Transcript

Intro

Noah Lewis: Welcome back to the Scholar Wealth Podcast. Evan and I are back for another speed round. Stephan is handing us the mic again this week to work through a batch of your shorter questions. We’ve got seven lined up today, covering everything from individual bonds versus bond funds at scale, to private credit as a diversifier, to how to evaluate a whole life insurance pitch, plus a few other planning topics. So let’s get into the first one.

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Q&A Speed Round

Individual Bonds vs. Bond Index Funds: When Does Scale Change the Answer?

Noah Lewis: My current portfolio has approximately $5 million in total assets. Roughly 20% is invested in a treasury index fund, and the rest is in equity index funds. As a person’s bond allocation grows in value, do you see any role for investing in individual bonds, either treasuries or corporates, rather than continuing to use bond index funds?

So as we kind of break this down and think about it in different ways, I think there are a couple of scenarios where either can make sense. For example, we like to use — for some of the clients who are thinking longer term, sometimes bond index funds can make a lot of sense, right? What it kind of does is the index fund will go and buy the new bonds, and the interest rates will change, and accordingly, the price of the bond index fund can change, right? So I think this works really well if you’re looking for simplicity and reducing the complexity in the portfolio. And that way it almost creates something that acts like a bond ladder, but you’re not actually going in manually and buying those bonds or trying to evaluate the price or whatever it is. It just kind of takes care of that for you. So I think that works really well from a long-term perspective, especially if you don’t need the cash immediately. You have a separate short-term reserve of cash, and you’re just kind of setting your bond portion of the portfolio.

Where it would make sense to go individual on the fixed income, I think, is when you have a specific liquidity need, and that way you can match up the maturity of the bond to the liquidity need. And that kind of mitigates the risk. If you’re building a bond fund, it’s not a complete stable value, right? And that asset value isn’t necessarily going to be one, like it would be in something like a money market fund. And so it mitigates the risk a little bit of the minor fluctuations that would happen. If you have a specific liquidity need, that’s where I think it would come in — to buy an individual bond and match the maturity.

Evan Mills: Yeah, I agree. I think when you look at individual bonds versus bond funds, you’re kind of managing dates on a calendar with the individual bonds. You have a liquidity need in the future, whether that’s three years down the line, you’re trying to pay for education, or you have a car need in the near future, and you have individual bonds that mature at the time that you need that liquidity. When you look at bond funds, now you’re trying to manage risk in your overall portfolio. I think where people get confused, though, is with interest rate risk. You see that a lot with the bond funds, and that’s what you’re trying to avoid with individual bonds. Now, that’s not to say that interest rate risk is going to mathematically go away with the individual bonds, but what it does do is it becomes less economically relevant to you. It doesn’t matter as much if interest rates rise and your bond decreases in value, because you’re not looking to sell it that year two or three. You’re looking to sell it at maturity, or wait for it to mature, and then you get the principal value back. And that’s when you actually need the liquidity, and that’s the whole idea with the bond ladder. You’re trying to line that up with your needs.

Noah Lewis: Exactly. Kind of building off what Evan said there, I think that’s one of the key misunderstandings, or things we have to get straight — that if you’re buying an individual bond, you don’t see the price fluctuating every day, because you buy it, and if you think, I’m just going to hold it to maturity, and you don’t have to sell, that need isn’t there to evaluate the market value of it. And if you’re holding it to maturity, it doesn’t matter, just like we said, and that’s where the use case comes in. But I think the fluctuation in market price doesn’t just go away just because you don’t see it, because there are interest rates that are changing also, which actually, on the market value perspective, does change the value of the bond or the bond fund. It’s just that when the price ends up dropping or something in a bond fund, it’s because it’s reinvesting at a higher interest rate, which eventually over time works itself out. You just don’t see it with an individual bond.

QQQ vs. MAGS: How to Think About Tilting When You’re Already Concentrated in VTI

Evan Mills: I need to put some cash to work in my IRA, and I have a fifteen-year-plus horizon. I’ve narrowed it down to QQQ or MAGS. My account is already eighty percent VTI plus a couple of thematic ETFs. My thinking is QQQ overlaps heavily with what I already own, so should I go to MAGS to tilt on those specific names?

