A Guide to Income Investment Strategies

Maybe you are looking for a way to build a supplemental income stream during your working years, or perhaps, you’re planning for retirement. Whatever your motivation, this is where income investing strategies can help. An income investing strategy revolves around building a portfolio that generates a steady income. With the right strategy, you can up your financial future with regular income that can lead you through your working years and well into retirement.

A financial advisor can help you find an income investing strategy that suits your financial needs based on your long-term goals.

What Is Income Investing?

Income investing is all about making investments that produce consistent income, either through dividends, interest or a combination of the two.

It usually appeals to those who need or want to increase their current income. You can use this extra money to cover everyday expenses, pay off student loans or other debts or fund other financial goals, such as planning for your child’s college expenses.

An income investing strategy is essentially the opposite of a capital appreciation strategy. Capital appreciation focuses on investing in companies that are poised to see significant growth over the long term. In this scenario, an investor is banking less on dividends and more on price appreciation. They hold shares of companies that tend to reinvest retained earnings for expansion, rather than paying earnings out to investors.

The overall goal of income investing is to provide an investor with passive income. Investors are less interested in stocks that may see big price jumps in years to come. Instead, they are looking at companies that have a consistent track record of paying out dividends to their investors. Therefore, they may lean more toward the dividend aristocrats or dividend kings rather than trying to find the next Amazon or Facebook.

What Does an Income Investing Strategy Look Like?

There are different ways investors can approach income investing, in terms of what they invest in and how they manage their portfolios. For example, an income investing strategy can focus on stocks, but it can also include other types of securities, such as:

• Bonds. When investing in bonds, there are several types to choose from, including municipal bonds, corporate bonds and high-yield, or junk, bonds.
• Real estate investment trusts (REITs). REITs are required to pay out 90% of taxable income to investors as dividends each year.
• Dividend-paying exchange-traded funds (ETFs). Popular types of ETFs include index funds and actively managed funds.
• U.S. Treasuries. Treasuries, such as T-bills or Treasury Inflation-Protected Securities (TIPS), can also be used for income.

Each of these investments can produce consistent income with varying degrees of risk. For example, Treasury bonds are virtually risk-free since they are backed by the full faith and credit of the U.S. government. However, they may generate a lower rate of return compared to a REIT, dividend stock or dividend ETF.

You can also look beyond traditional securities to include cash or cash equivalents in their portfolios. For example, you could invest in money market funds or keep a liquid reserve of cash in a money market account or certificate of deposit. These are relatively low-risk investments, but again, the trade-off can mean a lower rate of return and overall income.

Income Investing Strategy Examples

When investing for income, how you build your portfolio can depend largely on your risk tolerance, time horizon and overall financial goals. The less risk you are comfortable tolerating, for example, the more of your portfolio you may allocate to conservative investments. On the other hand, if you have a higher tolerance for risk, then dividend stocks or ETFs may make up the bulk of your portfolio.

With that in mind, there are a few examples of an income investing strategy.

• Bond ladder. A bond ladder is an investment strategy in which you purchase multiple bonds with different maturity dates and interest rates. This type of approach can allow you to enjoy a steady stream of bond income while managing interest rate risk.
• Real estate-focused. Real estate can be a useful hedge against inflation while producing passive income. An income strategy built around real estate investment might include portfolio allocations to one or more REITs, as well as dividend-producing real estate ETFs and real estate crowdfunding investments.
• Dividend stocks. There are two ways to build an income investing strategy around dividend stocks: buying individual stocks or owning dividend ETFs. Between the two, a dividend ETF approach is more passive since you just have to choose one fund, rather than buying and selling individual shares of stock.

Other Considerations

When applying an income strategy, there are a few things to remember.

Diversification

While you could put 100% of your assets into bonds, real estate or stocks, there is risk in doing so. An all-bond portfolio, for example, may fall short of your expectations in terms of returns. An all-stock portfolio or all-real estate portfolio, on the other hand, could increase the possibility of losing money. 

Diversifying and including a mix of income investments can help with managing risk and rewards.

Research

Next, it is important to research individual investments. With bonds, for example, you should understand what type of bond you own, its maturity date and how much interest you will be able to collect over the maturity term. 

It is also a good idea to know how to interpret bond credit ratings. This way, you can determine which bonds carry the highest or lowest degree of risk.

Estimate Returns

Lastly, with dividend stocks, it is helpful to understand the basics of how dividend yield and dividend payouts work. This helps you to estimate what kind of income you could expect. 

