FREE NEWSLETTER
IN 2014, AN INVESTOR asked Charlie Munger—Warren Buffett’s second-in-command—why he wasn’t investing in Apple. Munger responded that, “No matter what their financial statements showed,” he’d never have a high degree of confidence in the company. “It’s just too hard.”
Buffett agreed. But things changed. Today, Buffett’s Berkshire Hathaway is Apple’s third-largest shareholder, with holdings valued at more than $150 billion.
What should we conclude from Buffett’s about-face? In recent weeks, I’ve referenced studies on market timing and trading. What the data show is that it’s very difficult to forecast where companies, markets or the overall economy are headed. For that reason, investors are typically better served by not actively trading and instead opting for a buy-and-hold approach. This applies equally to individual and professional investors.
But what about Buffett’s experience with Apple? By changing his mind, Buffett made a fortune. Clearly, investors need to strike a balance. Yes, consistency is important. But no one should worship so stubbornly at the altar of consistency that they never do anything differently. Here are four areas where I suggest taking a flexible approach with your personal finances:
Asset location. Personal finance textbooks will tell you that it makes sense to hold bonds, which can be tax-inefficient, in retirement accounts. That’s to shield their income from tax until you withdraw from those accounts later. But this shouldn’t be regarded as an ironclad rule. Let’s look at how this answer might change over time.
During your working years, bonds serve an important role: Whether it’s saving for a big purchase or guarding against a rainy day, it can be valuable to own bonds for their stability. But because withdrawals from retirement accounts carry a tax penalty before age 59½, it can be counterproductive to house bonds in those accounts. That’s why I think it makes sense to override the textbook and hold at least some bonds in a taxable account during your working years.
Once you reach retirement, however, it often makes sense to flip that script. After 59½, you can access your tax-deferred accounts penalty-free, so it becomes less of a problem to hold bonds in those accounts. The bottom line: How you structure your portfolio will change over time.
Municipal bonds. If you’re concerned about bonds’ tax inefficiency, an alternative is municipal bonds, which are generally free of federal and sometimes state income tax. That’s a reasonable solution for taxable-account investors, but it’s important to be adaptable. Because everyone’s tax situation is different—and because everyone’s tax situation will change over time—you shouldn’t view this as a firm rule.
Suppose you’re in your working years and in the 37% federal tax bracket. To determine whether municipals make sense, you’d want to look at the following comparison: First, find the yield-to-maturity on a standard Treasury bond. Today, one-year Treasurys yield about 5.3%. Now, compare that to the yield on a municipal with the same one-year maturity.
Highly rated munis today are paying about 3.5%. But that 3.5% is free of federal tax, so we need to make an adjustment to compare it to the Treasury. Divide the municipal’s 3.5% by 0.63 (which is 1 minus 0.37, representing your tax rate of 37%). That gives us 5.6%. Now, we can make an apples-to-apples comparison. By a small margin, you’d come out ahead choosing the municipal at 5.6% over the Treasury at 5.3%.
But what if you’re in retirement, and your tax rate is nowhere near 37%? Let’s compare these same two bonds using a lower tax rate—say, 22%. When we divide the muni yield of 3.5% by 0.78 (1 minus 0.22, representing your 22% tax rate), the result is very different: 4.5%. In this case, you’d come out ahead, even after taxes, with a Treasury bond paying 5.3%.
The bottom line: Which bonds you choose, and which accounts you hold them in, will depend both on market rates and on your own tax situation. There’s no single right answer for everyone. And since most people’s tax situation changes over time, it’s important to revisit this question regularly.
Retirement account contributions. Today, many employers offer workers a choice in how they make retirement contributions. Traditional 401(k)s offer a tax deduction, while Roth accounts offer no deduction but do grow tax-free. Which should you choose? Like the bond question above, the answer will depend.
Here’s how to do the math: First, determine what your tax rate will be this year. Then compare that to what you think your rate might be in retirement. To be sure, it can be difficult to estimate that future rate, especially if it’s many years off. But at certain points in life, the answer is clear.
Suppose you’re just getting started in your career. You’re single and have a $50,000 gross income. Most likely, you’d be in the 12% tax bracket. How would that compare to your tax rate in retirement? My guess is your rate would be higher later, so I’d opt for the Roth contribution. Yes, you’d be forgoing a tax deduction, but only at 12%, and that might allow you to avoid paying a higher rate later.
Now, suppose you’re further along in your career, married and have a combined income of $400,000. In that case, you’d likely be in the 32% tax bracket—a fairly high rate. Again, it’s difficult to know for sure, but it’s quite possible you’d be in a lower bracket once retired. In that case, you’d benefit from a tax deduction this year. You’d thus choose to make tax-deductible retirement account contributions in years like this.