I think when you look at this, you have kind of a portfolio construction question rather than a concentration risk, in the sense that VTI is already heavily concentrated in these growth funds. It’s still a broad market ETF. You get exposure to large cap, small cap, mid cap, which is good, and it’s not as concentrated as QQQ and MAGS, which is a Mag Seven ETF, but it is still heavily tilted toward growth right now. And when you try to double down on your bet for these growth companies, it’s not a bad bet to make, but you have to understand what your risk is now.

The big thing that’s happening with tech funds is there’s a difference between business risk and valuation risk. No one’s saying that NVIDIA is going to close their doors tomorrow, or Amazon is going to suffer a major loss. That’s the issue that people are really looking at now — that, well, if these companies are so great, then why can’t I just buy their stock and it’s going to be fantastic? Well, the valuation risk is what you’re worrying about — that people are already valuing into the equity these perfect scenarios into the future, and if these perfect scenarios don’t come to fruition, well, your bet on these companies, whether they’re great or not, is going to kind of fail at the end of the day.

Noah Lewis: Yeah, I think that’s a really good point. I think another thing we see is VTI is already concentrated. We know that the concentration already kind of tilts toward that growth in tech and stuff. So whether you’re evaluating QQQ or MAGS to layer on top of VTI, either one of those kind of has that same attribute of overlap, right? So I think a bigger question could be, if we’re looking for some kind of diversification, maybe you would tilt something more like small cap, small cap growth or small cap value, or maybe even international, if you have a long-term horizon. Because whether it is QQQ or MAGS, both of those overlap, I think. And MAGS would just be more and more concentration, if you want that — and thinking that maybe the moat that has been created by these larger firms allows for things like more innovation, and that the winners will continue to win. But I think it’s also worth evaluating whether diversification in another high-risk asset class makes sense, like small cap or international.

Evan Mills: Yeah. I think that’s where the difficulty comes in from a QQQ versus a Mag Seven ETF — that QQQ is still a growth tilt, but a Mag Seven is kind of just seven companies, and now you’re betting on seven companies remaining at the forefront of the AI build-out. And all these companies are going to be reliant on AI, data centers, cloud computing, and all of them are so concentrated on the same engine that if that engine starts to fail a little bit, you have no backup to your true portfolio.

Private Credit as a Portfolio Diversifier: What the Volatility Numbers Don’t Tell You

Noah Lewis: Private credit and crypto feel like the two most disliked asset classes right now, and in my judgment, that’s where the opportunity is. Crypto’s not my thing, so I want to start a position in private credit. The best risk-managed way to do it seems to be a fund that spreads across multiple asset managers with no one manager making more than 10% of the fund. I need you to replace a small piece of my equity sleeve with the idea of bringing down volatility without sacrificing returns. Looking for suggestions on how to do better.

I think that’s a really interesting question. Anytime you get into alts, something like private credit or real estate, whatever it may be — you’ve got commodities out there — there are a lot of ways you could diversify, right? So I think there are a couple of things to touch on. I agree that if you’re going to replace a portion of the portfolio, I think equity is the way to go. Private credit, you know, even though it is credit, on the debt side of things, it’s not necessarily riskless. I know a big part of the controversy recently has been, who are we actually lending to? Is it kind of — has the due diligence really been done as far as whether this person who’s borrowing, or this firm that’s borrowing, can actually pay back the debt? So that’s really one of the first questions.

Another thing I want to touch on is the volatility piece, because as far as visible or perceived volatility, private credit may have an advantage over something like public, but part of it is whether it’s being marked to market or not. So for example, if you look at a bond fund, that’s being marked to market daily, right, at least. Or more than daily. So you constantly see any fluctuations in value. The difference in private credit is if it’s being appraised on a rather infrequent basis, it may appear that there’s less fluctuation in the price, but in reality, the risk may not actually be lower. So I think that’s an important thing to remember when we’re thinking about private credit.

