I love December. It’s dividend season for my mutual funds. Like a kid eagerly awaiting Christmas morning, I excitedly anticipate the arrival of my dividend payments. I don’t even have to unwrap them. They just show up in my investment accounts!

Dividends are pretty awesome, but I don’t want to overstate my reliance on dividend income in my early retirement financial planning. I’m a firm “slice and dice” index fund investor with fixed asset allocations I use to periodically rebalance my portfolio. Right now I’m almost entirely invested in equities through mutual funds. All those equity mutual funds pay dividends. This adds up to a lot of dividend income without even trying to be a dividend investor.

What is “a lot” of dividend income? You may recall from my “four months in retirement” update that we earned $13,134 of dividends in December. Here’s a snapshot from Personal Capital showing all the December dividends:

I didn’t sign up for Personal Capital until October, so I don’t have all of 2013’s financial information in their system. I manually totaled the dividends I received in 2013 from my financial institutions’ websites. What a pain. 2014’s dividend tracking should be much easier since Personal Capital is now tracking all investment transaction data from all of my accounts.

For all of 2013, we received $22,300 of dividend income (including the $13,134 received in December 2013). The dividends are concentrated in December because some mutual funds in our investment portfolio only pay dividends once per year, and the payment falls just before the end of the calendar year.

The $22,300 dividend total for 2013 includes dividends paid into our taxable brokerage accounts as well as those paid into our HSA, IRA’s and 401k’s. The distinction between taxable and tax deferred accounts is important because we can easily use the dividends in the taxable account for living expenses.

In December 2013, we received $4,850 of dividend income in our taxable accounts. For all of 2013, we received $7,700 dividend income in our taxable accounts.

Our retirement budget is $32,000 per year, which means the $7,700 in dividend income is enough to fund around 25% of our expenses during early retirement. The other 75% of retirement expenses will be funded by selling appreciated funds in the taxable account (for the first 10-15 years).

2014 Dividend Forecast

We have a lot of dividend income, but where does it come from? Take a look at my forecast of 2014 dividends. I used the currently reported yields on these funds when available. In the case of the international investments, I calculated the yields based on 2013’s actual distributions divided by the current share prices of the respective funds or ETF’s. My assumption is that the funds in my portfolio will pay the same amount in 2014 as they did in 2013. I actually expect the dividends to go up a small amount as long as the economy remains moderately strong in 2014. However for simplicity’s sake, I kept the dividends the same in 2014.

This table is an extension of my asset allocation table in this post.

You’ll notice the projected 2014 dividends of $22,590 are slightly higher than what we actually received in 2013 ($22,300). There are a few reasons. We were contributing to our investments all year, so dividends weren’t being paid in the early months of 2013 on some of our investments. Our portfolio differs from the all-Vanguard portfolio I show above for various reasons, with the result being the dividend yields are a little different where we own other mutual funds outside of Vanguard.

We don’t have exactly $1 million worth of dividend paying investments. We have a bit more than that. We also have some investments that don’t pay dividends at all (the crappy proprietary funds in my 457 account, for example).

In the 2014 dividend forecast chart, the yield on the entire portfolio is 2.26%. The actual 2013 dividend yield on our account was closer to 2.1%.

I provided the forecast chart because those are the funds where I want to be long term with my investments. I plan to sell some non-Vanguard funds and move to lower cost options at Vanguard (and keep more of the yield for myself!).

I want to point out a few things on the forecast chart. REIT’s and international funds tend to have the highest dividend yields. The “value” oriented funds also tend to pay higher dividends than blended or growth funds. I haven’t picked any of the funds in my asset allocation for their dividend paying ability, but by leaning toward value and international investments, I have inadvertently created a portfolio with a slightly higher dividend yield (at 2.26%) than the 1.95% yield offered by the Vanguard 500 index fund (for example).

The higher yields from the international funds can be deceiving because international companies are more likely to pay variable dividends from year to year. That is, in good years when the companies are highly profitable, they will reward shareholders by paying out most of the profits. In years where profits are slim, dividends are likely to be low or nonexistent. In other words, during a recession when profits are lower, an international mutual fund is likely to decrease dividends more than a domestic mutual fund. In 2009 and 2010, for example, the Vanguard Developed Markets fund paid 20-25% fewer dividends than the years before or after the recession.

Benefits of Dividends

In addition to being a good source of cash flow, dividends have a lot of other benefits, too.

Tax free income – If you are in the 15% tax bracket or lower, all of your qualified dividend income is tax free. For US funds, virtually all of your dividends will be qualified. For international funds, typically around half to two thirds of your dividends will be qualified dividends (with ordinary income tax being due on the non-qualified dividend income). Dividends can be a pretty sweet way to fund your retirement expenses since you could potentially enjoy a fairly high income yet pay zero federal income tax.

