Recently I got this email from one of our subscribers:

Tim, what's the easiest way to withdraw funds from income that ETFs produce?--T.W.

I recommend these three rules to income investors of all stripes, whether they use stocks, mutual funds or ETFs:

1. Collect dividends as cash -- Never automatically reinvest dividends. (With ETFs, this is easy.)
2. Focus on total return, not yield -- Plan to draw half your income from distributions and the other half from the sale of ETF shares.
3. Sell shares on a schedule -- Time the sales to the middle of the month, the middle of the quarter, and not December.

Those are the guidelines; now let's talk about what each means for ETF investors.

Collecting dividends as cash

ETFs are very well suited to income investors. Unlike mutual funds, distributions cannot be automatically reinvested, so they go directly into your cash account. (Some brokerages offer a dividend reinvestment plan that can then automatically reinvest them for you.) And whereas mutual funds are required to distribute taxable capital gains to their shareholders, ETFs can be managed so such gains are avoided. PowerShares, for example, has never made a cap-gains distribution on any of its funds.

This tax-friendly characteristic minimizes the possibility you'll buy a fund immediately ahead of a big distribution, which would cause you to owe taxes on what amounts to a return of your capital. That is, even though the value of your investment hasn't changed from just before the distribution to just after it, you still owe taxes on the gains the fund made during the year before you bought the shares.

So the nature of ETFs means that income distributions, from interest and dividends, arrive as often as monthly. Let's use Vanguard Total Bond Market ETF (BND) as an example. Somewhere between the fifth and the 10th of each month, this fund has paid distributions around 25 cents to 30 cents a share, which works out to an annual yield of 5.12%. iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) is yielding 5.63%, paying out monthly dividends recently of between 45 cents and 50 cents a share on a schedule similar to that of the Vanguard fund.

Even many equity ETFs have significant yields. iShares MSCI EAFE Index Fund (EFA) distributes dividend income annually in December; last year the distribution was $1.53346. (ETFs typically pay distributions in fractions of pennies. Most stocks and mutual funds do not.) That's equal to a yield of 1.84%, based on its recent share price. Vanguard Large Cap ETF (VV) yields 1.73% and pays quarterly.

Generally speaking, the record, ex-dividend and pay dates of income ETFs fall within a total period of five to seven days. For example, Vanguard Total Bond began trading ex-dividend on Oct. 1 to shareholders of record Oct. 3, and paid the distribution on Oct. 5.

There is one big exception to this rule: SPRD S&P 500 Trust (SPY), the most widely held ETF of all. It yields 1.77% and also pays quarterly. The next distribution will be $0.7187, paid on Oct. 31. But the ex-dividend date on those shares was Sept. 21. So planning an income stream from this fund is a bit of a headache. Fortunately, it's not one of our Model Portfolio holdings.

Focus on total return, not yield

My ETF Insider Model Income Portfolio is designed for an investor who takes the first 5% of its total return each year as income and leaves the balance of at least several percentage points to continue growing. Of this 5% return, about half comes from distributions. The other half comes from regular sales of ETF shares to make up the difference. On a $100,000 portfolio, that means distributions in the course of a year of $2,500 and the sale of $2,500 worth of ETF shares--perhaps 50 shares of ETFs with average prices of $50.

To return to our example of iShares MSCI EAFE Index Fund, it generated average total returns of 23.3% in each of the five years ended Sept. 30, 2007. That makes it a likely candidate to be trimmed from time to time to keep it in line with an asset-allocation target of 15%.

When to sell shares

I recommend timing sales of fund shares so they don't fall close to ex-dividend dates, which means the middle of the month for ETFs that make monthly distributions, the middle of the quarter for most equity ETFs, and November or January for funds that make one distribution in December.

Alternative approaches: fixed income vs. inflation

The alternative to my approach to income investing is to seek higher yields, and many retirees have substantially all of their investments in bonds for this reason. That creates, however, the dreaded fixed income. Expenses are not fixed; from property taxes to gas for the car, they go up and up.

My approach has inflation protection built in, because total returns are greater than income requirements, and your kitty--and your income stream--is constantly growing. Twenty years into retirement this approach provides twice the cash it did at the start, and at least the same amount of purchasing power. By contrast, a bond portfolio will be providing a steady stream of cash that's worth half as much then as it is now.

Income investing is really risky when you don't take any investment risk. The risk of inflation can't be avoided.