Another thing is, it’s nice to have the diversification benefit of spreading across multiple managers, even in this asset class, but the one thing to remember is any excess return you may be earning — not only are you paying each private credit manager, but you’re also paying the fund a fee too. So that’s going to kind of eat into returns and hurt the appeal of the strategy a little bit.

Evan Mills: Yeah. I think you did a good job of separating the volatility and lower economic risk. Just because you don’t see the volatility doesn’t mean that the volatility doesn’t exist. I’ve always heard that when you look at private credit, it’s like taking the temperature of a person, whether they’re healthy or sick, every five minutes or every three months. And that’s what’s basically happening in private credit compared to public debt. You get to see every single bit of volatility every minute, every second of this public debt, but when you go to private credit, it usually gets revalued quarterly, so every three months. So when you take a person’s temperature, you could take it every five minutes, and you find out when they’re sick and when they’re healthy, or you take it every three months, and you just think they’re healthy the entire time.

Noah Lewis: Mm-hmm.

Evan Mills: So when you look at that, you go, well, private credit’s a lot less volatile, it has to be a lot safer. And that’s not necessarily the case, which we’ve started looking at. Private credit’s been under a little bit of a microscope now, just because of everything that’s happening. And that comes from also the illiquidity premium that a lot of private credit comes with right now, that should not be seen as free alpha or a free return. People get a liquidity premium because your credit or your bonds in your portfolio is supposed to be something that you lean on in the uncertainty. And then when you try to lean on that in a bear market, well, now the fund is going to say, well, you can’t take out your entire principal or whatever we promised you can take out quarterly, because everybody wants to do that. And that’s where the shock absorber that debt and bonds are supposed to be in your portfolio, that’s where it kind of falls apart in times that you actually need it.

HSA Receipt Strategy: Is the Tax Triple-Play Actually Worth the Hassle?

Evan Mills: I’ve been maxing out my HSA for about six years and haven’t touched it. I pay medical bills out of pocket and save receipts. Everyone tells me that’s the play, but is that actually worth it, or am I making a complicated mess for myself down the road?

The HSA is probably one of, if not the most, tax-efficient account for retirees, or anybody really. It goes in tax-deductible when you put into the HSA, it grows tax-deferred, and then if it’s used for medical expenses, it comes out tax-free. So super beneficial. The difficulty is that if you have receipts in a shoebox in the back of your closet, that’s not really going to hold up in an IRS audit.

So the difficulty for the HSA and keeping track of all these receipts is making sure that you have a robust spreadsheet, and that shows whether you paid it out of pocket, making sure that insurance didn’t cover it, you didn’t get any deductibles on that for your tax return that year. And that’s where it becomes really problematic for people down the road. If you’re not willing to spend the time now organizing those receipts, then maybe it’s not worth the tax benefit that you get down the road. The complication now shouldn’t give you a headache later on down the road when you’re actually trying to pull it out.

A lot of people also spend years growing the HSA, paying out of pocket, like you said. A lot of people say that’s kind of the play, which it is. But if you get to end of plan or die with a large HSA, and you die after your spouse, now your heirs inherit this large HSA, which is all taxable income the year that they inherit it. So these are all problems that come from the HSA, and that’s not to say that it’s not a fantastic account, but it does come with some complications. And at the end of the day, you have to weigh whether those complications are worth the tax benefit they offer.

Noah Lewis: Yeah, I think that’s a really good point. From an advantage standpoint, it definitely does help. Like Evan said, it’s triple tax advantage, right? So you get the tax deduction on the front end. It’s tax-sheltered or tax-deferred through the growth, and tax-free distributions for qualified medical expenses. Definitely the benefit of keeping those receipts is it doesn’t even have to be a medical expense in retirement. If you keep those receipts, and they were qualified medical expenses, that kind of frees you up once you retire or anything, to pull those dollars out tax-free, right? So that’s definitely the main advantage. But I think that’s a really good warning too, of you can’t double dip, right? If you’re reimbursed by insurance, or you took a tax deduction for those medical expenses, you can’t go back and use the same receipt and pull that out tax-free. So that’s definitely a good warning.

