MorningStar's Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success outlines 3 Tax-Efficient Portfolios for Retirees / Conservative, Moderate, & Aggressive. Follow Christine on Twitter: @christine_benz.
CONSERVATIVE: This investment mix is designed to limit risk and keep the tax collector at bay.
Investors don't get a lot of gimmes, namely simple, low-risk, or no-risk ways to boost their take-home returns. But one of the key ones is managing your portfolio for optimal tax efficiency, thereby (legally) reducing Uncle Sam's cut of your return during the life of your portfolio. Banks and brokerage firms hire armies of lawyers to help wealthy individuals and families limit the taxes they pay on their investments, but they often charge a steep fee for their services. Basic tax-management techniques are a cinch to practice on your own.
Staying attuned to tax efficiency is particularly crucial for those nearing or in retirement. For one thing, most retirees are in drawdown mode, and some strategies for tapping your accounts for income incur fewer tax-related costs than others. Moreover, there's only so much money you can shelter in tax-protected vehicles, so many people come into retirement with substantial shares of their portfolios in taxable accounts. (The higher the level of wealth, the more this is the case.) Finally, retirees and pre-retirees are generally steering ever-larger shares of their portfolios into bonds and cash investments, and income from these asset classes is taxed at a higher rate than is the case for withdrawals from equity accounts.
Proper asset location, which determines the types of investments best-suited for particular accounts, and sequencing withdrawals from your various retirement accounts are key components of tax management for retirees and pre-retirees.
And to the extent that you hold retirement assets in your taxable accounts, it's prudent to concentrate the most tax-efficient investments there while reserving less-tax-friendly investments for your IRA or company retirement plan.
With that in mind, here's an example of what a conservative retiree's taxable portfolio might look like. It's appropriate for very risk-conscious retirees with a time horizon (estimated life expectancy) of 10-15 years. Thus, stability and preserving purchasing power are key goals for this portfolio.
However, individuals with that same time horizon might have higher or lower equity weightings, depending on their specific financial and family situations. Investors should feel free to customize the allocations and individual holdings as they see fit or simply use them as a guide when benchmarking their own portfolios.
A Conservative Tax-Efficient Retirement Portfolio
Vanguard Tax-Managed Capital Appreciation
(VTCLX)
20
Vanguard Tax-Managed Small Cap
(VTMSX)
5
Vanguard Developed Markets Index
(VDMIX)
5
Fidelity Limited Term Municipal Income
(FSTFX)
13
Fidelity Intermediate Muni Income
(FLTMX)
50
Vanguard Tax-Exempt Money Market (
VMSXX)
7
Asset AllocationAs with other model portfolios, I've relied on
Morningstar's Lifetime Allocation Indexes to guide the portfolio's asset allocation. However, your own taxable assets may be more or less stock-heavy than the portfolio featured here.
And while the portfolio includes a small cash position, it's there to improve the portfolio's overall risk/reward profile rather than to cover an investor's near-term cash needs. Your own positions in more liquid assets like cash and bonds may well be larger. That's because the conventional wisdom on sequencing in-retirement withdrawals calls for tapping any taxable accounts early on, the better to stretch out the tax-savings benefits of tax-sheltered vehicles.
Fixed-Income HoldingsMunicipal bonds and bond funds will make sense for the fixed-income component of many investors' taxable portfolios because income will be free of federal and, in some cases, state tax (provided you stick with bonds issued by municipalities in your state). Use
the Tax-Equivalent Yield function on Morningstar's Bond Calculatorto determine whether you're better off in taxable bonds or munis once you factor in taxes. If you're in the 25% tax bracket or above, munis will often be better than taxable bonds.
For this portfolio's fixed-income portion, I've relied on actively managed Fidelity municipal-bond funds because they're well-managed and their costs are reasonable. In terms of specific funds, Vanguard's suite of municipal bond funds is also very good and features even lower costs, and therefore would serve as a worthwhile substitute. For the cash component of the portfolio, I'm switching to Vanguard's municipal money market fund; in a low-return world, its rock-bottom costs give it a meaningful edge over other funds, including Fidelity's, which is fairly low-cost itself.
Stock HoldingsTaxable investors have even more choices on the equity side. Building a portfolio composed of individual stocks gives investors the maximum level of control over when they realize capital gains and losses, though many retirees prefer the low maintenance of mutual funds.
On the funds side, traditional index funds, exchange-traded funds, and tax-managed funds all do good jobs of limiting the tax collector's cut of investor returns. Ultimately, I decided to populate the portfolio's equity component with tax-managed funds for U.S.-equity exposure and an index fund for international exposure. Tax-managed funds have exhibited tax-cost ratios that are equal to or lower than those of comparable ETFs or traditional index funds. I also like the fact that tax-managed funds can adjust their strategies to suit the current tax climate, giving them an element of flexibility that traditional ETFs and index funds do not have.
