Most investors overlook an excellent way to earn higher after-tax income to finance their retirements.When “tax-advantaged income” and “retirement” are mentioned together, most people think of tax-exempt bonds or municipal bonds.
Most bonds issued by state and local governments pay interest that is exempt from federal income taxes. But that shouldn’t be your only consideration when planning a retirement portfolio. Tax-exempt bonds aren’t as good of a deal as many think, especially today.
Most states with income taxes allow their residents to exempt only the interest on bonds issued by the state or its local governments. Bonds issued by governments in other states often aren’t exempt from the state income tax. When you own a diversified portfolio of state and local bonds either directly or through a tax-exempt mutual fund, only a small portion of the bonds are likely to be exempt from your state’s income tax.
Also, the federal government might not fully exempt interest paid by state and local bonds. The interest is added back to your income when computing the tax on Social Security benefits, the Medicare premium surtax, and other Stealth Taxes. Some state and local bonds pay higher interest than others. But the federal government will tax the interest on many of these higher-yielding bonds, because they are what the government calls private activity bonds.
Recent economic events are another reason to be cautious about state and local bonds.The hibernation economy has greatly reduced economic activity, and that’s trimmed the tax revenue of most state and local governments. They are looking at substantially lower collections from sales taxes, personal and corporate income taxes, and, in many areas, real estate taxes.
Yet, spending by these governments is increasing because of the additional costs of responding to the pandemic. Unemployment insurance funds are being depleted rapidly because of the staggering increase in unemployment claims.
In addition, the governments have a large amount of fixed expenses because of services that have to be provided. These expenses have already added to the long-term debt problems most state and local governments have from pensions and other obligations.These factors combined make tax-exempt bonds a less secure investment than they were.
Congress is considering whether to bail out state and local governments and, if so, how much to transfer to them.You can earn higher and safer tax-advantaged retirement income through preferred securities.There are a number of different types of preferred securities, and they receive different tax treatments.
But many of them qualify as stock under the tax code, which means the income they pay is qualified dividend income (QDI).QDI is taxed the same as long-term capital gains. There’s a maximum 20% federal income tax rate, and taxpayers who aren’t in the top tax bracket pay a lower rate on QDI.
Preferreds pay higher yields than tax-exempt and investment-grade corporate bonds before considering taxes. After taxes, preferreds also pay higher yields than the alternatives, even for the highest-bracket taxpayers.We don’t need to delve into the details of which types of preferred securities qualify for QDI and which don’t. That’s a job for a mutual fund manger.Consider Cohen & Steers Preferred Securities & Income (CPXAX). Its yield based on the last 12 months’ distributions is 5.44%.
Suppose about 65% of the dividends are QDI and the rest are taxed at ordinary income. Someone in the top 37% tax bracket would have an effective tax rate of about 26% on the dividends, or an after-tax yield of about 4.03%. By comparison, Vanguard Long-Term Tax-Exempt Bond (VWLTX)has a yield of 3.15%. Vanguard Inter-mediate Tax-Exempt Bond (VCAIX) has a yield of 2.44%.
Assuming no state income taxes, each of the tax-exempt funds has a lower after-tax yield than the preferred securities fund.Of course, the after-tax yield on preferred securities will vary with the yields on the individual securities, plus the percentage of the dividends that are QDI instead of ordinary income. The Cohen & Steers preferred securities funds I’ve been recommending are actively managed.
Taxes are one factor the managers consider when investing the fund. The firm indicates that assuming 65% of the dividends will be QDI is conservative.Safety is another factor to consider. As discussed earlier, state and local governments’ finances are being hit hard by the pandemic. Historically, default rates on tax-exempt bonds are very low, but they’re receiving one of their hardest tests ever because of the pandemic. Some states and localities are going to have serious problems meeting their obligations without help from the federal government.P
referred securities are issued primarily by banking, insurance, real estate and utility companies. Most issuers are well-known companies and highly regulated. The banks and insurance companies are much more financially stable than they were before the financial crisis. The banks have improved their lending standards and have higher quality loans on their books. All these companies will have some hardships as a result of the pandemic, but they went into the pandemic in good shape and should be able to make it through the crisis without defaulting on payments.
Preferred securities pay higher yields than bonds from the same companies, because the preferreds have lower payment priority if the issuer files for bankruptcy. Safety is another reason I prefer an actively managed mutual fund instead of buying an index fund or purchasing individual preferreds.
An active manager can avoid the lower-quality issuers in an index and also can respond to changing business and market conditions.Since the pandemic began, for example, the Cohen & Steers preferred funds increased the quality of their holdings. Exposure to Europe has been reduced because of weaker economic conditions there. The funds also took advantage of times when panic or forced selling drove some securities prices to bargain levels.
For example, the funds have selectively purchased securities of pipe-line companies that recently declined sharply. The funds also invest globally, seeking quality income-paying securities from issuers around the world. In the last five years, a portfolio invested equally in shares of preferreds and tax-exempt bonds would have had a higher return and higher after-tax yield than tax-exempt bonds alone, according to a Cohen & Steers study. The blended portfolio also would have had less volatility over the five years.
Preferred securities are little under-stood and don’t receive much attention. Investors seeking tax-advantaged income should consider adding preferreds to their portfolios.