With so much attention paid to the daily ups and downs of the share market, it’s easy to forget that owning shares in great companies can be a powerful way to generate passive income.
Whether planning an early retirement or just wanting to supplement your current income in these uncertain times, owning shares that pay dividends is a great way to create a passive income stream that grows over time. And you don’t need to sell your shares to profit from holding them.
What types of shares create passive income?
When it comes to generating income from dividends, not all shares are created equal. An ideal income share is a company that produces regular and reliable cash flow year in and year out. These are often the big, well-established blue-chip companies that only need to reinvest some of their profits back into the business.
Utility companies often fall into this category because people will likely keep paying their electricity and water bills over time, even though the business cycle has ups and downs. Consumer staple products, supermarkets, and telecommunication companies can sometimes make great income investments for the same reason. To learn everything you need to know about dividends, read our excellent guide to dividend investing.
3 tips for picking income-generating shares
- A company’s dividend yield shows us the size of the annual dividend payment as a percentage of the company’s current share price. It’s a useful starting point, but bigger is not always better! The dividend yield can rise if the company’s share price falls. This sometimes happens when the market thinks future earnings (and dividends!) could be at risk.
- The best income-generating shares are companies that grow their dividend payouts over time as their earnings per share (EPS) increase. Like any type of share investing, starting early and keeping a long-term perspective is valuable to give dividends time to grow.
- Before buying a company for its dividend return, it’s a good idea to check its dividend history. Look for a consistent track record of dividend payments and growth over time. Reading the company’s dividend policy to understand what to expect is also a good idea. For example, one company might pay out 70% of profits as dividends, while another might pay 90%.
When do dividend shares pay investors?
If you’re relying on shares for your income, it’s essential to know when the cash will arrive, so you can always be sure you will have money available when needed.
Most dividend-paying companies in Australia make payments twice a year. This occurs after the company announces its half-year results (interim dividend) and again after the full-year results (final dividend). When the board of directors decides the company will pay a dividend, it will announce the payment date and date that the shares will go ex-dividend. An investor must own shares before the ex-dividend date to receive the payout.
Dividends are typically paid directly into your bank account. Some companies also offer a dividend reinvestment plan (DRP) in which shareholders automatically reinvest all or some of their dividends into new shares in the company.
Managing your dividend payments
What if your goal is to build a steady stream of income that comes in more regularly throughout the year? In that case, you could start by mapping out dividend payment dates on a calendar and looking for companies that provide some spread over time.
Each company will generally pay dividends in the same two months every year. With careful planning, you can ensure your portfolio delivers at least one dividend payment to you every month.
For example, Australia and New Zealand Banking Group Ltd (ASX: ANZ) usually pays dividends in July and December. Retailer JB Hi-Fi Limited (ASX: JBH) pays dividends in March and September, while Harvey Norman Holdings Limited (ASX: HVN) pays in May and November. These three shares alone will deliver dividend income in six out of 12 months of a year.
Frequency factor
Another option is to invest in companies that pay dividends more regularly. It’s less common on the ASX, but some companies pay quarterly dividends. For instance, healthcare company ResMed Inc (ASX: RMD) pays dividends quarterly. It typically pays in March, June, September, and December.
Some exchange-traded funds (ETFs) also pay dividends every quarter. In the past, these have included big ETFs like iShares S&P 500 ETF (ASX: IVV) and iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD). Generating income through ETFs comes with the added advantage of portfolio diversification, as owning ETFs means owning shares in many companies across many industries and even many countries.
How is income from shares taxed?
Many investors who generate income from dividends find the investment relatively simple regarding tax time. Dividends received from shares are classed as income. So, the dividend amount earned over the year is added to your employment income before being taxed at your marginal tax rate.1
However, a crucial difference is that dividends from Australian companies often come with franking credits. You receive these credits in addition to the raw dividend amount paid directly into your bank account.
Franking credits represent the tax a company has paid on its profits before distributing them as dividends to shareholders. This prevents dividend investors from being taxed twice on a company’s profits and may result in a lower tax bill for you.
It’s worth pointing out that investing in shares for income sits higher up the risk curve than some of the alternatives, like bank deposits or bonds. This is because the value of your shares can fluctuate.
However, by investing in strong, cash flow-generating companies and diversifying across different businesses and geographies, dividend shares can be powerful for creating juicy passive income over the long term.