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Basics of Investment Taxes

April 25th, 2010 No comments

When you invest money in regular taxable accounts (not your 529 college savings accounts, IRAs, 401Ks, or other retirement investment accounts), any money your earn is typically added to your total yearly income for income tax calculation purposes. In this article, I will discuss (3) common types of investments and what taxes will be due.

First, the Good News

No one likes paying taxes, but you are probably not shocked to find out that investors pay less taxes than workers earning income, or sometimes even savers. There are a number of reasons why this is the case.

1.      Public insurance programs (unemployment insurance, Social Security, disability programs, etc) are typically funded from deductions taken from worker salaries. These programs are designed to tie directly to employment. Investing income does not apply, so taxes do not apply.

2.      Legislators have over time given preferential treatment to ‘capital’ since this is the source of job creation.

3.      Investors sometimes pay taxes on investment income in addition to the corporate taxes already paid by the company. The lower investment tax rates try to lessen this double tax impact.

Earning income through investing can therefore off the opportunity to increase your take home pay more than working more hours, because you get to keep more of what you earn.

Next, Capital Versus Investment Income

To understand taxes, you first need to know the difference between capital versus investment income. Capital is the stake that you have in the investment, which is the value of the shares of the company or the total bond value. Capital has historically had the most favorable tax treatment, while investment income has less favorable treatment.

Let’s say you bought $10,000 worth of Johnson and Johnson (JNJ), and you earned $300 in dividends during the year. The total value of your capital is $10,000 (at the time you purchased the shares), and the value of your investment income is $300.

Capital Gains Taxes

Capital gains taxes come into play when you sell your investment. Using the example above, if we sell the JNJ shares for $12,000, a capital gain is realized. If the gain occurred on a short term basis (less than one year), you pay the same rate as your income tax rate. For a long term gain (greater than one year), the lower capital gain rate applies.

On to the investment types. This concerns (3) different types of investment income.

Fully Taxable Income

With a fully taxable investment, you pay your marginal income tax rate. This is the highest rate you will pay, it is the same income tax rate as if you earned additional money by working additional hours. You still pay less taxes because you do not pay any payroll taxes that would be due with work income, you pay just the income taxes.

There are many reasons why an investment would be fully taxable, here are a few:

  • The company itself is not required to pay any taxes due to its registration/structure. The most common examples are real estate investment trusts (REITs). The tax burden is passed on to the investor.
  • The company does not pay enough corporate taxes for investors to qualify for lower investment tax rates.
  • The investment is a bond or bond-like, these generally do not get the lower rates.

Non Taxable Investment Income

Some investments are not taxable at all. The most common examples are municipal bonds, which are issued by local/state governments typically to fund capital projects. If you otherwise have lots of other income, these can lower the amount of taxes you pay because the U.S. Federal Government also exempts these from taxation in addition to the local/state government that issued them.

Note that U.S Treasury bonds/notes are not the same as municipal bonds, they are used to fund the general operations of the federal government. They are fully taxable at the federal level at marginal income tax rates.

Qualified Investment Income

Most common stocks fall into the category of qualified investments (JNJ mentioned above is an example). Holders of qualified investments pay federal income taxes at a lower rate than their working income tax rates. The word ‘qualified’ has a specific meaning, in that the company must follow some rules that show that the company paid enough corporate taxes. Then, the investor gets the lower tax rate.

Two Views of the Same Investment…

April 23rd, 2010 No comments

How do you determine if your investment portfolio is performing well? If you are like many investors who are not full time professionals you will likely use some criteria external from the fundamental workings of the business or investment because you don’t have time to fully investigate or inspect each investment.

View #1 – Investment Market Value

By far the most common measurement is called market value. This is a single number that is the dollar value of all your investments if you sold them all at once at one point in time. If the market value is higher than what you paid for your investments, you made money. If the market value is lower, then you lost money. Of course these differences are on paper, because you never actually sold anything.

The market value is usually reported over multiple time frames. As an investor, you want to earn money sooner rather than later, so you need to know how much your investment changed during specific time periods.

