How To Earn Passive Income Through Dividend Paying Stocks And Mutual Funds

Stocks often get attention from investors for their potential to offer returns if their market value rises. However, they may also be used as a source for potential periodic income.

Many companies share a portion of their profits from time to time with investors through dividends. These payments can serve as an additional source of funds that may supplement your long-term plans.

You can tap into dividend opportunities either by investing in such companies directly or through mutual funds. This article explains how dividend-paying stocks and mutual funds work, when they may fit income-focused goals, how to get started in India, and the key risks to keep in mind.

Table of contents

• What are dividend stocks?
• Why dividend stocks are a relatively stable passive income tool
• How mutual funds may offer periodic income
• How to start earning dividend income with dividend stocks and IDCW from mutual funds
• Mistakes to avoid

What are dividend stocks?

A dividend stock represents ownership in a company that has a track record* of distributing a portion of its profits to shareholders in the form of dividends. These payouts are declared by the board of directors, and eligible shareholders—those appearing on the company's register on the record date—receive them. The ex-dividend date is typically one business day before the record date, and investors who purchase shares on or after the ex-dividend date will not receive the declared dividend.

To gauge the income potential of such stocks, investors often look at dividend yield, a commonly used indicator of how much dividend a company is paying relative to its current share price. Dividend yield is calculated as the annual dividend per share divided by the current market price of the stock.

While this number can offer a quick snapshot, it does not always reflect the full picture. Higher yields may appear when share prices are falling, and these yields may not always be sustainable. In India, some companies may show high yields at times, but investors must also consider factors such as financial strength, profitability, and cash-flow stability to assess whether such payouts may continue.

Mutual funds categorised as dividend yield funds invest in companies with a history of paying dividends or those with relatively higher dividend yields. These funds diversify across stocks, allowing investors access to a broader basket of dividend-paying companies rather than selecting individual stocks.

*Past performance may or may not be sustained in future

Why dividend stocks are a relatively stable passive income tool

• Regular cash flow: Dividend-paying companies may distribute income periodically without requiring investors to sell their shares. This may support income-seeking goals, though the payouts are not assured.
• Established companies: Businesses with a track record of paying dividends tend to be more mature, and their earnings may be relatively steady. This may reduce volatility compared with purely high-growth companies, although risks remain.
• Mutual fund access: Dividend yield mutual funds may be suitable for investors seeking a professionally managed and diversified investment route. As per SEBI’s guidelines, dividend yield mutual funds must invest predominantly in dividend yielding stocks.

While these features may support a passive-income-oriented strategy, investors must remember that dividend payouts can be reduced or suspended based on company performance. Stock prices may also decline, and there is no guarantee of favourable outcomes.

How mutual funds may offer periodic income

While dividend-paying stocks can provide direct payouts, mutual funds offer another way for investors to receive periodic distributions. Many equity schemes—especially dividend yield funds—invest in companies that pay dividends, and they also provide an IDCW (Income Distribution cum Capital Withdrawal) option for investors seeking cash flows.

Under the IDCW option, payouts come from the fund’s distributable surplus and are not assured. These distributions reduce the scheme’s NAV and may vary depending on market conditions, portfolio performance, and regulatory rules. This makes IDCW different from company-declared dividends, which come directly from a firm’s profits.

How to start earning dividend income with dividend stocks and IDCW from mutual funds

Here is a practical four-step process for Indian investors:

