Investing is about building wealth. Ultimately, however, you need to turn that wealth into cash you can spend. That’s where income investing comes in.
For most of us, that will mean years diligently investing in a growth-oriented stock portfolio, likely through a tax-advantaged retirement account like a 401(k) or IRA; then once you finally stop working, transforming those savings into something that will generate years of regular income. “In retirement, your objectives change—you want more certainty, lower volatility and lower stress,” says Thomas Salvino, an advisor in Chicago. “So your portfolio has to change.”
Mainstays of income portfolios include dividend-paying stocks, interest-bearing bonds and real estate. But building something that will produce a regular check for years—or decades—isn’t as simple as swapping your stocks for bonds when you leave the workforce. You’ll need to make the transition gradually and couple your income-generating investments with growth-oriented stocks to ensure you keep pace with inflation and don’t outlive your money.
One advantage you can count on: Thanks to a sharp rise in interest rates over the past year, it’s far easier to find good yields without taking on too much risk. “In the past, you really had to stretch to get yields,” says Bob Peterson, another Chicago-area advisor. “Now there are definitely more opportunities for income investors.”
What Is Income Investing?
The main goal of income investing is to generate income that you can live off of. But it’s not quite that simple. In addition, you want to grow, or at least preserve, your capital, so you don’t have to downscale your lifestyle as you age. And finally you want to make sure your income keeps up with inflation, which over decades can take an enormous toll; consider that $1,000 in 2000 is worth just $567 in 2023.
Achieving these interrelated goals requires you to balance various types of investments and change the mix over time. A 65-year-old’s portfolio might consist of, say, 60% bonds, 30% stocks and 10% real-estate investment trusts, or REITs, for example. Note that stocks are still a significant chunk of the portfolio.
“Stocks are your growth engine,” explains Brent Weiss, co-founder of financial advisor firm Facet, in Baltimore. “Being too conservative—for example owning only bonds—could be the riskiest thing you do, especially if you’re losing purchasing power to inflation.”
By age 75, a mix of something like 30% stocks, 50% bonds and 20% REITs, may be a more appropriate target. By age 85, most investors are focused mostly on income and capital preservation. Thus, a mix of around 20% stocks, 60% bonds and 20% REITs might be right. At that age, after all, you don’t have as much time to recover from the big dips that stocks are prone to.
There are no silver bullets when it comes to creating retirement income. Many retirees sell their investments and plow the proceeds into an annuity that promises to pay them a lifelong income stream. The simplicity is attractive. But annuities can be expensive, and often don’t match the long-term returns an income portfolio can provide. What’s more, once you’ve committed your savings to an annuity, your money can’t be regained without paying high surrender fees, if at all. “Getting your money back can be a real problem,” says Salvino.
Beware too of investments touting unusually high yields, as they may carry a higher level of risk or may even be fraudulent. Bear in mind that there’s no free lunch in investing—greater reward always involves greater risk. At the very least, think of extremely high returns as a red flag signaling that close scrutiny is warranted.
Types of income investments
The best income-investing portfolios include a mix of different income-producing assets, such as bonds, dividend stocks and real estate. Such diversification can help reduce risk and improve the potential for long-term returns.
Bonds lend a steady income stream and stability to a portfolio, while dividend stocks can provide higher yields and potential for growth. Real estate, meanwhile, promises a steady stream of rental income along with the potential for capital appreciation. Keeping a slug of money in cash or cash equivalents, such as Treasury bonds, means you won’t have to sell less-liquid assets, possibly at a loss, in an emergency.
Here’s a breakdown of the main options.
Dividend stocks
Dividend stocks are shares of companies that pay out a portion of their profits as dividends. High-quality dividend paying companies not only provide a reliable income stream but often increase their dividends over time, which can help to inflation-proof your portfolio.
While dividend stocks offer the growth potential that all stocks do, they have historically been less volatile than non-dividend-paying stocks. Owning them can help to reduce risk in a portfolio. Case in point: While the Vanguard S&P 500 ETF, an exchange-traded fund that tracks large-company stocks, lost nearly 20% last year, the Vanguard Dividend Appreciation ETF fell less than 12%.
Interested in buying dividend stocks but not sure where to start? Check out Buy Side from WSJ’s list of Best Dividend ETFs. or, if you are interested in individual stock, our roundup of top dividend stocks from prominent mutual-fund managers.
Bonds
Bonds are a cornerstone of income portfolios because, most obviously, they provide regular interest payments, usually twice a year. With their fixed maturity dates and rates of return, bonds are also generally considered less volatile than stocks; thus, they can reduce overall portfolio risk and help to preserve capital.
