Despite the firm's lineup of fine actively managed funds, equity index funds are a more tax-friendly choice.
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By Christine Benz | 09-14-15 | 06:00 AM | Email Article

Actively managed equity funds like  T. Rowe Price Blue Chip Growth ,         Equity Income , and  Mid-Cap Growth have long been considered the jewels in the crown at the Baltimore-based mutual fund giant.

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.

Its equity index funds? Not so much. Savvy investors know that index funds are a commodity, so low costs separate the good ones from the also-rans. While T. Rowe Price's index funds aren't in the category of egregiously expensive, investors can readily find much cheaper options at Vanguard, Fidelity, and iShares, among others.

So, why on earth would we recommend retirement-saver portfolios for taxable accounts that are anchored in index funds? In a word, taxes. Whereas my T. Rowe Price Retirement-Saver Portfolio for tax-deferred accounts included topnotch actively managed offerings like  Dividend Growth ,  New America Growth , and  Small-Cap Value , those funds aren't managed with any consideration for taxes, so capital gains taxes, in particular, will tend to weigh on their returns. Equity index funds, because they trade less and realize fewer taxable capital gains, tend to be more tax-efficient than active.

Take T. Rowe Price New America Growth, for example. Its annualized 15-year total return of 4.69% as of Aug. 31, 2015, is comfortably ahead of T. Rowe Price Total Equity Market Index's 4.15% gain. New America Growth is also a Morningstar Medalist fund, having recently received an upgrade to Bronze. But once its 1.23% 15-year tax-cost ratio is factored in--in part, a side effect of a portfolio overhaul after current manager Dan Martino took over in mid-2013--its 15-year aftertax return shrivels to 3.46%. The index fund has been more tax-efficient, with a tax-cost ratio of 0.53%, so its aftertax return is a touch better at 3.62%.

True, some of T. Rowe's actively managed funds have managed to beat the index fund on an aftertax basis, mainly because their pretax returns have been so strong. The fact that such funds generally grew over the past 15 years and, therefore, could spread their capital gains over a larger base of shareholders also helped on the tax-efficiency front. But whether these actively managed funds will be able to produce strong aftertax gains in the future is an open question. Even if their managers continue to deliver the goods on a pretax basis, capital gains distributions could erode their advantage after taxes are factored in. That consideration is particularly important right now, as many mutual funds have sizable embedded capital gains thanks to the multiyear rally in equities.

That's a longwinded explanation for why I've used index funds to provide equity exposure for these taxable portfolios. I've also used T. Rowe's excellent municipal-bond funds to populate the portfolios' bond positions. I'll do my part to keep a lid on taxable capital gains by making few, if any, changes to these portfolios over time.

Investors in tax-deferred accounts, or those who are in the 10% and 15% tax brackets and, therefore, are paying no capital gains taxes at all could reasonably use T. Rowe's actively managed equity funds in place of the index products featured here. Investors who are in lower tax brackets should also employ the tax-equivalent yield function of Morningstar's bond calculator to determine whether they're better off in taxable-bond funds rather than the munis featured here.

Portfolio Basics
As with all of my model portfolios geared toward retirees and accumulators, I used Morningstar's Lifetime Allocation Indexes to help guide the portfolio's exposures. I aimed to use  Morningstar Medalist funds where possible, though neither of the portfolios' equity funds receive analyst coverage or ratings currently. Note that the portfolio doesn't include exposure to each and every asset class included in the tax-deferred portfolios. I excluded commodities and Treasury Inflation-Protected Securities exposure because of their heavy tax costs, for example. Meanwhile, T. Rowe Price International Equity Index excludes developing markets.

Investors will, of course, want to bear their own situations and anticipated drawdown needs in mind before adopting any of these portfolios' allocations as their own. For example, if an individual is closing in on retirement but will be able to rely on a pension to meet their income needs in retirement, the Conservative portfolio featured here may, in fact, be too bond-heavy for their needs. On the flip side, a younger investor who is earmarking part of a taxable portfolio for a remodeling project in five years shouldn't run with the Aggressive portfolio; its 90% equity weighting could drop at an inopportune time, reducing the amount that's available to fund near-term goals.

Aggressive Tax-Efficient Retirement-Saver Portfolio
Time Horizon Until Retirement: 40 years | Risk Tolerance/Capacity: High | Target Stock/Bond Mix: 90/10

60%: T. Rowe Price Total Equity Market Index 
30%: T. Rowe Price International Equity Index
10%:  T. Rowe Price Summit Muni Intermediate

This equity-heavy portfolio keeps things simple by investing in a total U.S. market index fund and a developed-markets index fund in a 2:1 ratio. The U.S. fund includes broad exposure to the U.S. market, but the international fund tracks the FTSE All World Developed ex North America Index, which excludes emerging markets. Investors who would like emerging-markets exposure--and that's reasonable for investors with long time horizons, especially given what look like fair if not cheap valuations for emerging markets today--will want to make sure they have such exposure elsewhere in their portfolios.

I've used an intermediate-term muni-national fund to provide a bit of diversification. It has a fairly mild, 5.4-year duration currently, so it shouldn't be shocked too badly if interest rates trend up. Sibling T. Rowe Price Summit Municipal Income has a higher yield, but it also has a longer duration and lower average credit quality, so it may be a bit more volatile than investors would expect the safe portions of their portfolios to behave. 

Moderate Tax-Efficient Retirement-Saver Portfolio
Time Horizon Until Retirement: 20-Plus Years | Risk Tolerance/Capacity: Above Average | Target Stock/Bond Mix: 80/20

55%: T. Rowe Price Total Equity Market Index  
25%: T. Rowe Price International Equity Index
20%: T. Rowe Price Summit Municipal Income

As with the Aggressive Saver mutual fund portfolio, I've used Morningstar's Lifetime Allocation Indexes to help set the baseline asset allocations. In this case, I used the moderate version of the 2035 index.

While it's geared toward a slightly older investor--a 40-something who intends to retire in 20 or more years--this fund maintains a heavy equity weighting of 80%. Its key variance relative to the Aggressive portfolio is that its foreign-stock weighting is slightly lower and its bond position is slightly larger.

Conservative Tax-Efficient Retirement-Saver Portfolio
Time Horizon Until Retirement: 10 Years or Less | Risk Tolerance/Capacity: Low | Target Stock/Bond Mix: 65/35

50%: T. Rowe Price Total Equity Market Index
15%: T. Rowe Price International Equity Index
20%: T. Rowe Price Summit Municipal Income
15%: T. Rowe Price Tax-Free Short-Intermediate

Because it's designed for an investor who's just 10 years from retirement, this portfolio features a meaningfully smaller equity stake and a larger bond position than the Aggressive and Moderate portfolios. To begin stabilizing the portfolio to meet in-retirement living expenses, I've steered a portion of the fixed-income portfolio to T. Rowe Price Tax-Free Short-Intermediate, which has a modest yield but fairly mild volatility, too. Conservative investors might also consider deploying a portion of their equity (not bond) portfolios to  T. Rowe Price Tax-Free High Yield . While I consider it a niche fund and I would limit it to 10% of total assets (it lost 21% in 2008, after all), it could add a bit of extra diversification to the fixed-income portion of the portfolio. Here again, it's important for investors to consider their spending horizon, and not just their proximity to retirement, before adopting such a portfolio. My series of tax-efficient bucket portfolios for T. Rowe Price investors, geared toward retirees who are extracting cash flows from their portfolios, pick up where these portfolios leave off.

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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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