Where to Find Investment Income

July 7, 2016

Yields on bank accounts and money market funds continue to be negligible. That’s discouraging for people who anticipate cash flow from their savings. In some cases, such income is vital for paying ongoing expenses. Even if that’s not the case, the unearned cash flow would be a nice way to pad your portfolio. Of course, be sure to understand any investment carefully before you commit.

For taxable accounts

Generally, you should consider holding investments with tax advantages in a regular account. Some possibilities:

Municipal bonds. The interest is exempt from federal income tax, and local issues may be totally tax free. Some municipal bond funds have low expenses and strong track records. However, if you prefer more control over your holdings, you might construct a bond ladder—individual bonds with staggered maturities.

Example: Heath Jensen buys $50,000 of municipal bonds maturing in 2016, $50,000 of munis maturing in 2017, and so on, out to 2022. As the bonds mature each year, Heath will use the redemption proceeds to buy $50,000 of bonds one year further out, adding a rung to his ladder as a replacement.

Ultimately, Heath will wind up with bonds bought at a 7-year maturity, often a good combination of yield and reasonable waiting time till maturity. If yields should rise, as many people expect, Heath will be reinvesting the proceeds at those higher yields.

Dividend paying stocks. For the most part, people pay only 15% in tax on stock dividends. Those with modest incomes (taxable income up to $74,900 this year on a joint return, for example) owe 0% tax. The good news is that stock dividends can grow over time, if the company’s business is successful.

Of course, stock prices can fall sharply. If that happens, a 2% or 3% dividend won’t be much of a consolation. Still, steady investing in companies that are profitable enough to pay dividends has been a successful strategy, over the long term.

Equity REITs. Some real estate investment trusts (REITs) buy mortgages, whereas others own investment properties. Either way, REITs must distribute most of their profits in order to avoid corporate income tax. Thus, some REITs pay relatively high distributions to their investors.

What’s more, some distributions from REITs that own properties (known as equity REITs) are untaxed returns of capital. You might get 6% from an equity REIT but owe tax only on 4%. In this hypothetical scenario, the 2% that avoids current tax is subtracted from your basis in the REIT. A lower basis, in turn, can increase tax on a future sale. Even so, tax deferral and a possible shift to a lower tax rate on a future sale can amplify the benefits of holding equity REITs. (Again, REIT prices can drop, so there is risk to investors.)

For tax-deferred accounts

In your IRA, 401(k), or other tax-deferred retirement accounts, consider income producing assets that have no protection from current taxation. You can defer the tax on the investment income, perhaps until you’re retired, in a low tax bracket. Some possibilities:

Ginnie Mae funds. These funds hold mortgages that are supported by the Government National Mortgage Association (GNMA). The interest paid by homeowners is passed through to investors in the fund. Unlike other mortgage-backed securities, Ginnie Mae interest and principal repayment is guaranteed by the federal government.

Yields on Ginnie Mae funds are usually a bit higher than Treasury bond yields. Among other reasons, Ginnie Mae payouts are not exempt from state and local income tax, which is the case with Treasury bond interest. You can buy individual Ginnie Mae securities, but they can be complex because homeowners are repaying principal along with their monthly interest, so investing through a fund can offer simplicity.

High-yield bond funds. If you’re looking for yields, why not put some money into a fund with a name that promises steep payouts? Typically, these funds hold corporate bonds that are low-rated or unrated, often known as junk bonds. Because their credit quality is suspect, issuers must promise substantial yields to bond buyers.

It’s unlikely you would want to hold nothing but junk bonds in your retirement fund. Still, apartial allocation might deliver some significant income, if you can stand the volatility of this asset class. A financial adviser may be able to help you find a high-yield fund with relatively low yields and a solid performance history.

Floating-rate funds. The funds acquire loans made by banks and other lenders, often to companies with relatively low credit ratings. Not only do investors receive attractive yields, they also may get some protection against rising interest rates. That’s because the loans held by floating-rate funds typically have interest rates that reset periodically. Rising interest rates devalue most bonds and bond funds; with floating-rate funds, rising rates translate into higher yields for investors.

Floating-rate funds can be volatile—they lost heavily in the financial crisis of 2008. As is the case whenever you depart from familiar investments in search of higher yields, you should be sure you fully understand what you’re buying and what risks you might be facing.