How to Live on Dividend Income

Coryanne Hicks

If in real estate it's all about "location, location, location." When investing for retirement, it's all about "income, income, income."

"Income is the No. 1 key as you get older," says Dwain Phelps, founder and CEO of Phelps Financial Group in Kennesaw, Georgia.

Phelps says dividend income is something investors should be planning for starting in their 40s.

"Dividend income can be an excellent source of income, but it's important that investors understand the differences between interest income and dividend income," says Andrew Crowell, vice chairman of wealth management at D.A. Davidson & Co. in Los Angeles.

Here is what you need to know for setting up a lifestyle that relies on dividend income:

-- What Are Dividends?

-- How to Live Off of Dividend Income

-- How to Build a Dividend-Paying Portfolio

-- Be Prepared for Volatility

What Are Dividends?

"The term dividend refers to cash payments, typically paid quarterly, received for owning shares of stock in a company," he says.

Dividends are distinct from other investment income, like interest on bonds, in a couple of ways. First, dividends are taxed at the more favorable capital gains tax rates. This can be an important benefit for retirees who likely don't have a lot of write-offs, Phelps says.

At the same time, dividend investing is riskier than fixed-income investing.

"Stocks are generally more risky and volatile than bonds, whereas U.S. government bonds , by contrast , have never defaulted and are therefore seen as more safe," Crowell says.

Unlike interest payments, dividends are not guaranteed. But this very lack of guarantee is part of what makes them so powerful.

"Some companies have a strong track record of not only paying regular dividends but also increasing them annually," Crowell says.

Your dividend portfolio may be yielding 3% today but could be yielding 5% when you retire. This hope for dividend increases is one reason why Phelps likes to include dividend-paying companies in his clients' retirement portfolios.

[See: 8 Simple Rules for Investing in Retirement.]

How to Live Off of Dividend Income

"Living off of dividend income can be tricky for investors," says Richard Steinberg, chief market strategist at The Colony Group. "They must first focus on their spending or burn rate and resist the urge to buy only extremely high-yielding stocks to try and match an unsustainable spending lifestyle."

In today's low-interest-rate environment, he says that "aiming to build a diversified dividend strategy with a blended yield of 4% makes the most sense." Then, "if the underlying stocks appreciate another 3% to 4% per annum on average, the total return would be close to 7%."

Dividends will likely be only one bucket of income you have in retirement. If you have a pension or rental income and when you plan to take Social Security will all factor into how much dividend income you need.

Start with a financial plan that "identifies the assets, liabilities (and) income streams" you have, Crowell says. Your plan "will serve to inform both how much income is required and also how much is available to invest."

How to Build a Dividend-Paying Portfolio

To build a dividend - paying portfolio, look for companies that have a history of regular and increasing dividend payments across various sectors and payout levels.

"Dividend increases are directly related to the fundamental performance and cash flows of the underlying businesses," Crowell says. "Consistent increases demonstrate management's capital allocation discipline and a commitment to returning cash to shareholders."

You might start your search by focusing on companies that have consistently paid and increased their dividends for 10 years or longer.

"The longer the history of increases, the better, as it shows a company's propensity to return cash to shareholders," says Bill McMahon, chief investment officer at ThomasPartners.

But as all investors know, past performance is not indicative of future results. To "filter out companies that don't have the capacity to maintain and grow their current dividend rate," McMahon suggests "eliminating companies with payout ratios exceeding their historical averages, businesses that don't generate enough free cash flow to cover their total dividend outlay, and over-levered balance sheets."

Being lured into a bad investment by high yield is a common pitfall for dividend investors.

"A high-dividend yield might actually signal a company in distress," Crowell says. It can be "the proverbial canary in the coal mine, so dividend investors must do their homework."

"By contrast , some stocks come under temporary share price pressure which makes them accidental high yielders," he adds. "Assuming an investor has done the necessary diligence and has a longer-term time horizon, taking advantage of shares while they are temporarily low and offer a higher yield could prove rewarding over time as the investor gets paid to wait for the shares to recover."

[See: 54 Dividend Stocks Boasting 25-Year Dividend Growth.]

How to Diversify Your Dividend Portfolio

Given the risk involved in dividend investing, diversification is essential. Keeping the dollar amount invested in each position relatively spread out "will allow the portfolio to withstand a dividend cut in any one company without severely harming the portfolio's overall yield and income generation potential," McMahon says.

To create a well-balanced dividend portfolio, include companies "with different payout policies, sector exposures and growth rates," he says.

For instance, you might pair a slow - growing company with a high dividend yield like AT&T (ticker: T), which has a 5.34% dividend yield, with a lower yielding company like Starbucks ( SBUX) that yields only 1.85% but will likely grow its dividend at a faster rate, he says.

When used together in a portfolio, "the combination of the high yielder/slow grower and the fast grower/low yielder provide a solid blend of current yield (3.6% in this simple, two stock portfolio example) with a better-than-inflation combined expected dividend growth rate," McMahon says.

You should also pay attention to the cycl ical nature of the industries in which you invest.

"A company may be covering its current dividend easily when a commodity price is high, for example, but earnings and cash flow may prove illusory when that commodity price falls," he says.

[See: 8 Investing Do's and Don'ts During Market Volatility.]

Be Prepared for Volatility

While diversification should dampen your dividend portfolio's volatility, it's still to be expected.

"Investors using dividend-paying stocks for income must have a strong constitution," Steinberg says. Stocks are generally more volatile than bonds and fixed income.

"Be prepared to hold through the ups and downs of the stock market," he says.

The good news is that when volatility does arise, your regular dividend payments may cushion any price declines on your shares.

Coryanne Hicks is an investing reporter for U.S. News & World Report. She is an expert at investing strategies and theories, investor education, investing psychology and behavioral finance. Previously, she was a fully-licensed financial professional at Fidelity Investments where she helped clients make more informed financial decisions. She has ghostwritten financial guidebooks for industry professionals and even a personal memoir. She is passionate about improving financial literacy and believes a little education can go a long way. You can contact her at