How Can Income Investors Avoid the One-Two Punch?Dec 04, 2012
Low yields have battered income investors and now they're about to get hit with another punch: Higher taxes on dividends. Let's analyze how to avoid getting punched.
Anyone investing for yield income is about to get hammered with a one-two knockout punch. The first punch is/has been low interest rates and the second punch is higher looming taxes.
The chart below speaks to the first punch. It shows how the federal funds rate has drifted from 4% to near zero over the past four years, courtesy of the Federal Open Market Committee. The drop in the fund funds rate (the rate at which banks lend money to each other) has been particularly hard but not limited to fixed income investors in bonds (NYSEARCA:AGG), money market funds (Nasdaq:FFMXX), and bank deposit accounts.
Although The Economist labels this income deficit problem as “the complex effects of low interest rates on consumption and investment,” but there’s nothing complex about it. No one at the Federal Reserve Bank represents the financial interests of individual investors and savers. And the hostile environment facing investors is about to get even more hostile because of higher tax rates.
Beginning January 1, 2013 – tax rates on qualified dividend income from stocks (NYSEARCA:DVY) will jump from 15% to a top tax rate of 39.6%. If you’re in a top tax bracket, you’ll pay an additional 3.8% surtax to fund Obamacare. And if we combine today’s low rate environment with higher taxes on qualified dividend income – it’s a one-two knockout punch.
We’ve repeatedly warned our readers that buying higher yielding but riskier assets is dangerous. It’s like remodeling a sinking ship to make the boat look more attractive. During the 2008-09 meltdown, investors in high yielding junk bonds (NYSEARCA:JNK) and mortgage REITs (NYSEARCA:REM) got clobbered between 23-43%.
This time around, we are witnessing repeat behavior. We’ve even observed many highly regarded investment professionals acting just like the amateurs: Chasing high yielding sectors like REITs (NYSEARCA:REM), junk bonds (NYSEARCA:HYD), etc. – pretending that risk doesn’t exist. Don’t they know any better?
Likewise, tax exempt municipal bonds (NYSEARCA:MUB) have been sold as the panacea to higher looming taxes, but there’s no free lunch.
Credit risk has become a major factor for munibond investors (NYSEARCA:CMF) and major cities and municipalities from San Bernardino to Detroit are in dire straits. Strategic defaults are increasing. What about the possibility that municipal bond income could be taxed? (See “No Easy Money in Munis” by Jason Zweig.)
The only way for income investors to fight back is with a realistic plan that uses non-dividend income in conjunction with traditional sources to boost total returns. (As a side note, a major part of this also includes reducing onerous investment fees – as much as possible, which ETFs allow investors to do.)
The ETF Income Mix Portfolio we’ve assembled has been helping our readers to combat today’s anti-income/anti-investor climate. Since early 2012, our monthly income trades have averaged $1,040 per month* in cash flow in addition to traditional income sources coming from dividends. (Based on a hypothetical $100,000 all ETF portfolio) The only way to avoid getting punched, is to succssfully dodge the blows.
Income starved investors need to have a grown up view about their strategy. The Federal Reserve is not your friend. BernanQE & Co. has pledged to keep short-term interest rates at current levels until 2015. A proactive approach to higher income is the smarter road taken.
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