How To Build An Early Retirement, Tax-Free Income Portfolio With Closed-End Funds

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Includes: BUI, BXMX, DIAX, ETG, ETO, EVT, EXG, HTD, JGV, JMF, JTA, JTD, PDT, PHK, QQQX, SPXX, UTG
by: Able Danger

Summary

In reviewing many Early Retirement strategies, I found seeking to maximize qualified dividends using closed end funds optimal.

Although municipal bonds are typically used to generate tax-free income, bonds have their own set of risks and hedging considerations and will generally underperform stocks over time.

A portfolio focused on generating qualified dividends under certain circumstances can allow an individual to effectively eliminate taxes up to $91,000 per year for a married couple.

Closed-end funds represent a unique asset class that frequently trade at a significant discount to NAV and often generate tax-advantaged distributions in the 6%-9% range.

It all started with an interesting blog post from gocurrycracker.com that explored the concept of early retirement and generating tax-free income. Essentially, a married couple can earn currently around $91,000 per year and pay zero Federal income taxes, Social Security, and Medicare Taxes, if the majority of the money comes from dividends and long-term capital gains. I confirmed with moneychimp's tax calculator that this figure is generally correct. The tax-free elements make a portfolio like this even more valuable as $91k tax-free income is equivalent to around $115k-125k taxable, if you include state and Federal taxes at a combined marginal rate of 20% or $27,000. This will vary depending on if you live in a high income tax state or not.

Social Security and Medicare taxes adds another 10% bump in the taxable equivalent, or 15% if you consider the employer contribution or would pay self-employment taxes. It is generally very hard to sidestep these Social Security/Medicare taxes through deductions or regular tax planning as well. In total, taxes saved would run between 20%-25% or so of the $125k figure or $25,000-$35,000, depending on where you live and individual tax circumstances in the United States. At a 7.5% portfolio yield, it would take a portfolio of roughly $1.2M to generate the target income, which isn't an impossibly large amount of money to pull together. Some manage to get close to that by the time they are 30-40 years old.

While most people should be able to live quite well on $91,000 in most places not named Palo Alto in the United States, it is far more than enough to live in many of the countries that many expats have looked at, such as the Philippines, Costa Rica, Panama, and Ecuador. This has been dubbed "geographical arbitrage" where you live in one country, but get paid from investments/employment in a different currency. You can legally avoid most US domestic taxes and you can often avoid getting taxed in the host country you are living in as well. For me, the lower cost of living plus tax benefits of a properly structured portfolio beckon and locations with great weather don't hurt either, having shoveled more than enough snow in my lifetime and experienced sweating while standing completely still in 90% humidity. One need not necessarily move out of the country as that is impractical to some, but I'm a bit of an adventurous type, so it works for me.

The idea is that one could probably live quite comfortably in many locations (luxury condo, maid, driver) on $40k-50k per year in many places and save/reinvest the rest. Steven Bavaria's "Income Growth vs. Dividend Growth" income growth strategy would work well in this portfolio as one could plan to withdraw 4% per year or $48,000 annually and reinvest the rest, which is in line with the 4% rule for a portfolio as well for a high probability of success of maintaining that portfolio and income level for at least 30 years and is likely going to result in a consistently increasing income stream.

I wanted to craft a qualified dividend income focused portfolio with the goal of throwing off $91,000 in annual dividend income. My goal is to generate the maximum amount of tax-free income from a portfolio, which in turn minimizes taxes, assuming zero W2 income from traditional work or self-employment, while adhering to the basic tenets of diversification, position sizing, and other elements of risk management.

I am a fan of closed-end funds, and in my research, as an example, I came across the Reaves Utility Income Fund (NYSEMKT:UTG), which lists the stated goal of being "managed to seek tax-advantaged income" in the form of qualified dividends. Not surprisingly, last year UTG paid out 100% qualified dividend income. The Eaton Vance Tax Managed Global Diversified Equity Income Fund (NYSE:EXG) is another example of a closed-end fund where the distribution is your return, as Reuben Gregg noted.