When you open up your quarterly investment statements, the broker/investment firm will prominently display your ‘market value’ and a few calculations on your investment return which tells you how much the portfolio changed over the quarter or past year. This type of reporting is simple and to the point. It boils down all the changes (buys, sells, income, reinvestment) into an easily reported number.

View #2 – Investment Income

The measurement that we will primarily use here at @FinancialPlan is investment income. All of our investments here will earn income. So, to evaluate your portfolio over, say, a quarter the questions we ask are:

  • How much money did we make.
  • How much did it (increase/decrease) over the last quarter.
  • Was there any change that occurred in individual investments that might require us to make a change (investment decreased/increased income, buying/selling opportunity based upon market dislocation).
  • How should we allocate the money we made to new or existing investments?

Case Study – Realty Income from 2005-2009

In the IncomePort, we own a real estate investment trust (REIT) call Realty Income (O). As a REIT, the business model is simple to understand. They own a diversified set of commercial properties from which they collect rent. Each month they pay out most of the income from these properties to the shareholders.

As a simple income producing investment, one would think that the market would have a good understanding of its value and price it accordingly. However, over the years the market has chosen to value this company (its market value) all over the place.

Consider the following investment in Realty Income (O), from 2005-2009:

  • At the beginning of each year, you invest $500.
  • At the same time, you reinvest all the income from the previous year into additional shares.
  • At no point did you sell any shares.

How did this investment work out?

View #1 – Market Value Performance

At the beginning of 2009, you would have owned a total of 124 shares. The table below summarizes your investment. Unfortunately for you, every single share you bought was at a higher price than its January 2009 price. This means that if you sold the shares at that time you would have lost money.

Year Investment # Shares Market Value
2005 $500 21 $500
2006 $500 45 $1010
2007 $500 67 $1818
2008 $500 94 $2133
2009 $500 124 $2750
Total Invested $2868
Gain/Loss ($118)

View #2 – Income Performance

There is no difference here, you still own 124 shares. The tables below show what happened from an income view.

Year Investment # Shares Monthly Income
2005 $500 21 $2.48
2006 $500 45 $5.69
2007 $500 67 $9.18
2008 $500 94 $13.35
2009 $500 124 $17.74

Initially, this investment will pay you about $2.50 per month (the company pays its dividends out monthly). During the month of January 2009, you will be earning almost $18 per month. Pretty good, but most of this improvement was due to to fact that you reinvested more money. However, the other story here is that the company raised its dividend every quarter over those 5 years. So, even the initial $500 investment saw its income increase from $2.48 → $3.06 per month (23% increase).

Another way of looking at this is that the dividend yield increased from 6% to almost 7.5% per year.

So, even though the market says you ‘overpaid’ for your shares, from an income point of view, you are making more money every month.

Categories: Investing Tags:

How To Earn 8% Per Year Without Equity Risk

April 17th, 2010 No comments

There are many different paths one can take to make money investing. For most people, they invest either using an investment manager who actively picks components just for you or more typically advises you about what kinds of mutual funds to buy. Mutual funds themselves are either actively managed by teams, or they track market or sector indexes. The components of the indexes are determined by established third parties, such as Standard and Poor’s which, e.g., is well known for the S&P500 large capitalization index.

How do you make money with mutual or index funds?

The simple answer is that most of the funds largely bank on you making most of your money through capital gains, and a smaller amount through income. The often quoted benchmark long term return for the market of “8-11% average/year”, is comprised of about 2% of income and the other 6-9% for capital gains. Historically, income has accounted for a larger percentage of long term gains, but more recently the amount of income has gone down (the dividend yield for the benchmark S&P500 index is about 2% today).

So then, what is a Capital Gain? That’s a fancy word for getting someone to pay you more for your shares than you did. If they pay your more for your shares you have a gain, if they offer you less (and you sell), that’s a capital loss.

When is comes to traditional company stocks (which when combined together makeup the typical mutual or index fund), an investor will want to pay you more because of the companies earnings. If the investor believes that they will earn more in the future or if those earnings have actually materialized they might want to pay you more.

How Well Did this Work the Past Ten Years?

