Author Topic: Question about interest  (Read 3794 times)

Asgard01

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Question about interest
« on: April 30, 2014, 03:38:02 PM »
Hey all,

I am getting confused over the contents of this article.

http://www.forbes.com/sites/billharris/2012/09/26/your-retirement-dividends-or-capital-gains/
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We’ve all heard the old adage: spend investment income (dividends & interest) and leave principal alone (capital gains)

I thought interest was capital gains, as in the growth of the stocks you have but haven't sold yet which apparently is capital gains? What does this interest refer too then?

This all relates to me wondering how I am going to draw 4% when dividends of my funds only hit 1.7%. I did not want to eat into the shares themselves.

Chris

seattlecyclone

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Re: Question about interest
« Reply #1 on: April 30, 2014, 03:57:37 PM »
Capital gains income is defined as the growth in the value of your shares. So if you buy a share for $10 and it's worth $15 later, you have a $5 capital gain.

Dividends are not considered a capital gain, they're a separate type of payment. Perhaps confusing the issue is that dividends and capital gains are taxed at a lower rate in the US than other types of income are taxed. That doesn't make dividends the same as capital gains, but a lot of Americans will group them together because they're taxed at the same rate.

Interest is the income you receive from a bond or other debt. It's a periodic payment just like stock dividends, it just has a different name because it's a return on debt rather than equity. In the US, interest is taxed at the regular tax rate and not at the lower dividend/capital gain tax rate.

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This all relates to me wondering how I am going to draw 4% when dividends of my funds only hit 1.7%. I did not want to eat into the shares themselves.

It's okay to sell some of your shares. Historically the price of stocks has increased quickly enough to allow you to sell a small percentage of your shares every year and still maintain the same purchasing power over time.

Realistically, a company has two choices of what to do with its cash: they can pay it out to shareholders in the form of dividends, or they can hold on to it within the company to invest in future growth. Let's say Company A has a $1 million profit. They pay out the entire profit in dividends, and your shares retain the same value because the business is not growing. You have no capital gain income here. Company B, on the other hand, also has a $1 million profit, but they pay no dividend. Instead they use the money to upgrade a manufacturing facility to increase their production, or they increase the size of their sales force, or something along these lines. Investors notice this and the price of the shares goes up as the company grows. Here you have a capital gain income but no dividend income.

The article is talking about how many investors have a propensity to spend their dividend income, but not their capital gains income. They'll take all their dividends from Company A to pay their bills in retirement, but are afraid to sell some of their shares in Company B to unlock the profit they've earned from that investment. In reality there's no rational reason to do this. Dividends and capital gains are two different ways for a company to return value to its shareholders; you should take full advantage of both types of income in retirement.

warfreak2

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Re: Question about interest
« Reply #2 on: April 30, 2014, 04:01:07 PM »
"Interest" would be returns on savings accounts, CDs, &c. if you had those as part of your asset allocation.

Dividends are effectively a forced sale of your "principal", anyway. The adage should really be, "withdraw (either as dividends or by selling) less than your investment gains above inflation" and it's only an adage so don't take it too seriously. The 4% "safe withdrawal rate" is a conclusion from historical stock/bond/inflation data, and it is based on a strategy of selling to make up the gap between dividends and withdrawals.

maki

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Re: Question about interest
« Reply #3 on: April 30, 2014, 04:59:51 PM »
@seattlecyclone - that was an amazingly clear response. i benefited a lot from reading it. thanks!

Asgard01

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Re: Question about interest
« Reply #4 on: May 01, 2014, 01:31:49 AM »
Thanks for your comment seattlecyclone.

I am still a bit unsure about how selling works when I have a fund that has both shares - 60% and bonds 40%. If sell 2.3% each year when I reach FI, does this split what is sold between shares and stocks at that 60/40 ratio and if so is it fractions of all the shares/bonds etc. I wondered if they choose what to sell but assume it is fractions of all of them.

I still get this feeling that if I keep selling that 2.3% as my shares and bonds are finite! they will have to run out sometime! but I guess mathematically if my shares and bonds still rise then the fractions of shares I actually get rid of will be small. Also, in funds in the UK, you have units rather than shares but those shares ultimately represent fractions of real shares I presume. This is indeed confusing me. Could someone please help explain these queries.

Kind regards,
Chris

warfreak2

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Re: Question about interest
« Reply #5 on: May 01, 2014, 03:19:20 AM »
Sell whichever, as long as your asset allocation afterwards is still 60/40. You may even need to sell one to buy some of the other, to maintain your 60/40 ratio.

By the way, the 4% withdrawal rate means 4% of your initial amount - not 4% of your current amount. (Also, you adjust this amount up by inflation each year.) At some point, your dividends may actually be enough by themselves.

It's true that your shares and bonds are finite, but (assuming they grow fast enough) you sell fewer of them each time. If you keep cutting off 4% of a stick, there will always be more stick left*.

*As long as it's not made of atoms...

Workinghard

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Re: Question about interest
« Reply #6 on: May 01, 2014, 03:58:30 AM »

By the way, the 4% withdrawal rate means 4% of your initial amount - not 4% of your current amount.

I've totally missed that tidbit of information!

Asgard01

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Re: Question about interest
« Reply #7 on: May 01, 2014, 04:14:10 AM »

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Sell whichever, as long as your asset allocation afterwards is still 60/40

My point is that I only have one fund that contains both shares and bonds, all index linked etc. I just don't know how it works when I sell these, what is actually being sold in the background etc.

To workinghard, I also didn't realise that a few weeks ago.

Chris

warfreak2

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Re: Question about interest
« Reply #8 on: May 01, 2014, 04:19:06 AM »
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Sell whichever, as long as your asset allocation afterwards is still 60/40
My point is that I only have one fund that contains both shares and bonds, all index linked etc. I just don't know how it works when I sell these, what is actually being sold in the background etc.
Then you only have one thing to sell, so you sell it. What happens is the same as what I described, it's just that the fund managers do it for you.

Asgard01

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Re: Question about interest
« Reply #9 on: May 01, 2014, 05:08:30 AM »
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Then you only have one thing to sell, so you sell it. What happens is the same as what I described, it's just that the fund managers do it for you.

How do they do this though? Do they make it so it is evenly spread across my allocation and the sub funds that are part of the bonds or shares like do they sell according to the ratio as defined in the fund. If I sell £1000 for example, do they sell fractions of each sub fund according to the percents defined in the fund? I am referring to the vanguard life strategy 60% income fund.

Cheers
Chris

warfreak2

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Re: Question about interest
« Reply #10 on: May 01, 2014, 05:45:18 AM »
If I sell £1000 for example, do they sell fractions of each sub fund according to the percents defined in the fund?
Yep, exactly. The point is that before and after any deposit or withdrawal, the proportion should be as close to 60/40 as possible, because that's what the asset allocation of the fund is supposed to be.

They also rebalance (e.g. sell some stocks, buy some bonds) periodically to maintain this proportion, as stocks and bonds rarely grow at the same rate.