Time to Change?

Adam M. Grossman

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.

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