As people enter retirement, they seek to replace their earnings with income from investments, and most advisors are glad to buy them bonds, real estate funds, and high-dividend stocks. However, this approach is tax-inefficient and may even increase risk at precisely the wrong time. A total return approach can meet retirees’ cash needs with less tax liability per dollar of return, greater stability, and often far better performance.
With the Fed suppressing short-term and now even long-term interest rates, investors are taking more risk than ever for paltry returns. Junk bonds today pay barely 4 percent interest (see chart), despite their corporate issuers’ heavy debt loads and faltering profits in this economy.
Real estate funds (REITs) aren’t much better, paying roughly 4.5% in dividends, despite unresolved questions surrounding eviction moratoria and commercial property values. See that spike in the yield chart above? That represents the price of bonds collapsing last March. REITs also fell steeply, as you can see in this chart comparing the S&P 500, REITs, and junk bonds. Investors who reach for cash yield regularly suffer such harrowing volatility, and the rebound is not always so swift.
A single-digit tax rate?
Now consider taxes. Dividends are taxed like long-term gains, but interest income from bonds is taxed at your full marginal income rate. Taxes can be punishing for high-earners, but the main issue here isn’t the tax rate, it’s the amount of your cash flow subject to tax. Say you have a $1 million portfolio spinning off $40,000 in interest and dividends subject to a blended tax rate of 25%. You’ll pay $10,000 and net $30,000.
That would be fine if such a portfolio were growing strongly, but we often see lackluster growth from funds that prioritize yield. Some seem to be managed cynically, and essentially pay investors back their own money and call it income, thus creating a tax liability where there should be none.
Now consider the alternative, where we select a portfolio not for yield but for stability and total return, defined as the sum of interest, dividends, and price appreciation. We’ll generate our own dividends by selling investments and withdrawing the cash. When we sell $40,000 of investments, some of them may show capital gains, but in tactical portfolios the majority of proceeds is simply principal, which is subject to no tax. If your average capital gain on a sale is 10%, only $4,000 in this example is subject to tax. At a 25% rate, you owe just $1,000, or 2.5% of your distribution. To be clear, this isn’t the whole picture. You still owe tax on the reinvested gains, interest, and dividends that stay in the account, whether you own income funds or a diversified portfolio.
Don’t limit your options
By maintaining a focus on total returns rather than income alone, we can likely grow the account faster and sustain a higher safe rate of withdrawal. This is because we can give meaningful allocations to assets like growth stocks that can boost returns in bull markets, or gold, which can stabilize a portfolio in bear markets.
In retirement accounts, you have even less reason to seek income funds, as you either pay no tax at all (Roth), or you pay tax on the amount withdrawn without consideration for whether the money comes from interest, dividends, gains, or principal (Traditional). It’s all the same to the tax man, so all that ever matters in an IRA or 401(k) is your risk-adjusted return.
REITs and even junk bonds do have their places as diversifiers, but every investment should be selected for its potential contribution to overall risk-adjusted returns. When you try to optimize for a particular type of return you sacrifice either upside or stability, and neither is worth giving up without a corresponding gain in the other.