To start with the obvious, to live off portfolio income you need a big enough investment portfolio so that the stocks and bonds will pay enough interest and dividends to cover your expenses. From the perspective of a younger person, you need to start saving with the goal of the largest possible nest egg by the time you switch from working for an income to managing your investments for income.
Building a Nest Egg
In the early years of your career, even having any size of a portfolio can seem like a distant dream. However, the earlier you start saving and investing, the sooner you will have an investment account large enough to provide usable income. Regular contributions to tax-advantaged retirement plans like a 401(k) account at work, or an IRA, are the basis of building a nest egg. You can also have other, taxable investment accounts such as mutual funds or a stock brokerage account.
How Much You Need
You cannot live off portfolio income until you have accumulated a portfolio large enough to generate the amount of income you want or need. That depends on both the rate of return you could earn and your income requirements. As of 2013, investing in conservative government bonds would earn you 1 to 3 percent. Working with high-yield bonds and stocks, you could push that yield up to 6 to 8 percent. Divide the income you need by a representative earnings percentage to calculate a portfolio size goal. For example, to get $80,000 per year with 5 percent earnings, divide the $80,000 by 0.05 to find that you need $1.6 million of investment assets.
Sources of Income
At the point you obtain or have grown a portfolio large enough to generate income, you need to shift your investment capital into investments that pay income. The two choices are bonds, which make regular interest payments, and dividend-paying stocks. Each type of investment has its positives and drawbacks, so you will want to have some sort of balance between the amount of stocks and bonds in your portfolio. The actual investments may be individual securities or through funds such as mutual funds or exchange-traded funds.
Ravages of Inflation
One danger of living off portfolio income will be an increasing cost of living due to inflation. To make sure you can live off your investment income for many years, you must have an investment strategy to allow for more income in the future. One way is to reinvest a portion of your portfolio earnings, so the size of the portfolio will grow and be able to pay a higher future amount of income. Another path to growing income is to invest in stocks that are expected to steadily grow the size of the annual dividends paid.
Don't Forget Taxes
Remember to account for taxes that must be paid on your portfolio income. Unlike your paycheck from work, there is no tax withholding from your investment earnings. However, the government will still want its share, so you will need to make arrangements for quarterly tax payments out of your income stream. The tax rates on investment income can vary significantly. For example, you pay zero in taxes on municipal bond interest, and your full federal and state tax load on corporate bond interest. Stock dividends and government bond interest may provide some tax savings compared to fully taxable types of income.
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