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.)
You could invest in a wide variety of bonds. Some are backed by the federal government.
There are also state and local bonds, often called muni bonds. These bonds generally have lower returns because they’re viewed as safer investments.
You could invest in corporate bonds. This is essentially the debt of companies. These are usually riskier because some companies have a higher likelihood of failing.
Another option is investing in the corporate bonds of a specific company. By carefully choosing a company, you can try to lower your risk.
Alternatively, you could diversify your bond holdings by using bond funds.
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.
If you’d like to diversify, you could purchase mutual funds focused on long-term investing in dividend-paying stocks.
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.
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 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.
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.