An income investing strategy focuses on generating income from your principal rather than growth, i.e. capital gains. Income investors typically seek out investments that provide a regular income stream, such as dividends from stocks, interest from bonds, or rental payments from a property.
Investors might be interested in income investing in order to create an additional income stream during their working years. Other investors may focus on generating monthly income during retirement. Income investors need to take into account several factors, including the tax implications of different types of income.
How Income Investing Works
Income investing can be a way to generate a passive income stream that supplements ordinary income as well as retirement income. Rather than creating a portfolio that’s solely focused on capital gains, i.e. growth, an income investing strategy is geared toward setting up one or more sources of steady income.
Again, dividend-paying stocks, interest-bearing bonds, and real estate proceeds are common types of income investments that may provide steady cash flow. While many people associate investment income with retirement, many investors seek to establish other income streams long before that.
That said, these two aims — growth and income — are not mutually exclusive. In fact, an income-generating portfolio must also have a growth component, in order to keep up with inflation.
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Types of Income Investing Strategies
There are a range of income investing assets and strategies that investors can adopt, depending on their goals and preferences. For example, when creating an income-focused portfolio, it’s important to consider your risk tolerance, as different income investments may have different risk profiles.
1. Dividend Stocks
Dividend stocks are stocks that pay out regular dividends to shareholders. Not all companies pay dividends. Companies that do usually pay dividends quarterly, and they can provide a reliable source of income for investors.
Income investors are generally attracted to companies that pay out reliable dividends, like the companies in the S&P 500 Dividend Aristocrats index. Companies in this index have increased dividends every year for the last 25 consecutive years.
• Dividend Yield
One metric that income investors should consider is the dividend yield. While dividends are a portion of a company’s earnings paid to investors, expressed as a dollar amount, dividend yield refers to a stock’s annual dividend payments divided by the stock’s current price, and expressed as a percentage.
Dividend yield is one way of assessing a company’s earning potential.
While a high dividend yield might be attractive to some investors, risks are also associated with high-yield investments. Investors who want regular and consistent income tend to avoid stocks that pay high yields in favor of dividend aristocrats that may pay lower yields.
Recommended: Living Off Dividend Income: Here’s What You Need to Know
2. Bonds
Bonds are a debt instrument that normally make periodic interest payments to investors. Also known as fixed-income investments, bonds are typically less risky than stocks and can provide a steady stream of income. The bond’s yield, or interest rate, determines the interest income payment.
There are various bonds that fixed-income investors can consider. For example, government bonds are debt securities issued by a government to support government spending and public sector projects. Government bonds — like U.S. Treasuries and municipal bonds — are generally less risky than other types of bonds and can provide tax-advantaged income and returns.
Investors can also lend money to businesses through corporate bonds, which are debt obligations of the corporation. In return for money to fund operations, companies make periodic interest payments to investors. Corporate bonds carry a relatively higher level of risk than government bonds but also provide higher yields.
However, not all bonds offer yield to investors interested in generating regular income. Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond.
The upside of choosing zero-coupon bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.
Recommended: How to Buy Bonds: A Guide for Beginners
3. Real Estate
Real estate may be a great source of income for investors. Rents paid by tenants act as a regular income payout. Real estate may also offer long-term price growth, in addition to some tax benefits.
There are several ways to invest in real estate, including buying rental properties and investing in real estate investment trusts (REITs).
Recommended: Pros & Cons of Investing in REITs
4. Savings Accounts
Savings accounts are a safe and easy way to earn interest on cash. Savings accounts and other cash-equivalent saving vehicles like high-yield savings accounts or certificates of deposits (CDs) are often considered very low risk. But they also typically offer lower interest rates than you might see with other investments. Because these interest rates are typically lower than the inflation rate, inflation can erode the value of the money in these savings accounts longer term.
In addition, when you purchase a CD it may have more stringent minimum deposit requirements, as well as keeping your money locked up for a specific period of time. Still, they can be a low-risk way to earn income.
5. Money Market Accounts
A money market account (MMA) is an FDIC-insured deposit account that typically pays higher interest rates than a traditional savings account. However, MMAs may be more restrictive than a savings account, often only allowing a certain number of withdrawals each month using checks or a debit card.
Also, money in a money market account can be invested by the bank in government securities, CDs, and commercial paper — which are all considered relatively low-risk investments. With a traditional savings account, money is not invested.
But unlike most investments, money market accounts at most banks are FDIC-insured up to $250,000 for an individual, or $250,000 per co-owner in the case of joint accounts. In some cases investing in a money market account may earn a higher interest rate while still maintaining FDIC-insurance protection.
6. Mutual Funds and ETFs
Investors who don’t want to pick individual stocks and bonds to invest in can always look to mutual funds and exchange-traded funds (ETFs) that have an income investing strategy.
There are many passively and actively managed funds that invest in a basket of securities that provide interest and dividend income to investors. These funds allow investors to diversify their holdings by investing in a single security with high liquidity.
Understanding the Tax Implications of Income Investing
Another important aspect of investing for income is to consider the tax implications of different income-producing assets. Here are a few key considerations to be aware of:
• Dividends. Most dividends are considered ordinary dividends and are taxed as income. Qualified dividends are taxed at the lower capital gains rate. Be sure to know the difference.
