How to Build Your Own Retirement Income Fund

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As more and more baby boomers dive into retirement, the growing retiree market is becoming increasingly attractive to anyone with a product or service to sell. Brokers haven't been shy about packaging investment products designed for retirees -- particularly products designed to generate high levels of income, which is typically a high priority in retirement. However, you don't need to buy an off-the-rack (and potentially expensive) income fund for your portfolio -- you can build one yourself that you customize to your own preferences and risk tolerances.

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Income versus fixed income

Dividends (from stocks) and interest (from bonds) are two very common sources of investment income, but they have important differences. Interest falls into the category of fixed income -- whatever interest payment the bond issuer promises you is what you'll get. Dividends, on the other hand, are not fixed. The company issuing the stock decides anew each quarter how much of a dividend, if any, to issue.

Of course, some companies, particularly blue chip companies, prioritize issuing a dividend because they know that's a big reason why people buy their stocks. However, there's no guarantee on any dividend. Thus, while dividends can be an excellent source of income, it's important to include a large percentage of bonds in an income portfolio so that you have some amount of guaranteed income coming in.

Asset allocation

Fixed income aside, retirees are generally advised to keep the majority of their investments in bonds rather than stocks, anyway, because stocks are riskier and more volatile. Everyone who owned stocks during the 2008 stock market crash got a brutal lesson in this important investment rule. However, even retirees shouldn't ditch stocks entirely because, over long periods, stocks produce better returns than bonds do.

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A simple way to allocate your assets is to subtract your age from 110, and put that percentage of your investments in stocks with the remainder in bonds. Using this formula, a retiree aged 70 would put 110-70, or 40%, of his portfolio in stocks, with the remainder in bonds. As you get older, you'll want to keep revising your asset allocation according to the formula, because it will become more important to have a reliable source of income, and less important to keep growing your capital.

Diversification

One way to reduce the risk presented by all investments is to diversify. Picking a wide range of investments that react differently to various economic and financial pressures can ensure that, no matter what happens to the economy, something in your portfolio will continue to thrive. One great option for diversifying an income portfolio is to invest in a real estate investment trust (REIT) fund.

REITs essentially are real estate investments, and they react differently from both stocks and bonds to the various changes in the economy. However, be sure that you select an equity REIT fund, not a mortgage REIT fund -- the latter invests in mortgage loans rather than actual real estate and is far riskier and more volatile.

A cornucopia of bonds

Bonds come in a huge range of options -- picking ones from different categories will help you diversify your portfolio even further. Treasury bonds are often a mainstay of a retiree's portfolio since they're the safest possible bond, backed by the full force of the U.S. government. If rising interest rates seem likely, consider putting some or all of your treasury bond money in Treasury Inflation-Protected Securities, also known as TIPS, which have built-in inflation protection that can help out immensely if interest rates climb.

Retirees seeking to minimize their taxes can invest in municipal bonds issued by their own state. The interest from these bonds are exempt from both state and federal taxes.

High-yield corporate bonds, aka junk bonds, are risky investments, but you can reduce the risk somewhat by buying a bond fund that invests in junk bonds rather than buying individual ones. Because bond funds buy bonds from enormous numbers of companies, a few of those companies defaulting on their bonds won't be such a disaster as it would be if you only owned bonds from a handful of companies. However, because of the risk, you should still limit junk bond investments to a small percentage of your total bond portfolio.

Cash equivalents

Investments like CDs, money market funds, and the good old-fashioned bank savings account are the safest of investments, but the yield from these types of investments is extremely low. It's a good idea to keep some cash on hand because you can tap it easily in an emergency. These investments, however, should be only a small percentage of your portfolio. It's rare for the return on cash equivalents to even keep up with inflation, let alone produce growth.

Bringing it all together

Now that you're aware of the basic options for building an income portfolio, it's time to put all the pieces together. A sample income portfolio for a 70-year-old retiree could include 40% stocks, 55% bonds, and 5% cash equivalents. Of the stocks, 10% of the portfolio might be in a REIT fund, with the remaining 30% in high-dividend-yielding stocks and stock funds. (Whenever possible, use index funds rather than actively managed funds to minimize fees.)

Of the bond portion, 0% to 5% might be in junk bond funds, another 10% to 20% in TIPS, with the remaining 30% to 45% of the portfolio in standard treasury bonds, municipal bonds, and perhaps some good-quality corporate bonds or bond funds. The options for investing in bonds vary widely because current and predicted interest rates and inflation will affect how you can best allocate your bond money.

Where to keep your investments

There are three basic types of accounts that you can use to store retirement savings: a tax-deferred retirement account such as a traditional IRA or 401(k), a Roth IRA or 401(k), and a standard brokerage account. Both types of retirement accounts allow your investments to grow tax free, but when you take a distribution from a tax-deferred retirement account, you'll trigger an income tax bill for the year.

Distributions from Roth accounts are tax free, since you've already paid the taxes on that money. For investments in standard brokerage accounts, you'll pay capital gains taxes for transactions, along with taxes on dividends and (taxable) interest as they come in.

Most income investments should be tucked safely inside your IRA or 401(k), both traditional and Roth, which allows them to grow and produce income without creating an immediate tax expense for you. Splitting your investments between tax-deferred and Roth accounts lets you choose the source of your distributions, and therefore, manage your tax bill. Municipal bonds and any other tax-advantaged investments should live in a standard brokerage account -- there's no point in putting these investments in a retirement account that already provides similar benefits.

Divvying up your investments between multiple types of accounts can make things a little more complicated. When it's done right, however, it will give you a huge tax break. And saving a pile of money on your taxes will make your income stretch a whole lot further.

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