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.
If you really want to know how to calculate investment income, however, there are a few factors that will affect how much investment income you 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 get.
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, yield is of primary importance since 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 the yield.
Dividend/Cost = Investment Yield
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 reasonable.
But investing $10,000 to get income of $25 a month is not too enticing, especially when there is risk the value of the asset will drop!
That’s me. You may feel differently.
Factors Affecting Investment Income
Do you really get to keep the full $25 a month? 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 points to make around investment income calculations from stock dividends specifically which I’ll address next before moving into bond income.
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Investment Income from Stocks
The factors below are worth considering since they will affect your investment income.
Annual Dividends Vs Quarterly Dividends
Most stocks pay quarterly dividends and not annual dividends. This is important to note for two reasons.
- 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, 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.
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, they will need to be paid at some point.
Only by considering taxes can you get a true comparison among various types of income generating assets.
How to Calculate Investment Income from Bonds
Income from individual stocks 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.
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 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.
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
The investment income calculation for funds is the same as it is for stocks and bonds but there is yet another hidden factor.
An important factor to consider when it comes to fund income is fees. Like taxes, you 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”. I personally ran into this recently when comparing money market yields.
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.
Investment Income Shortcut
The fastest way to see investment income 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 makes 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. Remember, however, that investment income will change from year to year for almost all portfolios.
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. While these are the most common income investments, there are alternative investments with much more complex income calculations, such as real estate rental properties and covered call strategies.
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