Create Tax Free Income for Life with Municipal Bonds

Now that you’ve read the somewhat salacious title of this article, the real question becomes “is there any truth to it”? A second question might be similarly, “what’s the catch”? Well, I hate to disappoint you but there is no catch and it is possible to create a tax-free income stream for life. But how? It is done with an asset that has been around for literally ages—bonds.

 

Now that you’ve read the somewhat salacious title of this article, the real question becomes “is there any truth to it”?  A second question might be similarly, “what’s the catch”?  Well, I hate to disappoint you but there is no catch and it is possible to create a tax free income stream for life.  But how?  It is done with an asset that has been around for literally ages—bonds.

In particular, this strategy can be executed successfully by using tax-free, non-AMT municipal bonds (what is a AMT bond?).  Most investors shy away from bonds because they yield (or return) less than equities and tend to be more complex in nature.  However, the global bond market is larger than the global equity market by $30 Trillion (see here) although the portion we will discuss in this article is much smaller at just shy of $4 trillion.  So, why might you want to invest in municipal bonds to create tax free income for life?

What Are Municipal Bonds

First, municipal bonds represent an “I.O.U” issued by a governmental entity—usually state or local.  They get their “tax-free” status because the money raised by the bond issue is usually for a “public good or service” like schools or roads.  Money raised for these type of bonds are labeled as “general obligation” bonds and are backed by the full, faith and credit of the issuing entity’s taxing power.  Generally speaking, the more taxing power, the better the backing.  The idea behind tax-free interest from the bondholder comes from the fact that many schools and roads are usually funded by a large portion of taxpayer dollars.  Thus, tax-exempt interest was born to incentivize the public to keep paying their taxes to fund projects.  Ok, seems like a good deal, so why not use bonds in 100% of your investment portfolio?

There’s Still No Free Lunch

Well, like it’s been said before “there is no free lunch” and it is no different for municipal bonds. The rules of asset diversification apply even in the compelling case of tax-free income.  Bonds have historically had little correlation to equities except in market crises situations, so creating a portfolio of both equities and bonds makes a whole lot of sense as a long-term investor.  But when considering other fixed income vehicles like annuities or real estate which both generate taxable portfolio interest, individual municipal bonds make a good alternative.  Take the case with your typical annuity (fixed or variable) that carries an average 2-3% annual expense charge when you consider:  administrative, mortality and expense, mutual fund costs.  And although you may not see it, don’t forget there will be a commission paid to the broker that sold you the annuity.  So first year charges, can easily exceed 8%.  Finally, you still have to pay taxes on the annuity income stream on all gains beyond your cost basis.  Alternatively, you can invest the same amount into a diversified municipal bond portfolio and pay no taxes and receive tax free income until the bonds are called or mature.  As an added bonus, your estate will receive a “step-up” in basis at your date of death greatly reducing any potential capital gains.

Why Not Use a Bond Fund?

This is a good question, and the short answer is that individual bonds are actually cheaper and a much more effective way of achieving “tax-free income”.  Similar to annuities (mentioned above), bond funds have both explicit and implicit expenses.  The explicit expenses like marketing, administrative, sales loads, etc. show up in the annual expense ratio.  Granted, you can find a really low-cost index fund, but like actively managed funds, they have implicit costs which are not in the annual expense ratio.  For example, what happens when the fund manager receives new capital in the fund and is compelled to buy bonds in an expensive market, or alternatively faced with selling bonds into a cheap market.  This is referred to as liquidity premium (the former) or discount (the latter).  There is also “cash-drag” where the fund manager may hold extra cash just to satisfy “potential” fund redemptions.  Being a former portfolio manager myself, I realize not all bond fund managers effectively navigate these risks which translate in lower returns to fund investors.

“Buy and Hold”

Not the sexiest, but the “buy and hold” strategy for individual municipal bonds is by far the smartest.  Here’s a brief example of the power of compounding in this article.  Not only do you save the costs and expenses mentioned above, you also greatly reduce many of the risks that run off several other investors thereby creating a golden opportunity for the patient and savvy investor.

Check out these resources:

P.S. I apologize for the infrequency of written posts to my readers.  I’ve used the extra time to work on a book that I hope to have finished later this year.  Until then, enjoy the podcasts and these sporadicly written posts!

 

What is Your Financial Professional–A Broker or Fiduciary?

Summary:  Athletes understand “off-the-field” distractions.  None are probably worse than those of the financial variety.  Last April, the Department of Labor (DOL) decided that financial professionals giving advice for retirement assets must act in their client’s “best interest”.  Yes. You heard me right. Well, you may be thinking, “I thought my advisor was already acting in my best interest”.  Apparently not all advisors.  The scope of this article won’t cover the long history of the financial services industry (you can get that here).  However, I’ll provide you with a brief one.