If you are investing in ETFs, you will want to look at the expense ratio so you know how much it will cost annually to own the fund.

Pros and Cons of Income Investing

Income investing strategies may not be right for every investor, so it is important to weigh the advantages against any potential disadvantages. 

The main benefit of income investing is that it is generally less volatile than capital appreciation investing. A typical income investor holds bonds or invests in established companies. Therefore, they are more insulated against market swings that potentially cause substantial price drops.

On the other hand, income investing may carry more inflation risk for investors. When inflation creeps up and prices rise, purchasing power shrinks. Income investing can be problematic if the returns generated by your investments are not enough to keep pace with rising inflation.

Tax Implications

When deciding on an income investing strategy, it is important to understand the tax implications associated with various income-generating assets. Different types of income can be taxed differently, and preparing for these distinctions can help you optimize your investment returns.

Dividends are a common source of income for investors. Most dividends fall under the category of ordinary dividends and are taxed as regular income. However, qualified dividends benefit from a lower tax rate, similar to capital gains.

Real estate investments also come with specific tax considerations. Rental income is typically taxed as ordinary income, although you may be eligible for certain business deductions. If you invest in REITs, you might notice that dividend payouts are generally higher than those from traditional stocks. These dividends are taxed as income, but any profits from selling REIT shares are taxed at the capital gains rate.

Bonds present another layer of complexity in terms of taxation. The tax treatment of bond income depends largely on the issuer. For instanceL 

• Some municipal bonds offer tax-free income at both the federal and state levels, provided you reside in the issuing state. 
• Corporate bond income is subject to both state and federal taxes. 
• U.S. Treasury bonds are typically taxed at the federal level but are exempt from state taxes. 

Meanwhile, if you sell a bond at a profit, you may incur ordinary income or capital gains tax, depending on the circumstances.

Given the complexity of tax issues related to income investing, it can be helpful to consult with a financial advisor. They can help you prepare for and potentially minimize your tax liabilities, all with the goal of enhancing your investment strategy.

How to Build an Income Portfolio From Scratch

If you are new to income investing, getting started may feel overwhelming. However, a step-by-step approach can help you build a portfolio designed to deliver steady income while still remaining aligned with your financial goals and risk tolerance. 

Step 1: Define Your Goals and Time Horizon

Start by asking yourself: Why am I investing for income? Consider whether you are looking to supplement your salary with passive income, generate retirement income or fund a short-term goal. 

Your answer will determine how much income you need and how long your money should last.

Types of Financial Goals

Step 2: Determine Your Income vs. Growth Needs

Once you have identified your goal, estimate your income needs:

• How much monthly or annual income do you need your portfolio to generate?
• Will you reinvest this income or use it for living expenses?
• Do you need the portfolio to grow in value over time, or is preservation more important?

The answers will help you decide the right mix of assets, such as bonds, dividend-paying stocks or REITs.

Step 3: Choose Your Income Assets

Income portfolios can include a variety of securities:

• Bonds: These offer regular interest payments with generally lower risk.
• Dividend Stocks or ETFs: These investments provide income with potential price appreciation.
• REITs: These are real estate-based income vehicles that pay high dividends.
• Money Market Funds/CDs: These are ideal for short-term, low-risk income.
• Preferred Stocks: These often yield higher income than common stocks and often with less volatility.

Step 4: Sample Starter Portfolios

These are some sample allocations for income investors at different risk levels. Keep in mind these are just illustrative starting points, you can tailor based on your goals and preferences.

Examples of Income Investing Strategies

As you build your income strategy, remember to review your portfolio regularly and rebalance often to reflect changing market conditions or financial goals. When in doubt, working with a financial advisor can help you design a personalized plan with the right blend of income and risk management.

Bottom Line

Developing an income investing strategy can help simplify your plans for growing wealth and creating passive income. Rather than actively trading stocks, you may be able to put the bulk of your portfolio on autopilot. However, always remember to weigh the potential inflation risk this type of strategy may present, as this can ultimately determine whether an investment is a good fit.

A financial advisor can help create an income investing strategy for your portfolio based on your future financial goals, risk tolerance and overall time horizon. 

Investing Tips

• If you don’t necessarily need dividends for current income, but own dividend-paying stocks, you could choose to reinvest them instead. Many companies offer a dividend reinvestment plan or DRIP in which you can automatically reinvest dividends in additional shares of the same stock. This could make it easier to increase your position in a particular stock without having to pony up more cash out of pocket to buy shares.
• A financial advisor can help you develop an income investing strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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