• Real estate. Income from a rental property is generally taxed as income (although business deductions may apply). Dividend payouts from owning shares of a Real Estate Investment Trust (REIT) are typically higher than traditional equity dividends; these are also taxed as income. However, if there are profits from a REIT, these are taxed at the capital gains rate.
• Bonds. Bond income may be taxable, or not, depending on the issuer. Some municipal bonds are tax free at the federal and state level (if you live in the state where the bond was issued). Corporate bond income is taxed at the state and federal levels. U.S. Treasuries are generally taxed at the federal level, but not the state.
You may also owe ordinary income or capital gains tax if you make a profit when selling a bond.
As you can see, tax issues can be complex and it’s often necessary to consult a tax professional.
Example of an Income Investing Portfolio
When building a portfolio for any investing strategy, investors must consider their financial goals, risk tolerance, and time horizon. As with any investment portfolio, it’s possible to have lower or higher exposure to risk.
Here are some examples of hypothetical income investment allocations.
Lower Risk Tolerance
| Asset type | Percent of holdings |
|---|---|
| Bonds (government and corporate) | 60% |
| Dividend stocks | 20% |
| Rental property or REITs | 10% |
| Cash (savings account, money market account, and CDs) | 10% |
This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.
Moderate Risk Tolerance
| Asset type | Percent of holdings |
|---|---|
| Bonds (government and corporate) | 35% |
| Dividend stocks | 30% |
| Rental property or REITs | 30% |
| Cash (savings account, money market account, and CDs) | 5% |
This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.
Higher Risk Tolerance
| Asset type | Percent of holdings |
|---|---|
| Bonds (government and corporate) | 25% |
| Dividend stocks | 30% |
| Rental property or REITs | 45% |
| Cash (savings account, money market account, and CDs) | 0% |
This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.
Benefits and Risk of Income Investing
Like any investing strategy, there are both advantages and drawbacks to focusing on earning income through investments.
Benefits
The potential benefits of income investing include receiving a steady stream of payments, which can help to smooth out fluctuations in the market. In other words, even with a certain amount of market volatility, an income-generating strategy may produce income that provides a certain amount of ballast.
If an investor reinvests some or all of the income generated from a certain assets, whether bonds or dividend-paying stocks, this can add to the overall growth of the portfolio, thanks to compounding.
An income investing strategy may also provide diversification. For example, investing in REITs is considered a type of alternative investment strategy. That means, REITs don’t move in tandem with conventional assets like stocks, which may provide some protection against risk (although REITs can have their own risk factors to consider).
Risks
Investors who are pursuing an income investing strategy should be aware that investments that offer high yields may also be more volatile. The income from these investments may be less predictable than from more established investments, like blue chip stocks that pay out reliable dividends.
For example, a company with a high dividend yield may not be able to sustain that kind of payout and could suspend payment in the future.
When investing in bonds, investors need to know about the potential risks associated with fixed-income assets:
• Credit risk is when there is a possibility that a government or corporation defaults on a bond.
• Inflation risk is the potential that interest payments do not keep pace with inflation.
• Interest rate risk is the potential of fixed-income assets fluctuating in value because of a change in interest rates. For example, if interest rates rise, the value of a bond will decline, which could impact an investor who intends to sell some of their bond holdings.
Additionally, if investors take the income from their investment for day-to-day needs rather than reinvesting it, they may miss out on the benefits of compound returns. Investors could reinvest the income they earn on certain investments to take advantage of compounding returns and accelerate wealth building.
Factors to Consider When Building Your Income Investing Strategy
Building an income investing strategy takes work and time. Before creating a portfolio, you need to define your financial goals and consider your timeline for when you need the income streams. Below are some additional steps you could follow to create an income investing strategy:
• Assess your risk tolerance: It’s important to determine whether you want to invest more heavily in riskier assets, like dividend-paying stocks that may fluctuate in share price, or relatively safer securities, like interest-paying bonds.
• Choose your investments: As mentioned above, potential options for income investors include bonds, dividend stocks, and real estate investment trusts (REITs).
• Be mindful of taxes: Different types of income-producing assets may be taxed in different ways. It’s generally desirable to keep your portfolio tax efficient.
• Monitor your portfolio: It’s critical to regularly check in on your investments to ensure they are still performing according to your expectations.
• Rebalance as needed: If your portfolio gets out of alignment with your goals, consider making adjustments to get it back on track.
The Takeaway
An income investment strategy is, as it sounds, focused on using specific assets to provide income, not only growth (although income and growth strategies can work in harmony). Investing in dividend-paying stocks, interest-paying bonds, and other income-generating assets allows you to get the benefits of regular income streams and potential capital appreciation.
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FAQ
What’s the difference between income investing and growth investing?
The goal of income investing is to create a certain amount of steady income from different types of assets. Investing for growth is focused on the potential gains of the securities in a portfolio. In a sense, income investing can be more present focused, while growth investing may be oriented toward the longer term.
What is the best investment for income?
There are various income-generating investments, each with its own risk profile and tax considerations. When choosing the best income investments for you, be sure to consider how different factors might impact your plan.
What investments give you monthly income?
While it’s possible to obtain monthly income from various types of investments, even dividend-paying stocks (dividends are often paid quarterly), a common source of monthly income is property. If monthly income is important to you, be sure to select assets that can meet your goal.
Photo credit: iStock/LeszekCzerwonka
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