5 Portfolio Pitfalls and How to Fix Them

Key Takeaways

• One of the first pitfalls is too-aggressive asset allocations prior to retirement.
• Lack of diversification is another common issue that we run into. So, not only diversification at the asset class level—so, does someone have enough in safe assets to support their retirement spending—but also U.S. versus non-U.S. exposure, growth versus value exposure.
• Another issue is portfolio sprawl, this idea of too many accounts, too many holdings within those accounts, and how do we skinny them down to make them more manageable.
• Another pitfall is overspending in retirement. Setting an in-retirement spending rate is one of the hardest problems in financial planning, in part because it rests on a lot of unknowables.
• Tax inefficiencies are another pitfall, where people are paying more for their portfolios than they really need to be.

Christine Benz:

Hi, I'm Christine Benz from Morningstar, and thanks for joining me today. I'm going to be talking about five common portfolio pitfalls and how you can address them if you encounter them in your own portfolio. These portfolio pitfalls are all things that I observe frequently when I work with real-life investors on their own portfolios.

I've been working on portfolio makeovers for Morningstar for more than 10 years now. We've been putting the portfolio makeovers on Morningstar.com, and I typically do four or five a year. There are a few key goals of these portfolio makeovers. One is to showcase the portfolios and common issues that real-life investors face. I often hear from investors that it resonates with them when they see situations that reflect their own situations. I think it's also helpful to see investments and discuss investments in the context of actual financial plans, in the context of people's retirement plans or people's multitasking strategies if they're attempting to save for college and retirement at the same time. It's really helpful to see investments in an actual real world financial-planning context.

We also do Morningstar portfolio makeovers because we want to show how you can use Morningstar tools and research and analytics to make assessments about your own holdings. So, when I work through portfolio makeovers, I lean heavily on our analyst team to help determine whether to hold on to holdings that might appear in a portfolio or to replace them with more highly rated stocks or funds or ETFs. And finally, a goal of our Portfolio Makeover Week is to inspire investors to evaluate and improve their own portfolios. So, if you look through our portfolio makeovers, you probably will see a few things that dovetail with your own situation. If you can be inspired to make some changes to improve your own portfolio, that's all for the better.

Pre-Retirement Asset Allocation That's Too Aggressive

In terms of the specific pitfalls that I'll be discussing today—at the top of the list is too-aggressive asset allocations prior to retirement: people coming into retirement with just too much in stocks relative to their anticipated spending from their portfolios. I'll talk about why that's so common and how to troubleshoot that in your own portfolio if that's a situation that is similar to your own. I'll also talk about overspending in retirement. That's not squarely a portfolio problem. It's tangentially a portfolio problem. But it's super important in the context of making sure that a retirement plan is as solid as it can be. So, I'll talk about how to think about in-retirement spending rates. It's a big topic, but I will speed through and address some of the key things to be thinking about as you think about your own safe spending rate.

Lack of diversification is another common issue that we run into. So, not only diversification at the asset class level—so, does someone have enough in safe assets to support their retirement spending—but also U.S. versus non-U.S. exposure, growth versus value exposure. That's something that I have observed quite a bit of as I've looked across portfolios that I've reviewed recently, where people do have fairly large growth biases in their portfolio. And then another consideration that's top of mind for a lot of investors today is that their portfolios may not have adequate inflation-protection. So, I'll talk about how to think about that issue and add that inflation insulation to your own portfolio if you don't have adequate inflation-protection. Another issue that's perennially something I addressed with my portfolio makeovers is what I call portfolio sprawl—this idea of too many accounts, too many holdings within those accounts, and how do we skinny them down to make them more manageable. This comes up again and again in my portfolio makeovers. Whether people ask me for their help in this area or not, I typically am looking to streamline their portfolios. So, I'll share some guidance for doing that if that's an issue with your own portfolio. And finally, tax inefficiencies, or people paying too much for their portfolios in taxes than they really need to. I'll discuss some common issues in the realm of tax inefficiencies and also discuss how to make changes to make your portfolio more tax-efficient going forward. This is just a look at our X-Ray functionality, looking through a portfolio. You can see in the case of this particular portfolio, it's very heavily tilted toward stocks, U.S. stocks in particular. This is not at all uncommon, particularly given that until very recently we had seen U.S. stocks outperform most asset classes. And it's easy to see why investors often let their equity holdings ride, partly because we have had such very strong performance from stocks over the past decade.

