It is February 2017 and our family has almost no passive income!
What is passive income? It is an income source that requires little to no work to sustain itself. Some examples might be royalties from a book, rental income, or profit sharing from a business you part-own. Looking around the FIRE community, many people rave about owning rental real estate. While real estate is certainly a possibility we are willing to entertain, the frequent moves we make in the military coupled with the steep learning curve have so far kept us away from property ownership.*
Why passive income?
Because there are only 24 hours in a day and only 7 days in a week. I don’t want to be hustling for every one of them just to make a buck. I’d rather spend time with my family or do something else I love.
Our goal is to make $2,400 a year in passive income by the year 2020.
If not real estate, then what?
Since we already own a few stocks outside our retirement accounts which throw off some dividends, we have decided to build on this portfolio. While the IRS does not define dividends as “passive income,” I think they fit the requirements.
What is a Dividend?
Simply put, a dividend is the return of a piece of a company’s value to its shareholder. Dividends are usually paid quarterly as a small percentage of the stock price of the company, or as a fixed amount. A stable and gradually rising dividend usually indicates a health company, and CEO’s will go to great lengths to avoid the reduction of their dividends. If a dividend is reduced, investor confidence and the share price plummets.
Some companies offer no dividends, preferring to plow their earnings into growth.
Other companies have kept the same dividend for years and years, and are considered a very stable bet. Companies which have consistently kept or increased dividends for over 25 years are called Dividend Aristocrats, and they attract a devoted following of investors. Learn more about the Dividend Aristocrats Here.
Dividends come with risk as well. A company which pays out more than it earns each year may be trying to attract investors with large dividends or keep confidence high by not lowering the pay-out, but may itself be a poor investment risk. Generally, double digit dividends are considered risky, as are companies offering larger dividends than other companies in their sector. For example, financial companies often offer large dividends since their product is money, but it would be odd to see a new technology company offering a similar divided since most growing companies are using their extra cash to expand.
Dividends and FIRE
As a FIRE family, I see Dividend Investing to meet our passive income goals as having four benefits.
- Money in a taxable portfolio is more liquid, and since we eschew a large emergency fund, this allows us to invest more of our cash while maintaining access to capital.
- A taxable account is a good place to hold foreign investments in order to take advantage of any tax breaks.
- If we retire early it will be a decade or more before we can easily access money in our Retirement funds. Rules for early withdrawals may change. This taxable portfolio will serve as a bridge in those years.
- Stocks held in a taxable account can help us Tax Loss/Gain Harvest. We already own some stocks.
Why dividends over real-estate?
Simply put I think we can make as much with dividends as we can with real-estate while keeping our debt low and liquidity high. This is specific to our personal financial situation and our goals for the future. Also, I’m not planning on reducing our current retirement savings goal to meet the passive income goal, which means I’m allowing failure as an option.
Consider: A rental property’s rent is often referred to in a 10:1:1 ration. 10 months of the rent go to your mortgage and taxes, 1 month to the manager, repairs and vacancies, and one month to you as profit. Paula at Afford Anything outlines a basic 1% rule. Basically, if a property sells for $100,000, it must rent for $1,000/month to be worth the investment.
Let’s say we can buy a house valued at $100,000 for a $20,000 down payment with an 80,000 mortgage, at today’s low rates. I’ll say we can rent it for $1,200 and that we have good luck with tenants and repairs.
A 20,000 investment yields $1,200 in passive income, plus equity in the home.
Since I can’t tell you if we will sell the house for more or less than $100,000, or if the “more” is just due to inflation, I’ll disregard the equity. I’m also disregarding the equity because we might never plan on living in the house, and we don’t know when we plan on selling it, if ever.
$1,200 return on $20,000 invested = 6% rate of return
Working with dividends it is unlikely we will see a 6% rate of return without being overly risky. So we’ll shoot for a 4% rate of return. How much will we need to invest to generate the same value as that home with a 20K down payment?
$1,200 = X *0.04 X=$30,000
While $30,000 is considerably more cash to invest, it doesn’t come with the large debt that a rental does. Again, I see the benefits of having dividends as opposed to real estate in terms of liquidity and time. Selling a property if we need money is time-consuming, and a HELOC isn’t guaranteed. Selling a stock takes seconds. Managing a property can be fun, but takes time we don’t have, or money we won’t have, especially when we move. Managing a portfolio takes much less time. (and gives me an excuse to mess with individual stocks, since index investing gets so boring!) Both sales have tax implications.