If you invested in broad indexes or diversified mutual funds, you didn’t do too well compared with the previous ten years. It’s not because the companies themselves were performing poorly, in fact in many cases just the opposite. Consider a company such as Paychex (PAYX). Paychex as a company has performed very well by expanding its business and increasing its earnings. It’s just that if you bought the stock 10 years ago you simply would have paid too much.

So, there wasn’t anyone willing to pay you more because the stock was too expensive. The company did deliver results. So, after ten years you would have earned some dividend income, but the stock price has gone nowhere. This is how it sometimes goes when investing for ‘capital gains’.

There are 3 main variables to consider, if you are looking for capital gains:

  1. How much you initially paid.
  2. How well the company performs.
  3. How much a future investor will be willing to pay you.

If you get all these variables right you may make money, otherwise not.

If you invest in a mutual or index fund, it will expose you not to a few investments, but a bunch of investments. How it performs over time will be the average of all the investments;some will perform better than average, while others will perform worse than average.

As discussed above, earning an ‘average’ return does not offer a lot of certainty for getting the long term average return of ‘8-11%’ because the typical mutual fund is placing a large bet on capital gains, which has a fair amount of uncertainty. Note that this uncertainty also includes the possibility of doing much better than average.

How about finding the ‘above average’ candidates and investing in them? That can work if you can identify a strategy to find them, or hire someone to do it. It’s worth trying with some of your money, as we will attempt to do in the microPort.

Another Approach – Investing For Income

How about earning the low end of the long term stock market average – say 8% – consistently, in exchange for giving up potential higher returns through capital gains?

The IncomePort contains a few investments that offer the potential to earn 8%/year over the long term. No more, no less. These investments are a type of stock called preferred stock. It’s a bit of a misnomer to call these investments ‘stock’. This is what they have in common with typical common company stock:

  1. There is the word ‘stock’ in the name.
  2. They can be bought/sold just like stocks on exchanges.

That’s it. These investments have more in common with bonds, which are loans made to the company. Preferred stocks work the same way:

  1. Investors loan the company a bunch of money.
  2. The company periodically (typically quarterly) makes a fixed interest payment.
  3. The loans can go on for many years (30 years or more), sometimes never expiring because they can be renewable.
  4. The investment can be ‘called’ (closed out) as determined by its underwriting rules.

While the word ‘stock’ may be misplaced, the term ‘preferred’ is important; from the investor point of view it means ‘first in line’. When the company pays out its income, the preferred investor get paid first near the top of the list.

Understanding The Risk

Preferred stocks are tied to the company that issued them and their fate. Preferred stocks are not as safe as other bonds, such as Treasury Bonds which are virtually risk-free. However, the selections in the IncomePort are very good quality stocks that have paid interest for many years, and throughout the 2007 Great Recession without any interruption. There is good reason to believe that they will continue to pay going forward.

Like any investment it is not recommended that you put a large percentage in anyone single investment. However, putting some of your money in preferred stocks can be a good strategy to attain a stable and predictable return with lower exposure to the risks and uncertainty of regular stock investing. The potential to earn a market matching (or even market beating return) so easily shouldn’t be passed up.

A Sample Portfolio – Earns 7-8%

The portfolio below will earn 7% or more per year, depending of course on the price you pay for the preferreds. Click on each stock symbol to get quotes and other info. The dates next to each stock indicates which date the investment pays interest for the 1st quarter of each year (a similar date applies to all the other quarters of the year). When combined, this simple portfolio will pay income every two weeks throughout the year.

krb-d 1/1

hcn-d 1/15

cfc-b 2/1

krb-e 2/15

jpm-i 2/28

mer-m 3/15

mer-e 3/30

Categories: Investing Tags:

How to Make Money Monthly (or even faster)

April 10th, 2010 No comments

Before I started investing for income, I had money in regular bank accounts and money market accounts. This is a good place to start particularly if you want to accumulate money that you want to eventually put into other investments. Also, even if you do invest, you will still want to keep some of your money in these very liquid accounts just in case you need it.