MODERATE : This portfolio balances capital preservation with growth potential.
"Don't let the tax tail wag the dog." That conventional wisdom is sound advice. For example, if you were considering adding exchange-traded funds to your taxable portfolio to improve its tax efficiency, those holdings should also make sense from an investment standpoint.
At the same time, I can't help but think that managing for maximum tax efficiency is an undervalued aspect of portfolio management, particularly right now. The bear market of 2007-09 limited taxable capital gains and no doubt lulled many investors into a false sense of complacency about the impact that taxes can have on their returns. But given stocks' gains since the market bottomed in early 2009--and the fact that many mutual funds made big payouts in 2013--many investors may wish in hindsight that they had paid closer attention to tax management. Like limiting costs, managing for optimal tax efficiency is one of the few aspects of investing over which investors truly exert some control.
In another column, I shared
a model tax-efficient portfolio for conservative retirees with life expectancies of roughly 10-15 years. Many retirees obviously have much longer time horizons than that, however. So our moderate portfolio is appropriate for risk-conscious retirees with time horizons (estimated life expectancies) of 15-20 years. Stability and preserving purchasing power are key goals here, but so is capital appreciation. Investors should feel free to customize the allocations and individual holdings as they see fit or simply use them as a guide when benchmarking their own portfolios. For example, they might readily swap in ETFs to stand in for the tax-managed mutual funds that I've included here. The portfolios highlight some of the key concepts to bear in mind when managing a taxable portfolio at any age, not just during retirement.
A Moderate Tax-Efficient Retirement Portfolio
Vanguard Tax-Managed Capital Appreciation
(VTCLX)
32
Vanguard Tax-Managed Small Cap
(VTMSX)
5
Vanguard Developed Markets Index
(VDMIX)
11
Fidelity Limited Term Muni Income
(FSTFX)
11
Fidelity Intermediate Muni Income
(FLTMX)
38
Vanguard Tax-Exempt Money Market (
VMSXX)
3
Asset AllocationThis portfolio, like the previous portfolios, uses
Morningstar's Lifetime Allocation Indexes to guide its asset allocation. In keeping with the moderate allocations for someone nearing retirement, it maintains a roughly 50/50 split between stocks and safer securities like bonds and cash.
Bear in mind that this is just a model; your own risk capacity and the extent to which you have income from other sources will be key determinants of your own stock/bond/cash mix. Asset location and how you're sequencing withdrawals will also play a role in the type of assets you hold in your taxable accounts. For example, the conventional rule of thumb is that you should tap your taxable portfolios first during retirement, the better to stretch out the tax savings associated with IRAs. That may argue for holding more in steady asset classes like bonds and cash in your taxable accounts.
Moreover, you'll need to let your own spending needs drive your cash allocation. Although this portfolio does include a small slice in a municipal money market fund, the cash is there solely to improve the portfolio's risk/reward characteristics rather than to provide current income. That helps explain why its cash stake is lower and its total equity allocation is higher than is the case with
my model bucket portfolio for moderate investors; the bucket portfolio includes a sizable cash stake to meet near-term cash needs.
Bond HoldingsTo flesh out the portfolio's fixed-income holdings, I used the same municipal-bond funds here that appeared in the conservative portfolio: actively managed muni funds from Fidelity, which our analysts like for their sensible management and reasonable costs. (Bogleheads shouldn't despair: Vanguard's lineup of low-expense municipal-bond funds is also solid.) I opted for Vanguard's muni money market fund for the cash holdings; even though its yield, like that of most money market funds, is barely positive right now, its low costs should be a long-term competitive advantage. However, cash yields are so low right now--and the associated taxes are, as well-- that investors might reasonably invest in nonmunicipal cash holdings instead.
Although potentially higher tax rates will tip the scales in favor of municipal bonds for many investors' taxable portfolios, don't automatically assume that you must hold munis in your taxable account.
The tax-equivalent yield function in Morningstar's Bond Calculator can help you quantify whether you're better off, on an aftertax basis, holding munis or taxable bonds. You'll also need to gauge your comfort level with municipals: Some investors may obtain peace of mind by holding a mix of taxable and municipal bonds, even if doing so results in a lower aftertax return.
As with the conservative portfolio, this one forgoes inflation-protected bond exposure, even though the indexes I used as a blueprint call for it. That's because Treasury Inflation-Protected Bonds are a poor choice for taxable investors. And while I-bonds are more tax-friendly,
investors are limited in their purchases. That's not an impediment for smaller investors, but larger investors will have to get their inflation protection through TIPS and should do so within the confines of an IRA.