What we have now
As you can see, we still have some stocks left over from before my Index Investing conversion. Right now our $4,300 is throwing off $300 every year in dividends, which are subsequently reinvested. However, this basket of stocks represents the highest risk portion of our portfolio. Any additional funds we add will have a more stable dividend rate of around 3-4%. This should lower our current weighted average percentage and serve to smooth out the risk in this portfolio.
In the end, our goal is to have $2,400 in passive dividend income by the first day of 2020. It is going to be a long haul because it means a possible $60,000 investment if our dividend rate hovers around 4%.
Of course, we won’t have to invest every single dollar of the 60K. Hopefully, the portfolio gains value as the market rises. Our reinvested dividends should also help. Additionally, many companies increase their dividends annually or every few years.
Some common reasons not to do what we are doing:
Taxes: Dividends are taxed when they are generated in a taxable account. Many people put their dividend- paying stocks in their IRA’s, where they aren’t taxed annually.
Why we don’t care: This year I’m driving our Federal Tax rate to ZERO. The added income will be barely taxed, if it is taxed at all. That’s the benefit of having a high savings rate.
Leverage makes Real Estate very powerful
Why we don’t care: The thinking goes like this. “Why pay cash for something when you can put 20% down and get a cheap mortgage? If you have $60,000 to invest, you could take out three $100,000 mortgages for your rental properties.” We are already pretty well leveraged. We have a car loan and student loans still. In addition, the tax benefits for these large home loans may be going away.
- We will be moving this summer, which means our ability to live in the home for 2 years (and therefore exclude any capital gains from taxes) is diminished.
- President Trump may also force the removal of the mortgage interest deduction. Again, because we don’t have a federal tax burden, this deduction is worth even less to us now, but could be if we made some real money on the rentals.
There are tons of great property managers, pay them instead of working yourself.
Why we don’t care: I’m happy to pay myself to manage my property, but the fact is I just don’t know enough about rental real estate. This guarantees we would have to use a property manager, especially since we will be changing markets soon. This would be fine if we had a number of properties in a great market, but with our ability to only have one to start out, I think the returns are diminished.
Investing fees will eat up your gains.
Why we don’t care: Real Estate comes with plenty of fees too. Neither Mrs. MilitaryFIRE or myself is a Relator, and the real estate would expose us to state taxes. Our plan is to invest in low fee index funds for most of our passive income goal. That’s right, you can get index funds for your dividends! For example Vanguard offers a basket of high yield dividend earners, which is traded as an ETF with the symbol VYM. It has a low Expense Ratio, but not as low as their Total Market funds. Its yield is just over 3% in dividends, but I’m happy to trade a lower yield for lower risk.
If I buy individual stocks, I would have to pay the trade fees and hold my money in cash until I had enough to make a purchase worth it (for us that’s $2,000/ trade). After all that, I might pick the wrong stock. With Vanguard’s ETF I can buy one share at a time because Vanguard trades their ETF’s for free. I reduce the trading fees and the time drag of our money to zero. Even better, the risk is reduced since if one stock in VYM underperforms, it might drop out of the index and be replaced with a better stock, all at no additional cost to me. Ahh, the benefits of indexing.
Is this a hard and fast plan?
No. We are looking to buy a home to settle down. If the right deal in the right place presents itself, we will jump, even if that means having to rent it out when we move. That’s one of the reasons I want to have a bit of money laying around, in case we need to make a down payment.
Last month I made a sale from a photograph I put up on FineArtAmerica over 2 years ago. I haven’t even been to the website in 15 months, but I’m making money- now that’s the definition of passive income! If that keeps happening, we will need less and less dividend income. This goes for this blog too- support us by using our Amazon affiliate link —>
I’ll keep you updated on our progress towards this goal- What do you think of my comparison of real estate and dividend investing?
*I’ve never met anyone who makes good money on the old military plan of “I’ll buy a house, live in it, then rent it when I move” plan. Most people don’t want to live in properties that would make good rentals. If you are willing to live in and fix up a duplex in an upcoming part of town, more power to you.
Disclaimer: I am not a licensed financial counselor of any sort. The opinions contained here are my own. Investing has implicit risk, and past gains are no guarantee of future returns. You may lose money, including the principal. The US Government does not endorse any of my opinions.