Interest Income
Nearly everyone receives interest on some of their investments, and interest payments have historically been a source
of retiree income. Interest is paid on Certificates of Deposits (CDs), bonds, savings accounts, and several other investments.
However, with today’s interest rates rarely exceeding 1.5%, there’s very little opportunity to earn a decent return,
even with corporate CDs or municipal bonds.
The other disadvantage of interest-producing assets is that most interest is taxed as ordinary income. This includes
most interest that you either receive or is credited to your account and that can be withdrawn without penalty. Examples
include interest on bank accounts, money market accounts, certificates of deposit, and deposited insurance dividends.
Specific IRS rules apply to bonds, Treasury bills and notes:
- Interest on Series EE and Series I US Savings Bonds
generally does not have to be reported until the bonds mature or are redeemed.
- Interest from Series EE and Series
I bonds issued after 1989 may be excluded from income if used to pay for qualified higher educational expenses during the
year and other requirements are met for the Educational Savings Bond Program.
- Interest income from Treasury bills,
notes and bonds is subject to federal income tax, but is exempt from all state and local income taxes.
- Interest on
some bonds used to finance government and issued by a state, the District of Columbia, or a U.S. possession is not taxable
at the federal level.
- Municipal bonds and municipal bond funds are exempt from federal and sometimes state taxes (especially
if you live in the state of issue).
Because Municipal bonds are tax-exempt, they may be important for higher-income individuals. Also, the tax-exempt
and tax-deferred features of Government bonds may make them attractive. Finally a portfolio of laddered CDs with differing
maturity dates could ensure a steady liquid income stream of protected (up to $250,000) assets. See "Certificates
of Deposit" in the Investing section of this Website.
Dividend Income
One often overlooked source of regular retirement income is stock dividends. Dividend producing stocks have attributes
that make them ideal additions to your retirement portfolio.
Dividends are a portion of a corporation’s profits that
are paid to its shareholders. They are paid as a fixed amount per share – i.e., shareholders receive dividends
in proportion to their shareholding.
When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business
(called retained earnings), or it can be distributed to shareholders. There are two ways to distribute cash to shareholders:
share repurchases or dividends. Many corporations retain a portion of their earnings and pay the remainder as a dividend.
A company that has preferred stock issued must make dividend payments on those shares before money can be paid to the common
stockholders. The preferred stock dividend is usually set, whereas the common stock dividend is determined at the sole
discretion of the Board of Directors.
There are several things that you should know before aggressively investing in high-dividend paying stocks. These
include:
- Rationale for building a dividend stock portfolio,
- How to determine what stocks to buy,
- When/how
to buy, and
- Possible pitfalls
Rationale for Dividend Stocks
Before narrowing the discussion down to dividend stocks, let’s first consider the advantages of owning individual
shares of a corporation (i.e., stocks):
- You are purchasing ownership interest in an actual business. The
company sends you reports on its operation, lets you vote on important matters affecting it, and usually shares with you a
portion of its profits.
- Knowing that you have invested in a tangible asset with real value, you can better ignore
the day-to-day swings in stock market prices.
- You typically receive real monetary returns on you investment.
These payouts are normally taxed at a lower rate than other income (see Qualified Dividends below). Stocks are unlike
mutual fund shares that may report taxable gains to you (that you may not receive) even when they lose value.
During the first part of the twentieth century, dividends were the primary reason investors purchased stock. Today investors
purchase stock to: make a profit by buying low and selling high, achieve stock value appreciation, and receive dividends.
However, stocks in general continue to be a reliable investment as long as you do your homework and act like “an investor
instead of a speculator” (see How to Determine What to Buy below).
Stocks can help counter one of the most troubling financial issues in retirement – fixed Income. Inflation
will continue to erode your pension and assets until you’ve lost a lot of your early-retirement purchasing power.
Stocks address this by providing a two-fold hedge against inflation:
- They normally increase in value over time,
and
- Their dividend normally increases over time, providing you extra retirement income.
This brings up an important point: dividends are dependent on cash flow, not reported earnings. Consequently,
a Board of Directors could declare and pay a dividend if cash flow was strong even though the company reported a net loss.
This would be done to show continued dividend strength and prevent a possible decline in stock price caused by a change in
market perception.
A vast majority of dividends are paid four times a year on a quarterly basis. This means that a stock that reports
a quarterly dividend of $1.00 will pay you $0.25 each quarter. Some companies pay dividends on a monthly or annual
basis. In addition to regular dividends, there are times that a company may pay a special one-time dividend.
Cash dividends, as opposed to stock or property dividends, may be mailed to you but are normally direct deposited into your
bank or brokerage account. Stock dividends are pro-rata distributions of additional shares of a company’s stock
to owners of the common stock. Stock dividends are issued to prompt more trading and increase liquidity, encouraging
more buying and selling.
Ordinary cash dividends that meet specific criteria, as defined by the US Internal Revenue Code, are
classified as qualified dividends and taxed at the lower long-term capital gains tax rate. You can assume that
any dividend you receive on common or preferred stack is an ordinary dividend unless the paying corporation tells you otherwise.
The percentage tax on dividends is determined by the date on which the dividends are paid:
From 2003
to 2007, qualified dividends were taxed at 15% or 5% depending on the individual's ordinary income tax bracket,
From
2008 to 2012, the tax rate on qualified dividends was reduced to 0% for taxpayers in the 10% and 15% ordinary income tax
brackets, and
Beginning January 1st, 2013, dividends are taxed at 0%, 15% or 20%, depending upon
income. The 0% tax continues for taxpayers in the 10% and 15% brackets. It increases to 15% on any amount that
otherwise would be taxed at 25% to 39.6%, and to 20% on any amount that otherwise would be taxed at a 39.6% rate.
In order to be taxed at the qualified dividend rate, the dividend must:
- Be paid by a U.S. corporation, by a corporation incorporated
in a U.S. possession, by a foreign corporation located in a country that is eligible for benefits under a U.S. tax treaty
that meets certain criteria, or on a foreign corporation’s stock that can be readily traded on an established U.S. stock
market; and
- Meet holding
period requirements: You must have held the stock for more than 60 days during the 121-day period that begins 60 days before
the ex-dividend date (see definition below).