Accounts that you have at banks will typically pay interest every month. Typical public market investments pay dividends or interest quarterly. Some overseas stocks (e.g., European common stocks) pay even less frequently, typically twice a year.

If you want to earn money monthly how can you do this with typical public investments? Here are a few ideas.

Buy an Income Fund

If you are willing to consider a managed income fund, it’s not hard to find ones that pay out monthly. I’m not a big fan of funds due to investment costs and the fact that you don’t really have much control on what’s inside of the fund, you have to be able to trust the management. I do make some exceptions, e.g., in the IncomePort, we own some shares of a municipal bond fund (NNJ). Municipal bonds as well as other bonds are more difficult to buy and own directly so a fund can work here. (Treasuries are an exception, they can be easily bought directly from the Federal Government). Municipal bonds are exempt from your state income (in my case, New Jersey) as well as federal income taxes. These are a good addition to your portfolio.

Buy A Stock That Pays Out Monthly

There are stocks that pay dividends monthly, but these are rare due to the extra burden. It requires more administration and cost because each payment must be planned within the companies business model as well as all the documentation that is required from the SEC for each payment (a filing needs to be submitted for each one). As you will see below, those companies that have chosen to pay out monthly do it because they can easily based upon their business model.

Here are two examples. Because these companies earn rent every month off of real estate, they can chose to pay monthly.:

  1. Realty Income Corporation (O) – We own this in the IncomePort
  2. Inland Real Estate Corp (IRC)

There are some other examples, including timber and energy trusts.

  1. Enerplus Resources Fund (ERF) – We own this in the IncomePort

For a long list of stocks, trusts, and funds that pay out dividends monthly check out this seekingAlpha article. It’s out of date but still offers a good starting point.

Create An Income Stream With Multiple Stocks

By choosing multiple stocks with different monthly dividend payment dates within a quarter, it’s possible to create a monthly income stream. This is harder to do with common stocks, because you would want to pick stocks primarily by their individual merits, and not when they pay out. However, preferred stocks offer a good opportunity since they are often similar/interchangeable especially if you pick ones offered from the same company. Within the IncomePort we have already a good start in the creation of a monthly income stream using preferred stocks. I talked about preferred stocks previously in this article along with some reasoning why you would want to own these stocks. A recap:

The IncomePort contains a few investments that offer the potential to earn 8%/year over the long term. No more, no less. These investments are a type of stock called preferred stock. It’s a bit of a misnomer to call these investments ‘stock’. This is what they have in common with typical common company stock:

  1. There is the word ‘stock’ in the name.
  2. They can be bought/sold just like stocks on exchanges.

That’s it. These investments have more in common with bonds, which are loans made to the company. Preferred stocks work the same way:

  1. Investors loan the company a bunch of money.
  2. The company periodically (typically quarterly) makes a fixed interest payment.
  3. The loans can go on for many years (30 years or more), sometimes never expiring because they can be renewable.
  4. The investment can be ‘called’ (closed out) as determined by its underwriting rules.

Typical preferred stocks pay out interest quarterly. However, by buying a set of preferred stocks that pay dividends at different months, we can structure a portfolio that mimics a monthly dividend simply by buying at least (3) different ones -one for each month in a quarter. Doing a little bit extra leg work, I’ve come up with a list that goes one step further – getting payments every two weeks. Here’s the list, along with when each security would pay its dividend in the first quarter.

krb-d 1/1 – in the IncomePort

hcn-d 1/15  – in the IncomePort

cfc-b 2/1   – in the IncomePort

krb-e 2/15

jpm-i 2/28

mer-m 3/15

mer-e 3/30

All of these preferred stocks (including the ones not in the portfolio) are recommended. Each is an investment grade security as per Moody’s.

Categories: Investing, Make Money Investing Tags:

Shortcut: Income Estimator

March 21st, 2010 No comments

If you know the hourly rate, it is easy to calculate the annual earnings. For each 10 dollars per hour, multiply by 20,000 to get the annual earnings estimate.

For example, if you earn $35 per hour:

Annual earnings equals: 3 * 20,000 + .5 * 20,000 = 70,000 per year.

Categories: Personal Finance Tags: ,