Here is the next installment in our Reader’s Questions Series, which highlight questions emailed to me by you, the readers of Money Q&A. This time we’re talking about income replacement with dividends when you retire.
Be sure to find out at the end of this article how you can receive a free copy of Dave Ramsey’s book, The Total Money Makeover. If you’re not familiar with Dave Ramsey’s book, you should run right out and get it. It is one of the best personal finance books that everyone should read. Now….on to our reader’s question. This week’s Reader Question is from Ralph who writes…
“I am 54 and planning on retiring in another 10 years. I recently read a book about income investing where you buy stocks that distribute income through dividends. And, you use that for any monthly shortfalls between what you receive in social security, 401k, etc. and what you need to live on. But, the book never said at what time to start doing this. Is it when you are retired, couple years before you retire?”
The short answer to Ralph’s question is that you should probably start investing in dividend paying stocks as early as you can in life. Like most investments, the best thing young investors have is time on their side.
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I personally wouldn’t wait until you retire to start investing in dividend paying stocks, although you certainly can do that if you choose. It would take a lot of cash to buy enough shares of stock to generate the dividends needed for income replacement in one shot though. Buying a little along until retirement would be more feasible for most investors. Below are the details of what it would take.
Income Replacement with Dividend Stocks
For most people, it will take a lot of shares of stock to generate the replacement income needed in retirement from dividends. Assuming that most investors won’t have piles of cash available invest in a lot of stock when they hit retirement age, it’s best to start buying dividend paying stock as early as possible.
“Earlier is better than later to start moving money into dividend paying stocks,” says Blake, publisher and blogger at the popular personal finance site, The Dividend Pig. “Or, if you have a large amount of cash and want wait, you can purchase shares as you get closer to retirement age.”
In that case, Blake recommends at least starting to research which companies you’ll want to own, at what price per share, and exactly how much income you will need to replace with dividends.
Dividends Replacing Income In Retirement
My father-in-law retired about ten years ago as a mid-level banking executive. He’s one of the last of the generation who retired with a pension from his employer. He worked at the same corporation for over 25 years and also diligently bought shares in his company’s stock through stock options.
I can remember asking him during the financial crisis in 2008 if he was going to sell some of his company’s stock. He said that the price was irrelevant to him. My father-in-law cared more about the dividend. He was using the quarterly dividend from shares of his bank’s stock that he had accumulated over decades to supplement his retirement pension.
Of course, not everyone has a pension from their employer. And, many employers aren’t even offering them anymore. But, income replacement is income replacement. If you don’t have a pension, you will just have to save that much more in your 401k retirement plan, Roth IRAs, and taxable income accounts.
Example – Income Replacement with Dividends
So, just have many shares of stock would you need to replace your income in retirement using dividends? Here’s a simple example of what income replacement could possibly look like.
Let’s say that “Tom” worked for a company for 30 years and just retired. He has a 50% pension from his employer. And, he used to earn $60,000 per year before taxes at his job.
Most financial advisors recommend saving and investing enough money in order to replace 80% of your pre-retirement income during retirement. There are a whole host of reasons why the experts have settled on 80%. In theory, your expenses decrease in retirement. Some experts even go so far as to say that your retirement income replacement ratio can be as low as 70%.
So, continuing with the “Tom” example above and using an 80% retirement income replacement ratio and his 50% pension from his employer, Tom would need to income replacement through investments for $18,000 per year. That would allow him to continue living his current lifestyle that he was accustom to while working.
Tom earns $30,000 per year from his pension. And, he needs $48,000 per year to live on, which is 80% of his original salary of $60,000.
One of my favorite stocks to invest in is Coca-Cola (Stock Symbol – KO). Their stock price is currently $43.66, and the company has a dividend yield of 3.21%. Coca-Cola offers its shareholders a dividend of 33 cents per share each quarter.
If you wanted to earn $18,000 per year or $4,500 per quarter, you would need close to 13,650 shares of Coca-Cola. At its current share price of $43.66, that would cost you just over $595,000.
This is just using the dividends for income replacement and continuing to save the principal amount without selling any of the shares of stock. Depending on your age and retirement goals, you may be able to sell shares of the stock and use the dividends and slightly reduce the number of total shares that you would need.
You should seek the advice of a certified financial planner to provide you with a financial plan that suits your goals and retirement dreams.
Note – I am a current shareholder in Coca-Cola and continue to buy shares each month through dollar cost averaging and Coke’s DRIP program.
When to Start Investing in Dividends
So, to answer Ralph’s original question, “When should you start investing in dividends in order to have income replacement in retirement?” – It depends.
What are your goals? How much cash do you have available to invest?
If you have cash available at the end of your career and can invest in dividend paying stocks for income replacement, then that’s a great time to do so. But, for most of us, we will need to start investing early in order to build the large nest egg it will take for income replacement in retirement.
You should start investing as early as possible. Time is the biggest asset young investors have on their side. I personally use dividend reinvestment plans (DRIPs) to grow dividend stocks with compounding interest. DRIPs let you purchase shares directly from a company or their agent and save a lot of money on commissions. It’s also a wonderful way to dollar cost average your investments.
I ran the numbers for our fictional character Tom in a simple Excel spreadsheet using only shares of Coca-Cola. You would need to about 14.6 shares each month of Coca-Cola stock from the time you started working at age 22 until you retired at age 62 in order to have the 13,500 shares accumulated necessary to provide you $18,000 per year in dividend payments. This also assumes that you reinvest all dividends until you need to start using them at age 62.
There are many assumptions built into the formula of course. My calculations above assume a share price of KO of $43.66 at a 3% dividend yield.
Why Not Invest More In Your 401K Retirement Plan or Roth IRA?
Another good question is why dividend stocks? Don’t get me wrong. I love dividends and dividend stocks. But, what about maxing out your Roth IRA and 401k retirement plan first?
You can contribute up to $18,000 in 401k, 403(b), and most 457 retirement plans. If you are a federal government employee or member of the military, you can also contribute up to $18,000 per year in the Thrift Savings Plan. The catch-up contribution limit for employees 50 years-old and over is an additional $6,000 per year for a total of $24,000.
If you meet the income requirements, you can also invest up to $5,500 per year in a Roth IRA. And, catch up contributions for a Roth IRA are $6,500 total per year if you are age 50 or older.
Check with your employer or plan manager on your investment options. You can choose a fund that invests in dividend paying stocks in your 401k or Roth IRA. Many investment firms also offer self-directed IRAs and Roth IRAs. You can even invest in No Fee IRA from Lending Club with a self-directed IRA or a Roth IRA.
In our example above, Tom would need to invest almost $7,700 each year and reinvest his dividends in order to build a portfolio of 13,650 shares of Coca-Cola. This would generate the $18,000 per year he needed to supplement his pension and replace his income in retirement. This plan also lets him protect his principle and live off of the dividends it generated.
You should start investing in dividend paying stocks as early as you can in life. The best thing young investors have is time on their side.
What about you? Are you looking to use dividends for income replacement in retirement?
Past Readers’ Questions:
- Is A $1,000 Emergency Fund Enough To Start?
- How To Prioritize Which Bills To Pay First
- Should You Put Your Emergency Fund In Mutual Funds?
- How Do You Start Saving If You Live Paycheck To Paycheck?
- How To Find A Payment Plan Without Cutting Necessities
- Is My Money Save In A Bank?
- What To Invest In After The Company Match
Do you have a money question that you would like to ask? Email me your money, investing, retirement, savings, or other question to Questions [at] MoneyQandA.com. If I pick your question for the next article in the series, I’ll send you a free copy of Dave Ramsey’s book, The Total Money Makeover.