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 investment cost by the yield to get the amount of annual income. For example, if an investment that costs $100,000 yields 3%, investment income will be $3,000 a year.
After 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 after you calculate how much investment income you make.
In this post, I’ll share these other important factors you’ll want to consider in calculating and comparing investment income, a mistake many investors make in calculating investment income, and a shortcut for seeing how much investment income you’re getting now, so keep reading.
While I’m an AFC® (Accredited Financial Counselor) the information in this post was learned from creating investment income streams over the past eighteen years as well as my work as a financial coach helping others assess and establish income streams before retirement.
How to Calculate Investment Yield
Investment income is most often expressed as yield. This means that if your goal is investment income vs capital gains, knowing the investment yield is of primary importance; it allows you to compare income investments easier.
Let’s work backward 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 think of bonds as the main type of income investment in a portfolio, many investors have turned to dividend investing for income 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
Most investors consider the yield when evaluating income investments. Here’s a tip, though: Look at investment income from a dollar perspective, not only as a percentage, as yield is stated.
Looking at the dollar amount you’ll get from an investment puts that investment into better perspective when it comes to paying for lifestyle expenses as well as risk management.
To think of a 3% yield during times of very low interest rates sounds like a fairly good yield nowadays.
Using $10,000 of capital to get investment income of only $25 a month, however, is not too enticing, especially when there is a risk that the value of the asset might drop!
It takes a lot of $300 yields to support a lifestyle.
Most retired investors are seeking investment income vs capital gains. In other words, they’re beyond the growth or wealth building phase and looking for ways to live off investment income during or while preparing for retirement.
Next, then, let’s explore the factors that affect how much income you get to keep after the initial investment income calculation.
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. 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.
| Factor | Affects |
| Timing | Cash Flow |
| Taxes | Investment Income |
| Fees | Investment Income |
| Inflation | Value of Investment Income |
Investment Income from Stocks
Let’s look at each of these factors below since they may affect when or how much investment income you get to keep.
Timing – Annual Dividends Vs Quarterly Dividends
Most stocks pay quarterly dividends and not annual dividends, making cash flow tricky for many months for investors living off dividends.
- 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 trying to live off stock dividends. You may have some months without any dividends whatsoever.
- Note that many dividend income stock funds pay monthly dividends to make cash flow smoother for income investors.
Taxes on Dividend Income
Dividends are subject to federal income taxes. Qualified dividend income does, however, get a lower tax rate than earned income as of this writing.
Even though the taxes probably won’t be deducted before receiving the dividends, taxes will likely need to be paid on them by the correct time.
You get a true comparison among various types of income generating assets by considering after tax income. While the lower dividend tax rate on qualified dividends is helpful, many income investments have tax related benefits.
Therefore, owed taxes must be part of your final investment income calculation so you can compare and evaluate investments as well as apply the provided income against expenses.
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 from bonds is in the form of interest and not dividends.
When Do Bonds Pay Interest?
Investment income from bond 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
You’ll want to consider taxes when calculating investment income from bonds, too. As of this writing, most 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 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. You’ll want to factor this into your investment income calculation since we want to evaluate investments based on what we get to keep after fees and taxes. You can research 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.
Bond Risk
Bonds are known as a safe way to increase income before retirement while reducing portfolio risk.
It’s important to note, however, that bond risk increases when interest rates rise. This is because investors can get a higher yield from newer or other investments so bonds decrease in value.
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.
Like taxes, you likely won’t see the fees when you receive fund investment income whether it is from derived from stock dividends or bond interest.
Fees can range from less than about .05% to an expensive 3% or more per year so you’ll want to consider this in getting a true investment income calculation.
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 as “net of fees”. This means that fees are already taken out of the yield.
Inflation Eats Investment Income
Inflation is often forgotten as part of the investment income calculation since inflation is published outside of the investment itself.
Inflation isn’t a “what if” scenario. Inflation has existed almost every single year for the past few decades. I recall my father, ever the teacher, emphasizing the importance of considering inflation in calculating investment income after it rose to over 13% in the early 1980’s!
Even if inflation stays low, over time the effects of inflation compound making it a very serious threat for those trying to live off investments. Therefore, investors will want to account for inflation in retirement planning as well as investment income calculations.
Investment return after inflation is referred to as real return although many investors make the mistake of overlooking inflation.
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. The investment income from both of these inflation defensive assets can maintain their purchasing power during high inflation.
The reason inflation must be considered when calculating investment income is because it makes the income received worth less.
You can get the current rate of inflation here to calculate real investment return; you may be shocked by what you see.
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. You can also sort activity by dividends or interest at your brokerage firm, and then download the activity to a spreadsheet.
If you have income investments that pay quarterly income, such stock dividends, you may want to average three months of investment income to get a better estimate if you’re trying to plan for living off investments.
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 good estimate for the following year.
Remember, however, that investment income changes from year to year, if not month to month, for almost all portfolios. For example, the income from money market accounts can change daily; companies regularly change the dividends paid out to shareholders.
Common Mistake When Calculating Investment Income
A common mistake investors make when calculating investment income for an existing investment is using the current market value instead of their cost in the calculation.
Let’s say you bought an investment for $100,000 that was yielding 5%, or $5,000 investment income a year.
The investment price then rose to $200,000. If you calculated investment income using a market value of $200,000, your yield would be only 2.5% which is incorrect. Investment income is based on your cost for investments you own already.
Say the same investment decreases in price to $50,000 and continues to pay $5,000 a year income. You would get an incorrect yield of 10% for your investment if you calculated investment return using the market price vs cost.
The yield will be widely published for common investments you are evaluating for purchase. The yield will be based, of course, on market value for new investors.
Don’t make the common mistake some investors make when calculating investment income: your investment cost determines the income yield, not market value.
Portfolio Investment Income
It can be helpful to calculate portfolio income vs income from a single investment. If a million dollar retirement account yields 4% overall, for example, the amount of investment income would be $40,000 a year.
To see investment income from your portfolio as a whole, simply gather the amounts of investment income you’ve received from all sources, and organize them onto a spreadsheet.
While many investors consolidate their investments online now, having this information in a spreadsheet will provide an excellent analysis tool for various income generating assets while considering the related factors presented here, such as taxes and inflation.
Such a spreadsheet can be sorted, modified, and manipulated for further investment evaluation.
Resource for Calculating Investment Income
This Investment Income Calculator from Vanguard is a simple tool to calculate investment income on a given amount of capital.
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 covered call strategies, business or real estate investing.
Even in calculating net income from alternative investments, the bottom line is when actual net 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.
