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!
More: Start saving for a brighter future | Why big savers may be at risk | Why property is profitable
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yocox Good luck with your BTL venture. I did once buy a BTL flat on borrowed money. I found it difficult financially, not because of the interest, but, because I was delveraging, the capital repayments were really tought to manage. Unlike interest, these are not tax deductible. It's OK now, but it was really hard for 10 years. I would hesitate to do it again because I am too old to really get the benefit.
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My experience is also that income from property is ahead of income on cash even without potential capital growth. Leveraging capital growth (which I believe has never been down over a 25 year period) increases the return on investment. I have a couple of 100k flats that required 15k deposits. Capital growth aside, I'm currently clearing a couple of hundred a month on one and around 80 a month on the other, net of all fees. That's comfortably over 10% average ROI on the deposits. Capital increases and rent rises will add to this, rising interest rates will make them less profitable but then my cash deposits will do better. Another example of the benefits of diversification. Rate rises or falls will be positive or negative to different elements of my assets. And yes, I know that my deposits, plus, plus are at risk if there's a property crash and I need to sell at the bottom. Shares have been flat for a decade while properties have doubled in value, even after the 2007 correction.
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Cliff Three generations of my family have held property investments and they have turned out to be the best investments. The reasons for this are: O They survive for a long time. Companies and businesses go bust, get bought out and otherwise disappear (of the US top 100 companies in 1900 only GE and Kodak still survive and Kodak is pretty ropey) O Provided that leverage is low, rent (minus repairs etc) is actual spending money. Compare cash in the bank where you have to feed the interest back to try to offset Inflation. Over the long term property values should keep up with inflation. O Reasonable prospects of income (rent) tracking average earnings over the long term O Successful share investing needs constant work, research and worry (not helped by Mr Market flinging prices around). Unlike Warren Buffett, most of us do not have the time, the aptitude or the inclination. Property only requires plenty of common sense. Of course, there is much more aggravation than share ownership or money in the bank. There are bad tenants, although the chances of getting one can be reduced, but not eliminated. Maintenance e.g. a new roof may be requried, but this can be managed. On balance BTL with low leverage more closely approximates to your ideal "infinite" (I think you mean perpetual) income stream. On this model CGT is never a problem because you never sell the property(ies).
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27 July 2011