Retiring Early? Here's a Smart Investing Strategy to Consider

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If you’re thinking about retiring early, you need to have a financial plan in place.

You’ve probably been investing in an employer-sponsored retirement plan such as a 401(k) or 403(b). You may even have money socked away in a traditional or Roth IRA. But you’ll be on the hook for taxes and penalties if you touch those accounts before you’re eligible. You can withdraw any amounts you’ve contributed to a Roth IRA penalty-free but your money will stop working for you as soon as you withdraw it.

That’s where dividend investing comes in. It allows you to earn money in the stock market without selling any of your assets. Although dividend investing is often overlooked among younger investors, it might be an ideal strategy for someone pursuing early retirement.

Let’s dive into the power of dividend investing so you can determine if it’s the right move for you.

Image source: Getty Images.

How dividend investing works

When companies make money, they can share their earnings with investors through a dividend.

A dividend is a percentage of profits that is paid out to investors. Income investors love dividends because it’s a recurring stream of money that’s typically paid out on a quarterly or monthly basis. As long as a company’s board of directors declares a dividend, investors can look forward to dividend deposits in their account.

Dividend investing has been a hit among retirees who are looking for an extra stream of income. Although dividends have typically been a staple for older investors, there’s an opportunity for early retirees to benefit from dividends, too.

A lesser-known strategy for early retirees

Let’s say you manage to comfortably live off $40,000 per year. That means you’ll need $10,000 a quarter or roughly $3,400 a month to cover your expenses. Although you may have a healthy retirement account that can sustain you, you’ll have to pay a price for withdrawing funds before you’re eligible.

If you build a dividend portfolio that covers your annual expenses, you won’t have to worry about touching your retirement account. You can hunt for monthly dividend payers or you can develop a dividend schedule that allows you to receive paychecks from different companies every month.

Building a robust dividend portfolio may take time so consistency will be key. Set up a recurring investment every week or month so you can grow your portfolio. Also, you should consider participating in a dividend reinvestment plan (also known as a DRIP) and allow your dividends to produce more dividends.

If you want to add individual stocks to your portfolio, you can start researching blue chip stocks like Microsoft and Apple that have a high market capitalization. You can also peruse the list of Dividend Aristocrats and Dividend Kings — a grouping of elite stocks that have increased their payout annually for at least 25 or 50 consecutive years, respectively. To take your portfolio up a notch, you can explore real estate investment trusts (REITs). These investments typically pay a higher dividend yield than other types of assets.

Let the tax code work for you

Typically, early retirees may not earn as much money as they were when working full-time. This can work in your favor during tax time. When you trade in earned income for dividend income, you may be eligible to unlock qualified dividend tax rates for investments held in a taxable brokerage account. These rates — 0%, 15%, and 20% — are the same as the coveted long-term capital gains rates.

Let’s say you and your spouse earned $50,000 in dividend income during your first year of early retirement. For 2021, joint filers can skip taxes on qualified dividend income up to $80,800. That means you can fund your lifestyle without tax nuances bogging you down.

A lifetime of benefits

Dividend investing can work wonders for your portfolio if you’re trying to retire early. This extra stream of income can fill in the gaps to fund your lifestyle until your retirement benefits kick in. Even if you don’t need to tap into your dividend income as an early retiree, you can enjoy the benefits of dividends for the rest of your life.

As long as you are an investor and the company’s board of directors continues to declare dividends, you’ll keep earning dividend income — even if you never buy another dividend-paying company again.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Charlene Rhinehart, CPA owns shares of Apple and Microsoft. The Motley Fool owns shares of and recommends Apple and Microsoft. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.