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.
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.
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.
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.]
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:
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.
As a fee-only financial advisor, 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 maximize your money to achieve the life of your dreams.