Creating passive income in your portfolio
Key Takeaways
1. Diversification and stability: Diversifying with dividend-focused funds, fixed-income funds, and REITs can provide stability and steady income, benefiting both retirees and younger investors.
2. Tax advantages: Different types of income-generating assets have different tax implications, which is why strategic placement inside registered accounts, such as TFSAs and RRSPs, can help maximize tax savings.
3. Expert Guidance: With the increasing complexity of finding the right income-generating investments, it may be worth consulting with a financial advisor to put together a plan that considers your individual needs and goals
Creating an investment portfolio focused on generating income has generally been associated with retirees, but income-producing assets can play an important role in a balanced portfolio for investors of any age. As their investment goals and risk tolerance change, many investors will hold an increasing amount of fixed income investments given the historically low volatility associated with these securities. However, some risk-adverse investors, or those looking to preserve their capital, may choose to focus more on generating income from their portfolio than on capital growth.
A variety of mutual funds and ETFs can hold income-producing securities, such as dividend-paying stocks, bonds and funds that hold real estate investment trusts (REITs), providing regular payments that can help you pay for everyday expenses or purchase even more investments. These passive income investments, as they’re called, are a great way to potentially boost returns while minimizing involvement. Here’s how they work.
1. Dividend-focused funds
How they invest: Dividend funds invest exclusively in the stock of companies that share a portion of their profits with shareholders in the form of a dividend. An investor has an option to pocket the cash from the dividend or reinvest it back into the fund, which allows you to purchase more shares.
Income potential: Dividend-paying stocks can generate a reliable income stream that can help you pay for everyday living expenses. Many, though not all, of the underlying businesses have predictable cash flows, which allows them to maintain or grow their dividends over time. Fidelity offers a Canadian high dividend ETF and a U.S. high dividend ETF that targets high-quality large- and mid-cap dividend-paying companies. To see all Fidelity divided- focused funds you can find them here.
Tax treatment: Eligible dividends in Canada benefit from the federal dividend tax credit, which means they are taxed at a lower rate than ordinary income when held inside a taxable investment account. Dividends are not subject to any tax when held inside of a registered account, such as a Tax-Free Savings Accounts (TFSA) or a Registered Retirement Savings Plan (RRSP).
Diversification benefits: Dividend-paying funds could enhance portfolio stability because they tend to be less volatile. Regular income paid out by such funds can also provide a bit of cushion against market downturns.
2. Fixed income funds
How they invest: Fixed income funds buy bonds that are issued by governments and corporations. These investments generate interest that is disbursed to investors in what is known as a “coupon payment” at regular intervals, typically semi-annually or annually. Most fixed income funds will pay income to their investors at regular intervals, such as monthly or quarterly.
Risk management: Bond coupon payments tend to be predictable. Beyond income, holding stocks and bonds has typically been a risk mitigation strategy, because these two asset classes have traditionally been negatively correlated with one another. That means that when one goes up, the other tends to pull back. Owning both in a diversified portfolio can help smooth out returns and minimize losses.
Investor choice: The fixed income market is large and diverse, and there is a wide range of options to consider, from low-risk bonds issued by developed countries to high-yield corporate bonds that pay more because they’re at a higher risk for default. The fixed income options Fidelity Canada has to offer include Fidelity Global Monthly High-Income ETF and Fidelity Global Core Plus Bond ETF. To see all Fidelity Fixed income funds, you can find them here.
Tax treatment: Bond distributions do not receive special tax treatment, which means the payouts are taxed as regular income when held in a taxable investment account. Many experts suggest holding fixed income funds inside a TFSA or RRSP to avoid paying any annual tax on these payments.
3. Real estate investment trusts (REITs)
How they invest: REITs are publicly traded investment trusts that are known for delivering attractive dividend yields. These investments give you exposure to the real estate market by pooling several types of properties – whether office buildings, hotels, apartments, or industrial spaces, among others – into a single investment.
Income potential: By law, REITs must distribute at least 90% of their taxable income at least quarterly to shareholders. Because of that, many REITs offer higher yields than traditional stocks. Distributions typically come from a portion of the money the REIT collects from renters or tenants. Fidelity Global Real Estate Fund is an example of a fund that holds REITs and other securities associated with real estate. To see all Fidelity funds, you can find them here.
Tax treatment: If you hold a REIT inside of a taxable investment account, the income you receive will be taxed at your marginal rate. You can also hold REITs within your registered accounts to defer or potentially avoid tax altogether. An example of this registered account can be the TFSA.
Diversification benefits: Because REITs are exposed to the real estate market, they tend to be less correlated with company stocks, which can help your portfolio in a more volatile market. They’re also a good way to get access to property without having to own an office building or apartment complex outright – something average investors would have trouble doing in any case.
Whether you’re focused on maximizing your income in retirement to cover expenses or looking to diversify your portfolio, passive income strategies can play an essential role in helping weather volatile market environments. Finding the right income-producing investments can be complex, so consider talking to an advisor, who can help you create the right strategy for your needs.