A Brief History

Over the last several decades the financial services industry has been split into two camps: the broker-dealer community and the registered investment advisory (RIA) community.  Brokers act as intermediaries between financial companies and consumers.  At a time, they were the only way you could purchase a financial product.  The legal standard to which a broker is held is called the “suitability” standard. This means that any financial product or service sold to the client had to be “suitable”.  Unfortunately, suitability can be vague and was subsequently abused over the years causing some financial professionals to sell products that a client didn’t need.  Actually, this became so bad that Congress blamed the stock market crash of 1929 on abuses of the standard and the subsequent depression of the 1930s and created the U.S. Investment Advisers Act of 1940 (“the Advisers Act“).  This began the formation of the RIA community and the creation of many additional regulations which produced a higher standard–one that was in the “client’s best interest”.  This is why RIAs are referred to as fiduciaries.  In short, the Advisers Act required financial professionals whose business was “giving financial advice” to register with the state(s) in which they did business or the Securities Exchange Commission (“SEC”).  This provided the potential client with access to several pertinent details about the financial professional including methods of compensation.

Fast Forward to Today

More often than not, lawsuits against brokers are lost by clients because of the laxness of the suitability standard.  Brokers can always claim they were giving financial advice solely incidental to the product they were selling and were not in fact “financial advisors”.  Well the DOL rule eliminated this defense.  As a veteran of the financial services industry, I welcome this change and believe it will be a “rising tide that lifts all boats”.  Unfortunately, in each section of the financial services industry we will continue to have bad actors, but this new rule will lessen the promulgation of unsuitable financial products that lose investors money. The rule’s one shortfall at this point is that it only covers “retirement accounts”.  However, I believe that it won’t be too long before the “powers that be” realize that a client may have both retirement and non-retirement assets with a broker and both buckets need to be treated equally.  I have prepared a “Q&A” of sorts to answer what I think may be some of the questions individuals may want to ask.

Q: How can I found out if my advisor is part of a broker-dealer firm or a registered investment advisor firm?

Go to http://brokercheck.finra.org/.  Click the “firm” tab, and then type in the name of your investment professional’s firm. If the firm is a RIA it will say “investment adviser firm”. If it says “brokerage firm”, then your guy or gal is part of a broker-dealer.

Q: What is the main difference between a broker and a fiduciary?

A: The standard each is held to is the major difference. RIA firms comply with the legislation set forth by the US Investment Advisers Act of 1940 and hold themselves out as “investment advisers”. This transparency allows for potential clients to have access to the type of financial business and the methods of compensation the adviser will use. This can all be found on-line for every RIA and is called  the “firm brochure“.  (Look up one here.) Broker-dealer firms are not held to such a standard and there is no transparency on the type of financial business they are in nor the methods of compensation used.

Q. What are the specific changes the DOL is requiring?

A. They are numerous and can be found here. The “cliff-notes” version is this:  by January 2018 (at the latest), brokers engaging in prohibited transactions (see next question) will be forced to execute a “best interest contract” with their clients affirming that the transaction was in the client’s best interest.

Q: What is a prohibited transaction?

A:  There are 3 basic categories: 1) retirement account rollovers that specifically shift from low-fee to a high fee arrangement; 2) rolling assets from a 401(k) to an IRA where the advisor will receive an ongoing fee for management; and 3) switching client from commission based account (i.e. fee charged per transaction) to a fee-based wrap account (for which the advisor receives ongoing revenue).  All these activities are an acts of giving “financial advice”, thus the DOL is now requiring brokers to adhere to the same standard as RIAs.

 Q: Does this new rule apply to all types of accounts?

A: No. Sadly it doesn’t. This rule only applies to retirement accounts for now.

Q: What should I do if my financial professional is not a RIA?

A: This is a good time to have a conversation with your financial professional. Let them address your concerns about the implications of this rule and whether they and the firm they work for are willing to be held to a higher standard. They should be able to demonstrate their willingness to comply with the new rule and acknowledge any past deficiencies.  Need help on what to look for our ask?  Click here.

The ramifications of this new legislation will affect a lot of investors.  You should be aware of it and how you can continue to protect yourself and your assets.

Invest Wisely!

The Fallacy of Chasing Market Returns – Part 2

A formula for not chasing after market returns…[ecae_button]

So the last post, we began discussing the extreme fallacy in trying to beat the markets.  Although I believe it is truly a fool’s errand, I won’t spend as much time or words ranting and pontificating (so you can thank me later!) in this post.  Today will be spent giving you what you should be doing or at least thinking about.  As always, these are merely suggestions.  Any advice I give you here should be considered in context of your entire financial plan, so be sure you consult with a financial professional prior to implementing anything.

