What’s the best way to invest for income? The old approach was to invest in funds and ETFs that pay monthly or quarterly dividends and take those dividends in cash.
This passive approach to generating income is easy to follow, and many investors like getting regular dividends in their accounts, but it doesn't always work out as well as investors might expect. Here's why:
4 pitfalls of a dividend approach to income investing
1. Investors need growth and income
Most investors also need to invest for growth, so they can keep up with inflation and continue to steadily take income from their account for many years to come.
Choosing a stock or mutual fund solely because it offers a fat distribution, without considering its total return prospects, can lead to poor investment performance and diminished future income.
Consider Invesco Preferred ETF (PGX), for instance: it had an impressive 4.9% yield over the year ending April 30, 2021, according to Morningstar, but its total return was about 11% over the same period—which sounds good until you realize that other funds with similar risk were up more than 30% over that same time frame!
PGX’s 4.9% yield was nice to have, but most investors would have been better off seeing their investments rise 30% or more and then taking their cash needs from those gains.
2. Dividends can change over time
Income investors also prefer a steady income stream, but dividends can change over time depending on interest rates and a fund’s underlying stock or bond yields. So, one month your dividends might be enough to pay your bills, but the next month your dividends could fall short.
3. Dividends may not be as tax efficient
Importantly, a dividend approach to income investing may not be as tax efficient, given that nonqualified dividends are taxed as ordinary income, which can be as high as 37%.
4. Dividend-paying stocks can be volatile
With bond yields at such low levels, investors might consider dividend-paying investments, like dividend-paying stock funds. Funds that buy shares of companies that pay regular dividends may own more defensive companies, like utilities, but defensive stocks are still stocks. They are correlated with the stock market and when stocks fall, they’ll fall, too. We shared a chart showing the difference in volatility between SPDR S&P Dividend ETF (SDY) and iShares Core U.S. Aggregate Bond ETF (AGG) here.
Morningstar’s 2019 article, “Are dividend paying stocks a good substitute for bonds?, noted that “over the past 15 years, a period that captures the financial crisis, the S&P High Yield Dividend Aristocrats Index has a standard deviation of 13, versus just over 3 for the Bloomberg Barclays Aggregate Index.”
A total-return approach to income investing in 2021
In the accounts we manage for our wealth management clients, we take a more comprehensive and active approach that doesn’t rely solely on yields. Instead, we invest for total return, which is the combination of capital appreciation and income, rather than income. This way, we can target funds with strong growth potential, and we typically create a steady cash flow by realizing long-term capital gains.
Tax advantages of a total-return approach
Realizing capital gains is particularly beneficial for investors with taxable accounts because long-term gains are currently taxed at 0%, 15%, or 20%. If you are married and filing jointly, and your income is less than $80,000, you’d pay 0% on long-term gains. (You’d pay 12% on nonqualified dividend income.) If you and your spouse have a higher income, say $350,000, you’d still be better off realizing long-term gains (taxed at 15%) than dividends (taxed at 32%).
While the Biden administration has proposed raising taxes on capital gains for households with income over $1 million, it’s unknown what tax changes could actually become law.
Income investing in a low interest rate environment
Some investors worry about selling shares to generate income, but this may be increasingly common given that bonds yield so little. “The current low-interest-rate environment also means that most retirees will need to derive some of their cash flows from trimming appreciated holdings rather than relying exclusively on income distributions to meet their living expenses,” Morningstar explained.
By using capital gains for income, FundX advisors can create a more predictable income stream for their wealth management clients. And client appreciate that they'll always know how much they can expect to see in their account, no matter what happens with interest rates.
A total-return approach to generating income used to be unconventional, but now even Vanguard recommends it, noting in an April 2021 report that "a broadly diversified total-return approach addresses many of the risks and pitfalls of an income-focused strategy in the current low-yield market environment."
If you’re looking for a better approach to generating income in this low yield environment, then set up a time to talk with a FundX advisor here.
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