EXG has averaged around 9.9% in total return annualized over the past 5 years, and that is close to the annualized yield on the fund. Additionally, the fund appears to be fairly tax-efficient as well paying out a high proportion of return of capital, which is not surprising given the options writing strategy. Clearly, some CEFs are focusing on the tax efficiency of their distributions, so the next step is to find CEFs focused on generating tax-free income for further analysis.

Nuveen makes this very easy with a one-page sheet showing the tax characterization of their CEFs; other fund families are not so helpful. I went down the list and selected funds for further analysis that didn't pay a majority of "Non-qualified dividend income." Many of these funds I already owned or had an interest in, such as the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX), Nuveen Dow 30 SM Dynamic Overwrite (NYSE:DIAX), Nuveen S&P 500 Dynamic Overwrite Fund (NYSE:SPXX), and the Nuveen Nasdaq 100 Dynamic Overwrite Fund (NASDAQ:QQQX).

Next, I then evaluated the funds to see if this was a fund strategy/segment that I would want to own and is it reasonably priced. For example, I liked the Nuveen funds above as these are designed to mimic the market performance of the underlying indexes and have an option overlay strategy, which generates more income and reduces risk. I also looked at relative valuations using the Z score/Z stat, and I looked at how the fund performed over the past several years to include 2008.

I also must caution that one shouldn't select an investment just to avoid taxes, but to generate a reasonable investment return. That said, the central question I wanted to explore is how tax-advantaged can I make those returns from an equity-based portfolio of otherwise solid investment vehicles and ask myself "would I buy these CEFs based on their overall risk and performance?" Also, it can't be guaranteed that every single year this portfolio will generate 100% non-taxable income, it doesn't have to. A married couple can deduct $19,500 in ordinary income and still pay no taxes as long as the rest is qualified dividends, LTCG, or non-taxable return of capital, so there is about 15% of wiggle room for short-term capital gains, non-qualified dividends, payments in lieu of dividends, etc.

Constructing the portfolio

In compiling my list of CEFs, I focused on funds that generated qualified dividends, paid non-destructive return of capital (NYSE:ROC), ideally by design, and it was also acceptable to pay out long-term capital gains (LTCG). All of these strategies result in a zero tax bill at the end of the day, although with ROC, it has more of an effect of deferring taxes.

REITs are out as their payments don't count as qualified dividends. MLPs are in. Option Income funds are in as well as they tend to generate distributions mostly made of non-destructive return of capital. Preferred funds are also in. Utilities are in. Also, I don't buy CEFs trading at a premium, ever, and I do track Z scores as a measure of relative value in my selection focusing on -1.5 or cheaper for increasing positions and avoiding/selling as Z scores approach +2.

Municipal bonds are typically the investment vehicle of choice to generate tax-free income, but equity closed end funds (CEFs) are likely to offer better long-term, total return prospects for an early retiree. Bonds also present other risks not present with equities, such as interest rate sensitivity. There certainly could be a place for some allocation to Munis, but I focused on the equity construction first. I could see a place for Munis if one wanted to generate tax-free income in excess of the $91k figure where taxes start to creep in and to provide additional diversification.

CEFs usually trade at a discount to NAV, which has the effect of increasing the yield on price, described as a "windfall yield" by Doug Albo vs. the yield at NAV. CEFs also can engage in strategies that open ended funds or ETFs typically can't, such as covered call writing, which is defensive and generates income, but underperforms in a strong bull market. MLPs tend to pay out mostly ROC.

