What Is Portfolio Income?

For most people, portfolio income is their pathway toward financial freedom. Money saved during the working years can be used to create an investment portfolio that can then generate income during retirement. In this article, we’re going to show you how to create an income-producing portfolio.

Income can be basically broken down into three types:

Earned income is money you receive from work and includes salaries, wages, commissions, bonuses and tips.
Passive income: Think “unearned” income that can come from a variety of sources, including royalties from creative works, property rent payments, affiliate marketing and income from a limited partnership in which the investor owns a share of a business but does not participate in its operation.
Portfolio income is income generated from investments such as stocks, bonds, mutual funds, exchange-traded funds (ETFs) or real estate. It consists of capital gains, dividends and interest from a traditional savings account, a money market account, a certificate of deposit (CD) or a bond.

Portfolio Income Vs. Passive Income

Passive income is money received regularly without having to perform active work. Sources can include royalties, a pension, rental income or a business venture in which the investor is not actively involved.

Portfolio income comes in the form of dividends from stocks, mutual funds, exchange-traded funds or real estate investment trusts (REITs). It also comes from interest such as that paid by bonds or in the form of capital gains.

With inflation running at 3.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.

How Is Portfolio Income Created?

1. You can start creating portfolio income by buying a dividend-paying stock, most of which pay dividends quarterly. If you don’t need the dividend income for everyday expenses, and if the company allows it, consider putting the dividends back into the cpmpany to get more shares. This is called a dividend reinvestment, or DRIP, plan. Like all stocks, there is risk with dividend-paying stocks that their share price can go down or that the company can decrease the dividend amount.

Besides looking at the dividend amount per share, also look at the dividend yield. This is the current annual dividend per share divided by the current share price.

2. Buy shares of a dividend exchange-traded fund or a dividend mutual fund. They are both pooled investments that hold securities such as stocks, bonds, REITs and alternative investments. Some ETFs and mutual funds are actively managed while others track an index such as the S&P 500 index.

Money market mutual funds hold short-term Treasurys, such as T-bills, certificates of deposit (CDs) and repurchase agreements (repos). The yields on money market mutual funds rise and fall along with interest rates. You can buy or sell shares in mutual funds, which are known as NAVs (net asset values), once a day at the close of the market. Shares of ETFs can be bought or sold throughout the trading day.

Bond funds focus on specific types of bonds or on bond indexes. Bond funds are susceptible to rising interest rates. When interest rates rise, the value of shares in a bond fund fall, and when interest rates fall, the value of shares in a bond fund rise. Companies, governments and agencies issue bonds to raise money. A bond has a face or par value, an interest rate and a maturity date. The interest rate reflects the level of risk, and most bond interest is paid semi-annually.

Treasurys, which are issued by the U.S. Treasury, have virtually no risk, while the risk level of corporate bonds is rated by bond rating agencies such as Moody’s, Standard & Poor’s and Fitch, and is based on the bond issuer’s ability to make the interest payments and to repay the principal. Once issued, bonds can be bought and sold on the secondary market, with the price of a bond rising if interest rates go down, and falling if interest rates go up.

3. Capital gains are another way to create income from an investment portfolio. Capital gains derive from the sale of an investment at a profit; for example, if you bought 100 shares of a stock at $30 a share and a year later you sold those shares for $50 a share, your capital gains would be $2,000.

4. Residential or commercial real estate held in an investment portfolio can provide rental income, however, an investor must consider the cost of maintenance as well as property taxes. Real estate is not very liquid since it cannot be sold quickly. A way to avoid these pitfalls is to invest in a real estate investment trust (REIT). A REIT holds a number of properties that have similar characteristics or it can hold mortgages. REITs are traded just like stocks and must pay out 90% of their taxable income to unitholders in the form of dividends. REITs are a good way to diversify an income portfolio since they aren’t strongly correlated with stocks.

Portfolio Income Example

Let’s create a fictional investor named Joe. He’s male, 45-years-old, married with two kids who are nearing college age. Joe has $50,000 to invest and several investment goals:

In the short run, he’d like his portfolio to provide enough income to help offset the cost of college tuition for his two children.
Joe and his wife would like to start a home improvement project, and any portfolio income could be put towards that.
In the long run, Joe would like to see how much income the portfolio could generate as he starts planning for his retirement.

The steps Joe can take to build his income portfolio:

1. Joe can transfer some of his savings into a certificate of deposit (CD). Joe has learned that Utah-based Mountain America Credit Union is offering an annual percentage yield (APY) of 5.25% with a minimum deposit amount of only $500 and a term of one year. If Joe deposits $10,000, at the end of one year he will have earned $525 in income.

