Building A Diversified Income Strategy
September 25, 2019 by Herbert K. Daroff, J.D., CFP, AEP
It’s no wonder that most clients are confused as they approach the income distribution phase of their financial plan (which used to be called “retirement”). Think of a series of 3(x) by 3(y) by 3(z) cubes each one representing all of the various investments that this client might own. Let’s start with just stocks and bonds. In their equity (or stock) portfolio cube, the x-axis is small-cap, mid-cap, and large-cap companies.
The y-axis is value, blended, and growth companies. The z-axis is domestic (U.S. companies), global (companies that operate both inside and outside of the U.S.) and foreign (companies outside of the U.S.). Then, there is their bond cube. The x-axis is short-term, intermediate-term, and long-term. The y-axis is corporate, government, and municipal. The z-axis, just like the stock cube, is domestic (U.S. companies), global (companies that operate both inside and outside of the U.S.) and foreign (companies outside of the U.S.).
Now, with just these two cubes, you can own individual stocks and bonds. You can buy mutual funds that own stocks and/or bonds. You can buy exchange traded funds (ETF) that own stocks and/or bonds. ETFs have four advantages over mutual funds.
- 1. ETFs are traded all day long, like individual stocks and bonds. Mutual funds are only traded at the end of the trading day.
- 2. ETFs tend to have lower internal fees than mutual funds.
- 3. You can purchase financial hedges (puts, calls, collars, etc.) on ETFs to manage the risk of ups and downs in price, but not on mutual funds.
- 4. ETFs are more income tax efficient than mutual funds. With mutual funds, you can incur income tax consequences even if you don’t trade the mutual fund. You are taxed on the activity of the manager.
One advantage that ETFs have over individual stocks and bonds is diversification without owning hundreds of individual securities. In addition to buying individual stocks and bonds or bundles in the form of mutual funds or ETFs, you can buy index funds and ETFs. The index can measure large or small areas of the overall investment market worldwide.
Tax Efficiency
Regarding tax efficiency, some assets have their own built in, like muni-bonds. Others, like individual value stocks, result in the investor paying mostly capital gains on dividends and sale, instead of ordinary income. For other less tax efficient assets, you may want to hold them in a qualified retirement plan, individual retirement account, and/or an annuity. A variable annuity lets you build up a portfolio just like inside a 401(k) plan. An indexed annuity measures your performance as if you owned an index.
Some variable and indexed annuities offer up side and down side hedges on market performance. The advantage of the 401(k), for example, IRA, and annuity is the deferral of income taxes until some point in the future. The disadvantage is that all of the income coming out is taxed at ordinary income tax rates. If you contribute the funds in a tax bracket higher than when you take distributions, then the tax deferral may have worked for you. The problem is that we have no idea what future income tax brackets will look like, even if you are receiving lower income than you are earning when you make the contributions.
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