This slide captures with the green bars what the S&P 500 would have returned on a predividend basis, and that bright aqua bar is what the S&P 500 returned over the past decade factoring in dividends. You can see that it handily outperformed the lines at the bottom of this chart, which depict the return that bond investors earned over the same decade. And so, you can see that many investors, if they've just been letting well enough alone in their portfolios, have ended up with more equities than they might consider ideal, especially if they're getting closer to retirement. This isn't such a big deal for people who are in their 30s, 40s, even early 50s. But for people who are getting close to drawing upon their portfolio, having too much in equities can be problematic.

What we've seen so far in 2022, you don't need me to tell you this, is that equities and bonds have simultaneously performed poorly, and that has left a lot of investors who were approaching retirement scratching their heads about what to do about how their portfolios should be positioned. This pattern has been quite unusual in modern market history, where bonds had a really nice diversifying effect for stocks where when we saw stocks fall in periods of bear markets, we often saw bonds at least hold value or maybe even gain a little bit of value. We didn't see that this time around in part because interest rates are bugging both stock investors and bond investors. Rising interest rates depress the value of already existing bonds, where investors who hold such bonds say, "Well, never mind those bonds. If newer bonds are coming online with higher yields attached to them, I want them instead." That pushes down bond prices. Stock prices have also been affected by rising interest rates, in part because there's an expectation that if rates continue to rise that they will begin to affect the economy with implications for corporate earnings. And so, that's why both stocks and bonds have fallen simultaneously this time around.

You can see that if an investor were coming into a year like 2022 and getting ready to retire, he or she might be scratching their head about where to go for cash in a tough year for both stocks and bonds. And incidentally, non-U.S. stocks haven't been any great shakes so far in 2022. In fact, they've actually underperformed U.S. stocks. So, an investor who had a fairly slight position in cash and was actively drawing upon that portfolio might be wondering where to go for cash. So, this is just an illustration of why it's important to make sure that your portfolio has adequate liquidity, has adequate allocations to very safe assets that you could draw upon in this type of scenario. If an investor spends through that $50,000 cash allocation, he or she may not have an easy source of additional funds to turn to. I suppose bonds would be next in the queue because they've performed the least poorly relative to the other asset classes, but nonetheless, it's not a great position to be in.

And that's why I'm such a big evangelist for the idea of using a bucket type strategy, or thinking about a bucket type strategy as you decide how to allocate your assets for retirement. So, just to illustrate how a bucket approach would look in practice: Bucket 1 would hold portfolio withdrawals for years one and two of retirement. That would be a highly liquid portion of the portfolio, where you'd have mainly cash assets or entirely cash assets, assets with FDIC guarantees, assets that today promise a somewhat higher return than they did even a year ago. But you don't want to overdo that Bucket 1 because on an inflation-adjusted basis, of course, you're in a losing position. But the idea is that you're at least stabilizing the cash flows for years one and two of your retirement.

Bucket 2 is a high-quality fixed-income portfolio, mainly. You might hold a little bit of dividend-paying equity exposure with this portion of the portfolio, and this would hold roughly eight years' worth of portfolio withdrawals.

And then, Bucket 3 is the growth engine of the portfolio. But the idea is that it's holding assets for years 11 and beyond of retirement. So, it's a globally diversified equity portfolio. That's where I would hold any aggressive nonequity positions that I happen to have in my portfolio. If I had commodities, if I had a position in precious metals or gold, if I had high-yield or emerging-markets bonds, for example, I would think of them as belonging in that equitylike bucket of my portfolio. But I think this is just a neat strategy for thinking about how much to drop into each of the asset classes as retirement approaches.