Just how steady are bond returns? Bonds’ worst performance in the past quarter-century, as measured by the Bloomberg U.S. Aggregate Bond Index, was negative 13%, in 2022. That’s far better than stocks’ worst year, 2008, when the S&P 500 index plunged 37%. Of course, different types of bonds have different characteristics.
- U.S. Treasurys are the safest type of bonds, a fact that outweighs their unexciting yields.
- Treasury inflation-protected securities (TIPS), a type of bond issued by the U.S. Treasury, help protect your portfolio’s purchasing power.
- Corporate bonds, used by businesses to borrow money, often offer higher yields but are somewhat riskier.
- Municipal bonds, or munis, are issued by local and state governments and certain utilities. Munis’ yields are usually modest, but the fact that the bonds are often exempt from federal and state taxes translates into higher effective returns, especially for investors in higher tax brackets.
- High-yield bonds, issued by companies with lower credit ratings, can be as lucrative as their name suggests, but they are considered to be the riskiest type of fixed income.
Investors seeking a simple way to diversify their bondholdings have a host of fixed-income mutual funds and ETFs at their disposal. Funds tend to be far more convenient for most investors. But the trade off is customization and control: For instance, fund managers might sell certain holdings before they mature, making overall returns less predictable.
Real estate
Real-estate investment trusts (REITs) are a popular way to access rental income without directly owning property. REITs are companies that own and operate income-producing properties, from apartment buildings to office buildings to strip malls. They distribute most of their income to investors as dividends, which are typically delivered directly into your investment account.
There are also plenty of mutual funds and ETFs that provide a cost-effective way to diversify your REIT holdings. So while funds’ returns might be lower than a top-performing individual REIT, they can also be less risky.
Rental properties that you own directly are often another part of the retirement-income puzzle. Their income stream might very well exceed what you can earn from a REIT. But being a landlord can be quite a hassle. You need to be ready to deal with property maintenance and repairs, property management fees, potential vacancies and property taxes, to name just a few of the tasks.
How to combine income and growth investing
Transforming an investment portfolio from its growth-oriented “accumulation” phase to its more conservative, pension-like phase is a process that should start five to 10 years before retirement. That will help you manage your tax bills and give you flexibility to sell in favorable conditions.
One of the biggest threats to any investment portfolio occurs when the owner needs to cash out a portion of it at the wrong time—such as during a bear market like the current one. That’s because, while stock prices are down you can expect them to snap back when the next bull market arrives. Bonds, by contrast, are steady but don’t have the same growth potential as stocks. By cashing out your stocks at a moment when prices are depressed and stashing your money in bonds, you risk locking in any recent losses for years to come.
Starting your stock-to-bond transition early can also give you time to ride out any rough patches in your career or personal life. Moving money into bonds—and also maintaining a healthy emergency fund, that’s separate from your investments—can help you avoid having to raid your stock portfolio to fund living expenses, if you lose your job or are forced to retire early for health or other reasons.
In addition to navigating rocky markets, you’ll also have to contend with Uncle Sam. Each time you sell a chunk of growth-oriented investments, you’ll face a capital-gains tax bill. Selling a little each year can keep the size of those checks you’ll need to write to the IRS more manageable. “You don’t want to wait till the day you retire to decide you want an income portfolio,” Peterson says. “It would be too painful from a tax perspective.
How income investments are taxed
In addition to taxes you will likely owe when you sell your growth portfolio, you will also need to get used to the notion that income investments are taxed differently, and often more heavily, than stock market gains, which benefit from favorable capital-gains rates.
Interest on corporate bonds, for instance, is taxed at generally higher income-tax rates and, unless you live in a low or no tax state, you may be taxed at the federal, state and local levels. REITs are also taxed as ordinary income. But Treasury bond interest, while taxed as income at the federal level, is free from state and local tax. And qualified stock dividends, on the other hand, are taxed at the long-term capital-gains rate, which is usually lower than a taxpayer’s income-tax rate.
There are ways to minimize your annual tax hit too.
Asset location—choosing which kind of account will house a given asset—can make a big impact. “It’s not just what you own, it’s where you own it,” says Weiss. One common practice is to place investments that generate high levels of taxable income, such as bonds, in tax-advantaged accounts like IRAs or 401(k)s. That allows investors to defer taxes on earned interest until withdrawals are made. Dividend stocks, whose income is subject to the lower capital-gains rate, and muni bonds, which are typically exempt from federal taxes, are better suited for taxable accounts.
The transition to retirement creates many questions, the biggest of them being how to fill your time. But if you plan your income-investing strategy carefully, you’ll never have to worry about where your next paycheck is coming from.
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Meet the contributor
Steve Garmhausen
Steve Garmhausen is a contributor to Buy Side from WSJ.
