Our model portfolios are designed to facilitate in-retirement cash flows--and to limit Uncle Sam's take.
By Christine Benz | 09-14-15 | 06:00 AM | Email Article

Just a few years ago, many investors greeted the topic of tax efficiency with a shrug--and maybe a yawn. Mutual funds still had plenty of capital losses on their books that they could use to offset capital gains, so capital gains distributions were few and far between in the early parts of the market recovery. Investors may have also been harvesting their own losses that they could apply to gains, further limiting the tax bite.

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. Follow Christine on Twitter: @christine_benz.

Fast-forward to today, however, and it's easier to make a case for paying attention to tax efficiency. Continued strong market performance meant that many mutual funds made significant capital gains distributions in 2013 and 2014, having burned through their available loss carryforwards. And while it's hard to get excited about bond income, period--before or after the haircut of taxes--taxes exact just as big a toll, if not larger, in percentage terms as they ever did. The Medicare surtax that went into effect in 2013 creates an added incentive for high-income investors to pay attention to tax efficiency. In an era in which returns could be constrained going forward, paying a tax-cost ratio of 1% or 2%--not uncommon among many mutual funds that are not explicitly managed for tax efficiency--will be a significant drag on take-home returns.

Of course, an obvious way to limit taxable capital gains and income distributions is to stash investments inside of tax-sheltered accounts. But once those receptacles are full, investors have no choice but to save inside of taxable accounts. And building assets in taxable accounts can even be desirable, for reasons outlined in this article, especially in retirement. By saving in each of the main types of tax wrappers during the accumulation years--tax-deferred, Roth, and taxable--a retiree can exercise at least some control over the taxes she pays in retirement.

My original "bucket" portfolios--time-segmented portfolios geared toward aggressive, moderate, and conservative retirees--were created with tax-sheltered accounts in mind. The three original portfolios consist of traditional mutual funds, while the other three are composed exclusively of exchange-traded funds. But those same portfolios can readily be adjusted to make them more tax-efficient, as we've done with today's series of model portfolios.

Higher Equity Positions
For these three tax-efficient bucket portfolios, I employed the same general asset-allocation parameters that I used with the other bucket portfolios. Specifically, I carved out a cash component to cover a retiree's near-term expenses--the linchpin of the bucket system--and relied on Morningstar's Lifetime Allocation Indexes to help guide the long-term portfolios' exposures.

It's worth noting, however, that these portfolios feature slightly higher equity positions than is the case with my other retiree bucket portfolios. The reason is that I avoided some of the higher-risk/higher-income fixed-income types that appeared in my other portfolios--for example, high-yield and emerging-markets bonds. Because their income distributions are taxed at investors' ordinary income tax rates, they're a better fit for tax-sheltered accounts. These investments have risk/reward profiles that fall between equities and bonds, so it's reasonable to nudge up the tax-efficient portfolios' equity exposures to compensate for the fact that they're missing here. (A retired investor could reasonably employ a small stake in high-yield municipal bonds in lieu of some of the high-quality exposure featured in this portfolio--say, 5% of the total portfolio--but the sector has enjoyed such a strong runup that I didn't include such a stake in these portfolios.)

Retirees will want to be sure to "right-size" the components of these portfolios based on their spending plans and other considerations, however. If they're prioritizing withdrawals from their taxable portfolios over other account types--in line with tax-efficient withdrawal-sequencing considerations--they may want a larger cash component than is outlined here. (I typically recommend that retirees hold six months' to two years' worth of planned expenditures in true cash instruments.) Moreover, retirees will want to take into account their own time horizons, risk tolerance, and investment goals when setting their allocations. As with the other retiree bucket portfolios, the asset allocations shown here assume that the retiree will spend all of his or her assets, which may not be the case for those who would like to leave a bequest to loved ones or charity.

A Tax-Efficient Makeover
Despite having asset allocations that are similar to the other bucket portfolios, the specific holdings differ. On the equity side, I employed tax-managed funds for U.S. equity exposure and a core index fund for non-U.S. exposure. While tax-managed funds, index funds, and exchange-traded funds all tend to distribute fewer taxable capital gains than most active funds, tax-managed funds are explicitly managed to reduce the drag of taxes. Because Vanguard no longer offers a tax-managed international fund, I employed an ultra-low-cost foreign-stock index fund, which also features very strong tax efficiency.

On the fixed-income side, I eschewed bond funds with higher incomes and, in turn, higher tax costs. Instead, I employed municipal-bond funds--in this case, from Fidelity. I stuck with the firm's short- and intermediate-term core muni funds, as the risk/reward profile of long-term munis doesn't appear especially attractive at this juncture. (Of course, I would have said that a few years ago, too, and long-term bonds have continued to rally.)

For the cash piece--bucket one--an online savings account will tend to be the highest-yielding option, even on an aftertax basis. While a municipal money market fund might make sense for cash holdings in a higher-yield environment, such funds' yields are barely positive today. Meanwhile, online savings accounts currently offer yields close to 1%.

Aggressive Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 20-25 Years | Risk Tolerance/Capacity: High | Target Stock/Bond/Cash Mix: 60/30/10

10%: Cash (online savings account)
10%:  Fidelity Limited Term Municipal Income
20%:  Fidelity Intermediate Municipal Income
10%:  Vanguard FTSE All-World ex-US (the  exchange-traded fund is fine, too)
40%: Vanguard Tax-Managed Capital Appreciation
10%: Vanguard Tax-Managed Small Cap

Moderate Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 15-Plus Years | Risk Tolerance/Capacity: Average | Target Stock/Bond/Cash Mix: 50/40/10
10%: Cash (online savings account)
15%: Fidelity Limited Term Municipal Income
25%: Fidelity Intermediate Municipal Income
10%: Vanguard FTSE All-World ex-US (the exchange-traded fund is fine, too)
30%: Vanguard Tax-Managed Capital Appreciation 
10%: Vanguard Tax-Managed Small Cap

Conservative Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 15 Years or Fewer | Risk Tolerance/Capacity: Low | Target Stock/Bond/Cash Mix: 35/55/10
10%: Cash (online savings account)
20%: Fidelity Limited Term Municipal Income
35%: Fidelity Intermediate Municipal Income
5%: Vanguard FTSE All-World ex-US (the exchange-traded fund is fine, too)
25%: Vanguard Tax-Managed Capital Appreciation
5%: Vanguard Tax-Managed Small Cap

Securities mentioned in this article

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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