Imagine having a way to create a flow of passive income while you sleep. Or to earn reliable extra money so you can take an early retirement or a much-needed holiday break! Sound too good to be true?
Of course, you can always stash your savings in a term deposit at a bank and earn a little income from the interest.
But investing in quality dividend-generating shares is an easy, accessible way to put your hard-earned money to work, building a generous passive income stream that grows over time.
And you don't need to be a millionaire or financial genius to start your wealth creation plan. You don't even need to worry about selling your shares to profit from holding them.
So how does it work?
First, let's gain a basic understanding of dividends and how they can help boost your capital returns.
In a nutshell, your investment in an ASX stock gives you part ownership of that company, so you're entitled to a share of its profits through dividend payments.
Companies fund their dividend payments from annual profits and long-term cash flow and typically distribute the payments to shareholders twice a year.
It's important to note that not all publicly listed companies pay dividends, and the total annual payment amount can change from year to year. However, most dividend-paying companies aim to increase their dividends over time, depending on their earnings.
What types of shares create 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 also typically 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 ASX dividend shares and how to get them working for you, read our excellent guide to dividend investing.
Three tips for picking income-generating shares
- 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%.
- 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 helpful 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.
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 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.
Foolish takeaway
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.
Want to learn more about investing?
You've come to the right place!
This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.
Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.
Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.
- The previous article in this section is about investment strategies
- Check out our next article on investing in growth shares
