An income investing strategy revolves around building a portfolio that generates a steady income. Maybe you’re looking for a way to build a supplemental income stream during your working years or for retirement. This is where income investing strategies can help. A financial advisor may also be able to help you find an income investing strategy that suits your needs.

What Is Income Investing?

Income investing is all about making investments that produce consistent income, either through dividends, interest or a combination.

Income investing may appeal to those who need or want to increase their current income. The extra money generated by your incomes could be used to cover everyday expenses, pay off student loans or other debts, or fund other financial goals, such as saving toward your child’s college expenses.

An income investing strategy is essentially the opposite of a capital appreciation strategy. Capital appreciation focuses on investing in companies that are poised to see significant growth over the long term. In this scenario, an investor is banking less on dividends and more on price appreciation. They hold shares of companies that tend to reinvest retained earnings for expansion, rather than paying earnings out to investors.

The overall goal of income investing is to provide an investor with passive income. Investors are less interested in stocks that may see big price jumps in years to come. Instead, they’re looking at companies that have a consistent track record of paying out dividends to their investors. So they may lean more toward the Dividend Aristocrats or Dividend Kings rather than trying to find the next Amazon or Facebook.

What Does an Income Investing Strategy Look Like?

There are different ways investors can approach income investing, in terms of what they invest in and how they manage their portfolios. For example, an income investing strategy can focus on stocks, but it can also include other securities, such as:

• Bonds. This includes municipal bonds, corporate bonds and high-yield or “junk” bonds.
• Real estate investment trusts (REITs). REITs are required to pay out 90% of taxable income to investors as dividends each year.
• Dividend-paying exchange-traded funds (ETFs).
• U.S. Treasuries. Treasuries such as T-bills or Treasury Inflation-Protected Securities (TIPS) can also be used for income.

Each of these investments can produce consistent income with varying degrees of risk. For example, Treasury bonds are virtually risk-free since they’re backed by the full faith and credit of the U.S. government. But they may generate a lower rate of return compared to a REIT, dividend stock or dividend ETF.

You can also look beyond traditional securities to include cash or cash equivalents in their portfolios. For example, you could invest in money market funds or keep a liquid reserve of cash in a money market account or certificate of deposit. These are relatively low risk but again, the trade-off can mean a lower rate of return and income.

Income Investing Strategy Examples

How you build your portfolio when investing for income can depend largely on your risk tolerance, time horizon and overall goals. The less risk you’re comfortable tolerating, for example, the more of your portfolio you may allocate to conservative investments. On the other hand, if you have a higher tolerance for risk, then dividend stocks or ETFs may make up the bulk of your portfolio.

With that in mind, here are a few examples of what an income investing strategy might look like:

• Bond ladder. A bond ladder is an investment strategy in which you purchase multiple bonds with different maturity dates and interest rates. This type of approach can allow you to enjoy a steady stream of bond income while managing interest rate risk.
• Real estate-focused. Real estate can be a useful hedge against inflation while producing passive income. An income strategy that’s built around real estate might include portfolio allocations to one or more REITs as well as dividend-producing real estate ETFs and real estate crowdfunding investments.
• Dividend stocks. There are two ways to build an income investing strategy around dividend stocks: Buying individual stocks or owning dividend ETFs. Between the two, a dividend ETF approach is more passive since you just have to choose one fund, rather than buying and selling shares of stock.

Other Considerations

There are a few things to remember, however, when applying an income strategy.

First is diversification. While you could put 100% of your assets into bonds or real estate or stocks, there’s risk in doing so. An all-bond portfolio, for example, may fall short of your expectations in terms of the returns generated. An all-stock portfolio or all-real estate portfolio, on the other hand, could increase the possibility of losing money. Diversifying and including a mix of income investments can help with managing risk and rewards.

Second, it’s important to research individual investments. With bonds, for example, you should understand what type of bond you own, when that bond is set to mature and how much interest you’ll be able to collect over the maturity term. It’s also a good idea to know how to interpret bond credit ratings. This way you can determine which bonds carry the highest or lowest degree of risk.

Lastly, with dividend stocks, it’s helpful to understand the basics of how dividend yield and dividend payouts work. This helps you to estimate what kind of income you could expect. And if you’re investing in ETFs, you’ll want to look at the expense ratio so you know how much it’ll cost to own the fund annually.

Pros and Cons of Income Investing

Income investing strategies may not be right for every investor, and it’s important to weigh the advantages against any potential disadvantages. The main pro or benefit of income investing is that it’s generally less volatile than capital appreciation investing. A typical income investor holds bonds or invests in established companies. So they’re more insulated against market swings that potentially cause substantial price drops.

On the other hand, income investing may carry more inflation risk for investors. When inflation creeps up and prices rise, purchasing power shrinks. Income investing can be problematic if the returns generated by your investments aren’t enough to keep pace with rising inflation.

Tax Implications

When deciding on an income investing strategy, it’s important to understand the tax implications associated with various income-generating assets. Different types of income can be taxed differently, and preparing for these distinctions can help you optimize your investment returns.

Dividends are a common source of income for investors. Most dividends fall under the category of ordinary dividends and are taxed as regular income. However, qualified dividends benefit from a lower tax rate, similar to capital gains.

Real estate investments also come with specific tax considerations. Rental income is typically taxed as ordinary income, although you may be eligible for certain business deductions. If you invest in REITs, you might notice that dividend payouts are generally higher than those from traditional stocks. These dividends are taxed as income, but any profits from selling REIT shares are taxed at the capital gains rate.

Bonds present another layer of complexity in terms of taxation. The tax treatment of bond income depends largely on the issuer. For instance, some municipal bonds offer tax-free income at both the federal and state levels, provided you reside in the issuing state. In contrast, corporate bond income is subject to both state and federal taxes. U.S. Treasury bonds are typically taxed at the federal level, but are exempt from state taxes. And selling a bond at a profit may incur ordinary income or capital gains tax, depending on the circumstances.

Given the complexity of tax issues related to income investing, it can be helpful to consult with a financial advisor. They can help you prepare for and potentially minimize your tax liabilities, all with the goal of enhancing your investment strategy.

Bottom Line

Developing an income investing strategy could simplify your plans for growing wealth and creating passive income. Rather than actively trading stocks, you may be able to put the bulk of your portfolio on autopilot. Remember to weigh the potential inflation risk this type of strategy could present when considering whether it’s a good fit.

Investing Tips

• If you don’t necessarily need dividends for current income, but own dividend-paying stocks, you could choose to reinvest them instead. Many companies offer a dividend reinvestment plan or DRIP in which you can automatically reinvest dividends in additional shares of the same stock. This could make it easier to increase your position in a particular stock without having to pony up more cash out of pocket to buy shares.
• A financial advisor can help you develop an income investing strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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