There are two basic ways to make money from stocks and bonds. The first is to wait until the investment goes up in value, and then sell it -- that's called capital gains. The second happens when the stock or bond issuer pays you to reward you for having bought the investment in the first place. For stocks, this is called a dividend; for bonds, it's interest.
Investments that produce income
The big benefit of option No. 2 is that, when you receive dividends or interest, you get an immediate payout and still own the investment. That means that you have a shot at getting more dividends and interest in the future, and can sell the investment later to (hopefully) pick up some capital gains, as well. Selling an investment for capital gains is a one-time payoff; getting dividends and interest is an ongoing income stream, which makes it a perfect option for retirees.
But not every investment will produce a good income stream. Choosing investments that will produce lots of income for you is an important part of retirement planning.
Bonds are basically IOUs -- you're lending a company or agency your money, and in return, the bond issuer pays you interest on your loan. The riskier the loan, the higher the interest the bond issuer will pay you to compensate you for your risk. Thus, a bond issued by the federal government will have a relatively low interest rate because there's almost no chance that the federal government will fail to pay back its debt to you.
A bond issued by a state or local government will have a slightly higher interest rate because there's a bit more risk associated with it, and bonds issued by companies will have yet higher interest rates. Corporate bonds are rated based on the risk, with extremely safe ones rated AAA and the very riskiest ones rated C (by Moody's rating system), or D (by Standard & Poor's rating system). Anything rated less than BAA (Moody's) or BBB (Standard & Poor's) is considered a junk bond and is highly risky.
Many stocks are broadly classified as either growth stocks or value stocks. Growth stocks belong to companies that are focused on growth, so these companies generally prefer to put their money into expanding operations rather than paying dividends.
Value stocks are much more likely to pay regular dividends. They're companies that are stable, but generally undervalued according to their fundamentals and when compared to their peers. Stock research tools and resources will typically include a stock's dividend yield history, which will give you some idea of how likely that company is to pay high dividends in the future. Of course, a company doesn't necessarily need to be undervalued to pay a dividend; there are plenty of over- and fairly valued stocks that also send you a regular check. Make sure you do your research before buying.
Choosing your income investments
It would be nice if choosing the right income investment was as simple as looking for the stocks and bonds that produce the highest yields. Unfortunately, there's a bit more to finding the perfect investment than that.
For bonds, higher yields are associated with higher risks. There's a reason why the companies at the bottom of the ratings scale are there -- frequently, it means that the company is on the verge of bankruptcy, and if that happens, you could lose your entire investment.
Choosing a dividend stock also requires you to look at more than just the yield. Of course, if you don't want to go through the fuss and bother of researching individual bonds and stocks, you can take the simpler option of picking up a high-dividend stock mutual fund and a bond fund, or even an all-in-one income fund.
Mutual funds and ETFs that specialize in maximizing dividend and interest income rather than capital gains are usually called income funds, and you can find them at any major broker. Many income funds are designed specifically for retirees. When comparing funds, don't forget to check out their fees and fee structures, since a fund with high fees may end up giving you less income than you expect -- a large percentage of the income you make from the fund will go toward paying fees rather than coming to you.
The IRS requires you to pay income tax on your dividends, so the best place for dividend-producing stocks is a retirement account such as a 401(k) or IRA. Any dividends from stocks within these accounts won't be taxed until you actually take a distribution from the account. In fact, if the stocks are inside a Roth IRA, the dividends will never be taxed.
As for bonds, some interest payments are taxable and others aren't. In brief:
- Interest from corporate bonds is always taxed.
- Interest from federal government bonds is taxed by the federal government but not by your state.
- Interest from municipal bonds from another state is taxed by your state but not by the federal government.
- Interest from municipal bonds from your own state is tax-free both at the state and federal level.
Thus, bonds that are partly or fully taxed are best off inside retirement savings accounts, while municipal bonds from your own state can stay in a regular brokerage account as tax-free income.
Diversify your income
Having lots of different sources of income is safest. At the very least, it's wise to have both bonds and high-dividend stocks of various types to protect you from any market upsets. Having a nice bundle of highly rated bonds and solid dividend-producing stocks all wrapped up in a tax-advantaged retirement account will keep your income stream going indefinitely.