Could you use an extra $500 in monthly retirement income? Of course you could. Even if you already feel good about the progress of your long-term savings, diversifying your retirement plan with dividend-paying funds adds another layer of security for your senior years. Plus, it's not terribly hard to do. Just follow these four easy steps and you're on your way to a nice stream of dividend income in retirement.
1. Choose a dividend fund
Step one is choosing a dividend fund. A fund is easier to manage than a handpicked portfolio of stocks. You do lose a little bit of your investment to fund fees, but that expense pays for a diversified portfolio that's likely less risky than one you built yourself.
Also, dividend funds are easy to come by. Reputable fund families like iShares, Vanguard, and Schwab have low-fee options with distribution yields of 3% to 4%. Examples include iShares Select Dividend (NASDAQ:DVY) with a yield of 3.8%, Vanguard High Dividend Yield (NYSEMKT:VYM) with a yield of 3.17%, and Schwab U.S. Dividend Equity (NYSEMKT:SCHD), with a yield of 3%.
Distribution yield is the annual dividend payout divided by the fund's share price. This is a vital metric, because you can use it to estimate what size investment you'd need to produce your targeted dividend income.
2. Set your savings target
Next, you'll use your fund's dividend yield to set your savings target. Let's use iShares Core High Dividend ETF (NYSEMKT:HDV) as our example. This fund has a strong distribution yield of 3.95% as of Nov. 30, 2020. Your goal is to earn $500 monthly in dividends, which translates to $6,000 annually. To estimate how much of that fund is needed to generate your goal income, divide $6,000 by the yield.
You could use the fund's exact yield of 3.95%, but it's wise to use a lower figure. Here's why. A fund's dividend yield is calculated as of a point in time, and it fluctuates as the share price moves up and down. Defining your savings target with a lower yield, say 3.5%, builds in a cushion in case things change. There's no downside other than you'll save a bit more. The upside is you might overshoot your goal, which would deliver even more income in retirement.
Sticking with the 3.5% yield estimate, you'd need about $170,000 worth of HDV shares to throw off $6,000 in annual dividends.
3. Automate and reinvest
You probably don't have $170,000 in unused cash sitting around. But you can accumulate that amount with disciplined savings over time. If you have 20 years between now and retirement, for example, you can get to $170,000 by saving about $330 monthly, assuming the fund grows at 7% annually on average. This fund's five-year average annual return is 6.93%, and it has returned 9.44% annually since its inception. Use the SEC's savings goal calculator to estimate the monthly savings needed based on your timeline to retirement.
Once you know the monthly savings required, automate your contributions to a tax-advantaged retirement plan, such as an IRA or 401(k). In those accounts, your earnings, including dividends, are tax-deferred. You don't want to pay annual taxes on those dividends because it'll slow down your growth. And, since there are no tax implications, you can afford to reinvest all of that dividend income. That'll provide some nice momentum as you grow your share count.
4. Wait, watch, and adjust
From there, all you have to do is wait, watch, and adjust. Check in on the growth of your dividend fund position periodically and recheck the numbers to ensure all is going according to plan. Know that your growth won't follow a straight-line trajectory -- you'll have great years and not-so-great years. Don't be scared off by shorter-term market downturns. Falling share prices work in your favor to some extent, because you can pick up more shares for your budgeted monthly investment. Unless you see a fundamental change in your fund, stick with the plan and keep on investing.
You can also adjust your plan as your situation changes over time. Say you decide that $1,000 in monthly dividend income sounds like a better target. Run through these same steps to figure out how much more you'd need to save. Now that you know the process, you can use it to create the retirement lifestyle you really want.