What is Income Investing and How Does it Work?
Every investment strategy has its benefits, which is why it’s always a good idea to chart out what you’re looking to get from investing before committing to a specific approach. If you’ve always loved the idea of setting up a passive income stream, then it might make sense to get into income investments.
Like a high-yield savings account, some money that you invest in the stock market — whether it’s in ETFs, mutual funds, or even bond funds — is going to generate money on an annual basis. This profit from your income portfolio manifests in the form of interest payments or dividend payouts, all of which increase your cash flow beyond the money you earn working your 9-to-5 job.
If having your money earn you money sounds like music to your ears, read on to learn how income investing can deliver just those results.
What is income investing?
Put in its simplest terms, income investing is a way to turn a larger sum of money into a source of fixed income, or passive income. A good example of income investing involves any time you receive an inheritance or even if you won the lottery (it is just an example after all!). An investment portfolio would be a portfolio constructed of different assets that would help you generate a consistent return from that sum of money on an annual basis.
So, if you generally make $65,000 each year, but receive an inheritance or life insurance settlement of $500,000, one thing you could choose to do with that amount of money is immediately invest it. Putting that $500,000 in an investment portfolio that earns a return of 5% annually means that in addition to your salary of $65,000/year, you would also receive an extra $25,000 from your income investments. As a result, your new income would be $90,000.
Drawing money safely from your investment accounts is at the heart of many retirement funds that look to provide you with consistent income in addition to social security when you’re no longer working. That being said, fixed income investing is just as beneficial if you get a large amount of money earlier in life, too.
Getting started as an income investor
Unlike other forms of investing, income investing looks for consistent, steady gains rather than finding opportunities for major growth. Instead of chasing stocks that could grow at impressive interest rates, knowing that you will likely get a certain return on your investment is much more important—even if it’s only 2% or 3%. Dividend payments are also a key component of income investing.
The ins and outs of dividend payments
Put in its simplest terms, a dividend is a payment that a company gives to its investors as a way of rewarding them for investing in the company by buying shares in the first place. Dividends are paid out to an IPO and that payment amount (which can be in the form of more shares of stock or cash) is ultimately determined by the board of directors.
Beyond stocks, some ETFs and mutual funds also pay out dividends. As you select different fixed-income securities for your income investment portfolio, it can be helpful to look at the dividend yield for the stocks you’re comparing. By knowing how much a company pays out each year in a percentage related to its stock price, you can better select assets with a higher yield and boost your passive income.
Which asset classes are best for income investors?
When it comes to asset allocation as an income investor, consistency is key. That’s why you’ll often look to invest at least part of your portfolio in your preferred stock: blue-chip stocks. A blue-chip stock is stock in a company that has offered consistent, reliable performance for years or even decades.
Companies like Apple, Amazon, and Disney are all widely considered to be blue-chip stocks since the companies they represent have strong business strategies and cash reserves to weather downturns as well as capitalize on good economies. If the stock price of some of these larger companies are giving you pause, you may want to mix up your income investment portfolio with the following fixed income securities, too:
REITs (real estate investment trusts)
If you’re looking for consistent, large dividends, real estate investment trusts (commonly abbreviated to REITs) are a great option. When you invest in a REIT, you’re investing in companies that help finance commercial real estate development in a variety of sectors and industries. In addition to helping to diversify your portfolio and offering solid dividend payouts, REITs also offer the potential for good long-term returns.
Municipal bonds
If you want to help your local city, municipal bonds are a great way to do that while still offering you a return on your investment. Municipal bonds (often called “munis”) are sort of like a loan you give the city to help work on public work projects such as the construction of a library. Many munis are tax-exempt, which can help maximize your return on them. Yields on munis are generally higher than other bonds, but you may owe taxes on them, too, so be sure you thoroughly research them before investing.
Corporate bonds
Just like a city may use municipal bonds to raise money, a corporate bond is something a company can issue to raise capital for various endeavors. A corporate bond carries more risk than U.S. Treasury bonds so they generally have a higher interest payout. Corporate bonds can also be traded on the secondary market.
Government bonds
One of the most low-risk options when it comes to investing in bonds, government bonds help the government meet its spending needs. Since government bonds are low-risk, they offer a lower return, but when you need consistent income, government bonds are a key part of your investment portfolio.
Related: What Are Bonds And How To Buy Them
Money market accounts
If you want a safe place to park your money where it will grow gradually, a money market account can offer you a higher interest rate than you might normally get in a savings account at your local bank. While you do sacrifice some of the growth potential by investing money in a money market account, you do make up for that with some added liquidity than other investment vehicles in this list.
Related: Best Money Market Accounts 2021
Costs/Fees
As is the case with any form of investing, the brokerage you use may charge certain fees on the purchase and sale of securities in your income investing portfolio. While individual bonds may have their tax exemptions, you will also need to pay income taxes on some of the money you withdraw from your portfolio.
It’s important to work with an experienced tax professional to ensure that your tax rates are properly calculated and accounted for any time you’re withdrawing money from your portfolio that could be subject to capital gains taxes or income taxes. Tax treatment can impact how much money you’re able to truly spend each year from your income investment portfolio, so it’s important to get right or you may find your budget is much tighter than you’d initially estimated it would be.
Pros/Cons
Pros
- Offers passive income. If you want to retire someday, you’ll want to make sure that your investment portfolio is set up in such a way that it maximizes the consistency and stability of your returns. Income investing is ideal for this kind of passive income, making it a crucial concept at the heart of many 401ks and retirement portfolios.
- A proven, consistent strategy. Thanks to the stability offered by the consistent interest rates and dividend yields, income investing is a relatively safe investment strategy to adopt.
Cons
Requires a large portfolio value. To make money off of an income investment portfolio, you need to start with a large sum of money. While some people can amass this kind of wealth through retirement accounts at work, not everyone has several hundred thousand dollars to invest and begin drawing money from in their 20s or 30s. As such, unless you’ve just inherited a sizeable amount of money, income investing isn’t something you’ll be able to successfully execute until later in your life.
The bottom line
At its heart, income investing is a consistent and stable way to draw money from your investment portfolio without losing too much of your principal investment. By investing in safe fixed income securities like bonds, money market accounts, REITs, and blue-chip stocks, you can diversify your portfolio while still ensuring that you have money and dividend payments on an annual basis to serve as your income.
Especially if you plan to one day retire, setting up an income investment account is a must-complete task since it will allow you to supplement your Social Security income. While you might not have enough wealth to start income investing today, it’s nonetheless an important concept to understand so that you can execute this strategy in the future.
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