Portfolio income: Here’s why dividends are so important

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Portfolio income is a very important part of investment total returns. Far too often though investors only focus on changes in a stock or fund’s price, giving an incorrect picture of their portfolio returns.

Portfolio Income - Dividends

What is portfolio income?

Portfolio income is paid out to investors, as cash or additional shares. This income is in addition to any changes in share prices and contributes to a portfolio’s total return. The two sources of portfolio income are interest from bonds and dividends paid to stockholders. (What are stocks? Here’s an explanation.)

What are dividends?

Many companies have reached a point where they generate substantial profits each year. When this happens the company’s board of directors can decide to pay out a portion of the profits to their shareholders. Not every profitable company pays dividends though. Management decides the best use of profits, often using some for continued growth and some to reward investors.

Why dividends for income versus bonds?

Bonds do a good job of stabilizing a diversified investment portfolio against economic downturns. When stocks do poorly, bonds tend to do well. But many people think of bonds for income – especially in retirement. In reality though, the income generated from bonds over the past 10+ years really hasn’t been that great.

Bond yields have been rising a bit recently along with interest rates. Even so, the Vanguard Total Bond Market ETF (BND) is currently paying just a 2.50% yield. Let’s compare that to the SPDR S&P 500 ETF (SPY) which is currently paying a 1.92% dividend yield. [Both of those yields are as-of April 7th 2017.]

Portfolio income and total return

The Total Bond fund is paying more income than the S&P 500 fund – so that’s the better choice, right? Portfolio income is an important part of an investment’s return, but it is only part. To understand the true return of an investment you need to look at changes in the stock or fund price in addition to any income paid. This is referred to as an investment’s total return.

Let’s look at some information and charts to help understand total return.

This first chart and data set is for the Total Bond fund mentioned above.

Portfolio Income: BND Returns

If you put $10,000 into that fund ten years ago, your investment today would be worth $14,146.93. That’s a total return of 41.46% in a 10-year period. A more common way to express investment returns would be the average annual return. In this case the average annual total return of this investment would be 3.53% per year.

While that isn’t horrible, let’s consider if you put the same amount into the S&P 500 index fund mentioned above.

Portfolio Income: SPY total returns

In this case the same $10,000 investment ten years ago would now be worth $18,901.76. That’s a total return of 89.03% – an average annual total return of 6.40%.

From a return perspective you need to consider: Is the small difference in annual yield (bond interest versus dividend income) worth the lower total return? In this example that works out to almost 3% per year lower total return holding bonds versus general market stocks.

Note that I said “from a return perspective.” Return isn’t the only consideration here. Individual risk tolerance is another big factor in determining your ideal investment portfolio. While the bonds didn’t perform as well over ten years, they also didn’t drop in value when the recession hit in 2008. For some people the peace of mind that bonds bring is worth a lower return. You need to make a personal judgement balancing risk with the level of total returns needed to achieve your financial goals.

How is portfolio income taxed?

I’m glad you asked because that’s another important consideration!

Since bond income is essentially interest paid on a loan you made to the company, it is taxed as ordinary income. So whatever your personal income tax rate is – that is the tax rate you will pay on bond income. Now there are some exceptions when holding federal bonds, but those bonds also pay lower interest yields.

Dividend income is a share of profits that the company generated – after they already paid corporate income taxes. Because of this most dividend income is treated differently from a tax perspective.

There are two types of dividends: Ordinary Dividends and Qualified Dividends. Ordinary dividends are taxed at the same income tax rates as bond income. Qualified dividends are taxed at capital gains tax rates. Most dividends for long-term investors are taxed at the lower capital gains rate.

What makes a “qualified dividend”?

The rules to make something a qualified dividend in most cases are pretty simple. 1) The dividend needs to be paid by a US corporation and; 2) the investor needs to have held the stock at least 60 days.

Our dividend portfolio

I already shared our full portfolio here in a previous post. What I didn’t note in that other post was the amount of current dividend yield for our holdings. So here is the yield per investment and a calculation of the total portfolio yield. [Math alert: I got the total dividend yield by multiplying the yield by the holding percentage then adding up all the totals.]

Income Portfolio Dividend Yield

Dividend taxes on our portfolio income

Remember above the two requirements for a dividend to be Qualified and taxed at the lower capital gains rate? Well, you can see above clearly that most of the dividend income from the Betterment account fails the test. Emerging Markets is definitely outside of the United States. That Developed Markets fund is also a mix of non-USA companies.

My family is going to have about $25,000 of taxable dividend income this year. For simplicity let’s look at an example and assume that is our only income for the year.

