KATHLEEN NEMETZ, MBA, CFP®, CDFA®
May 28, 2015
originally published on Nerdwallet.com
If you’re age 50 or older and are like most investors, you’re investing largely in mutual funds through an employer-sponsored retirement plan. If you have a brokerage account, you’re probably choosing funds rather than individual stocks.
Investors who have a little more knowledge will often assess the balance of their holdings and the ratings of the funds they own. They may subscribe to newsletters or visit financial sites that provide guidance and recommend stocks and funds.
So much of that guidance, however, is focused on growth — the potential for price appreciation as investments increase in value. The only way to turn investment growth into cash is to sell the investment. As investors get closer to retirement, though, they want to know more about how much income their portfolios are earning — that is, how much cash their holdings are actually generating. Growth may be high, but income may be quite low.
So what is an investor to do? Ride the hills and valleys of the market and hope for the best from a growth standpoint? Or take steps to lock in more certainty about income?
Making the transition from growth-focused investing to income is often challenging. Investors comfortable with stock funds may have a hard time adjusting to the notion that a mix of securities might better achieve their income goals.
To choose the strategy that’s best for you, it’s important to understand some income-related financial terms and definitions.
To explain yield, I often use the analogy of a house rental. Say you rent a house to a tenant. The rent you collect, minus your expenses, is your yield — that is, the income from the property. The rent by itself is not the value of the property. The property value can rise or fall independent of the rent you receive. You realize a gain or loss on the property only when you sell the house. In the interim, you can take deductions against income on your taxes.
Stocks pay dividends, bonds pay interest, and these payments are made on specific dates, often several times a year. Divide the annual amount of payments by the value of the stock or bond to determine the effective rate at which it pays income. That is yield.
Dividends are paid by common and preferred stocks, usually on a quarterly or semiannual basis. Preferred stocks are a type of fixed-income instrument, with a guaranteed dividend. Common stocks are the more typical equity issues; their dividends aren’t guaranteed, although they have greater potential for growth.
Interest accrues and is paid on debt instruments such as certificates of deposit and bonds. The bond owner receives interest, usually twice a year, in the form of a “coupon” payment. (Bond funds usually distribute interest monthly.) Investors get their principal back when they redeem the CD or bond.
Capital gain distributions
Capital gains are the fruits of growth — money made by selling an investment for more than you paid for it. Mutual funds declare and distribute capital gains from the sale of investments within the fund. These distributions are typically not guaranteed.
Other income sources
Annuities produce regular, guaranteed payments that are usually a mix of income and a return of capital. Depending on the annuity, there may be a guarantee of lifetime income.
Covered calls are an additional source of revenue for people who own a portfolio of common stocks. Engaging in a call strategy requires an in-depth conversation with your financial advisor to review your risk tolerance and the tax implications for realized gains.
What income sources are right for you?
Well-diversified investors may be using a mixture of all these strategies to produce the annual income they need from their accounts. The actual allocation of weight among strategies may depend on the risk tolerance of the investor, as well as the amount available to invest. All of these decisions are made in the context of an investor’s need for liquidity — the ability to convert investments to cash. Investors who are already retired are normally advised to keep a percentage of assets in cash to have available for emergency needs. This lets them avoid “fire sale” events should markets turn down.
A discussion with a financial planner can help you identify the income sources that make the most sense for your retirement. Tax issues should also be considered, as larger withdrawals from IRA and 401(k)-type accounts can affect your tax rates. Having tax-free Roth IRAs can help as well.
This information is not intended to be a substitute for individualized tax or legal advice. Please consult your tax or legal advisor as appropriate regarding your specific situation.