How to Build a 4.75% Income Fund

Want to build a diversified, tax-efficient, and low-cost income fund for your clients? Here’s a surprising way to do that with a broad-based index fund like the S&P 500.

According to S&P Dow Jones Indices, the S&P 500 had a 4.75% yield for the 12 months ending September 30, 2018. That yield came from a 1.81% dividend yield and 2.93% stock buyback yield1. You or your clients may say you can’t spend the buyback yield. I beg to differ. Consider the following example.

Say you bought 100 shares of Fiduciary Consulting Co. (FCC) for $10 each a year and a day ago. Since FCC has 10,000 shares outstanding, you own 1% of the company (100/1,000). FCC made $6,000 over the past year, or 60 cents per share, and wants to return it to shareholders. Let’s also say that FCC stock went up by $2 and is now trading at $12 a share.

FCC could pay a 5% dividend and you’d receive $60 and be taxed at 15% (unless your income is very high) on your federal tax. You’d pay $9 in taxes and be left with $51.

FCC could also decide to buy back some stock with this $6,000 cash. At $12 a share, it can buy back 500 shares, leaving 9,500 shares outstanding. If you then sold five shares for a total of $60, your gain would be $10 and you would have a $1.50 tax from the long-term capital gain. You’d have $58.50 in your pocket and still own 1% of the company (95/9,500). Buybacks are superior to dividends because less goes to taxes.