What Is Income Investing and How Does It Work?

There are two ways to build wealth through investing. You can: 

1. Buy assets that appreciate in value over time; or 
2. Buy assets that you can generate revenue from. 

The second option is what’s called “income investing.”

Income investing can provide you with supplemental income that you can use now or when you are ready to retire.

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What Is Income Investing?

Income investing is a strategy for generating income from your investment portfolio. This means you don’t need to sell or cash them in to get money out of them.

Some examples of income investments are:

• Dividend-paying stocks
• Interest from bonds
• Payments from rental properties

The goal of income investing is to create cash flow for yourself that covers your expenses and doesn’t require you to work another job.

How does income investing work?

Income investing is a different approach from other investment strategies, where you buy and hold assets for a long time, waiting for them to eventually grow in value. 

Real estate is a good example of this. Many people buy a home expecting it to appreciate. When they are ready to retire, they can sell their home and pocket whatever it grew by. The profit comes as a lump sum, which they can then use to cover living expenses in retirement.

But income investing allows you to earn regular income regardless of when you plan to retire. 

Instead of buying a home and waiting for it to appreciate, income investors purchase real estate as rental property, collecting monthly rental payments from it. 

Those payments can cover the mortgage, and whatever is left over can be pocketed now or invested into other assets. This is a popular strategy investors use to generate passive income.

One of the challenges with income investing is building a portfolio that allows you to keep up with inflation. 

For example, while generating $3,000 a month might be enough to support you today, that might not be true a decade from now. 

Income investing requires you to allocate your assets so that you have a diversified mix that increases in value and also provides income. 

READ MORE: Active vs. Passive Investing: Which Is Best?

How To Invest for Income

To invest for income, you want to choose assets that provide consistent cash payments. 

Some popular types of income investments are:

• Savings accounts
• Bonds
• Mutual funds
• Certificates of deposit (CDs)
• Real estate
• Real estate investment trusts (REITs)

Once you figure out which assets you want to invest in, determine how much of those assets you want to allocate in your portfolio. 

As you get closer to retirement you’ll want to increase the allocation of assets that generate income, like bonds. These are safer and relatively stable. They can provide fixed-income payments that can replace your paycheck when you finally retire.

Choose the right investments for you

There isn’t a one-size-fits-all approach to choosing income-generating assets. It varies based on your age, the time horizon you wish to invest for, your risk tolerance, and your personal financial goals. 

Some investors may choose to only invest in dividend-paying assets like stocks, while others may prefer to generate revenue from rental properties. 

Regardless of your preference, it’s good to reduce risk by diversifying the ways you generate income. When you’re ready to begin income investing, assess your personal risk tolerance and goals to identify which assets to include in your portfolio.

Finally, calculate how much money you need to live off of and when you’ll need to start generating income from it. Take inflation into account and an increase in your cost of living after you retire.

READ MORE: How Much You Need to Retire

Income Investment Strategies

There are different strategies you can take with income investing. 

Fund investments

One of the best ways to invest in income-generating assets is to invest in exchange-traded funds (ETFs) or mutual funds. 

These are securities that bundle different assets together. They allow you to diversify risk across multiple types of stocks instead of putting all your eggs in one basket.

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A bond ETF is a great way to do this. Bonds are relatively safe, as they are backed by the government. You receive interest payments and when your bond reaches maturity, you can cash it out to get your principal investment back. 

Bond ETFs like the Vanguard Total Bond Market ETF bundle a bunch of bonds together. This gives you exposure to more than 10,000 bonds while still allowing you to earn interest.

You can buy ETFs on investment platforms like Webull, Robinhood, and Fidelity, even if you don't have much money to start. For example, Webull lets you start investing in fractional shares — including of ETFs — for just $5.

READ MORE: Webull Review: How It Compares for Beginner Investors

IRA investments

While an IRA isn’t an income investment, you can use your IRA to hold onto income investments — and with a Roth IRA, any income you earn is yours to keep tax-free. 

That means if you buy Vanguard’s bond ETF in a Roth IRA, any interest you earn isn’t taxed as income (unlike with a traditional IRA or a 401(k)). This is important, as interest from other types of accounts is considered taxable income and can increase how much you owe at tax time. 

