Schwab's solid exchange-traded funds make these stock-heavy portfolios straightforward, cheap, and effective.
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By Christine Benz | 09-17-15 | 06:00 AM | Email Article

Taxes are unavoidable, right? Right up there with you-know-what.

Some investors think so, but the truth is that, with a little bit of effort, it's not difficult to greatly reduce the drag of taxes on your portfolio's return--and those tax savings can add up to some serious money over time.

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.

Taking advantage of tax-advantaged wrappers like IRAs and 401(k)s is one key way to enhance your bottom-line returns, of course. And if you're investing inside of a taxable account--for liquidity reasons, to reduce the drag of taxes on your in-retirement withdrawals, or because you've maxed out all of the available tax-advantaged options--it's also wise to give due attention to the tax costs of the types of investments you hold there.

Investors in higher tax brackets will tend to benefit from prioritizing municipal bonds for their fixed-income exposure in their taxable accounts; muni income is exempt from federal and, in some cases, state and local income taxes. Investors have even more choices for tax-efficient equity positions. Investors who are in the 10% and 15% income tax brackets don't need to worry too much about tax efficiency with their equity holdings, because their long-term capital gains are taxed at 0%. But investors who are on the hook for capital gains taxes can reduce them by holding individual stocks (which give them maximum control over capital gains realization), equity index funds and ETFs, and tax-managed funds.

Portfolio Basics
To help showcase sound asset-allocation and portfolio tax-management principles, I've created a variety of tax-efficient model portfolios for retired and still-accumulating investors; you can see them all on our new Model Portfolios home page. For not-yet-retired investors who are using Schwab's supermarket to invest in a taxable account, I've created three tax-efficient Retirement-Saver portfolios: Aggressive, Moderate, and Conservative. I used Morningstar's Lifetime Allocation Indexes to guide their asset-class exposures. I employed municipal-bond funds available on Schwab's OneSource platform to fill out their fixed-income positions, focusing on those that receive medalist ratings from Morningstar's analyst team. I used Schwab exchange-traded funds for the portfolios' equity exposure, but Schwab investors could also reasonably use Schwab's traditional index mutual funds instead of the ETFs shown here.

Investors should also be sure to keep asset-location and time-horizon considerations in mind when deciding what to put into their taxable portfolios. Because equities tend to be more tax-efficient than taxable bonds, conventional wisdom holds that accumulators should maintain an equity-heavy stance in their taxable accounts while holding more bonds in their tax-sheltered accounts. But time-horizon considerations might suggest they do just the opposite: If they're saving for shorter-term, nonretirement goals in those accounts, they'd likely want to hold more cash and bonds than is depicted in these portfolios.

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

10%:  BlackRock National Municipal
25%:  Schwab International Equity ETF
5%:  Schwab Emerging Markets Equity ETF
60%:  Schwab US Broad Market ETF  

Geared toward a young accumulator with a long time horizon for his or her taxable retirement assets, the Aggressive Schwab Tax-Efficient Saver mutual fund portfolio uses the allocations of Morningstar's Lifetime Allocation 2055 Aggressive Index to guide its weightings. That index devotes more than 90% of its assets to stocks, including a healthy dose of foreign names. Thus, anyone considering such a portfolio should not only have a long time horizon but should also be able to tolerate the volatility that can accompany a very high equity allocation. Although the Lifetime Allocation Indexes call for a dash of commodities and TIPS exposure for inflation protection, neither of those asset classes is tax-efficient, so I didn't include them here. 

I used two broadly diversified equity index funds for the bulk of the stock portfolio--a larger position in a total U.S. market tracker and a smaller stake in a fund that tracks the FTSE Developed ex US Index. Both feature low costs and broad diversification. Because the foreign-stock index fund excludes emerging markets, I took a small position in a dedicated emerging-markets ETF. A young investor has a sufficiently long time horizon to ride out the extra volatility that frequently accompanies emerging markets. Moreover, given how beaten-up emerging markets have gotten over the past year, it looks like a reasonable time to initiate a position. 

Because the bond position is in place for diversification rather than to supply liquidity, I staked out a position in an intermediate-term municipal-bond fund rather than a short-term vehicle. However, investors who expect to tap their portfolio in the short term should steer toward a short-term-oriented muni fund. The Bronze-rated BlackRock National Municipal draws upon the firm's deep resources and experience managing municipal-bond money. (Senior analyst Beth Foos notes that the firm currently runs about $100 billion in muni assets.) Foos notes that the fund's modest use of leverage has the potential to heighten volatility, but she points out that over time the fund has been no more volatile than its typical muni-national intermediate-term category peer.

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

20%: BlackRock National Municipal
20%: Schwab International Equity ETF
5%: Schwab Emerging Markets Equity ETF
55%: Schwab US Broad Market ETF 

This portfolio is geared toward a slightly older investor--one who intends to retire in 2035. (Assuming a retirement at age 65, our hypothetical individual would be in his or her 40s today.) But the Moderate portfolio, like the Aggressive version, includes a large stock position and a still-sizable allocation to foreign names. The main adjustment is a slightly larger core bond position and slightly lower stakes in the foreign and U.S. stock market ETFs. 

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. 

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

15%:  Wells Fargo Advantage Short-Term Municipal Bond
20%: BlackRock National Municipal
12%: Schwab International Equity ETF
3%: Schwab Emerging Markets Equity ETF
50%: Schwab US Broad Market ETF 

Because the bond piece of this portfolio is larger than the Moderate portfolio's, it's also more diversified. While younger accumulators can get away with a single well-diversified bond fund--in this case, BlackRock National Municipal--people closing in on retirement will want to start diversifying their fixed-income exposure and teeing up cash for in-retirement living expenses. With retirement 10 years into the future, it's too early to start raising cash, but pre-retirees might consider steering part of their fixed-income sleeves to a short-term bond fund that could be readily converted into cash. After all, having sufficient short-term assets in the portfolio can help mitigate sequencing risk--the chance that a retiree could encounter a lousy market right out of the box. I used Wells Fargo Advantage Short-Term Municipal Bond to fulfill this role. A few other medalist short-term funds are available on the Schwab no-transaction-fee, no-load platform, but this Bronze-rated fund offered the best combination of seasoned management, risk controls, and not-egregious fees. Note that longtime manager Lyle Fitterer and his team have usually favored a more credit-sensitive profile rather than taking on duration risk.

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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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