Individual Components

SYM

Position size

Strat

Yield

Discount

BXMX

6.1%

S&P 500 Over Write

7.67%

6.13

DIAX

11.0%

Dow 30 Over Write

7.16%

9.22

ETG

5.5%

Global Dividend

7.3%

6.76

ETO

5.5%

Global Dividend

9.12%

4.42

EVT

5.4%

General Equity

8.64%

10.54

HTD

5.5%

Preferred and Dividends

7.17%

10.78

JGV

5.4%

Glob div

8.44%

13.13

JMF

5.4%

MLP

9.07%

13.6

JTA

5.5%

Cov call

8.25%

9.64

JTD

5.4%

Tax advantage Dividend

8.25%

9.4

SPXX

12.3%

S&P 500 Over Write

7.49%

10.56

QQQX

10.9%

Nasdaq 100 Over Write

7.27%

6.85

UTG

0.5%

utility

6.27%

4.13

PDT

10.1%

Preferred

8.05%

9.66

BUI

6.0%

utility

8.01%

12.38

First, I started with a strategy I like, which is selling options on an underlying index, hence the inclusion of SPXX, DIAX, BXMX and QQQX, which anchor the portfolio and should generate market type returns. These funds seek to replicate the underlying performance of the S&P 500 index, Dow Jones, S&P 500, and QQQ indexes respectively with less volatility. The only difference is that BXMX has a 100% option portfolio overwrite, while the remainder have a dynamic overwrite and target 55% of the portfolio. Both BXMX and SPXX are focused on the S&P 500 so there is obviously overlap there, but BXMX should be much more defensive in a down market.

These option income funds represent 45% of the portfolio with individual weightings of BXMX (6.13% discount, 7.67% yield) with a 11.15% position, DIAX (9.22% discount, 7.16% yield) with a 11.02% position, SPXX (10.56% discount, 7.49% yield) with a 12.30% position and QQQX (6.85% discount, 7.27% yield) with a 10.94% position. Nothing particularly flashy with these selections and in theory, these picks should largely track the market with additional downside protection. Doug Albo recently had a great article on DIAX. These funds pay quarterly.

For some international exposure, I went with the Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (NYSE:ETO) (4.42% discount, 9.12% yield) at a 5.5% position, Eaton Vance Tax-Advantaged Global Dividend Income Fund (NYSE:ETG) (6.76% discount, 7.30% yield) with a 5.5% position, and Nuveen Global Equity Income Fund (NYSE:JGV) (13.13% discount, 8.44% yield) with a 5.4% position. These funds do have a large percentage of funds invested in the US. These have a bit higher distribution and pay monthly.

For preferred exposure, I went with John Hancock Premium Dividend Fund (NYSE:PDT) (9.66% discount, 8.05% yield) at a 10.13% position, Nuveen Tax Advantaged Dividend Growth Fund (NYSE:JTD) (9.4% discount, 8.25% yield) at a 5.4% position, which owns some preferreds, John Hancock Tax-Advantaged Dividend Income Fund (NYSE:HTD) (10.78% discount, 7.17% yield) at a 5.5% position owns some preferreds as well. I liked PDT in particular for a higher weighting due to their 2008 performance and .25 beta.

For MLPs, I selected Nuveen Energy MLP Total Return (NYSE:JMF) (13.60% discount, 9.07% yield) at a 5.4% position. The MLP sector has endured a bloodbath in the past 9 months or so, although midstream companies haven't been punished quite as bad as the upstream exploration companies, as of late, some of the bigger midstream companies are down 15%-20%. You may see this as a buying opportunity or just may opt to avoid the sector altogether. This is a good example of some of the irrational pricing seen with CEFs.

JMF is trading at a 12% market discount, but a very similar fund, FMO, is trading at a 2.35% discount and actually traded at a premium several times going back to October 2014, while JMF has been stuck at a solid 8% discount. The funds have 9 of the exact same companies in their top 10 holdings that represent 75% of the investment portfolio. I'm not sure why the market feels that JMF is more than 5x less valuable than FMO given nearly very similar holdings, but such is the insanity of CEF investors, as Doug Albo has documented.

For general equity and utilities, I selected UTG (4.13% discount and 6.27% yield) for a token .49% position, Nuveen Tax Advantaged Total Return Strategy Fund (NYSE:JTA) (8.25% yield and 9.64 discount) for a 5.5% position, and Eaton Vance Tax-Advantaged Dividend Income Fund (NYSE:EVT) (10.54% discount and 8.64% yield) for a 5.4% position. Utilities have been an interesting sector of late, as there seems to be a rotation out of them and as discounts have expanded recently. This is why I held back on buying more UTG despite it being the fund that got me interested in the application of maximizing qualified dividends.

