We've designed these portfolios to maximize returns while limiting Uncle Sam's take.
By Christine Benz | 09-16-15 | 06:00 AM | Email Article

Relatively high market valuations suggest that investors should plan for muted market returns over the next decade, according to a range of experts. Vanguard founder Jack Bogle and Morningstar's Matt Coffina have both pegged real equity-market returns in the mid-single digits. And don't get your hopes up for bonds either, as starting yields have historically been a good predictor of the return you're apt to earn in the future. The yield on the Barclays U.S. Aggregate Bond Index is just over 2% currently.

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.

Against that backdrop, it's more important than ever to tighten up all of the costs in a portfolio, as doing so is a sure way to enhance your take-home return. That's one of the reasons Morningstar often discusses the importance of selecting low-cost investments and limiting trading costs, and it's also a key reason we pay so much attention to tax efficiency. In addition to taking full advantage of their tax-sheltered wrappers, such as IRAs and 401(k)s, investors can reduce the drag of taxes by paying close attention to how they manage their taxable accounts.

Keeping a portfolio tax-efficient tends to be a particularly big issue for retirees. That's because bonds typically grow in importance in investors' portfolios as retirement draws near, and income from taxable bonds is dunned at ordinary income tax rates versus the lower tax rates that apply to capital gains and dividends. Moreover, long-run bond returns are apt to be lower in absolute terms than long-term equity returns, meaning that taxes can gobble up a bigger percentage of their payouts. Thus, I created a series of tax-efficient model "bucket" portfolios with retirees in mind; they rely on municipal rather than taxable bonds for their fixed-income exposure.

But accumulators should also stay attuned to tax efficiency in their taxable accounts. In general, patience should be the watchword: Not only should they limit the trading they do in their portfolios, with an eye toward limiting taxable capital gains distributions, but they should also seek out stock funds that employ patient, low-turnover strategies. Exchange-traded funds, index funds, and tax-managed funds all tend to have very low turnover and, in turn, do a good job reducing the tax collector's cut of their portfolios' returns.

My six model "saver" portfolios--featured on our new Model Portfolios home page--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. 

A Tax-Efficient Makeover
For these three tax-efficient portfolios, I employed the same general asset-allocation parameters that I used with the other bucket portfolios. Specifically, I relied on Morningstar's Lifetime Allocation Indexes to help guide the long-term portfolios' exposures.

Accumulators will want to be sure to "right-size" the components of these portfolios based on their human capital, their risk capacity, and the complexion of their tax-sheltered portfolios, however. For example, a 50-year-old who is focusing on equity funds within her 401(k) because her plan doesn't offer many decent bond options may want a higher bond allocation in her taxable portfolio.

For the saver portfolios, as with the retiree bucket portfolios, I focused on tax-managed and index funds for equity exposure, and municipal-bond funds for fixed-income exposure. To be sure, broad-market index exchange-traded funds--and to a lesser extent, traditional index funds--tend have very low turnover and, therefore, distribute few taxable capital gains on an ongoing basis. Despite posting a nearly 16% annualized gain over the past five years, for example,  Vanguard Total Stock Market Index has a tax-cost ratio of just 0.49%--and that's for investors who are in the highest tax bracket. Tax-managed funds' aftertax returns aren't better across all time periods, but the funds are explicitly managed to reduce the drag of taxes. That could be an advantage in a different tax regime. For example, if dividends were once again taxed at investors' ordinary income tax rates, the tax-managed fund could change its strategy to suppress dividend payers. 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.

As with the tax-efficient bucket portfolios, I employed municipal-bond funds--in this case, from Fidelity. Because the moderate and aggressive portfolios assume long time horizons of 20 years or more, I stuck with an intermediate-term fund for the fixed-income piece. Such a fund may have more interest-rate-related volatility than a short-term fund, but its higher yield will help make up for the greater short-term volatility. And because these portfolios aren't geared toward investors who are actively tapping their principal, I didn't include a cash component.

Aggressive Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 40 Years | Risk Tolerance/Capacity: High | Target Stock/Bond Mix: 90/10
10%:  Fidelity Intermediate Municipal Income
25%:  Vanguard FTSE All-World ex-US (the  exchange-traded fund is fine, too)
50%:  Vanguard Tax-Managed Capital Appreciation
15%:  Vanguard Tax-Managed Small Cap

Moderate Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 20-Plus Years | Risk Tolerance/Capacity: Above Average | Target Stock/Bond Mix: 80/20
20%: Fidelity Intermediate Municipal Income
25%: Vanguard FTSE All-World ex-US (the exchange-traded fund is fine, too)
40%: Vanguard Tax-Managed Capital Appreciation
15%: Vanguard Tax-Managed Small Cap

Conservative Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 10 Years or Fewer | Risk Tolerance/Capacity: Low | Target Stock/Bond Mix: 65/35
15%:  Fidelity Limited Term Municipal Income
20%: Fidelity Intermediate Municipal Income 
15%: 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

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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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