This is a sample ETF Bucket portfolio using the same general structure. We're assuming a $750,000 portfolio. We're assuming a $30,000 annual spending rate from that portfolio. For that cash bucket, for that Bucket 1, we've got $30,000 x 2 going into that portion of the portfolio. Bucket 2 is that high-quality fixed-income portfolio accounting for another eight years' worth of those portfolio withdrawals, and it's stair-stepped by risk level. So, you can see at the front end of that bond portfolio, we've got some low-risk bond types and then an intermediate-term bond fund, which will have more volatility and, indeed, real losses in 2022. And then Bucket 3 is the growth engine of the portfolio. It's mainly a diversified equity portfolio with a little dash of high-yield bond exposure. But that's how this would look with an actual portfolio. I've created a lot of different model portfolios on Morningstar.com, many of which are organized around this general bucket framework.

Just a quick note on bonds. We talked about why bonds have been so disappointing so far in 2022. I grabbed this slide from my colleague, Amy Arnott, that looks at the magnitude of losses in bonds, and I think that really that's the reason to keep the faith in your fixed-income investments: that when we look over market history, we see that stocks and bonds tend to have losses in a similar ... the periods in which they have losses have been similar, but the magnitude of those losses have been different and much worse for equities than bonds. So, whether you're looking over a quarterly time horizon or an annual time horizon, the magnitude of those fixed-income losses, at least over market history, has been much less than has been the case with equities.

The point of this slide is to illustrate that if you are an investor who is approaching retirement and you find yourself with a lot of equities in your portfolio, I think the key thing to remind yourself of is that even though you didn't catch the absolute top in terms of derisking your equity portfolio, you've nonetheless had a really good run in your equity portfolio most likely. Assuming that you've been a longtime holder of stocks, you've had returns that are in line with or even better than, in the case of the 10-year return, what historical averages have been with stocks. So, if you're looking at your portfolio today, if you're in drawdown mode, if you're in retirement or you're getting close to retirement, I don't think that there's shame in derisking your portfolio even if you didn't manage to catch the absolute top of the stock market. You still have an enlarged stock portfolio because stocks have been so good for so long.

If you are derisking in your preretirement years, just a couple of tips to bear in mind: One is that the starting point for deciding your in-retirement asset allocation is to look outside your portfolio. Start by thinking about income that you'll get from Social Security or from a pension and use that to determine how much you'll need to withdraw from your portfolio. Start by maximizing those nonportfolio income sources. That in turn can help lessen your portfolio withdrawal needs. It's also important to mind the tax consequences of any repositioning, especially if you are lightening up on equity holdings. If you need to make changes to get your asset allocation more in line with where you want it to be, concentrate the selling in your tax-sheltered accounts where you won't owe taxes to do that repositioning.

At the same time, I think it's helpful to bear in mind where you will go for your withdrawals in retirement. So, taxable assets when we think about the queue that you might use for retirement spending, the order in which you would deplete your various accounts, taxable assets often go first. So, if that's your strategy, you would want to make sure that you have ample liquidity in your taxable account. It's also helpful to not wait until the year before retirement or the six months before retirement to make these changes. Ideally, you would be taking a little bit of risk off the table in the years leading up to retirement rather than waiting until the last minute.

And finally, just another note on the role of safe assets and the interplay with inflation: As we've had inflation coming on strong so far this year, to me, that really underscores the value of not overdoing your allocation to safe assets. Even though they've been the only thing that have held their ground so far in 2022, this isn't a typical year. So, I think you want to be careful not to overdo those safe assets because the inflation will eat away at your purchasing power there.