Because Roth IRAs are retirement accounts you won’t be able to make withdrawals until age 59½, unless you want to pay a penalty. The good news is that you can reinvest your interest income into buying more income-generating assets to quickly grow your portfolio.

READ MORE: Traditional IRA vs. Roth IRA

Dividend income investments

Dividend income investing focuses on earning dividends from stocks. 

Many companies (although not all) regularly redistribute a portion of the company’s earnings back to shareholders. This is determined by the board of directors and is usually paid out monthly or quarterly.

A few well-known companies that pay dividends include:

• Coca-Cola
• PepsiCo, Inc.
• Colgate-Palmolive Company
• McDonald’s Corporation
• AT&T 
• Verizon 
• Exxon Mobil

One drawback to consider when building a portfolio around dividends is that the dividend amount can change. In an economic downturn, a company’s board of directors can choose to suspend the dividend in order to preserve capital or reinvest revenue back into the company. 

This is a risk to consider when you use dividends from individual stocks to generate income.

REITs

There’s a special type of stock that is guaranteed to pay dividends called a REIT, or a real estate investment trust

A REIT is a specific type of company that is required by law to pay at least 90% of its taxable income to shareholders in the form of dividends. 

While real estate can be volatile depending on market conditions, the fact that REITs have to redistribute their income to shareholders can make them a good source of dividend-producing income.

If you're interested in investing in real estate but don't have much money to start, you could try out a platform like Fundrise, which allows you to buy fractional shares of real estate investment projects, called eREITs, for just $10. 

READ MORE: Fundrise Review: Invest in Real Estate for $10

Growth Investing vs. Income Investing

When you start investing to earn income, you might consider a growth investing strategy. 

Growth investing is when you invest in stocks that are expected to rapidly appreciate in value. The idea is to profit off growth stocks by selling them for more than you paid for them. 

Tesla is a great example of a growth stock. Investors believe the stock will eventually take off and try to get in early before it does. If they’re correct the value of their portfolio will dramatically increase as a result.

Growth stocks may pay dividends but that isn’t always the case. They can also be quite volatile. 

A growth stock can rapidly appreciate during a short period of time — as Zoom did at the beginning of the pandemic — but then fall shortly after. This is a risk to consider before adding growth stocks to your portfolio.

Income investing and growth investing aren’t mutually exclusive. It’s possible to invest in both at the same time, especially if you invest in an ETF that has a mix of both income-generating stocks and growth stocks. 

Knowing your personal risk tolerance and managing your expectations will help you ensure you’re building a portfolio that helps you work toward your financial goals.

How Are Income Investments Taxed?

Income earned from an investment, like interest and dividends, is taxed as ordinary income. This means you’ll claim them on your taxes just like you claim income earned from your day job. 

Whatever tax bracket you fall in is where your investment income will be assessed. 

But there are a couple of exceptions to this. Roth IRAs, for example, are a special type of retirement account where investment income isn’t taxed. 

Also, high-income earners may be required to pay an additional 3.8% tax on top of their regular income tax rate for income earned from investments.

You’ll also need to be mindful of capital gains tax. 

• Short-term capital gains is for assets that are sold within a year of purchasing them.
• Long-term capital gains is for assets that have been held for more than a year. 

Capital gains only apply when an asset is sold. Depending on when you sell it, the profit you earn may be taxed at your ordinary income rate. This can be substantial, eating away at your earnings — so be mindful of when deciding when to sell an asset.

TL;DR

Income investing is when you invest in assets that earn you money on an ongoing basis, rather than only once you’ve cashed them. Examples are stocks that pay dividends, rental properties, and bonds or savings accounts that pay interest.

Because your income from these investments might not match inflation, you want to diversify your portfolio with a mix of different types of investments — both income-generating and other types, like growth stocks or value stocks.

For more investment advice, check out these episodes of the Erika Taught Me podcast:

• Building Actual Passive Income
• The Missing Piece in 99% of Financial Advice
• Why the Rich Get Richer

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