 Leave behind the days of “in and out” of the market. 

One of the more insightful quotes of Sir John Templeton was when he said,

“The best time to invest is when you have money.  This is because history suggests it is not timing which matters, but time”.

Now, who are you and I to question one of the most successful investors of all-time?  Let’s explore his perspective because there is a simple wisdom behind what he says.  Googling Sir John’s history is helpful, because it will uncover that he and his family survived some of the worst times in US economic history.  Despite the struggle his outlook remained positive.  My observation in all my years of helping individuals invest their money is that, rarely is the focus not on the myopic goal of beating the market.  Sir John’s simple wisdom suggests a singular focus,  but on something much more valuable than the money we invest—it is time.  All around us we see the result that time has on nature (probably the most profound of all) and in all aspects of our lives.  And although we all learn the lesson of compounding interest from books like The Richest Man in Babylon or the lesson of discipline and frugality from The Millionaire Next Door those lessons are not applied.  Whereas, if the average investor spent less than he or she made, invested 15-20% of their gross income in low cost funds into a qualified retirement plan, he or she would have accumulated a tremendous amount of capital to live on throughout retirement.  However, more often than not, news and print media panic individuals into buying and selling their investments far too often incurring fees and taxes that erode their investment capital leaving them frustrated and effectively poorer.  My simple suggestion is to let time be your ally.  If you are in your 20s and you are reading this, good for you.  You can literally start a savings discipline that could last the better part of 40 years and the older you will thank the younger you for it, trust me.  For those of us that are older, we can still start with the caveat of less time, but hopefully with enough wisdom not to repeat foolish mistakes of the past.

Diversify not just across asset classes, but goals. 

If I have mentioned it before, it deserves another mention, I consider The Aspirational Investor by Ashvin Chhabra a must-read for the DIY investor.  If you consider yourself smarter than the average bear based on your current portfolio, please do yourself a favor and pick it up. He establishes a good foundation for how investing should be broadened to include our life goals and not just the pursuit of better than market returns.  I think he uncovers something key and it leads to my next suggestion.  Finding more contentment in your life will be the key to increasing your net worth (and thus your wealth).  We all see the struggles that some “wealthy” people have and wonder why their money doesn’t bring more happiness in their life.  This is because wealth does not bring happiness to you unless you are already content.  Contentment has to do with understanding that what you value and what you believe is worth more than just money.  This inevitably leads to finding ways to use your money to promote your values and what you believe in.  This is the “quan”, as it were, that Cuba Gooding, Jr. mentions in the movie Jerry Maguire.  In the movie, although he chases the big contract, Cuba’s character realizes it means nothing without his values and the people he loves around him to enjoy it ( (his “quan”).  This realization hits Tom Cruise’s character also when he realizes that what he values is not the chase of being this hot shot agent, but being there for people.  This becomes his source of true contentment. (Pardon my Rotten Tomatoes review!)  What’s my point?  Understand what you value, then use your money for those things.  This will lead to financial contentment, which will inevitably lead to increasing your net worth.  All of which have nothing to do with beating the market.

Put Your Money Where Your Heart Is

More important than putting your money where your mouth is…put your money where your heart is!

Often I find that the psychology of investing and financial management is more complex than the mechanics of it.  Once a person understands why they behave a particular way about money, they easily accept the changes needed to get them to their financial destination.  But without fail, unless these behavioral patterns are understood, people only find limited success.  Ultimately, their financial goal progress is stifled until the “a-ha” moment arrives.  So, how do most happen upon this so-called nirvana of financial omniscience?  Well, more than being magical, it is a progressive journey and not always intuitive.  Recently I recorded a podcast on “Aligning Your Capital with Your Values” part 1 and part 2 that highlights what I’ve uncovered in nearly two decades of work. Here are some things I’ve noticed that have created success with financial plans.

Create a money creed.

Establish what is important to you and write it down!  Instead of feeling neutral about money and what it can be used to do, many people either feel a sense of abundance or one of scarcity.  Unfortunately, this can produce a mindset of overconfidence or fear.  Instead, individuals should focus on all the things that money cannot replace like relationships, integrity and beliefs.  The end goal should be to use money and value people, not the other way around.  This is why it is important to think about the things you value and let that drive how you will think about and therefore use money to build around those values.

Create an accountability system.

