True financial independence is being able to live off investment income without spending down your investment capital.
Here’s how to calculate investment income: Multiply the investment cost by the yield to get the amount of annual income. For example, if an investment which cost $100,000 yields 3%, investment income will be $3,000 a year.
Investment income can be calculated for each investment or as an average for a portfolio. If a $1,000,000 investment portfolio yields 4% overall, for example, the amount of investment income would be $40,000 a year.
When calculating investment income, however, there are a few factors that will affect how much of your investment income you’ll get to keep at the end of the day. There are also timing factors that will affect your ability to easily live off investment income once you do figure how how much investment income you make.
After sharing some tips for evaluating investment income, I’ll share these other important factors you’ll want to consider in calculating and comparing investment income, and a shortcut for seeing how much investment income you’re getting now, so keep reading.
How to Calculate Investment Yield
Investment income is most often expressed as yield. This means that if your goal is investment income, as opposed to investment growth, knowing the investment yield is of primary importance; it allows you to compare income investments easier. Let’s work backwards from the simple formula above.
Investment yield is calculated by dividing the dollar amount of income you get from an investment by the amount you paid for that investment.
While most investors still logically think of bonds as the main type of income investments, many investors have turned to stock dividends over recent years since bond interest is so low. For this reason, we’ll start with a dividend example to calculate investment yield.
Dividend/Cost = Investment Yield
For example, if you invested $10,000 in the stock of Income Inc, and Income Inc paid a 3% dividend yield, your investment income would be $300 a year.
Evaluating Investment Income
Here’s a tip about investment income: Look at investment income from a dollar perspective, not only as a percentage.
Looking at the dollar amount I’ll get from an investment puts that investment into better perspective. To think of a 3% yield during times of very low interest rates sounds like a fairly good yield. Investing $10,000 to get income of $25 a month, however, is not too enticing, especially when there is risk that the value of the asset will drop!
It takes a lot of $300 yields to support a lifestyle.
Factors Affecting Investment Income
Do you really get to keep the full $25 a month that comes in the form of investment income?
Unfortunately, you may not, so keep reading to get a full perspective on how investment income from stocks and bonds works when you’re trying to live off investments.
There are a few factors in the table below that affect investment income calculations from stock dividends, specifically. Let’s address each of them before moving into bond income.
|Inflation||Value of Investment Income|
Investment Income from Stocks
The factors below are worth considering since they will affect your investment income.
Timing – Annual Dividends Vs Quarterly Dividends
Most stocks pay quarterly dividends and not annual dividends, making cash flow tricky for some months.
- Make sure you are dividing the annual yield by 12 to get a monthly perspective on investment income, even though it is received quarterly. This is because most of us think of monthly spending when looking to cover expenses from investment income.
- Most companies tend to pay dividends the same months as other companies pay dividends, so it’s important to consider this in planning cash flow around investment income if you’re relying on stock dividends. You may have some months without any dividends whatsoever.
- Note that many income focused stock funds pay monthly dividends to make cash flow smoother for their investors.
Taxes on Dividend Income
Dividends are subject to federal income taxes. Qualified dividend income does, however, get a lower tax rate as of this writing. Even though the taxes probably won’t be deducted before receiving the dividends, taxes will likely need to be paid at some point.
Only by considering taxes can you get a true comparison among various types of income generating assets.
Investment Income from Bonds
Let’s move to investment income from bonds. Fees and inflation are addressed later in this post since these two factors relate to investment income from bonds as well as stocks.
How to Calculate Investment Income from Bonds
Income from individual bonds is calculated in the same way that investment income is calculated for stocks. The math is the same, but the income you get is in the form of interest and not dividends.
When Do Bonds Pay Interest?
Investment income from bonds interest can be even trickier to plan cash flow around than stock dividends. This is because most bonds pay interest twice a year. Some bond funds may, however, pay monthly income. Other bonds, such as EE Series bonds, pay interest when the bonds are redeemed.
Taxes and Bond Interest
Much like stocks, taxes are a consideration for bonds, too. As of this writing, bond income, when applicable, is taxed as ordinary income. This can result in higher investment income tax rates than that of stock dividends.
Whether or not a bond is subject to federal income tax depends on the type of bond it is. For example, many investors buy municipal bonds to avoid taxes on bond income.
Note that the tax rules can also vary for federal income tax vs state income tax, so remember to investigate this or ask your CPA.
It is necessary to reduce expected interest income by the amount of estimated taxes you’ll need to pay in order to truly evaluate and compare income investments. This is true even though you won’t see the taxes paid as you receive the interest income.
Fund Fees Affect Investment Income
Many investors buy funds instead of individual securities. The investment income calculation for funds is the same as it is for stocks and bonds but there is yet another hidden factor.
It’s important, however, to know the fees when it comes to investment income from funds. Like taxes, you likely won’t see the fees when you receive your investment income whether it is from stock dividends or bond interest.
Fees can range from less than .10% to an expensive 3% or more per year so you’ll want to consider this in getting a true investment income calculation even though they won’t be paid at the time income is received.
Sometimes there are even layers of fees, such as fund fees and wealth management fees.
It is important to note that often, however, the yield is expressed “net of fees”. This means that fees are already taken out of the yield.
Inflation Eats Investment Income
While inflation can be even harder to estimate than taxes and fees when evaluating investment income, it’s important to consider. For this reason, not including inflation as a factor affecting investment income in this post seems irresponsible to me.
This is because inflation depletes the purchasing power of investment income unless it is from an inflation protected source, such as TIPPS bonds or real estate rental properties.
Inflation isn’t a “what if” scenario. Inflation has existed almost every single year for the past few decades. Inflation even rose to over 13% in the early 1980’s! Even if inflation stays low, over time it compounds making it a real threat for fixed income investors.
A Shortcut to Calculating Investment Income
The fastest way to see investment income you’ve already earned is by checking your brokerage account or statement.
The total income year to date will be shown on most statements. You’ll also note various posts to your account from dividends and interest as they are paid during the month. Online tools at your broker make this easy to see.
If you have income investments which pay quarterly income, such a stock dividends, you may want to average three months of investment income to get a better estimate.
If you haven’t had a lot of change in your portfolio, or there haven’t been major economic changes, you can usually check the prior year’s investment income off your broker’s year end statement for a decent estimate for the following year. Remember, however, that investment income changes from year to year, if not month to month, for almost all portfolios.
The income from money market accounts can change daily; companies regularly change the dividends they pay out to shareholders.
Simply gather the amounts of investment income you’re received from all sources, and organize them onto a spreadsheet.
Resources for Calculating Investment Income
Here are a few resources if you want to better understand or calculate investment income.
Investment Income Calculator from Vanguard
This page from the IRS helps understand more about taxes on investment income.
Investment income defined by Bank Rate.
Investment Income from Alternative Investments
It’s simple enough to calculate investment income from traditional investments like stocks and bonds. It’s more complex to calculate investment income from alternative investments such as real estate, covered call strategies or small business investments.
Even in calculating net income from alternative investments, the bottom line is that income is the amount that is paid to you, less all related expenses.
Watch my video about investment income from both alternative investments as well as traditional investments.
Summary for Investment Income Calculation
Now you know how to calculate investment income for stocks and bonds, and several factors that will affect that income. After you’ve calculated all your investment income, the next step is to begin increasing it, unless, of course, you’re happy with the amount of investment income you’re receiving.