If those were qualified dividends, and we had no other income, there would be a 0% (ZERO) effective tax on this income. That’s awesome… but not the case here.

Since these are ordinary dividends, again assuming no other income, the effective federal tax rate will be 11.3%. While I don’t like paying any more taxes than I need, I’m okay with this. Why?

You can see that the total portfolio above has an effective dividend rate of 2.96%. Since I’m a simple guy, if I were to manage this investment portfolio on my own, I’d have four simple funds like shown in my Motif account. Here’s how that would look:

Portfolio Income Motif

So with my fund picks I would get 2.27% effective yield, with 1.76% of that tax free (because I hold more than 60 days, and everything but ACWV are USA funds).

I know I’m getting a bit technical here, but I’m almost done. Is 1.76% tax free better than 2.96% taxed at 11.3%? No, not even close. The yield is way more than 11.3% greater in the Betterment investing account so it more than makes up for the difference in increased taxes. Even if the entire 2.27% were tax free the math would still work to favor the Betterment holdings.

Portfolio income for retirement

Far too many financial advisors recommend that the closer you get to retirement, the more bonds you should hold in your portfolio. On the surface this sounds like a decent idea. Bonds won’t drop in value nearly as much as stocks, so your portfolio balance shouldn’t tank. Bonds also provide steady income.

BUT… once you enter retirement you might have twenty – or even thirty – years left to support yourself. If you retire at 62 there is a great chance you’ll live until at least 82. Both of my grandmothers made it to age 100! If you are mostly invested in bonds with “fixed income” that income isn’t going to increase much. There’s a chance that it won’t even increase as much as inflation.

Also, most American’s don’t retire with such a large nest egg that they can live off 2.5% of their investments. They more likely will need to draw twice that much – perhaps 10% or more each year. If you retire with a half million dollars invested, that’s a comparison of $12,500/year versus $50,000/year.

To have even a chance of such a hefty draw down requirement, most retirees need to seriously consider staying mostly invested in stocks. Someone might still outlive their money, but with the total return of stocks being almost twice that of bonds – at least with stocks the retiree will have a better chance of their life savings lasting.

Are you new to investing?

If you are new to investing I first recommend you read our post 6 Things to Take Care of Before You Start Investing.

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As a financial life planner I can help you clarify your dreams and priorities, then develop an actionable plan to achieve your goals. Having a financial plan for your life includes much more than just investing, but intelligent investing is definitely part of the solution. Reach out and let's talk about how I can help you achieve the life of your dreams.

 

 

 

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8 Comments

  1. Francesca - From Pennies to Pounds April 12, 2017 at 11:51 am - Reply

    Oh gosh, I still find investing very confusing. I really need to start though, as I’ve just paid off my debt and want to take some positive steps for the future!

    • Brad Kingsley April 12, 2017 at 2:20 pm - Reply

      Hi Francesca – thanks for the comment. Investing doesn’t have to be confusing. In fact, far too many people over-complicate it. Simple investing is fine and in many cases produces better results. This topic was a bit more advanced for people who like digging into some details. The takeaway though is that the total return of an investment is more than just the change in the fund price. If you get a couple percentage points of additional return each year from dividends, it can make a HUGE difference on the end result of your account.

  2. FIscovery April 12, 2017 at 10:15 pm - Reply

    I love the back to basics posts backed by real world examples – – I cannot stress how valuable these kinds of posts are – – please, please post more like this and often – thank you for leveling the playing field. 🙂

    • Brad Kingsley April 13, 2017 at 1:45 pm - Reply

      Thanks Fiscovery!

  3. SMM April 19, 2017 at 6:23 pm - Reply

    Wow, 46% VS 89% that difference is insane! Sometimes it really is important to write down this stuff in order to compare and contrast. And I agree that once we retire at the standard retirement age people are living longer these days so you shouldn’t have your complete portfolio in bonds anyway.

    • Brad Kingsley April 19, 2017 at 7:45 pm - Reply

      Yeah, it’s crazy. With retirees potentially needing a portfolio to last 30+ years, having stocks – income-producing stocks – might be the difference between outliving your money and leaving a nice legacy to the next generation. Thanks for stopping by!

  4. Mustard Seed Money May 20, 2017 at 2:13 am - Reply

    I was a big fan of growth stocks until one day I read up on dividend paying stocks. Ever since then I made the switch and I’ve never looked back. Watching that quarterly dividend drop into my account every three months is so wonderful especially when it can buy new shares through a DRIP. Definitely one of the smartest things I’ve done in awhile.

    • Brad Kingsley May 20, 2017 at 10:47 am - Reply

      Thanks for sharing MSM!

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