Inroads To Income

Building A Diversified Income Strategy

Today’s retirement options don’t have to be so confusing

by Herbert K. Daroff, J.D., CFP, AEP

Mr. Daroff is a contributing editor to Advisor Magazine, and is affiliated with Baystate Financial Planning, in Boston. Visit www.baystatefinancialplanning.com

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.

How About Real Estate?

What else can you invest in besides stocks and bonds? How about real estate? Let’s create a cube for that asset class. The x-axis is domestic (single houses, multi-family houses, apartment buildings, etc.), corporate (office buildings, for example), and institutional (warehouses, for example). The y-axis held for income, held for a combination of income and growth, held for growth. The z-axis, just like the stock and bond cubes, is domestic (U.S. real estate), global (real estate holdings both inside and outside of the U.S.) and foreign (real estate outside of the U.S.).

  • You can own individual parcels of real estate and/or Real Estate Investment Trusts (REIT). And, now there are also Qualified Opportunity Zone investments, too.
  • You can add a fourth cube for mortgages on those various types of real estate assets, individual notes or in bundles of notes.

Real estate is considered an “alternative” investment. So, too, are precious metals (gold, silver, etc.), commodities (farm products such as soy beans and oranges), currencies other than the U.S. dollar (foreign governments and crypto), investments in private companies, investments in companies that invest in other companies (private equity, venture capital, hedge funds, etc.), art, antiques, rugs, and much more. Alternative investing tends to have higher minimums to get in, higher fees, and higher risks, but may have higher returns.

Saving as much as you can now and spending as little as you can later will help the funds last, but that may not be consistent with your wish list, now or later. Postponing Social Security until age 70 and Required Minimum Distributions from retirement accounts and annuities to age 70½ will also help your income stream for longevity and inflation. However, that takes some planning...

How To Own A Diversified Portfolio

How you own your diversified investment portfolio (asset allocation) should take into consideration your income distribution strategy (asset location).

1. Consider creating four boxes to hold your investment cubes.

2. Taxable accounts that hold mostly tax advantaged asset classes, such as value stocks, muni-bonds, and investment real estate.

3. Retirement accounts that hold mostly tax inefficient asset classes, such as bonds (other than munis) and some equities (other than value stocks).

4. Consider holding the most aggressive positions inside variable annuities with lifetime income benefit riders and investment hedges.

Consider growth stocks for your Roth accounts

If you own Apple stock, for example, in your retirement account, it comes out as ordinary taxable income. If you own it in your taxable account, it comes out at capital gains rates. If you own it in your Roth, it comes out tax-free. Consider cash value from life insurance instead of cash, for better net after tax return. Keep in mind that the death benefits from that life insurance can later be used to fund the income taxes when your surviving spouse converts your traditional retirement accounts into Roths.

Finally, much of the problem with any income strategy is not knowing how long you will live or the future of inflation rates.
We don’t know future income tax brackets, but we can plan for both high tax rates and low during retirement with qualified and Roth retirement accounts. We don’t know future investment returns, but we can plan for both up and down markets, with hedged returns from \annuities.

Save More… Spend Less

Saving as much as you can now and spending as little as you can later will help the funds last, but that may not be consistent with your wish list, now or later. Postponing Social Security until age 70 and Required Minimum Distributions from retirement accounts and annuities to age 70½ will also help your income stream for longevity and inflation. However, that takes some planning. And, some of the decisions may not be within your control. You may not want to retire until age 70 or later, but that doesn’t mean that your boss agrees.

Financial Planning models are flawed, in my opinion, when they assume that anyone will run out of money. They are based on continuing the lifestyle net after taxes and inflation regardless of the value in the investment accounts. We are not lemmings that will simply walk off the cliff. If investment accounts decline, lifestyle may need to decrease. Major causes of investment accounts declining in value is failure to plan for medical and custodial care expenses. Medicare and Medicare supplements are essential for future medical expenses. Custodial care planning (with proper trusts) and insurance (with standalone coverage or coverage combined with life insurance or annuities) has become an integral part of your financial plan. Don’t leave work without it. Don’t start your income stream without it.

Life insurance can replenish the investment accounts for those that survive you. Having life insurance gives you the permission to spend principal as well as income knowing that the principal will be recovered at your death.◊