With the Morningstar U.S. stock index up 31.56% year-to-date (as of Dec. 27, 2019), and the stock market breaching new highs seemingly on a weekly basis, it’s no wonder that Americans are checking their 401(k) plans and investment portfolios with renewed interest as a new decade dawns.
When they do, one of the first issues to cover is figuring out their portfolio income.
In a word, portfolio income is the totality of investment income in a single portfolio, including dividends, interest, and capital gains. In many cases, portfolio income also includes any money (in the form of royalties) from real estate investments.
What’s not included in portfolio income is any passive income generated by an individual or institutional investor. In general, any income earned from business operations would not be included in portfolio income. Likewise, money earned on the job as a full- or part-time employee, or a self-employed contractor, isn’t considered portfolio income – it’s better known as earned income.
In general, think of portfolio income as money you’ve earned via investing in vehicles like stocks, bonds, funds, real estate and other investments. If it’s money in your portfolio from investing, then it’s considered portfolio income.
Portfolio Income Examples
Portfolio incomes can come from three primary sources:
Interest is cash paid out, usually at a fixed rate, as with a U.S. government bond, bank savings or checking account, or money market or certificate of deposit. Consider a bank checking account that pays 2% interest. If you have $10,000 in your bank account earning 2% interest, you’ll have $10,200 in the account at the end of one year.
Stocks that pay dividends are a particular favorite of income-minded stock market investors. Let’s say you own 100 shares of a stock that pays a 2% dividend. If the stock, for example, trades at $100 per share, you would receive $2 for every share of stock you own.
This is cash paid out for investments, like stocks and funds, that gain in value. For instance, if you buy a share of stock worth $50 and the stock rises to $60 per share, you’ve earned $10 in capital gains.
The Three Primary Types of Income
To make an even sharper distinction between portfolio income and other forms of income, let’s examine portfolio income versus passive income and earned income.
This is income you earn through the output of labor and services (i.e., your job as a full-time salaried employee, as a freelance professional, or from a small business you might own, for example.)
Earned income usually comes in the form of a paycheck, direct deposit, or revenues earned from a business you own. In most cases (an IRS 1099 freelancer being a good exception), income earned on the job is taxed before you receive a paycheck, as municipal, state, federal, and Social Security taxes withheld.) Self-employed individuals are responsible for paying their own taxes on earned income, including their Social Security taxes.
Earned income is taxed at rates between 10% for low-income earners and up to 37% for high-income earners.
This type of income is most often derived from money earned without really laboring for it. In real-life terms, passive income could come from rental income on an apartment you own, income from a business where the owner isn’t actively involved in any work that led to passive income earned, from pension or retirement fund income, from a limited (business) partnership, or from royalties earned on a book or film/television appearance.
Passive income is taxable, just like active (earned) income. There is some overlap with portfolio income and passive income, as dividends and interest earned in an investment portfolio are deemed to be “passive income” by the IRS. Passive income usually is the lowest form of income earned, usually at a 10% to 15% effective tax rate.
As noted above, portfolio income is derived from so-called “paper investments” like stocks, bonds and funds that pay dividends, interest and capital gains. Portfolio income is taxed at up to 20% of income earned.
Tips on Boosting Portfolio Income
Once you’ve come to grips with portfolio income and know how it works, put that knowledge to good use with these portfolio income amplification tips, which are especially helpful for long-term investors:
Build a Financial Firewall
Even though the stock market is in explosive mode, smart investors need to always account for significant stock market volatility.
With volatility a risk, it’s a good idea to park some cash in your portfolio, primarily for liquidity’s sake. Aim for a portfolio cash equivalent of one year’s worth of expenses. In addition, set aside two to four years' worth of household expenses either in short-term fixed income product or fixed-income funds.
That will provide your portfolio with some much-needed downside protection in the event the stock market does go in reverse – and if it doesn’t you’ll have a level of comfort that your portfolio is well protected if and when you need it.
Aim for Growth and Income
With your portfolio adequately protected, now’s the time to start building portfolio income and position it for more robust growth, with your risk tolerance and time horizon in mind.
A good addition to your portfolio that covers growth and (especially for) income simultaneously are dividend stocks and funds. One tip in choosing the correct dividend stocks is not only focus on a stock’s dividend rate, but also take a closer look at the underlying company’s cash flow health. Businesses with good cash flow are businesses that will be good dividend options over the long haul.
Go the Automatic Route
A good income-minded portfolio plan should involve a regular dose of investment activity. Get the job done by having your broker or financial adviser set up an automatic investment plan. Most plans offer automatic investment plans with multiple investment options, including dividend stocks and dividend index funds. Make it a habit of investing regularly and get used to seeing your portfolio grow accordingly – all through the consistent investment of funds.
It’s also advisable to reinvest dividend gains, also on a regular basis. That establishes an income-producing mechanism in your portfolio that builds assets over the long term. That should be the goal of any portfolio income investment strategy.
The Takeaway on Portfolio Income
Any investor interested in growing the value of his or her investment portfolio should know that portfolio income is a critical driver of total return.
That’s the case if you’re just starting out as an investor in your early 20s or if you’re set to retire at age 65 or older. It’s also the case no matter what investments you hold in your portfolio.
The fact is, you need income at any stage in your life and getting it from your investment portfolio is one of the most effective ways of generating cash you can use in the short- or long-term that you’ll put to good to live a more comfortable lifestyle.