How to create an infinite income

Why toil all of your life, when you can create regular income that could outlive you?

It's sometimes said that investing is a two-sided coin. On one side, you have risk and the other, returns.

Then again, on one side could be capital gains (the profits made when you sell assets at a profit) and the other, income (the cash payouts from owning certain assets).

A taxing problem

Here in the UK, income tends to get taxed more heavily than capital gains. For instance, the two highest bands of income tax are 40% (which kicks in above £42,475 a year) and 50% (which applies over £150,000 a year).

On the other hand, the standard rate of capital gains tax (CGT) is 18%, rising to 28% for those in the higher tax brackets for income. What's more, each individual has a tax-free allowance for CGT, which is £10,600 in the 2011/12 tax year.

Thus, capital gains have the edge over income, at least when it comes to taxation. However, income is often very regular, while capital gains are far less predictable. Indeed, capital gains can be minimal for years, then suddenly jump or slump during extreme share or market movements.

Income-generating investments

As an investor, I prefer the solidity of income to the uncertainty of capital gains.

What's more, it's become my long-term goal to build up a basket of assets of sufficient size to replace my entire income. At this point, I can decide whether to continue working, stop work and manage my portfolio, or do a bit of both.

In other words, what I'm after is a portfolio that will produce solid, rising earnings over time. In fact, my aim is an income so solid that it will outlive me.

To build a sound foundation for my income-generating portfolio, I need to diversify -- spread my money around. This involves directing money into the four main asset classes for private investors, which are shares (also called stocks or equities), bonds, property (real estate) and cash.

How does each of these assets generate income?

1.     Shares pay dividends

I like to own shares that are very liquid, which means that they are easily bought and sold.

Also, I prefer to own shares which pay generous dividends -- the regular cash payouts made to shareholders, usually half-yearly or quarterly. For a safe, solid, growing income, I prefer to hunt among the big fish: members of the FTSE 350 index.

Within the blue-chip FTSE 100 index are some real 'dividend Goliaths' -- companies which pay out billions in cash dividends to their owners. In one year, Royal Dutch Shell paid out £6.6 billion in dividends, Vodafone Group £4.3 billion, HSBC £4 billion and GlaxoSmithKline £3.4 billion.

I already own shares in GlaxoSmithKline and would be happy to add any of the three other shares to my 'infinite income' portfolio.

2.     Bonds pay coupons

In financial markets, bonds are also called fixed-interest investments, because (surprise, surprise) they pay a fixed rate of interest.

Bonds are debt instruments: IOUs issued by companies, governments or other bodies.

Bonds do two things: pay a fixed income throughout their lives, known as a 'coupon'. At the end of their lives, bonds mature and return the original debt to bondholders. Usually, bonds are issued at, say, £100 and redeemed for the same amount, known as 'par'.

While the income paid by bonds is fixed, bond prices go up and down, moved around by interest rates, inflation, market movements and demand. Thus, the only way to be sure to redeem a bond at par is to own it until maturity.

I'm not a big fan of UK and US government bonds. I think they are too expensive, thanks to today's record-low interest rates. However, I am quite keen on corporate bonds, especially bonds from rock-solid companies that pay coupons exceeding 6% a year.

3.     Property earns rent

Buy-to-let (BTL) investing involves buying a property to let out to tenants. Instead of a homeowner loan, the landlord has a buy-to-let mortgage, usually at yearly interest rates between 4% and 6%. To get such a loan, a landlord has to stump up a deposit of 25% to 40% of the purchase price.

As I'm keen on low-maintenance, no-fuss income, I have never gone down the BTL route. Also, though rents have been rising for a year or two, I strongly believe that property prices are too high and, therefore, rental yields are too low.

Hence, I wouldn't buy individual properties to rent at this time.

However, I do plan to diversify into Real Estate Investment Trusts (REITs). These collective investments buy a wide range of UK and foreign property and then channel their tax-efficient income and profits to shareholders as dividends.

4.     Cash pays interest

Last but not least, we have the simplest asset: cash deposits. It’s best to put your cash in a Best buy cash ISA, where you won’t pay any tax. Top fixed-rate cash ISAs pay upwards of 3% a year.

Why pay tax?

To maximise this 'infinite income' over time, I intend to make full use of the UK's two favourite tax shelters: Individual Savings Accounts (ISAs) and a low-cost pension called a SIPP. By squirreling my cash inside these popular tax havens, I keep both income and capital gains out of the taxman's grasp.

In summary, by investing steadily over decades, I aim to produce a generous, tax-free income which could even outlive me. That's what I call stress-free living!

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