options.
Individual investors cannot usually afford or do not desire to purchase and manage these types of properties on their own.
A REIT gives smaller individual investors access to this part of the real estate market. There may be high investment management fees associated with these investments, though.
Real estate crowdfunding platforms
These platforms allow people to invest in different ways depending on the particular platform.
Some offer REITs. Others allow partial ownership of specific properties.
The platform typically performs due diligence and prepares properties for investors. Then, investors choose which properties or investments they want to invest in.
You may have to qualify as an accredited investor to invest using some of these real estate crowdfunding platforms.
Risks of Income Investing
Income investing may be a popular way to invest. It doesn’t come without risks, though.
If you’re considering income investing, make sure you understand the following risks. Then, have plans for how to offset them.
Interest rate risk
Interest rate risk refers to the chance that interest rates may change during the period you hold your investment. This matters for certain types of investments more than others.
But why do interest rates impact investment? Some investments specifically pay interest as part of the benefit of investing in them. For example, bonds may have a fixed interest rate they pay over the bond’s life.
A bond’s term may be 20 years. You can almost guarantee the prevailing interest rates at the start of the bond’s life will be different than at the end of the bond’s life.
Let’s say a bond pays 3% interest. If interest rates increase to 4%, people won’t want to buy the bond for the full price. This is because they can get more interest elsewhere.
To offset higher interest rates elsewhere, you’d have to take less than full price for your bond to sell it.
The opposite also occurs. If interest rates drop to 2%, your bond now pays higher than the market interest rate. In this instance, it can sell for a premium.
Credit risk on debt investments
Credit risk describes the chance that a bond issuer won’t be able to make their payments. If this happens, your bond or other debt investment could become worthless or drastically drop in value.
U.S. government bonds essentially have little to no credit risk due to their track record of payments. This isn’t true for other types of bonds, such as corporate or municipal bonds.
Companies and governments that issue debt-based investments, such as bonds, usually get rated before selling debt.
These ratings focus on the financial health of the bond issuer. This also ties into the likelihood you’ll get paid back as the terms state. The better the credit rating is, the lower the interest rate these entities usually have to offer to sell bonds.
If an issuer’s credit rating changes while you hold a bond, it could impact the price you could get for selling it. Ratings that get stronger could benefit you financially. Decreasing ratings could damage your bond’s value.
Inflation risk refers to the possibility that your investments or money may lose real purchasing power due to increasing prices.
This risk applies to all investments. Even so, income investing usually worries about this more. That’s because returns on income investments usually trail more aggressive investments.
The simplest example to understand involves a simple savings account.
Let’s say you have a saving account paying 0.5% interest. If you have $1,000 in that account at the beginning of the year, you’ll have $1,005 at the end of the year.
If inflation didn’t exist, you’d have an extra $5 at the end of the year. Since prices are still the same, your purchasing power has increased.
Unfortunately, inflation is a fact of life. Let’s say the inflation rate ended up at 2% for that year.
To have the same purchasing power as you had at the beginning of the year, you’d need $1,020. You only have $1,005, though. This results in a loss of purchasing power due to inflation.
Risk of limited growth
Income investments don’t usually provide as strong returns as other more aggressive investments might.
This is because they focus on providing a steady income stream rather than optimizing growth potential.
To achieve this goal, income investments must be more conservative. This may allow them to provide a better chance of meeting their income production targets.
For example, a dividend stock doesn’t reinvest all of its profit to grow the company more. They may focus on paying out dividends to shareholders, instead.
To offset this risk, you can diversify your investments to provide some exposure to growth-focused investments while still investing in income-focused investments.
Investing for income has one major negative downside. These investments regularly generate income.
If that investment is held in a taxable investment account, you’re required to pay taxes on those income payments. This continues each year there is a distribution.
Other investments that focus on growth without paying out income may qualify for long-term capital gains tax rates. To qualify, you must hold the investments for more than a year before selling them.
These lower tax rates help investors save money on taxes.
Dividend and interest tax rates may be higher than long-term capital gains tax rates, depending on the circumstances.
Income investments may also increase in price before you sell them. If this happens, you may have to pay capital gains taxes when you sell them, as well.
Tax Considerations About Income Investing
Each type of investment comes with its own tax considerations. As long as your assets aren’t in a tax-advantaged account, they’re usually taxable in some way.
In general, there are two different types of taxes you might have to pay.
One tax is your ordinary income tax rate. This is your marginal tax rate on your next dollar of income.
The other tax is called the capital gains tax. This is a lower tax rate for certain investments and investment income.
Interest income is normally considered ordinary income for tax purposes. A special rule exists for municipal bonds. The interest from these qualifying bonds is not taxable on your federal income tax return.
The tax treatment for dividend income varies. Some dividends are ordinary dividends taxed at ordinary income tax rates. Others may be considered qualified dividends, which are taxed at capital gains tax rates.
Taxation for rental real estate is much more complex.
Since rental real estate is technically a business, you get to deduct your expenses from your income before you pay taxes. In fact, landlords may show a tax loss despite having positive cash flow.
In these cases, you may not have to pay federal income tax during these years. You may have a large tax bill when you eventually sell the rental property.
Tips for Income Investors
Any type of investor is likely looking at how they can optimize their investing.
1. Optimize for tax efficiency
Investors can benefit from prudent tax planning. Take a look at your assets and figure out how you can reduce the taxes you owe on them and the income they put off.
This may require changing where you house different types of investments.
In general, it makes sense to put the highest income-producing assets in Roth-based tax-advantaged retirement accounts. These accounts don’t usually have to pay taxes in the future. An example is a Roth IRA.
You can then move your lower income-producing assets. Ideally, you’d put these into traditional retirement accounts. If you’ve exhausted your tax-advantaged accounts, a taxable account is another option.
These investments put off less income.
You won’t owe as much tax on them as you would your higher income-producing assets.
2. Dividend reinvestment
If you’re an income investor, chances are you’re relying on the income to fund your lifestyle. If this is the case, it doesn’t make much sense to reinvest your dividends.
Reinvesting your dividends can help you get more shares of stock. This may result in more dividends later.
If you don’t need the income, reinvesting your dividends could help your future financial situation.
You Choose If Income Investing Is Right For You
Income investing is for those with relatively low risk tolerance that need to earn a reliable income. There are many ways you can be an income investor.
It’s easy to be unsure which method is best for you or how to enact a particular type of income investing.
In these cases, consider hiring a fiduciary financial planner. They can help you draw up an investment plan for your specific situation.