Pros and Cons of Income Investing

You may be thinking of transitioning from growth to income investing before retirement.

The pros and cons of income investing are outlined in this post based on what I’ve learned from almost 40 years of investing in stocks and bonds with a focus on more alternative income investing for the past 15 years.

While I’m an Accredited Financial Counselor® I mostly write out of the box investing insights based on my own experience from the school of hard knocks.

Cons of Income Investing

It’s hard to be negative about any asset that pays you while you own it but there are a few cons with income investing.

Monthly Income Varies

One of the cons of income investing is that the income varies from month to month with many of investments that pay out income. This can be a challenge when you are living off investments.

Variable monthly income is true for of the following income producing investments:

Stock Dividends

Most dividends make quarterly payments. This means you will go 2 months without getting a dividend check from any one company.

Investors can work around this by owning stocks that pay dividends on differently quarterly schedules, but this seems like putting the horse before the cart.

Also, dividend payouts often change from quarter to quarter, making it hard to plan around this highly passive but capital intensive income investment.

Covered Calls

Covered call income is even less predictable that dividend income.

But many covered call strategies involve selling call options 6 weeks out, completely throwing any hope of monthly income planning.

This lack of predictability, however, is more than made up for in the fact that covered call income is three to eight times that of dividend income even with conservative estimates.

You can read more about covered calls in my post Are Covered Calls a Good Strategy?

REITs and MLPs for Income Investing

REITs and MLPs are much like dividend stocks in that they usually pay quarterly dividends which are also subject to change from quarter to quarter.

One advantage of REIT and MLP funds over individual securities is that many REIT and MLP funds pay out monthly income which is nice for retirees living off investments.

Small Business Income (Which I consider an investment)

Part of being an entrepreneur is getting okay with inconsistent monthly income. If you have a membership or recurring business model, income can be more consistent.

But for most businesses, income is uneven from month to month.

Low Yields from Income Investing

The low yield from income investments is a huge con of income investing. It has been a problem for years.

As of this writing, the dividend yield on stocks in the S&P 500 index, for example, has been hovering close to 2% for over a decade.

With inflation being around 2%, this gives a zero real dividend return from S&P 500 stocks. You can check out the current yield here but then keep reading to see the remaining pros and cons from income investing.

The yield on 30 Year Treasury Bonds is only slightly better than S&P 500 stocks at around 2.50%. This is ever changing but here is a great resource to see what the yield is at the time you are reading this.

Note: I have no affiliation with this resource. I just think this information is super valuable for my readers:).

Like some of the other cons of income investing, the low yield problem can be overcome by investing in other types of income producing assets as covered in my post How to Get More Income from Your Investments.  

Taxes from Income Investing

Taxes are another potential con of income investing. Since different types of income investments are treated differently for taxes, you’ll want to do some research here.

Other huge factors affecting taxes from income investing are the type of account earning the income, your marginal tax rate, and whether you’re withdrawing the income from the account.

Fortunately, as of this writing, qualified dividends come with a tax break for most investors.

Real estate rentals, small business, MLPs and REITs also often come with tax advantages over earned income. Taxes are always a consideration for any type of income so be sure to ask your CPA or do some research.

Income Stocks Lag Growth Stocks

While this post is about the pros and cons of income investing in general and not dividend investing specifically, most income investors own at least some dividend stocks.

For this reason, it’s important to address the reality that income stock investments tend to lag growth focused stock investments during times of strong economic expansion.

Growth Vs Income Is a Trade Off

Income investments typically provide investors with lower capital gains than growth investments. This is a trade off that every investor can choose to make or not.

As always, beginning with an overall wealth plan that defines investing goals and acceptable risk leads investors to the best investing objective.

Read my related post How to Create a Wealth Plan here. 

Pros of Income Investing

Again, there’s a lot to love about an asset that pays you to own it. Here are some of the biggest pros of income investing.

Investment Income During Bear Markets

With income investments, the income continues to flow in regardless of what the overall market is doing unless there has been some negative change in the company.

During bear markets, capital gains often disappear for most income generating assets with the exception of US Treasury bonds. This makes income investing ever more endearing when a stock bear market occurs, and investors detest growth stocks that have fallen from grace.

Income Investments Vs Retirement Withdrawals

Income investments allow investors to live off investments. This is the foundation of financial independence. Let me explain more.

