How to build a better 5 percent income fund

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(MoneyWatch) I know a way investors can build a simple, diversified, ultra low-cost stock portfolio that pays 5.08 percent annually with no taxes on part of the income. Forget the expensive dividend funds that were dogs in 2012. The iShares High Dividend ETF (HDV), for instance, yielded only 3.38 percent and had a total return (including stock appreciation) of only 9.67 percent in 2012. Compare that to the build-your-own income strategy which yielded 16.45 percent.

First, a little background. In addition to paying dividends, companies return cash to shareholders by buying back their own stock. As you will see in following simplified example (that we can then apply to the real world), these stock buybacks are the key.

Say you own 100 shares of Cashgen Inc. The company has 10,000 shares outstanding and is selling for $10 a share, which also happens to be your purchase price. That means you own 1 percent of Cashgen (100/10,000). Cashgen has $3,000 of cash from profits, representing a 3 percent distribution, that it decides to return to shareholders. If Cashgen declares a dividend of 30 cents a share, you will get $30, a dividend that will be taxed at 15 or 20 percent, and the price of your stock will decline to $9.70 a share. Your 100 shares still represent 1 percent ownership in the company. 

But there is a second way Cashgen can return the $3,000. It can purchase 300 shares, which represents 3 percent of its outstanding shares, leaving 9,700 shares still trading. You could sell three shares of your stock to Cashgen or anyone else and receive the $30 proceeds. Since the cost of your shares is $10 each, you owe nothing in taxes. After your sale of three shares, you are left with 97 shares of the company that now has 9,700 shares outstanding. This leaves you with the same 1 percent ownership of Cashgen (97/9,700). You merely saved a tax bill on receiving the $30.

OK, let's get away from theory land and implement this tax-efficient income plan. As it happens, U.S. companies paid a dividend of about 2 percent last year and, according to Standard & Poor's, bought back their own shares at an annual rate of 3.08 percent of their outstanding shares. That's a total distribution of 5.08 percent.

Instead of buying a less diversified and more expensive dividend fund, just buy a total stock index fund like the Vanguard Total Stock Index Fund (VTI). Collect the 2 percent dividend and then, once a year, sell the percentage of shares American companies repurchased, which amounted to 3.08 percent in 2012. In this way you'll own about the same percentage of American companies at the end of the period as you did in the beginning, and will only have to pay taxes on the gain from the sale, rather than the whole sale.

Now it's true that companies are also issuing shares at the same time they are buying back shares, so your actual ownership share in American capitalism may decline a bit. This is also true in a dividend fund, since those stocks paying high dividends also issue new shares. Unlike times past, companies are at least buying back more shares than they are issuing.

So this income strategy takes in the full 5.08 percent cash returned to shareholders and is far more tax-efficient as the income on the total stock fund is only based on gains. Make sure you own the total stock index fund for at least a year and one day in order to recognize long-term capital gains. In 2012, this strategy resulted in cash flow of 5.08 percent and portfolio appreciation of 11.37 percent, for a total return of 16.45 percent. 

In addition to paying higher income, this strategy has you far more diversified by owning thousands of underlying stocks, rather than a handful of high dividend yielding stocks. Can it get any better? Yes, rather than paying high fees for a dividend fund, you'll pay as low as 0.04 percent annually -- the lowest-cost Schwab Total stock ETF.

Finally, and this is the cherry on top, Wall Street doesn't make any money off this high-income strategy.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.