• Define your goal and allocation: Decide what level of income you are aiming for and what proportion of your portfolio you may allocate towards dividend-oriented holdings. Investors seeking substantial annual income may require a large corpus, given that dividends are variable and not assured.
• Choosing dividend stocks:
  • Review dividend yield but avoid relying solely on high numbers. Elevated yields may indicate falling stock prices or business stress.
  • Examine the potential sustainability of payouts by evaluating cash flows, earnings consistency, and payout ratios.
  • Maintain sector and company diversification to reduce concentration risk.
  • Use a demat and trading account to buy shares, and track ex-dividend dates, record dates, and company announcements.
• Choosing dividend mutual funds
  • Select schemes classified as dividend yield funds, whose investment objective focuses on investing in companies with higher dividend yields.
  • Confirm that the fund maintains at least 65% equity allocation, as required by regulation, and understand the very high risk nature of such funds.
  • Choose between the growth option and the IDCW option, noting that IDCW payouts reduce NAV and are based on distributable surplus.
  • Complete KYC and invest through the AMC or an AMFI-registered distributor.
• Integrate into your portfolio and review
  • Maintain a balance between dividend-oriented holdings and growth-oriented assets to support long-term potential wealth creation.
  • Consider reinvesting some payouts to build corpus over time.
  • Review at least annually to check whether companies or funds have altered their payout patterns, whether expenses remain reasonable, and whether risk levels align with your goals.
  • Monitor tax treatment each financial year.

Read Also: What is dividend payout ratio?

Mistakes to avoid

• Chasing only high yield: A very high dividend yield may signal business weakness or a sharp fall in the stock price.
• Ignoring risks: Dividend payouts may decline or stop in challenging conditions such as economic downturns, company financial distress, regulatory changes, or industry-specific challenges. They are not guaranteed and depend on company profitability and board decisions.
• Concentrating in one stock or sector: This increases company-specific and sector-specific risks.
• Overlooking costs: Higher expense ratios in mutual funds may reduce net potential payouts over time.
• Neglecting taxation: Dividend and IDCW payouts are taxable at slab rates, affecting net income. This is over and above the capital gains tax that applies upon redemption on the potential profits earned on your investment.
• Relying solely on dividend income: Dividend strategies may complement, but not replace, a broader long-term investment approach. Focusing only on income may limit long-term wealth creation.
• Neglecting long-term compounding: Choosing the IDCW option in mutual funds may lead to frequent payouts that reduce NAV and leave less capital invested for potential compounding over time.

Dividend strategies may be more suitable best as a part of a broader, growth-oriented portfolio rather than the primary approach, especially for those who are still in the wealth accumulation stage of their financial journey.

Read Also: How to Identify High Dividend Paying Stock & Mutual Funds

Conclusion

Dividend income from stocks and mutual funds may support income-oriented goals for investors in India. It may provide periodic cash flow, complement long-term appreciation strategies, and offer diversification benefits when incorporated thoughtfully. However, successful implementation requires careful selection, diversification, evaluation of payout sustainability, cost management, tax awareness, and regular monitoring. Dividends and IDCW payouts are potential, not promised, and investors must consider market-linked risks at every stage, including market volatility, interest rate changes, sector-specific downturns, and macroeconomic factors that could impact both dividend sustainability and underlying asset values.

FAQs

How often do dividend stocks pay?

A company may distribute dividends once a year or more in some cases, depending on its dividend policy. Mutual funds may declare IDCW payouts periodically (though this is not guaranteed) based on available distributable surplus and scheme policies, subject to regulatory guidelines.

Can I live off dividends?

While it may be possible, it generally requires a substantial portfolio and an understanding that payouts vary and are not guaranteed or fixed. For most investors, dividends and IDCW payouts may supplement other income rather than serve as the primary source.

Are dividends guaranteed?

No. Companies may reduce or suspend dividends based on profits, cash flows, or strategic decisions. Mutual fund IDCW payouts are also not guaranteed and depend on the scheme’s distributable surplus.

Do I need a lot of money to start investing in dividend stocks?

For mutual funds, you may begin with relatively modest investment amounts such as Rs. 500, generally. Thus, mutual funds may provide an accessible way to gain exposure to a diversified portfolio of dividend-paying companies. Building a similar portfolio through direct equity investments may require more capital.

Are dividend stocks suitable in a recession?

Dividend-paying companies may sometimes be relatively less volatile compared with certain high-growth companies. However, recessionary conditions may still affect earnings, payouts, and share prices. Dividend strategies remain subject to market and business risks.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed. The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.