If you are retired and looking to live off of the income your portfolio generates, then real estate investment trusts (REITs) are likely to be on your investment list. While they can generate a lot of income, there's a small problem with the business structure (more on this later). But when you pair a REIT with a Roth account, you can get something very attractive.
What's a REIT?
At its core, a REIT is a company that owns physical property that it rents out to tenants. There are unique types of REITs that don't follow that mold, notably mortgage REITs, but traditional property-owning REITs are the most common. What makes a REIT different from a traditional company that owns property is that a REIT doesn't have to pay corporate-level taxes so long as 90% of taxable earnings get passed on to investors via dividends.
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That's a fabulous thing, because it means there's no double taxation of dividends, as would take place with a regular corporation. The trade-off is that shareholders have to pay taxes on the dividends at their normal income tax rate. This feature of REITs is one of the main reasons why REIT dividend yields are generally so high. To put a number on that, the S&P 500 index fund will net you a yield of around 1.7% today. The Vanguard Real Estate Index ETF, a rough proxy for the REIT space, has a yield of 3.9%. That's more than twice as high!
And there are individual REITs with even higher rates. For example, Digital Realty, which is focused on owning data centers, is yielding about 4.4%. W.P. Carey, with a highly diversified portfolio of real estate, has a dividend yield of nearly 5%. And these are large, well-respected, and fairly conservative REITs. Digital Realty has increased its dividend annually for 18 consecutive years, and W.P. Carey's streak is up around 25 years. There's a good reason why dividend investors like these stocks.
Only there's that tax headache, because the dividend income gets counted and taxed like a shareholder's regular income. With a top tax rate of 37% in 2023, investors potentially have to give up a big chunk of any dividends to Uncle Sam.
That's a problem especially if you are trying to live off of your dividend income, not to mention that taxable income in retirement can mess with certain benefits like Social Security. Luckily, there's a workaround.
Like chocolate and peanut butter
Even if you don't like Reese's, you know the candy brings together two divergent flavors to create something that people see as very special. That's exactly how investors should feel about putting a high-yield REIT, like W.P. Carey or Digital Realty, into a Roth account.
To simplify things, a Roth is a retirement account that gets funded with after-tax dollars. Since the owner has already paid taxes on the money going into the account, any money pulled out of the account after age 59 1/2 is accessed tax-free (assuming the account is at least five years old). There are some limitations to consider, such as the fact there are strict rules on pulling earnings out of Roth accounts before reaching the minimum age for qualified distributions, so you should understand those ins and outs before opening one. But with this high-level view, it's easy to understand the benefits of putting a REIT into a Roth.
By doing so, you get to keep all of your dividend income without the taxes. Think about this for a second; using the top tax bracket of 37%, your after-tax yield from W.P. Carey is more like 3.2%, while Digital Realty's after-tax yield would drop to roughly 2.8%. These are rough estimates, of course, but it brings the big picture into clearer focus. You can materially increase the income from your portfolio of REITs if you put them into a Roth.
The advantages of this strategy are clear. However, investors do have to accept that they won't have easy access to the earnings in their Roth account until closer to retirement, and they get no tax benefit from capital losses.
A free lunch?
"There are no free lunches on Wall Street" is a common investment saying, and there really aren't. But putting a high-yield REIT in a Roth is about as close as I've found to free food around here. Despite the mentioned drawbacks, the benefits should outweigh the negatives over the long term.