Accountability can often be a scary word, depending on what you are unwilling to be transparent about.  However, I’ll submit that being unaccountable in your financial management plan can be catastrophic. How are most people held accountable?  Budgeting. Yet, in 2013, Gallup found that 2 out of 3 Americans didn’t have a budget.  So what is my advice?  Establish a budget.  At a minimum, quantify your discretionary and non-discretionary expenses.  Having a list of all your non-essential expenses will help you understand what can be reduced or even eliminated from your spending.  This will give you the extra cashflow to pay down debt and save toward your goals.  Accountability may also come in the form of hiring a financial advisor to help you clearly articulate goals and stay accountable to what you want to do.  Whether you choose the DIY route or the coaching route, the bottom line should be achieving results.

Create a realistic plan that includes an investment policy statement.

Most individual investment plans lack an investment policy statement (“IPS”), and the ones that do are usually not thorough enough.  A complete IPS has the following components:

  • Risk tolerance– including an investor’s willingness and ability to accept risk;
  • Return objectives – the rate of return needed to meet current and future cash flow needs;
  • Tax, legal and other constraints– will there be gifting concerns, tax considerations or other important reasons to include;
  • Asset allocation- all assets should be considered not just those that will be invested “in the market”.  The Aspirational Investor by Ashvin Chhabra is a good treatise on the inclusion of total net worth, not just investable assets.
  • Monitoring system – arguably one of the most important parts of the process to gauge whether or not progress is being made towards goals.  I advocate a system that tracks the desired return for a group of assets to an appropriate benchmark.

So there it is, a framework for not just putting your money where you mouth is–but where your heart is!

3 “To-Dos” on your Path to Financial Literacy (unabridged version)

Want to win with money? What to experience financial wholeness? Here are 3 tips to help.

Just recently I provided a few tips on how to become more financially literate.  It was such an interesting exercise for me because I wanted to boil it down into three succinct points.  After all, who wants a big list of stuff?  When I finished the email, I thought it would make for an interesting topic in this blog with just a bit more expansion on each idea.  So, here we go…

1. Take some time to explore your “money mindset”.  I find that a lot of clients often view money differently on paper than they do emotionally.  Like anything in life, money has feelings around it and sometimes those feelings are from false notions.  What false notions?  Usually, they are called “biases” or filters. (I’ve written about this in a previous post.) But the point is that they keep you from seeing something from what it really is.  When it comes to money and finance this can happen.  For example, if you grew up poor you may have the mindset (or bias) that causes you to live in a place of “scarcity”.  I find that these people, unless corrected, will always feel that they never have enough regardless of how much is in the bank account.   But like you can probably guess, the “enough” really doesn’t have anything to do with money.  The feeling of completeness and wholeness has to come from another place.  On balance, you have to be able to find a way to spend some, save some and give some. Ideally, we should be more neutral about money and realize it is just a tool or a “means to an end”, rather than having overly negative or positive notions about it.

2. Look to get a professional’s opinion on your situation.  Sometimes it can be difficult to sort out #1 without intervention. The beauty about having another person “in the room” to help you talk through that exercise is you are less likely to succumb to your biases. This is why I would recommend hiring a financial professional to handle your money goals.  Why?  Well, you would never consider playing the role of dentist and fill your own cavity or give yourself a root canal.  I mean, even dentists have their own dentists.  Same as physicians, lawyers, etc. and the logic is fairly sound.  The risk of messing up the procedure is high without some assistance or oversight. The money a dentist could save doing his own dental procedure does not outweigh the benefit received from letting someone else do it.   Conversely, however, nearly everyone tries to handle their own finances without professional advice.  (Clue:  It is not a money issue, it is a control issue.) You can argue that although not as potentially damaging as trying to drill on your own teeth, a wrong move financially has social, psychological and possibly physical ramifications also.  The bottom-line is that a good financial advisor can help you establish realistic goals and provide accountability while preventing you from making a costly error when life throws you a curveball.

3. Be Different in All the Right Ways.  I know, I hate clichés also.  And although this seems counter-intuitive, it makes a lot of sense.  Generally speaking, I find that most people are very reactive with their money.  I mean they let things happen to them instead of happening to things.  For example, funding an emergency fund of 6-12 months of living expenses seems to be common sense.  But, this is something that often doesn’t get completed for various reasons, when in fact, emergencies happen more often than people think.  I would say that at least 40% of all people I speak with (even more of my peers) have not completed a will, health care directive or power of attorney.  However, if any one of them were to become incapacitated, it would be very difficult to act on their behalf to fulfill their wishes.  My advice, instead of being reactive, be proactive.  Instead of being on the defensive, be offensive.  One thing is for sure, following the “herd mentality” usually doesn’t help you become the millionaire next door.

Plain old common-sense is often not “common” at all when you dive into the behavioral aspects that keep people from winning with their money.  It is a matter of becoming really smart around your feelings and removing mental obstacles that keep you from doing the right things even if it takes a little coaching to get you there.