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Income Investing - Definition, Strategy, Pros & Cons
Income investing involves using income producing assets such as dividend stocks, bonds, money market accounts, CDs (Certificates of deposit), and GICs (guaranteed investment certificates), etc., to help generate an additional source of income. Instead of investing for growth, the main goal of income investing is to help supplement your income.
This article will help you understand what income investing is, how it works, and the pros and cons of adopting an income investing strategy.
What is Income Investing and Why it Matters
Income investing involves using investments to help generate a steady source of passive income. Several different kinds of investments can be used to help generate income, such as bonds, dividend-paying stocks, and GICs, etc. The best kind of investments to use will depend on your budget, financial goals and risk tolerance.
Income investing can be used to help generate supplemental income throughout your life and in retirement.
How Income Investing Works
Income investing involves adding investments to your portfolio that provide a steady stream of income. Instead of trying to generate profits by buying and selling stocks, income investing focuses on buying investments that can generate an ongoing cash flow. This is achieved by investing in assets such as dividend-paying stocks, bonds, real estate investment trusts, money market funds and exchange-traded funds (ETFs), etc.. The best type of assets to invest in largely depends on your income, financial goals and time horizon, and risk tolerance.
Types of Income Investments
Income can be generated by investing in several different types of assets.
Dividend-paying stocks
Dividend stocks provide regular payments to stockholders, typically on a quarterly basis. When considering whether to invest in dividend stocks, consider the value of dividends paid per share and the stock’s dividend yield. The dividend yield is calculated by dividing annual dividend payments per share by the current price of the stock.
Like any stock, the price of dividend stocks can fluctuate based on changes within the company or industry in which the company operates, and broader changes in the market. In addition, companies can always elect to change the value of dividends paid to shareholders at any time.
Mutual funds
Mutual funds hold a range of stocks, bonds or other securities within a single fund. They’re typically built and actively managed by professional money managers. Investing in mutual funds makes it easy to invest in a diversified range of assets. Mutual funds can be used to help generate income when they include dividend stocks and fixed income securities like bonds. These funds are specifically called income funds, which is a type of investment vehicle where the money collected from various investors is pooled together to invest in different income producing assets. If the value of mutual fund shares increases, there may be a potential to sell your shares for a profit. However, it’s important to note that the market can go up or down and funds could also lose value if market conditions sour.
Exchange-Traded Funds (ETFs)
ETFs, like mutual funds, hold a collection of stocks, bonds or other assets. When you invest in an ETF, you’re buying a share of those investments. ETFs are highly flexible and can be bought and sold on the stock exchange throughout the day. Like mutual funds, ETFs (specifically income funds) can generate dividends for investors, which are typically paid on a monthly basis, when they include dividend stocks and fixed income securities like bonds.
Real estate and REITs
Owning a residential property, office space, or other industrial space can generate rental income for investors. However, rental properties also come with expenses such as maintenance costs and property taxes. Real estate can also be difficult to sell, making real estate investments relatively illiquid when compared to other kinds of investments such as stocks, bonds or other securities.
You can also invest in a Real Estate Investment Trust (REIT). A REIT is a publicly traded company that owns, operates or finances income-producing properties. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves. REITs typically pay dividends to investors and can be traded on the stock market like stocks, bonds, and other securities.
Money market funds
Money market funds are a type of mutual fund. They invest in money market instruments that are highly liquid and low-risk securities. In Canada, money market funds are required to invest at least 95% of their assets in Canadian-dollar debt securities with a maturity date of less than one year. Money market funds, also known as cash equivalent funds, provide investors with fixed interest payments with little capital risk. Money market funds are considered to offer a reliable stream of income with less risk than investing in stocks or bonds.
Bonds
Bonds are fixed income securities issued by corporations or governments. Bonds pay a predetermined rate of interest to investors on a semi-annual or other predetermined frequency. When the bond matures, your initial investment will be paid back to you in full. While bonds are relatively low risk, no investment is 100% risk free. There’s a risk that the bond issuer will default on their payments. Though that risk is relatively low in the case of government issued and investment-grade corporate bonds, it’s still a risk. Also, as the risk is low, the returns are also low.
GICs
A GIC is a safe and secure form of investment to help grow your investment with confidence. You invest a specific amount of money, for a specific period of time. You’ll earn interest on your investment, which depends on the type of GIC you choose, and the associated interest rate being offered. Interest is earned on a monthly, bi-annual, or annual basis – or whenever the GIC matures. Once the GIC matures, you’re guaranteed to get 100% of your principal back.
Advantages of Income Investing
Supplements fixed income
Income investing can be a great way to help supplement your income. It’s an investment strategy that focus on creating a passive source of income that can be used to cover everyday expenses.
Potential capital stock growth
If the stocks you hold increase in value over time, you may be able to sell them at a profit and add those profits to your savings.
Risks and challenges associated with income investing
Market volatility
One of the biggest risks of income investment is market volatility. Economic downturns and market crashes can cause the value of your investments to drop and lead to substantial losses. That can be a serious problem if you depend on your investments to generate an income.
Interest rate risk
Changes in interest rates can have a significant effect on the value of fixed-income investments like bonds. Bond prices typically fall when interest rates rise, which can result in capital losses for investors. On the other hand, bond prices tend to rise when interest rates fall, generating capital gains.
Inflation risk
Inflation reduces the purchasing power of your money over time. If inflation rates rise it can cut into, or even overtake, the interest you earn on your investments. If you rely on investment income to pay your bills, you may end up finding it hard to make ends meet.
Dividend cuts
Dividend cuts can decrease the income you earn from your investments. Always research a company’s financial health, dividend history, and payout ratios before deciding to invest in dividend stocks.
Income fluctuation
Interest payments and dividends can increase or decrease over time. That can make it hard to rely on your investments to generate an income. You can insulate yourself from these fluctuations by investing in a range of securities like stocks, bonds, real estate and commodities. That way, losses in one area may be offset by gains in another.
Tax Implications of Income Investing
Interest income and bonds
Interest income is the least tax-efficient form of investment income. That’s because you’ll need to pay tax on any interest you earn. How much tax you pay will depend on your marginal tax rate. Interest earned on bonds will be taxed the same as any other income. That means any interest payments you receive will be taxed at your marginal tax rate the same as any other income you earn.
Dividends
Dividends provided by eligible Canadian corporations will be subject to the federal dividend tax credit, allowing you to keep a higher percentage of the investment income you earn. Dividend income can be more tax-efficient than interest income.
Capital gains
Profits generated from selling an investment will be subject to capital gains tax. However, you only pay tax on 50% of any capital gains you earn. The amount of capital gains you earn will depend on your book value. The book value of mutual funds is determined by adding the total amount of contributions made to a mutual fund, plus any reinvested fund distributions, minus any withdrawals.
Conclusion
Income investing can provide investors with a passive source of supplemental income. And if the income investments you own appreciate in value, you can sell them for a profit, generating additional earnings. However, all investments come with certain risks. But if you are aware of these risks, and take steps to manage them, you can use income investing to your advantage.
Start using investments to potentially generate additional income today by opening an investment account with TD Direct Investing.
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