Tax Planning Tips and Fund Picks: A Q&A With Morningstar's Christine Benz

One of the most common requests that Morningstar StockInvestor editor Matt Coffina receives from his subscribers is to provide guidance on asset allocation. The past two issues of StockInvestor have featured discussions between Matt and Christine Benz, Morningstar's director of personal finance; they've covered asset allocation, retirement portfolio planning, and tax issues. Below is an excerpt of their conversation; you can read the first part of their discussion, which focused largely on retirement portfolio planning, here.

Matt Coffina: What's your view on target-date funds and robo-advisors, two increasingly popular ways to automate the asset-allocation process?

Christine Benz: Advisors often criticize target-date funds as "one-size-fits-none," and I understand that critique. For example, the typical target-date fund will be too conservative for a person with a pension, and it may be too aggressive for a person with really volatile human capital, like a real estate broker.

But I am a fan of target-date funds, because I remember the days before they were widely available. Back then, many 401(k) investors would allocate their portfolios by selecting the funds with the highest five-year returns, or perhaps put 10% in each of the 10 choices. Target-date funds enable investors to build and maintain sensible, well-diversified portfolios that account for their life stage and are totally hands-off. Another finding from our fund flow data is that target-date fund investors tend to stay put, so their realized returns are very close to their funds' returns. In terms of outcomes, I view target-date funds as the industry’s biggest home run over the past several decades.

That said, I like target-date funds less for retirees. When you take a distribution from one of these funds in retirement, you are selling a portion of your holdings in every asset class. If you're following a bucket approach, it would be better to have a choice of whether to trim the stock or bond piece of your portfolio, based on whatever has performed best.

Robo-advice has enormous potential--it can deliver some of the same benefits of target-date funds, but with greater customization. Tax management seems to be one of the key areas in which robo-advice can add value. But there are several caveats. The first is that there's a cost associated with robo-advice. If your situation isn't that complicated, you may be better off with a simple target-date fund, especially for your retirement assets. (Target-date funds aren't managed with regard to tax efficiency, so they aren't as well suited to taxable accounts.) Second, if you have enough assets with a given fund company or brokerage firm, you may be eligible for some free financial-planning time with a human being. Finally, I would argue that the robo-advisors currently available do just a small piece of the planner's job. A good financial planner or advisor will counsel you on much more than just your asset allocation: for example, whether to pay down your mortgage or invest in the market, or whether you need long-term care insurance. We may eventually get to the point where robo-advisors deliver holistic advice like that, but we're not there yet.

MC: Most investors have a hodgepodge of accounts--I know my family does. For example, you might have a 401(k), some rollover IRAs from former jobs, a taxable brokerage account, and a handful of savings accounts or CDs, all at different financial institutions. Any tips for managing this complexity?

CB: You're right, portfolio sprawl is a big issue. I often advise pre-retirees to think about how they can collapse like-minded accounts. For example, roll over the 401(k)s and all of the small IRAs into a single large IRA for each spouse. But there's only so much streamlining you can get away with. Most importantly, investments with differing tax treatments need to stay apart.

When it comes to deciding how to sequence withdrawals from those various accounts in retirement, the key is to preserve accounts with the best tax-saving features for as long as you can. Taxable accounts often go first in the queue, followed by tax-deferred, followed by Roth. Besides having the best tax-saving features, Roth IRAs are ideal assets for your heirs to inherit, since they aren't subject to required minimum distributions during your lifetime and your heirs won't owe taxes on withdrawals. If you're past age 70 1/2 and subject to required minimum distributions, taking those RMDs from tax-deferred accounts should be a priority over any other type of withdrawal, because the penalties for missing RMDs are so large.

You can also think about this general framework when deciding what kinds of assets to put in each account. If your taxable account is going to get tapped first, you-d want to be sure to hold some liquid assets in it; perhaps that's where you put "bucket 1." But keep in mind that these are just guidelines--there may be years in which it makes sense to take Roth distributions because you're in a really high tax bracket and have few deductions. A good tax advisor can be a great companion in retirement, not just as you prepare your return, but as you plan withdrawals.

MC: Any other suggestions to maximize tax efficiency in a portfolio? What are the three most important steps investors can take to lower their tax burden?

CB: The first would be to take advantage of tax-sheltered wrappers, because even a tax-efficient taxable portfolio is not going to be able to keep up with one that offers tax-free or tax-deferred compounding. I'm also a big fan of health savings accounts as an investment vehicle for healthy people who have the wherewithal to pay healthcare expenses out of pocket. The HSA offers the only three-fer in the whole tax code: pretax contributions, tax-free compounding, and tax-free distributions for qualified healthcare expenses.

