I missed a blog entry last weekend as I focused my energy on studying for the the final exam for my financial planning course. It’s never a bad idea to generate one’s income from diversified sources.
One interesting concept from the course was earning passive income from a life annuity. Retirees, especially may favour the predictability of the passive income generated from annuities.
Life annuity for passive income
Investopedia explains a life annuity as
a financial product that features a predetermined periodic payout amount until the death of the annuitant. Annuitants pay premiums or make a lump-sum payment to secure a life annuity. Life annuities are commonly used to provide or supplement retirement income.
A life annuity is a good way to get passive income to supplement one’s retirement income, including Old Age Security (OAS) payments and Canada Pension Plan (CPP) income. An advantage of life annuities is that they have no market risk, and you would get that predictable, set payment through your life.
For example, if you bought a life annuity that pays you $1,000 a month, you will get that $1,000 monthly no matter what the financial markets do.
You also don’t need to do anything to get that income. Once you buy the life annuity, you simply start collecting that passive income. The older you are, the higher the income you get and the less income tax you pay on the income (if it’s generated in a non-registered account). Canadian policyholders of life annuities get protection from Assuris if their life insurance company fails.
A disadvantage of annuities is that they don’t adjust to inflation and therefore don’t maintain your purchasing power. Canadian investors may take on greater risk via dividend stocks to potentially maintain or increase their purchasing power from dividend growth.
When you buy shares of common stocks, you can potentially share the profits of the businesses if they pay out dividends. Typically, dividends are paid out from net income.
For instance, National Bank of Canada’s (TSX:NA) trailing-12-month payout ratio is about 36%, which is relatively low as the big Canadian banks typically have a normal payout ratio in the 40-50% range.
You can build a diversified portfolio of dividend stocks, on the Canadian Dividend Aristocrat list, which tend to pay out increasing dividends. If you have decades until retirement, it may be worthwhile to build your dividend portfolio one stock at a time, aiming to buy when quality shares are cheap. The longer you have until retirement, the better this strategy may be.
Usually, low-yield dividend stocks have higher growth rates in their profitability, which sometimes translate to higher dividend growth rates
Alternatively, passive-income investors could directly buy units of the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX:CDZ) to earn income that’s immediately diversified across 95 dividend stocks right now. Currently, the dividend ETF offers a yield of about 3.6%.
Earn passive rental income from real estate
Landlords know that real estate investing isn’t a way to earn truly passive income, especially if you have multiple properties. Managing properties yourself can quickly become a job. Some landlords end up hiring professionals, which increases their operating costs, saving them time to enjoy other things.
If you’re purely seeking passive rental income, Canadians can consider investing in real estate investment trusts (REITs) instead. I believe researching REITs is less work than managing properties, but others may have different experiences.
In any case, I think REITs are a good option for passive income. Canadians can look at iShares S&P/TSX Capped REIT Index ETF (TSX:XRE) for Canadian REIT ideas. Currently, the REIT ETF yields 3.6% and has 21 holdings.
Canadian REITs typically pay out monthly cash distributions that may consist of dividends, interest, other income, foreign income, return of capital, and capital gains. Assuming you hold REIT units in a non-registered account, these cash distributions are taxed at different tax rates depending on what they are.
Interest income, other income, and foreign income at taxed at your marginal tax rate. Dividends are taxed at favourable rates while capital gains are taxed at half of your marginal tax rate. Return of capital reduces your adjusted cost basis and are ultimately taxed like capital gains when your adjusted cost basis turns negative.