The bottom line: Especially when it comes to anything tax-related, it’s important to periodically reevaluate decisions. What makes sense at age 25 may not make sense at 45, and what makes sense at 45 may not make sense at 65.
New investment options. When building an investment portfolio, simplicity is a great virtue. That’s why I try to steer clear of Wall Street’s “innovations.” But just like Buffett, it’s important to keep an open mind.
Sometimes, something new comes along that’s worth our attention—direct indexing, for instance, which could be valuable in some situations. And sometimes investments that were previously tried-and-true change in ways that make them less attractive—many emerging markets funds, for example.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
It’s amazing how timely this article was. I’m not one to use the overused word “literally”, so I’ll forego it. Let’s just say I was thinking through how to wisely invest a lump sum of dollars into my taxable brokerage account, debating the pros and cons of municipal bonds vs. a total bond market index fund. I couldn’t come to a decision, so I decided to procrastinate and catch up on a few Humble Dollar articles. Yours was, perhaps divinely, the first I saw. Until now, all our bond funds have been in tax-advantaged accounts, so this investment was to be my first foray into bonds in a taxable account. Your article taught me how to do the math, and ultimately we went with the total bond market index fund over the munis. Thanks, Adam.
With the “muni math”, I think it’s relevant to use one’s effective tax rate (i.e. the average rate paid across one’s entire income), and not the marginal rate that the fund companies will tout (e.g. who cares if the last dollar is taxed at 37% if the average tax rate on all dollars is 25%).
In the example above, an investor with a 37% effective tax rate would be in the top 1% of earners, so the calculation would not be relevant for the other 99% of us. An effective tax rate of 25% would involve household income of well over $300,000. The tax equivalent yield of the muni at a 25% effective rate would be 4.67% — below the 5.3% Treasury rate.
Not using one’s effective tax rate can lead to the wrong conclusion with the muni math.
“Those accounts” are taxable accounts, right? It’s not clear.
No, “those accounts” refers to tax-deferred accounts, not regular taxable accounts.
Direct indexing is just another way to say not indexing. It’s active management with a different name.
Regarding Roth conversions, the research paper by Vanguard is a good read: https://advisors.vanguard.com/iwe/pdf/ISGBETR.pdf
Great article on the need to stay flexible Adam. Not to be nit-picky, but I think the math for comparing muni bonds to treasuries needs to be revisited. To compare the after-tax return on Treasuries (subject to Federal tax) with Munis (NOT subject to Federal tax), the calculation needs to compare the return of Treasuries as follows: the 5.3% rate for the Treasuries will have an after-tax return of 5.3% x .63=3.33%, in which case you would then choose the Muni’s rate of 3.5% over the after-tax rate of 3.33% of the Treasuries.
Don’t you reach the same conclusion about munis vs. Treasurys whether you use your method or Adam’s? Your method gives the after-tax return on Treasurys while Adam’s method gives the taxable-equivalent yield on munis.
I guess I’m not quite following here. Unless…via Adam’s method, the yield on the Treasuries would need to be 5.6% to beat the 3.5% Muni yield if you’re in the 37% tax bracket? I’ll buy that, it’s just that stating that as… “By a small margin, you’d come out ahead choosing the municipal at 5.6% over the Treasury at 5.3%.” seemed a little odd, since, in that case, you’d always choose the higher number regardless. But you are correct; I was thinking of a comparison of 3.5% vs. 5.3%, and tossing in the 5.6% in that way was a little confusing to me.
Always owned tax frees in my taxable accounts because in the day, last decade, rates were quite high, even double digit at one time. Many wealthy people own lots of munis. I actually bought hi quality munis in my IRA when rates a few years ago were near zero. The default rate on investment grade munis is like .04%; quite safe
taxable munis could be useful as an alternative to corporate bonds in an IRA
I’m still not sure you need to hold bonds in a taxable account during your working career. Lets say you hold some bonds in your retirement accounts and only low-cost stock index funds in your taxable account. When the need arises for your safe bond money, sell the stocks in your taxable account. In your retirement account, make a corresponding sale of bonds and purchase of stocks.
I think this would remain a valid approach in retirement as well.
Very helpful, thanks.
Thanks for yet another great article, Adam! People who have followed Buffett and Munger are aware of their preference to invest in or own companies with a “moat”. Buffett recently observed that most i-phone owners would sooner give up their second car than their phone. Perhaps this may partially explain their revised opinion on investing in Apple?
I agree, Jack. Also, I believe I’ve heard Warren indicate that he considers Apple an indispensable consumer products company, which we Buffett followers know he’s comfortable owning (e.g. Coke, Kraft-Heinz, Fruit-of-the-Loom, etc.).