Being careful about what you put inside your taxable accounts is also crucial. ETFs and index funds can be very tax-efficient, but individual stocks can make a lot of sense here, too, because they give you control over when you realize capital gains and losses. Individual stocks are great assets to pass to heirs, since your heirs' cost basis will "step up" to the stock price at the date of your death. If investors hold bonds in their taxable portfolios, Fidelity's municipal-bond funds are easy to recommend, with their low costs and experienced management. Investors who live in particularly high-tax states, such as California or New York, might investigate a state-specific municipal bond fund to avoid both state and federal taxes on their income.

My last tip gets back to withdrawal sequencing from your various accounts during retirement. You have the most control over your income in the years after you've retired but before RMDs commence, which can make this an ideal time to either spend from your tax-deferred accounts, thereby reducing your RMD-subject balance, or convert those assets to Roth. If you plan well, you may be able to take a little bit from several of your accounts each year to stay in the lowest possible tax bracket throughout your retirement.

MC: How do Social Security, pensions, and other retirement income fit into the bucket approach?

CB: I usually advise retirees and pre-retirees to start by thinking about their income needs in retirement. Let's say you'll need $5,000 a month. Subtract from that any stable sources of income you'll be able to rely on, such as Social Security or a pension. Maybe those income sources supply $2,000 per month. So that means you're counting on your portfolio for $3,000 of monthly income, or $36,000 a year. You can then stress-test that amount by seeing what percentage of your total portfolio balance it works out to: Is the initial withdrawal in the ballpark of the 4% guideline? If your total portfolio is worth $1 million, you're in good shape--the withdrawal of $36,000 is 3.6%. But if you have $750,000 saved, the initial withdrawal would be 4.8%--arguably too high.

This illustrates the value of maximizing other income sources to help reduce portfolio withdrawals, which is why we've seen an explosion of interest in maximizing Social Security benefits. Every year a retiree is able to delay receipt of Social Security beyond full retirement age (currently 66) yields a roughly 8% increase in guaranteed benefits--a very attractive payoff. Of course, not everyone can delay, and those who are in poor health probably shouldn't. But it can be a powerful strategy for those who can take advantage.

MC: What's your view on exchange-traded funds versus open-end mutual funds?

CB: Exchange-traded funds are another of the investment industry's best innovations from the past few decades. I like them for their tax efficiency and generally low fees, and it's easy to craft a very well-diversified portfolio with just a handful of ETFs. Simplicity is a great and underrated virtue in investing, in my opinion. Even so, my personal feeling is that traditional index funds can be just as cheap and tax-efficient as ETFs, so unless investors specifically value the intra-day trading of ETFs (and I'm not sure why they should!), an index fund can usually do the job just as well. One common point of confusion is that ETFs and index funds are universally tax-efficient. That's not so: Tax-inefficient assets like bonds and REITs are still tax-inefficient inside of an index fund or ETF wrapper.

Active mutual funds have higher costs. There's also the fact that most active funds don't beat their benchmarks. And active funds can make big, unwanted capital gains distributions at inopportune times, which is why I recommend that investors keep them out of their taxable accounts. However, I do think there is a case to be made for certain active funds, specifically those that offer downside protection. A good example is

.

MC: As I said at the beginning, StockInvestor is all about individual stocks. I can't recall ever mentioning a mutual fund or exchange-traded fund, let alone recommending one. For a change of pace, what are some of your favorite funds and ETFs at the moment?

CB:

Because I like simplicity, it’s easy to recommend the total market trackers from Vanguard, Schwab, or iShares. All three firms offer excellent core index funds with very low costs; price wars among index fund providers have been good for consumers! Fidelity also fields some good, inexpensive index funds. I already mentioned Vanguard Dividend Growth as a go-to recommendation for retirees. In my personal portfolio, I've long been a happy holder of

MC: Thanks for sharing your perspective with us, Christine. To sum up, we believe investors can benefit from thinking of their portfolios as containing distinct buckets based on when they're likely to need the funds. This setup provides the psychological support to continue holding stocks through a prolonged bear market: Confidence comes from knowing that you have at least one or two years' living expenses in cash in bucket 1, and several more years' expenses (more for retirees, less for younger investors) in high-quality short-term bonds in bucket 2. As always, patience, discipline, and a long-term investment horizon are prerequisites for a successful stock investor.