2. Joe is willing to take on some risk by investing in an individual high-dividend stock. He’s set his sights on Devon Energy (DVN), which currently has an annual dividend yield of 10%. With a market cap of $32 billion, this Oklahoma City-based energy company explores for, develops and produces oil, natural gas and natural gas liquids within the U.S. DVN has a low PE ratio of 5.45, and a high earnings per share (EPS) ratio of 9.17. If Joe buys 200 shares at $50 per share (DVN is actually trading at $49.99 as of this writing) he would receive $1.25 per share per quarter or at the end of the year $1,000 in income.

3. Joe can take advantage of high-yield ETFs. The Vanguard International High Dividend Yield ETF (VYMI) tracks the FTSE All-World ex U.S. High Dividend Yield Index that contains high-yield dividend stocks from countries outside of the U.S., including Japan, U.K., Australia, Canada, China and Brazil. VYMI provides a dividend yield of 4.6%, and it has a low expense ratio of 0.06%. Trading at approximately $62.00 per share, if Joe buys 161 shares and receives a dividend of $0.88 per share quarterly, he will receive approximately $566.72 in income at the end of one year.

4. Joe can invest in a dividend-paying REIT such as Sun Communities (SUI). It owns manufactured housing (MH) communities, recreational vehicle (RV) resorts and marinas. SUI is North America’s largest publicly traded MH owner/operator, the UK’s second largest MH owner/operator and it is the largest owner/operator of marinas in the U.S. SUI has either maintained or increased its dividend every year since going public and it currently has a 3.1% dividend yield. That means that Joe’s $10,000 investment would yield dividend income of $310 at the end of one year.

5. Joe can invest his final $10,000 in an asset allocation fund such as the Invesco Balanced Multi-Asset Allocation ETF (PSMB), which is a “fund of funds.” PSMB invests between 45% and 75% of its assets in equity ETFs and between 25% and 55% in fixed income ETFs. Its current yield is 3.04%, so Joe’s $10,000 would yield $304 at the end of one year.

Let’s add up Joe’s total portfolio income given the five investments: $525 + $1,000 + $566.72 + $310 + $304 = $2,705.72That is a 5.4% yield on Joe’s $50,000 total investment.

How To Increase Portfolio Income

One way to increase portfolio income is to write a call option on shares held within a portfolio. A call option is a contract between a seller and a buyer for the buyer to purchase a certain number of shares of a stock at a certain price up until a specified date in the future. The call option gives the buyer the right, but not the obligation, to purchase the shares.

For example, say an investor holds 100 shares of Microsoft (MSFT) in their investment portfolio. Currently, MSFT is trading at around $315.00 a share. The investor could create a call option for those 100 shares at $325.00, which is known as the option’s strike price, and he could sell that call option for $2.00 a share. That would net the investor $200 (100 shares x $2.00 a share = $200) and this is known as the option premium.

If on the option expiration date, Microsoft is trading below $325.00, the option buyer won’t exercise his or her option and the owner of the shares gets to keep the option premium. But, if Microsoft is trading above the strike price, then the option purchaser most likely will exercise the option, and the owner of the shares is obligated to sell the shares at the strike price. Besides achieving a capital gain, the portfolio owner also gets to keep the option premium.

Is Portfolio Income Taxed?

The tax rate on active income varies from 10% to 37%. The tax rate on passive income depends on the source of the passive income and the investor’s tax bracket. Generally, the tax rate on passive income is between 10% and 15%. Passive income losses can’t be used to offset active income or portfolio income.

Portfolio income receives favorable tax treatment because dividends and capital gains are taxed at a lower rate than earned income. Also, portfolio income isn’t subject to Social Security or Medicare withholding. The tax on capital gains depends on whether the gain is long-term or short-term, with short-term capital gains taxed at the investor’s regular income tax rate, and long-term gains taxed at between 0% and 20%, depending on the investor’s annual taxable income, marital status and filing status. Portfolio losses can be used to offset capital gains.

Portfolio Income FAQs

Is portfolio income passive or non-passive income?

Many financial experts categorize portfolio income as a form of passive income, however, in this article we’ve shown that there is a distinction between the two.

Is portfolio income taxed?

Yes, but dividends and capital gains are taxed at a lower rate than earned income. Also, portfolio income isn’t subject to Social Security or Medicare taxes.

This article was originally published by Forbes.com. Read the original article here.