Get the Growth and Income You Need

September 4th, 2014
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Investing Daily Article of the Week

by Philip Springer, Investing Daily

As you approach or live in retirement, it usually becomes necessary to generate income from your investments for expenses. Achieving that goal poses a major challenge in this era of miniscule savings rates and rock-bottom bond yields.

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At long last, the Federal Reserve is planning to start raising short-term interest rates in 2015. This will be the Fed's first rate hike since December 2008, when the federal funds rate fell to zero-0.25%. Nevertheless, short rates will remain extremely low. While longer-term yields may rise, they're also likely to stay depressed. Various reasons include a sluggish global economy and strong investor demand for income in a yield-starved world. Currently, the benchmark 10-year US Treasury issue pays only 2.4%, but that's higher than the yields on most other government bonds around the world. Other fixed-income vehicles pay somewhat higher yields, with varying degrees of risk.

These dynamics continue to help make dividend stocks the best investment alternative. Many pay current yields higher than those of Treasury securities, with the probability of future dividend hikes and good capital-appreciation potential over time.

These six guidelines will help you pay for your living expenses and safeguard your financial security:

#1: Invest as much as you can in growth-oriented investments. There's no magic formula. It depends on your income needs, your risk tolerance and market conditions.

If you're in or near retirement and in good health, you may well live another 20 or 30 years. Despite periods of extreme market volatility, history shows that the surest way to build a large nest egg is to invest as much as possible in equities.

Investments that provide little or no growth suffer from diminishing purchasing power, even in these low-inflation times. Worse, in a regular account, investment income from cash equivalents and non-municipal bonds is heavily taxed, at ordinary rates plus any state income taxes.

But the need to invest for conservative growth doesn't mean you should buy and hold through thick and thin. You need to make adjustments for market conditions, lowering your equity allocations when prices rise to dangerous levels or when adverse market conditions heighten the probability of a sharp decline.

#2: Adapt your portfolio to changing needs. If you'll need cash for living expenses within the next several years, you've got to minimize your risk with some of your assets.

The greater the percentage of your portfolio you use for living expenses each year, the more you need to rely on income-producing assets, such as bonds and high-yield equities.

Another approach: Set aside three to five years' worth of living expenses. Then invest the rest, mostly in equities, as market conditions allow.

Suppose you estimate you'll need $150,000 from investments for expenses over the next three years. Keep that portion primarily in cash equivalents and short-term bonds or funds. Yes, your yield will be low. But capital preservation is the key.

#3: Make changes gradually. A common mistake income-seeking investors make is to sell equity investments that have served them well. This needlessly creates capital-gains taxes and sacrifices growth potential.

But if you plan ahead, there usually will be no reason to sell or buy except on an investment's merits. As you sell investments, you can replace them with others that will better meet your long-term needs. For instance, if you sell a growth vehicle that no longer offers good potential, replace it with a conservative total-return investment that pays more income.

#4: Sell assets for income without creating a heavy tax burden. In general, you should sell assets in your currently taxable accounts first. First, take dividend income and fund distributions in cash instead of reinvesting them. You pay tax on these payouts anyway.

Next, sell investments with the highest cost basis and therefore low or no taxable gains. In this category are bonds, bond funds and cash equivalents. And if you unload losing investments, you can offset your tax bill on any gains you've taken on others. Finally, if you do sell long-term winners, your capital-gains tax will be 20% or even much less.

#5: Keep tax-deferred accounts intact as long as possible. Distributions are taxed at ordinary rates. Until you reach the deadline for mandatory withdrawals, draw cash from your currently taxable accounts. Retirement-account assets will continue to grow unhindered by taxes. Later, you can tap your retirement accounts, which will have enjoyed longer tax-deferred growth.

#6: Consolidate your portfolio. Over time, it's only natural to accumulate many investments. But it becomes difficult to adequately monitor a large number. And your portfolio is unlikely to perform up to its potential or meet your needs if you have so many holdings.

Start weeding out lower-quality investments and build your stake in the better ones. Consider setting a minimum requirement for each investment, such as $5,000 or $10,000, or 2%-3% of your portfolio. This will help you decide whether an investment is good enough to increase or whether you should get rid of it.

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