Psychology of automatically receiving dividends – In early retirement, you might worry excessively about selling in a down market and how to fund next month’s expenses. When markets are in the dumps, dividends can provide pain free cash in your pockets! They keep arriving (for the most part) in good markets and bad. Unless your portfolio’s yield is higher than your withdrawal rate, you’ll still have to sell some of your holdings to fund your monthly expenses, but having a large part of your expenses automatically funded by dividends can make it less painful.

Long term growth of dividends – The dividends paid by the stocks and funds you own will increase as the underlying companies grow their profits over time. The growth in dividends will keep inflation at bay. Dividends can grow faster than the rate of inflation, thereby providing a real increase in your standard of living.

Emergency funds – If you hit a bump in the road and need an extra source of cash before you reach financial independence, you can consider your dividends as a source of emergency funds. At a 2% yield, a “modest” portfolio of $100,000 can produce $2,000 of dividend income per year. I was lucky to never need the extra cash while working, but when my job suddenly ended and I decided to retire, it felt great to know I had an instant source of about $8,000 per year with a few clicks.

Dividend focused portfolios

If you want to become a dividend investor, you could copy my asset allocation and get a 2.26% yield without trying very hard.

Or if you want to be a hot shot investor, you can try to hand pick the “best” dividend stocks out there and craft a portfolio that pays 3-4% or more. I’m not particularly good at picking stocks so I wouldn’t personally choose this route.

I like easy solutions that don’t take a lot of work. Vanguard has a few excellent offerings that are dirt cheap (which is a good thing when you are shopping for an investment).

The Vanguard High Dividend Yield Fund is available in mutual fund or ETF format (ticker: VHDYX or VYM respectively). The ETF version (VYM) has a nice low expense ratio of 0.10% (which is great!). This fund invests in stocks that consistently pay higher than average yields today. The fund yields about 3% currently.

You can sacrifice a bit of yield today in exchange for higher dividend growth in the future with two different Vanguard funds. The Vanguard Dividend Appreciation Index Fund (ticker: VDADX for mutual fund or VIG for ETF) is the better choice since it has a low 0.10% expense ratio and a current yield around 2%. The other option, the Vanguard Dividend Growth Fund (ticker: VDIGX) comes with a higher expense ratio (0.29%) and a similar 2% yield.

Another great way to put together a dividend focused portfolio is by purchasing a basket of solid dividend paying stocks through Motif Infesting (full review here). For $9.95, you can buy a slate of up to 30 stocks. You can choose your own 30 stocks based on your own dividend screens. For example, yield over 4% with a history of stable and growing dividends. Or you can pick from one of Motif Investing’s many pre-selected “motifs” (basket of stocks) centered around high dividend yield or dividend growth. Buying motifs is slightly more complicated than buying a dividend mutual fund, however you can skip the 0.10% to 0.29% expense ratios by owning the stocks directly. That means a 3% yield after expenses would become 3.1% to 3.29% without the expenses. Definitely worth checking out Motif Investing if you want to maximize your yield.

Parting Thoughts

Dividend yields can be a great way to generate cash to fund an early retirement. I personally don’t put too much emphasis on dividends in my own portfolio, since I’m expecting long term appreciation of my investments to keep me flush with cash as I continue to enjoy my early retirement. But a 2-3% dividend yield can fund the majority of your budgeted retirement expenses if you don’t exceed a 4% annual withdrawal rate from your portfolio.

I came of age and started buying my first investments during the roaring 1990’s tech bubble when everyone was making easy double digit returns and no one cared about a few percent yield. The focus was all growth growth growth, and sometimes profit profit profit was ignored. After the tech bubble burst and double digit losses replaced double digit gains, the dividend investors sat back and smiled since their dividend focused portfolios sailed through the crash relatively unscathed.

A decade later, the old high growth tech bellwethers like Apple, Microsoft, and Intel have become somewhat boring dividend payers (yes, Apple is boring).

Some companies are good at consistently earning money but still don’t pay any dividends at all. Warren Buffett’s Berkshire Hathaway is one of those companies. Mr. Buffett thinks it more efficient to reinvest all the corporate earnings from Berkshire’s holdings instead of giving part of the earnings to shareholders in the form of dividends. Berkshire Hathaway’s impressive track record of outperforming the S&P 500 by 4-5% annually for a few decades means Mr. Buffett knows what he’s doing.

I mention Berkshire Hathaway’s solid investment performance to highlight a company you would completely miss if you were strictly a dividend investor.

Dividend focused strategies can pay off, but so can investment strategies that are spread across many asset classes.

Do you follow a dividend-based investment strategy? What’s your dividend yield?

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