Utilities and REITs were being bid up as bond proxies given the low interest rate environment over the past several years, and investors are now a bit more cautious toward these industries in anticipation of the Fed rate increase they have been telegraphing all year long. Most expect a token 25 BP increase in late 2015 or even early 2016. I doubt that a quarter point increase is going to result in a meaningful increase in yields to fixed income and with Europe engaging in their own QE type policies and cutting interest rates, the Fed probably doesn't have much room to increase rates. All in all, this price action seems to be a relative overreaction to the headlines and probably represents a good point to establish a position with utilities.

UTG is actually trading at a 4% discount vs. an average discount of 5%, so I only opened a small position to monitor as the relative valuation isn't very good. BlackRock's Utility and Infrastructure Trust (NYSE:BUI) (12.38% Discount, 8.01% yield) appears to be a better choice on a relative discount basis, trading at a Z score of -1.3 or 1.3 standard deviations below where it normally trades, which should be expected about 8.5% of the time (12% discount vs. an average of 9.7%), so I opened a 6% position in BUI. Keep in mind that just because the trading range for a CEF may be an anomaly right now, there is no reason that it can't become the "new normal."

Reuben Gregg had a great article on PIMCO High Income Fund (NYSE:PHK) and what happened in 2009, specifically looking at how in the world PHK took off like a rocket ship and soared to a 50%+ premium and stayed there for years on end after trading near NAV for years previous to 2009. Theories abound about why this happened, and many attribute it to the real or imagined "Bill Gross" effect, but there is no doubt that PHK flew into the premium stratosphere and stayed at the 50% or higher level for years, although it has recently come down to "only" a 26.83% premium.

If such a financial anomaly with PHK can exist for 5+ years, there is no reason that BUI couldn't settle in and be repriced to an average 13% discount; however, CEFs have also shown to have statistically significant mean reversion, which can generate alpha. At the end of the day, my crystal ball is cracked and out of warranty, so I don't even try to predict price movements, although I do try to position myself as advantageously as possible to price changes should mean reversion take place now or in the future.

Given 2 funds that are likely to pay 100% tax-advantaged distributions, I would rather own the one trading below the average discount. If nothing else, I know I can get over 1% in "windfall yield" over NAV buying the CEF at a 13% discount, which is the point of this portfolio more so than chasing underlying price movements.

In analyzing the BUI tax efficiency, they paid 17.61% in qualified dividends, 25.44% long-term capital gains, and 56.95% of return of capital, but unlike Nuveen, BlackRock doesn't make it easy and doesn't post this information online, so I had to call and dig it out of them. BUI also writes options, so a higher percentage of ROC isn't surprising and should be expected.

Thanks to the wonderful portfolio tool investspy.com, I can calculate some good statistics on this portfolio and I know my beta is .65, which is helpful for hedging and to have some idea on how volatile the portfolio should be vs. the S&P 500. If one wanted a bit more assurance against an adverse price movement, they could look at hedging using SPY puts or short the SPY index, say shorting 1000 shares of SPY to offset roughly 20% of the 1.2M CEF portfolio price movements. In the event of a 10% correction, one would expect the CEF portfolio to be reduced about 6.5% or $78,000, but by throwing on a hedge by shorting 1,000 shares of SPY, about $20,000 of that loss should be offset by a corresponding gain in the hedged portion of the portfolio. Shorting SPY comes with carrying costs of paying the dividends and margin borrowing, but it is one way to add additional protection to your portfolio. ReelKen has some very interesting strategies on hedging that could be useful in a portfolio such as this.

Conclusion

This portfolio accomplishes my targets of creating a $91,000 annual income that is mostly tax-free while maintaining diversification and should be less risky than owning the S&P 500 outright. There are opportunities to increase your income through reinvestment of dividends, although capital gains over time are likely to be minimal. The blended yield of the portfolio is 7.78%, which means it would take about $1.16 million to construct the portfolio. Closed-end funds are a great tool to generate this level of income, and I think the tax efficiency of many closed-end funds is an underappreciated element of the investment vehicles.

Disclosure: I am/we are long DIAX, UTG, BUI, JGV, JTA, JMF, HTD, PDT, BXMX, SPXX, QQQX, JTD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The yield and Discount information is from www.cefconnect.com and is believed to be reliable at the time of publication.