Rebalancing Across Taxable, IRA, and 401(k): Account by Account or All at Once?

Noah Lewis: I’ve got money spread across a taxable account, an IRA, and a 401(k). When it’s time to rebalance, do I do it in each account or look at the whole thing together? And how often should I actually be doing this?

This is a fantastic question, and definitely something that we address in comprehensive planning. So I think when you’re asking about optimization, right, that’s when we kind of not only look at asset allocation, which is more frequently or commonly known as a strategy or thought process. What we look at a lot of times is tax location, which basically says, based on the tax treatment or the tax consequences of the underlying asset class, what is the best way to place those across the aggregate portfolio?

So it’s not just saying, okay, maybe I have a seventy-thirty portfolio with seventy percent equities and thirty percent bonds, I’m going to allocate each account like that. That is completely fine to do. But if you really want to get granular, what you can do is place things like bonds, which are going to generate coupons and taxable income, inside of those tax-deferred vehicles like a traditional IRA or a 401(k), for example. And then in those taxable accounts, maybe you want to orient those more toward growth, or things that don’t produce taxable income. Again, like bonds, we would want to keep out of the taxable accounts, and maybe something like small cap we would want to throw in there. And then obviously with the Roth IRAs as well, those are never going to get taxed again. So maybe that’s the place where you want to put your highest growth assets. Again, don’t throw off the aggregate allocation. We’re just being smart about where we place those asset classes. But at the same time, they can create a little bit of alpha. I think research has suggested somewhere between five and 30 basis points on an annual basis.

The one thing I do want to warn against is there is a pursuit of optimization in this area where we could say, okay, perhaps I can earn 30 bips a year in alpha via tax location, right, which is smart. The one risk that gets introduced — which maybe this would make you think twice about introducing some oversight or working with your advisor, because if you’re doing it yourself and if you get — if you’re not super, super careful, and you miscalculate things or throw things off a little bit, you wouldn’t want to throw off your aggregate asset allocation just in the pursuit of a little bit of alpha. Because it’s easy, I think, if you’re setting every account with the portfolio aggregate allocation target, it’s easy to keep track of it. But if you’re really trying to do an elaborate tax location strategy, sometimes it can be easy to throw off your aggregate numbers, because not everything looks the same. And so what you wouldn’t want to do, for example, is target a 70/30 aggregate portfolio, and somehow you accidentally end up eighty-five percent equities and 15% fixed income in pursuit of a 30 basis point annual tax alpha. So I think that’s something I would warn against. But at the same time, if you have some oversight, or you know you’re implementing it correctly, I think it’s worth it from an optimization standpoint.

Evan Mills: Yeah. When you go into kind of mishandling your accounts or holdings, you also get into wash sale rules that say, well, now I’m going to rebalance my portfolio. I’m going to go into taxable brokerage, I want to rebalance it, let’s harvest some losses. And you harvest $5,000 worth of losses, which is great. Now you have areas to sell some positions that have maybe gained over the years, and now get to mix it around. The problem comes from the accounts might be treated differently, and accounts might have different holdings in them. But say you have a like account in both your brokerage and your IRA, and you say, well, I’m just going to click, at the beginning of setting up my IRA, reinvest dividends. Now suddenly you’re going to reinvest dividends in your IRA, and the five thousand dollar tax loss opportunity that you had in your taxable brokerage all goes away, because you have a five dollar dividend in your IRA.

So making sure that you rebalance per household, making sure that you rebalance correctly in each account, but understanding that all these accounts work together. Like you said, you made a good example of the difference between asset allocation of what you own, and then asset location of where you own it. But it needs to be done together. Household rebalances should be done together, because that’s going to get a little bit more complicated, as you pointed out. Maybe it is just not worth the hassle of trying to save thirty bips, and you just have all the accounts allocated the exact same and simplify things a little bit. But if you have a good advisor, you have a team that understands the benefit of asset location, that is certainly a beneficial thing and something that you get free alpha from.

Are Municipal Bonds Actually Better Than Treasuries After Tax? Running the Math

Evan Mills: I’m in the top tax bracket, and my broker keeps pushing me toward municipal bonds for the tax-free income. When I look at treasury yields and back out my taxes, I’m not sure municipals are actually the better deal. What am I missing?