Stock HoldingsFor a taxable portfolio's equity holdings, investors have several terrific options from which to choose: individual stocks, traditional index funds, ETFs, and tax-managed funds. Ultimately, I decided that tax-managed funds represented the best combination of low maintenance, diversification, and tax efficiency for the portfolio's domestic-equity exposure. I used a Vanguard index fund for international exposure.
AGGRESSIVE : Here is a model portfolio for younger retirees, pre-retirees, or those with other income sources.
I've written articles featuring several tax-efficient model portfolios over the years, which in turn have sparked many useful comments from readers.
Several of you noted that you'd like to see a greater focus on income production, while others quibbled with my recommendation of tax-managed funds for the portfolios' equity components. (More on this in a moment.) Others of you noted that you're looking to your portfolios for greater return potential than my
conservative and
moderateportfolios, each of which devoted less than 50% to stocks, could provide.
My aggressive tax-efficient model portfolio is for those of you who seek to be (or have time to be) more aggressive. It's appropriate for retirees and pre-retirees with time horizons (estimated life expectancies) of 25 years or more or for those who can look to other sources of income, such as a pension or part-time work, during their retirement years. Capital appreciation is the key goal here, but the portfolio also pays attention to limiting big market downdrafts.
As with the other two portfolios, this one is built with an emphasis on total return rather than current income for a couple of key reasons. Given low yields, it's currently a tall order to generate a meaningful income stream strictly from the income a portfolio's holdings kick off; to do so, you've got to either have an awful lot of wealth or be willing to take on a lot of risk. Second, I generally favor total-return approaches for taxable portfolios because the total-return strategy allows investors greater control over when (and whether) they receive taxable income.
An Aggressive Tax-Efficient Retirement Portfolio
Vanguard Tax-Managed Capital Appreciation
(VTCLX)
35
Vanguard Tax-Managed Small Cap
(VTMSX)
5
Vanguard Developed Markets Index
(VDMIX)
15
Fidelity Short-Intermediate Muni Income
(FSTFX)
8
Fidelity Limited Term Municipal Income
(FLTMX)
35
Vanguard Tax-Exempt Money Market (
VMSXX)
2
Asset AllocationThis portfolio, like the previous portfolios, uses
Morningstar's Lifetime Allocation Indexes to guide its asset allocation. In keeping with the moderate allocations for a 59-year-old, it holds a bit less than 60% in equities and the rest in safer securities such as bonds and cash.
Retirees with greater appetites for risk (and importantly, a safe stream of income from other sources) can think about nudging the equity weighting higher; the aggressive summary allocations on the Lifetime Allocation Indexes document can help guide you into the right ballpark.
It's also worth noting that even though this portfolio includes a cash allocation (Vanguard's muni money market fund), it's there strictly to improve the portfolio's risk/reward characteristics. Your own spending needs will help you arrive at how much to hold in cash; one to two years' worth of living expenses is a good rule of thumb. The difference in the role of cash helps explain why this portfolio's cash stake is lower and its total equity allocation is higher than is the case with
my model bucket portfolio for aggressive investors; the bucket portfolio includes a sizable cash stake to meet near-term cash needs.
Stock HoldingsAs with the other two portfolios, the aggressive portfolio gets its equity exposure from tax-managed mutual funds and an index fund for foreign exposure. I based that decision on two factors: one, the tax-managed funds' strong past tax-efficiency statistics versus those of exchange-traded funds and traditional index funds, and two, tax-managed funds' abilities to adjust their strategies to suit the current tax climate. I used the index fund for foreign exposure because Vanguard plans to merge
Vanguard Tax-Managed International (VTMNX) into
Vanguard Developed Markets Index (VDMIX); the two products offer similar exposure at a very low cost.
Bond HoldingsTo flesh out the portfolio's fixed-income holdings, I used the same municipal-bond funds here that appeared in the conservative and moderate portfolios: actively managed muni funds from Fidelity, which our analysts like for their sensible management and reasonable costs. Vanguard's muni lineup serves as a low-cost, low-maintenance alternative.
Although potentially higher tax rates will tip the scales in favor of municipal bonds for many investors' taxable portfolios, don't automatically assume that you must hold munis in your taxable account.
The tax-equivalent yield function in Morningstar's Bond Calculator can help you quantify whether you're better off, on an aftertax basis, holding munis or taxable bonds.
As with the previous two portfolios, this one forgoes inflation-protected bond exposure, even though the indexes I used as a blueprint call for it. That's because Treasury Inflation-Protected Bonds are a poor choice for taxable investors. And though I-bonds are more tax-friendly, purchasers are limited to $10,000 a year. That's not an impediment for smaller investors, but larger investors will have to get their inflation protection through Treasury Inflation-Protected Securities and should do so within the confines of an IRA
.
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