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Top Funds for Tax-Efficient Bucket Retirement Portfolios

Tue, 15 Sep 2015

Tax-managed, index, and municipal-bond funds from Fidelity and Vanguard are among the best options for investors looking to minimize the tax drag on their portfolios, says Morningstar's Christine Benz.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. It's Model Portfolio Week on Morningstar.com, and today we're talking with our model portfolio maven, Christine Benz, about some of her favorite picks for tax-efficient bucket portfolios in retirement.

Christine, thanks for joining me.

Christine Benz: Jason, it's great to be here.

Stipp: A lot of retirees will have taxable accounts, and today you brought some tax-efficient picks for those accounts for bucket portfolios. Before we get to the picks, though, what is this bucket approach? Can you sum it up for us?

Benz: This approach is not original to me. Harold Evensky, the financial planner in Coral Gables, Florida--it's really his brainchild. The idea is how can we get retirees comfortable with holding equities as a portion of the portfolio? His idea was if we set up enough conservative assets in the portfolio--so if we set aside near-term living expenses in what he calls bucket one, which is kind of a cash bucket, and maybe set aside some bond investments in bucket two--then that will allow the retiree to ride through the volatility that will inevitably accompany the equity investments in the portfolio.

Stipp: Folks who are in retirement often have different types of accounts from a taxable perspective--some IRAs, they have some taxable accounts. Obviously, tax efficiency is important for the taxable accounts. So, if I do have a mix, should I mirror my asset allocation in my taxable accounts as I do in, for example, an IRA account?

Benz: Here again, you want to let your spending time horizon drive the way you position each of these portfolios. Say I'm someone who is subject to required minimum distributions and those RMDs are fulfilling most of the income needs that I have from my retirement portfolio, I want to position that portfolio more conservatively. I want to tee up the money to supply my spending needs. So, I'd want to have more cash and bonds in that portion of the portfolio. If that IRA were supplying all of my income needs, I'd want to position my taxable portfolio more aggressively because I'm not actively drawing upon that portfolio. So, I'd hold more stocks in that portion of the portfolio, maybe very little in bucket one--the cash piece--and maybe relatively less in bucket two as well. So, let your spending horizon drive what you do.

Stipp: So, assuming that I have set up some type of bucket portfolio in taxable accounts and I'm looking for tax efficiency, you brought some investment ideas. Let's start with bucket one: I'm looking for tax-efficient short-term investments--really short-term liquid investments. What should I be looking for?

Benz: Well, you probably want to have tax efficiency on your mind. But at this point, when you look at the yields on municipal money market funds versus taxable money market funds, the yields are so low across the board that even when you factor in the tax savings that you might get by investing in the muni fund, it's still not a big differential. So, that's probably not a reason to go out seeking a municipal money market fund at this point.

Look for the highest yield that you can find and don't worry too much about tax consequences. For most investors, their best option for bucket one within their taxable account will be some sort of an online high-yield savings account or an online money market account; that will tend to give them the highest yield--in some cases, about 1% currently--and also the best liquidity, so the most ready access to their cash without any limitations on withdrawals.

Stipp: How about bucket two? This is still relatively short-term, but a little bit longer term than that cash bucket.

Benz: That's right. You'd step out a little bit on the interest-rate-sensitivity spectrum. I would venture into a bond fund. For most investors with taxable accounts in retirement, they would probably want to be thinking about some sort of a municipal-bond fund. When I populated our model portfolios, I really liked some of our analysts' Gold- and Silver-rated municipal-bond funds. They tend to like the funds from Fidelity, especially. Fidelity Limited Term Municipal Income (FSTFX) is one that I used in the model portfolios. They also like the municipal-bond funds from Vanguard. They are nice and cheap. A couple that I would point to would be Vanguard Intermediate-Term Tax-Exempt (VWITX) as well as Vanguard Short-Term Tax-Exempt (VWSTX). The Short-Term Tax-Exempt fund has a very, very low duration. So, it's just a baby step beyond some sort of a cash account. It will tend to have very, very low volatility.

Stipp: In bucket two, I might also have some intermediate-term bond exposure. What are some of your tax-efficient recommendations there?

Benz: Here again, I think the funds from Fidelity and Vanguard shine. Fidelity, I should mention, has a very high percentage of our Gold-rated municipal-bond funds. One we like there is Fidelity Intermediate Municipal Income (FLTMX). T. Rowe Price Summit Municipal Intermediate (PRSMX) is another fund that we like as well as Vanguard Limited-Term Tax-Exempt (VMLTX). That's one that I own personally.

Stipp: So, when you look at bucket three, this is going to be longer-term investments--a lot of stocks. What do you want to look at--and look for--from a tax-efficiency perspective for bucket number three?

Benz: Certainly, if you are an individual-stock investor--someone who likes to pick individual equities--this would be a really appropriate spot in your portfolio to hold them because you exert a lot of control over the tax efficiency, over the tax realization, the realization of capital gains. So, if I held individual stocks, I would keep them in bucket three. I would think about holding them in a taxable portfolio.

When I thought about putting together the equity components of these portfolios, I generally leaned on exchange-traded funds, index funds, and tax-managed funds. ETFs and index funds tend to be naturally tax-efficient--these are equity funds--because their trading is very, very low; they realize very few capital gains. So, they are reliably tax-friendly holdings, especially if they are broad-market index funds. There's not a lot of trading up and down the capitalization ladder. They tend to be very, very tax-efficient over time.

When I put together the Vanguard portfolios, I did lean on their Tax-Managed Capital Appreciation (VTCLX) fund. I have long liked Vanguard's tax-managed lineup because the funds are explicitly managed to downplay taxes--to reduce the effects of capital gains taxes. The thing I like about that approach is that it makes them able to be somewhat responsive to whatever happens to the tax regime. So, if we go back to a situation where dividends are once again taxed as ordinary income, they could kind of restructure that portfolio to downplay dividend payers as a percentage of the portfolio. I like that they will tend to be more responsive to the tax climate, even though index funds and ETFs are nice, tax-sensitive holdings as well.

Stipp: Are there any investments for my taxable account that I should just steer clear of because they really don't have tax efficiency whatsoever?

Benz: There were a few categories that I did not include in the tax-efficient portfolios that I made room for in the tax-deferred portfolios. So, commodities-tracking investments tend to be somewhat tax-unfriendly, especially those that use futures to track commodities prices. The reason is that a portion of your gains from a fund like that would be taxed at the long-term capital gains rate, but a portion would be taxed at your ordinary income tax rate. So, that tends to make them tax-unfriendly.

TIPS--Treasury Inflation-Protected Securities--is another category that I would tend to want to keep out of a taxable account because you're taxed not just on those interest payments but also on the inflation adjustment that you receive to your principal. Then finally, real estate investments is another category that I would tend to want to downplay in a taxable account--the reason being that those dividends are very lush in some cases, but they are nonqualified dividends. So, you are taxed on them at your ordinary income tax rate.

Stipp: Most retirees will have a mix of accounts by the time they reach retirement. Thanks for helping us optimize those taxable accounts with these tax-efficient picks today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason. Thanks for watching.

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