The main way to earn passive income is through dividend paying stocks. Simply reinvesting dividends time after time will eventually increase your number of shares due to compounding.

Not all companies pay a dividend, but many do. And many companies have a history of raising the size of their payouts every year. When investing in dividends, it is critical to do your homework and research a company’s financial health before investing.

1. Stable Income Another is the stream of steady income that dividend investing can yield. Although stock prices rise and fall, dividends are paid directly to investors by the companies themselves on a quarterly or yearly schedule, depending on profits; that passive income stream can help cover living expenses. Still, some investors elect to take and reinvest their dividends, which makes the power of compounding even stronger. If you bought Coke three decades ago and also reinvested your dividends, you’d have many more shares today because of the power of compounding. Nonetheless, it is significant to account for what comes at a price with dividend investing. There could be firms paying high single-digit yields, which might suggest that they are troubled and, in the future, will have to cut or cancel dividends – which is why high-quality diversification with solid growth stocks is so determinantal.
2. Tax-Free Dividend-paying stocks and municipal bonds allow high taxpayers to capture tax-free income, keeping more of their money in circulation and not sitting idle in a savings account. Dividend payments are also taxed by the federal government only once per year. Finally, many investors can take advantage of a dividend reinvesting plan (DRIP) tool, whereby all dividend payments are automatically reinvested into additional shares of the stock at each payment cycle, serving to further boost after-tax returns. Make sure, if you are investing in funds with a dividend bias, that the companies in the funds have a record of increasing their payouts over time, which will create a diversified yield-bearing portfolio with several compounding engines for long-term asset growth. To take advantage of lower taxes on payouts from these fund types, a person might use accounts with tax-advantaged treatment such as the Roth IRA or Health Savings Account (HSA). In this way, they can lower their tax liabilities to virtually nothing, which should increase their passive income over time.
3. Diversification Dividend investing is defined by Investopedia as ‘a style of investing where the focus is placed on purchasing stocks that pay out a portion of their profits to their stockholders as cash dividends on an annual or periodic basis, and provides the investor with dividend income and stock price appreciation.’ Dividends can make up as much as half of an investor’s return, whether he or she is earning the income by holding the stocks or appreciating the returns by making sales. By spreading your money across many different firms – thus diversifying – you reduce the effect of industry-specific risk on your portfolio. For example, if you drop in the price of oil, companies that use energy extensively could suffer – investing across many firms that use this type of energy will lower an investor’s exposure to this kind of sector-specific risk. Reinvesting your dividends helps boost your return, and gets you to your FIRE destination faster. Completely divesting into dividend stocks might seem most appropriate for savers only a couple of decades away from retirement – but the strategy can work for all wealth builders.
4. Growth Companies distribute dividends to investors as a further source of passive income on the side of principal, and as a way to share profits. Dividends can be received in quarterly payments, and those payments can also be reinvested for further passive profits. As you consider dividend stocks, look for ones that raise their payouts every year. This shows the soundness of the business, and provides some protection against inflation, something that is not possible with high yields alone. Dividend-paying mutual funds (or exchange-traded funds) suited for investors on almost any budget, and that hold large numbers of dividend stocks, can help you lower your research workload and become an excellent way to build passive income streams with very little hands-on work from you. Just make sure to do some analysis on what level of risk and what investments work with your investment goals first!