Retirement Withdrawal Strategies

Traditional retirement planning is based on withdrawing 2 to 4% annually from your retirement account to pay for living. Stock retirement accounts grow in one of four ways.

  • Savings deposits
  • Dividends
  • Capital gains
  • Compounding from dividends and capital gains

Similarly bonds in retirement accounts get interest income which is typically also reinvested and compounded in the years before retirement. And bonds may also have capital gains.

These retirement withdrawals will, hopefully, be taken from the capital gain, dividend, interest or compounding layers in your retirement savings.

But this isn’t always the case. It depends on how much the retiree is withdrawing, how much is saved, the investment income and the capital gains in the retirement savings account.

Income Investing in Retirement

On the other hand, by income investing with a focus on higher yielding assets, investors can make more income. This lowers the need to withdraw money  from their retirement savings (from any of the four layers).

While most retirement portfolios shift toward income producing assets in retirement, like bonds or dividend stocks, the income is still very low for most standard funds and investments as we saw above.

For example, as of this writing, a typical stock dividend fund may yield 3.25%. With inflation at 2%, this leaves investors and retirees with a real income return of 1.25%.

Read my related post Is Dividend Investing Worth It? 

On the other hand, there are many income investing newsletters, services and wealth managers that generate income closer to 8% or even 9%.

While some of the investments have risk, this income investing risk is lowered by two factors:

  • Broad diversification in various asset classes, such as preferred stocks, baby bonds and REITs
  • The fact that the assets pay dividends

Let’s do some simple math to illustrate this point.

Income on $1,000,000 in High Yield Investments

For a retiree with an investment portfolio of $1,000,000 in income investments yielding 8%, the income would be $80,000 a year before fees and taxes.

This comes out to a generous $6,667 a month mostly passive income.

Income on $1,000,000 in Typical Dividend Stocks and Treasuries

On the other hand, an investment portfolio in more traditional dividend stocks and Treasury bonds would generate around $32,500 a year on a million dollar portfolio. This is again, before fees and taxes.

The investor would receive $2,308 a month in this case.

There is a difference of almost $4,000 a month income from investments. This could make or break a retirement plan.

And remember that with the higher yielding investments, the retiree could likely leave their retirement savings in tact without spending it.

See my related post How Much Do I Need to Invest to Make $10,000 a Month? for more examples.

Could the investments in the retirement savings grow from capital gains? They could as long as valuations and economic trends are considered before investing.

This is how the wealthy invest. This is how endowments are run with the goal of leaving the principal in tact and focusing on income generation.

Types of High Yield Investments

Income investments can be broadly diversified. While most people think only of bonds and dividend stocks for income investing, there are many slightly alternative investments such as REITs, MLPs, preferred stocks, baby bonds and convertibles.

Real estate rentals are another good option for income investing, as well as short term rentals, with just a little more effort.

Covered calls can be sold on dividend stocks (during bull markets) to significantly increase yield without increasing investment risk. Since the covered call income reduces the cost of the underlying stocks, risk is actually a little lower when covered calls are sold than when they aren’t.

Read more about this in my article Does Living Off Covered Calls Really Work?

And buying or starting a small online business are also excellent opportunities for investors looking to increase income.

By investing in income producing assets, investors can generate higher income and reduce if not replace the need to withdraw investment savings to live. Whenever savings can be left to grow, investment risk is reduced.

Income Producing Assets and Capital Gains

There is an assumption that income producing assets are stodgy and without growth opportunities, but this isn’t necessarily the case.

Investors can buy income generating assets at low valuations and ride them to high valuations all the while earning income from them.

This can be done with dividend stocks, real estate, MLPs, REITs and even bonds at times.

You may have read here about how, in the early 1980’s, my dad bought municipal bonds selling at huge discounts and yielding up to 25% tax free.

Those bonds, of course, increased in value as interest rates subsequently fell since new bonds had lower interest rates.

This was when I learned firsthand the importance of investing. And I also learned that income investments `can undergo major capital gains while you own them if you buy and sell around long term cycles.

Click here to read my related post Income Producing Assets That Shine.

Pros and Cons of Income Investing Summary

These are the major pros and cons of income investing. As you can see, in addition to paying investors to own them, income investments have many other benefits, too, from an overall wealth building perspective.

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