For one, you might not actually be missing anything. Just because it’s tax-free doesn’t necessarily mean that it’s superior, and it definitely doesn’t mean that it’s less risky. So when you look at the tax-equivalent yield, you should be looking at whether it is a better opportunity for you in the tax sense, but also on the risk sense. If you back out your taxes and do a tax-equivalent yield, and the municipal bond is yielding a higher return, there’s also a reason why it’s yielding a higher return. You’re not getting a free lunch in that sense. You have added risk if you’re going to get a higher return. The other thing to understand is that municipal bonds exist per state, and making sure that you do the right tax-equivalent yield as well, getting rid of the state and local taxes, depending on where you’re able to invest and what municipal bonds you’re able to gather up and invest into, is also important. And that municipal bonds are not a blanket to throw over a whole asset class. Municipal bonds vary by location and creditor and who’s actually offering these bonds, and understanding that these bonds are not risk-free. They come with creditor risk, and they come with callability, and these added risks should warrant added returns, but those added returns can increase the risk in your overall portfolio.

Noah Lewis: Absolutely. Yeah, and I think it goes back to that basic calculation too, of tax-equivalent yield. Conceptually, right, you learn about municipal bonds, and if you’re just kind of going back and forth in a chat with somebody, it’s like, man, it’s tax-free, boom, and then go to the next thing. It definitely makes a lot of sense to go back and actually calculate it. On a tax-equivalent yield basis, what are you getting from the municipal bond? Because it’s easy to say, well, I’m in a relatively high tax bracket, right, I’m a high earner, so it must make sense, I need the tax-free income. But until you actually go run that calculation — maybe they only make sense if you’re absolutely maxed out, and you’re almost there, but you’re not. And then even in that case, sometimes you have to run it and say, okay, the excess yield on a tax-equivalent yield basis is going to be five basis points to throw municipal bonds in there. Maybe there’s excess credit risk, maybe the duration doesn’t match what I actually want, and then on top of that, the complexity you’re adding to the portfolio — wouldn’t it be better to just throw it in a money market fund and then call it a day? It depends kind of on what the yield is, so I think you have to measure all those factors before you make decisions.

Evan Mills: Yeah, I think you’re totally right there. Just because tax freedom can help a return, it doesn’t really help a bad investment. So really understanding where this investment is coming from, and then the added risks that come with muni bonds or treasury entities or corporate bonds — these all have to be factored in, not just what’s the impact for the yield, and that’s the only thing that you’re really focused on.

How to Evaluate a Whole Life Insurance Pitch

Noah Lewis: An insurance agent has been pitching me on a whole life policy as a way to build tax-free retirement income on top of my 401(k). On paper, the illustrations look great. What should I be watching out for?

I think this is a really, really common pitch to be had, right? A lot of times you get in there, and there are elaborate pitches. They kind of build the narrative. Okay, you’re good to go, you’ve got your 401(k), you’ve maxed it out, we’re not worried about that. Now you’ve got the decision to make. You’ve got a taxable account, right? And then you’ve got maybe whole life insurance as a different way to invest.

I think it’s interesting. There are a few considerations. One are the underlying assumptions. If you’re building a narrative, and you work for an insurance company, for example, what is the best way to build that narrative in favor of the whole life policy — which, as you may know, sometimes for the same death benefit amount can be 10 times as expensive on a premium basis, right? So how do we pitch this and make it make sense? I’m not saying they’re all bad, right? But I think a lot of it comes in the underlying assumptions, as far as what the tax rate is. If you’re investing in a taxable account, I guess assuming the highest marginal rate, for example, so you have less being invested in the taxable account, and then what the taxes look like on the back end as well. And then even market returns, right? Because if it’s a whole life policy and it’s not variable, you’ve got the guaranteed cash value increase, which is guaranteed, that’s true. But maybe there are some assumptions in the dividends. Okay, these dividends are going to come out, they’re going to be guaranteed every year, kind of in the more favorable projections perhaps. It’s going to increase the cash value this much, or we’re going to offset premiums this way. And then after it’s all said and done, of course, the calculations show that it’s going to outperform buying term and investing the difference.

