How to Use Dividends for Retirement Income

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Dividends can be a significant source of income for your retirement. If you reinvest your dividends while you're saving for retirement—meaning you use dividends to buy more shares in the companies that are paying the dividends—you can build up a solid portfolio of dividend-paying stocks.

Once you retire, you can take the dividend payments to cover at least part of your living expenses, and you'll still retain ownership of the stocks, which may continue to pay dividends for the remaining years of your life. You can have the dividend payments mailed to you in the form of checks or authorize the companies to deposit them directly into your bank account.

Dividends' Contribution to Total Return

In most recent time periods, dividends have contributed an outsized percentage of stocks' total return to investors. For example, in the 1970s, dividend payments resulted in a 4.2 percent return on stocks while price appreciation produced only a 1.6 percent return. In the 2000s, dividends returned 1.8 percent while the price of stocks declined 2.7 percent.

The exceptions to dividends' exceptional contributions to overall return have, not surprisingly, been periods with long bull markets: In the 1980s, stocks returned 12.6 percent from price appreciation and only 4.4 percent from dividends. In the 1990s, the figures were 15.3 percent and 2.5 percent, respectively.

Dividend Yield

The dividend yield is the ratio of a company's annual dividend to its stock price and is expressed as a percentage. For example, if a stock is trading at $64 and it pays a quarterly dividend of 60 cents, its dividend yield is 3.75 percent. To calculate that dividend yield, you must first multiply the quarterly dividend ($0.60) by 4 to get the annual dividend of $2.40. You would then divide $2.40 by $64 to get 0.0375. Multiply that number by 100 to arrive at 3.75 percent.

One investment strategy is to invest in stocks with the highest current dividend yields. (You can also invest in a fund that has the same goal; as with individual stocks, you can reinvest dividends paid by stocks held by the fund into more shares of the fund or you can take the dividends in cash payments.) However, it's important to keep in mind that even companies with a long history of paying significant dividends every quarter can suddenly cut their dividends. And the high dividend yield could have resulted more from a drop in the stock price—that may continue—than an increase in the dividend.

Dividend Growth

Another strategy is to invest in stocks whose dividends have been growing or are expected to grow. You can use online stock screeners to find stocks of companies that have increased their dividend.

Just like a high dividend yield, a currently growing dividend payout isn't a sure sign of a company that will continue to pay rising or even substantial dividends in the future. Reality Shares Advisors provides a DIVCON health rating for dividend-paying stocks that estimates the probability a dividend will grow or be cut within the next 12 months. The rating system is based on a company's cash flow and earnings, among other factors.

Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.