How do you generate income from shares?

How do you generate income from shares?

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 you are planning an early retirement or just want 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. You don't even need to worry about selling your shares to profit from holding them.

What types of shares create income?

Not all shares are created equal when it comes to generating income from dividends. An ideal income share is a company that produces regular and reliable cash flow year in, year out. These are often the big, well-established blue-chip companies that don't need to reinvest all their profits back into the business. 

Utility companies often fall into this category because people are likely to 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

  1. 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 that future earnings (and dividends!) could be at risk
  2. 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, it’s valuable to start early and keep a long-term perspective to give dividends time to grow
  3. Before buying a company for its dividend return, it's a good idea to check the company's dividend history. Look for a consistent track record of dividend payments and growth over time. It is also a good idea to read the company's dividend policy to understand what to expect. For example, one company’s approach might be to 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 important to know when the cash will arrive. This is so you can always be sure you will have money available when you need it.

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 a dividend will be paid, the company will announce the payment date as well as the date that the shares will go ex-dividend. To receive the dividend, an investor needs to own shares before the ex-dividend date.

Dividends are typically paid directly into your bank account. In some cases, you can elect to receive your payment via a cheque in the mail. 

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 their 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 3 shares alone will deliver dividend income to you in six out of 12 months of a year. 

Another option is to invest in companies that pay dividends more regularly. It's not as common on the ASX, but some companies do pay quarterly dividends. Healthcare company ResMed Inc (ASX: RMD) pays dividends quarterly, for instance. 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 lots of companies across many industries and even many countries, too. 

How is income from shares taxed?

Many investors who generate income from dividends find the investment relatively simple when it comes to tax time. Dividends received from shares are classed as income. As such, the amount you earn in dividends over the year is added to your employment income before being taxed at your individual marginal tax rate.

However, one important 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 a  powerful vehicle for creating juicy passive income over the long term.

Guide last updated 30 March 2022. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns and has recommended Harvey Norman Holdings Ltd. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended ResMed. The Motley Fool Australia owns and has recommended Harvey Norman Holdings Ltd. The Motley Fool Australia has recommended ResMed Inc. and iShares Trust - iShares Core S&P 500 ETF. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

 

Top 3 ASX Dividend Shares To Buy

Now that you know the basics, here are a few Foolish dividend share ideas to get you started! This free report names the 3 dividend shares The Motley Fool's crack team think you should buy and hold for YEARS.