There are a lot of different variables that can be tweaked a little bit to build that narrative. I think there are a couple of things to think about, and what you’re looking for is exactly the details on what the assumptions are. How realistic are those assumptions? And then thinking about the narrative too, and the way it’s pitched. Okay, you’re going to have a whole life policy. We’re going to create generational wealth, because it’s going to be a tax-free inheritance. Not only that, but you’re going to have tax-free income coming out. It’s like, let’s check a couple of those assumptions for a little bit, because tax-free income — how would it come? It would come in the form of a loan against the policy. You can’t have your cake and eat it too, in the sense that you can’t take a loan from the policy, never pay it back necessarily without consequences, and have your whole death benefit, and say, okay, well, I’m going to have tax-free income for the entirety of my retirement, and also leave a massive inheritance for my children. Because the loan amounts are going to reduce the cash value or the death benefit amount. If you take out too large of a loan from the policy, and it were to lapse for any reason, you could be facing some kind of taxable event, right, where maybe the difference between the surrender value and the basis is taxed at ordinary income.

So there’s kind of a threat there of your payment down. And so I think, because of the fact that you cannot truly have your cake and eat it too — I mean, you can in a way, but it’s not the rosiest picture of taking lifetime tax-free income and then having the full death benefit. I think you really start to weigh, well, if I need insurance, does it make more sense to get a term policy that’s a tenth of the cost, and then invest the remainder? Which I know is kind of a basic thing to say, but that’s really what you have to evaluate — if you can’t have your cake and eat it too in a whole life policy 100% on each side of that, then does it make more sense to truly go pure? And I think a lot of the times the answer is yes.

Evan Mills: Yeah. I think when you look at whole life versus term insurance, you have to understand that the insurance broker is offering an insurance policy. It is an insurance policy at the end of the day, and this policy has to answer an insurance problem. And if you don’t have an insurance problem, you don’t have an investment problem, then whole life might not actually be the answer, and you might have to go to term, because you need a life insurance benefit, because that’s the problem that you’re trying to answer, and not truly an investment problem.

So you said, if you have this life insurance policy and you’re taking a loan out and you get this tax-free income and everything looks rosy — you get tax-free income and you’re spending money, and all of a sudden you go, well, I don’t want this whole life policy anymore, and you let this policy lapse. All of a sudden the IRS is going to come after you, because the policy lapsed, and now they’re coming with a tax bill on income that you’ve already spent or don’t have, and now this random income bill is coming and you have to cough up liquidity, or you’re in some serious problems. This is the added risk that comes with these whole life policies, that of course the insurance agent is going to look at giving you this packet of papers that show, well, this is what’s going to be your return as long as the market returns ten percent, and you’re going to be able to withdraw a hundred thousand dollars per year at age sixty. Well, you should probably stress test that as well beforehand. What happens if the market doesn’t return ten percent and it returns six? What happens if I need to start pulling from the cash value of the policy at fifty-five instead of sixty or sixty-five? Or what happens if the market has a sharp downturn as soon as I want to pull from it?

These are all things that you should stress test, and not just take the numbers that they give you at face value, and really understand the benefits of whole life, because there are benefits, but also the added risk that you are putting on yourself and/or your estate at the end of the day, versus something that’s a little bit simpler like term, that you plan out when you want it to end, and as soon as it lapses, then good, because hopefully at that point you have assets that can be passed on to your heirs, and it did the exact same job. And now you don’t have that added risk.

Outro

Evan Mills: And that’s going to wrap up our speed round. A big thanks to all of you who sent in these questions.

If something we covered today raises questions for you, or there’s a topic you’d like us to dig into in more detail, send it our way. We read everything that comes in, and a question like yours is what makes this show. Stephan will be back next week with the regular format. Until then, thanks for listening, and we’ll see you next week.

Disclaimer: The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice. The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, you should consult with a qualified financial advisor who can assess your individual financial situation, objectives, and risk tolerance.