I have a friend whose dad, let’s call him Xenophilius (yes I’m friends with Luna Lovegood *eye roll*), is retiring next year. And in talking to my friend, the topic of retirement strategies came up. And the idea of matching dividend payments to cover monthly expenses popped into my head. Xenophilius immigrated here from another country. Most immigrants in my culture are unaware of how retirement works in the US. In Asia, there isn’t a 401(k) or Roth IRA in which they can invest. So as such, Xenophilius does not have a fully funded retirement account for him next year. Although he does have some money saved, but it wouldn’t be sufficient for 20+ years.
Given that his retirement is next year, this means that IRA’s are not the solution. IRAs require that the account be held for at least 5 years before withdrawing. Otherwise the IRS will crack down with a penalty charged.
There are only a few solutions in this case. Open up a brokerage account and start investing in low-risk liquid securities with income streams. Or find a high-yield savings account and start saving up there. Lastly, he could find a post-retirement job to supplement the current savings.
I toyed around the idea of having him invest in dividend paying stocks to provide a stream of income that will match his monthly expenses. Let’s pretend that his expenses are low and he manages to retire in a low cost-of-living city. His monthly expenses are $1,000. So he needs $1,000 in liquid cash every month to survive.
How can we use stocks dividend payments to match his $1,000 monthly expenses?
I have mentioned before the monthly dividend paying Realty Income (O) stock. Over the last 5 years, O has paid between $0.182 and $0.221 every month just for holding 1 share of stock. To play it safe, let’s assume that O pays $0.18 per month in dividends.
- Company: Realty Income Corporation
- Ticker: O
- Date: 12/3/2018
- Last Price: $64.45
- Dividend Yield: 4.11% per year
- Dividend per share: $0.221
In order for Xenophilius to have his expenses covered every month, he would have to purchase 5,555 shares of O. Today, December 3, 2018, O closed at a price of $64.45. That means Xenophilius would have to purchase $358,019.80 worth of O shares in order for this to work.
The Flaws of Dividend Payments
I decided this was not practical. Nope, not at all. Not to mention there would be tax implications. Realty Income is a REIT so the dividend payments are treated as ordinary income rather than qualified dividends. If they were qualified dividends then he’d basically pay no taxes (until he starts making more than $38,600 per year in dividend income). Because this will be taxed as ordinary income, Xenophilius would have to buy even more shares of O (6200 shares in total, or nearly $400,000 worth of shares) in order to offset the losses in taxes. Since he would be earning $12,000 a year, he would be put in the 12% tax bracket. Ordinary income up to $9,700 is taxed at 10% and the other $2,300 is taxed at 12%.
This means, in calculation, he would owe $1,246 in taxes the following year from his $1000 per month dividend income. Because taxes take a chunk out of that dividend, that means he has to earn MORE in dividend income to offset it. If he wants to have $1,000 per month after taxes, then he would be to be earning close to $1,115.86 per month in dividend income. This is assuming that we’ve calculated his effective tax rate (average tax rate) correctly which was approximately 10.38%.
Taxes aren’t the only problem either. Putting $400,000 into one asset, even if he had that amount of capital, is inherently risky for a retiree.
Ultimately the most practical solution at this point is to start building a nest egg in a high-yield savings account. Perhaps in the future we can revisit a strategy to match monthly expenses with a CD ladder or a money market account paying out interest payments.