Improving Returns

Many people have two pockets for their retirement money: tax deferred retirement accounts like IRAs and 401Ks and savings that has already been taxed, such as bank CDs and brokerage accounts. I'll skip ROTH IRAs for now as they are a hybrid (and not relevant to the main point of this article).

How do you manage this dual nature? What investments do you put in which pocket? This is not an easy question. Today I'll address one aspect of it.

Taxes do matter; for this analysis I'll use a 28% Federal tax rate. That's the AMT rate. I will leave State income taxes out; incorporating them is rather obvious, but since state tax rates vary widely, you have to do this part yourself.

A municipal bond portfolio that yields 5% will produce $5,000 for every $100,000 invested, after Federal taxation, which is zilch for most municipal bonds. For a taxable bond portfolio, one would need a yield of almost 7% to recover the same 5% aftertax yield. How to calculate this? Take the 5% and divide it by the decimal equivalent of 100% minus the tax rate, viz. 28%, which quantity is 72% which has a decimal equivalent of 0.72: 5% / 0.72 = 6.94%, almost 7%.

[NOTE: using the widely applicable 25% Federal marginal tax rate produces a 6.67% effective rate and the point still works; if your Federal marginal tax rate is 15%, stick to taxable fixed income investments.]

Investing at 6.94% in taxable bonds would give you a LOT of risk today (those are junk bond levels), but investing in municipal bonds at 5% is rather easy and can be done with solid A and AA rated bonds of good quality.

Therefore, much of the fixed income portion your retirement fund - my Krypto Fund - should be put in the taxable pocket and be invested in municipal bonds yielding over 5%.

This strategy must be tempered a bit due to the relative illiquidity of municipal bonds. You should do this only for the stable base portion of your Krypto Fund, which is in fact what Krypto does do. This portion is the part you do not expect to need to use to re-balance.

By using municipal bonds this way, you will increase the return of your Krypto Fund a lot. You're getting effectively 7% in fixed income, not the 5% available in corporate bonds. That extra 2% is a lot. Another way to think of it is this: I target a 5% taxable withdraw rate as readily achievable over a long term in the Krypto Fun with minimal risk of every running out. Getting 7% effective taxable return on a big part of the fixed income investments provides me a 2% per annum cushion that could be reinvested as reserves for unforeseen costs or big market pullbacks like 2008-9. That's good.

By the way, the rest of the taxable pocket for your Krypto Fund should be heavily geared to stocks for which low capital gains tax rates apply. This also gives you an edge for your returns for your Krypto Fund.

Word of the Day

"Syncretism" - noun [$10]
Syncretism means 1. the combination of two different forms of belief or practice (or art); 2. the fusion of two or more original different inflectionist forms.
Sentence: Long term retirement investing practice is necessarily a syncretism of the taxable and the tax free worlds of investments. One needs to combine the two worlds optimally to obtain the highest return for desired risk levels.