Excessive Retirement Spending

Pitfall 2 that I want to touch on is overspending in retirement, and this is something that I do observe when I work on some of the portfolio makeovers for people who are actively drawing upon their portfolios. I would just start by saying setting an in-retirement spending rate is one of the hardest problems in financial planning, in part because it rests on a lot of unknowables. At the top of the list would be how long you'll live. None of us knows how long we'll live. It's very difficult to plan for that uncertain time horizon. Will it be 15 years? Will it be 35 years? We don't really know at the outset of our retirements.

We also don't know how the market will perform or behave over our specific drawdown period. That's another big wild card. We don't know what inflation will run. We had several decades leading up to this year where inflation was nice and low. Now we're seeing inflation run at more meaningful levels. We don't know whether that will persist in the future. People who are setting up their in-retirement withdrawal plans today don't know how high to make inflation to adjust their spending in retirement.

And finally, you don't know the trajectory of your own spending. Even though you may have done your forecasts and even factored in big-ticket items like cars that you'll need to buy or home repairs that you'll need to make, it's difficult to account for each and every last expense in retirement. In fact, I often hear from retirees who talk about some big wild-card expense that came out of the blue, like big dental bills or big home repairs, things that they just didn't account for, and a biggie in many plans today especially is uninsured long-term-care expenses. Many people have decided to forgo long-term-care insurance because their portfolio values have been so nicely enlarged, but they're not sure whether they will have long-term-care expenses, and they're not sure how large those expenses might be.

This slide, I think, nicely illustrates how the right withdrawal rate is so time-period-dependent and so dependent on how stocks and bonds perform over your specific drawdown period. This is a slide that was prepared by my former colleague, David Blanchett, and this looks at the right starting withdrawal rate over rolling 30-year time horizons in market history. And you can see that over various points in time that the retiree got lucky and was able to take more out of his or her portfolio because the markets performed really well, and at other points in time, retirees weren't so lucky and would have had to make do on less if they wanted their portfolios to last over a 25- or 30-year time horizon.

I would just call your attention to the period in the mid-60s to early 70s. That's the period that financial planner Bill Bengen focused on when he did his seminal research on in-retirement withdrawal rates and concluded that even if you encountered an Armageddon-type market that roughly 4% was the most you could have taken out in that very bad time period. That's where the 4% guideline came from. But this slide illustrates how the right withdrawal rate really has been all over the map depending on what the stock market did, depending on what the bond market did over the specific 30-year horizon.

Before we go any further, it's important to understand what the 4% rule stipulates. First of all, it doesn't mean that you take 4% of your balance year in and year out. That's largely because most retirees don't want that kind of fluctuation in their annual portfolio withdrawals. If you think about it, taking 4% of a balance in 2022 when almost everything in your portfolio is down would mean a meaningful reduction in your spending. Most retirees just aren't comfortable with those types of radical adjustments. Instead, the 4% guideline assumes that someone takes a 4% starting withdrawal in year one of retirement and then inflation-adjusts that dollar amount thereafter. So, assume that someone has a $1 million portfolio. Four percent of that $1 million portfolio would translate into a $40,000 portfolio withdrawal in year one of retirement. That would be $41,000 and change in year two of retirement, assuming a 3% inflation rate. But the base idea there was that Bill Bengen knew from working with clients that retirees didn't want to have huge fluctuations in their portfolio cash flows. They wanted something resembling their paycheck in retirement. They wanted a stable standard of living from the portfolio. Bengen, as I mentioned, stress-tested the 4% guideline over many different market environments. It's been subsequently stress-tested and has held up pretty well. So, I think that's one reason why I think it's a reasonable starting point as you think about your in-retirement spending rate and setting that spending rate.

But there are a couple of important caveats to bear in mind in line with that 4% guideline. One is that it's based on historical market returns. But of course, we all know that the future could look quite different than the past. If the market turns out to be worse over your own 25- or 30-year time horizon than it was in any of the periods that Bengen observed, the risk is that if you take the 4% guideline and run with it, you could overspend and then have to cut back later in life. I think that's something that most of us would rather avoid if we possibly could.

On the other hand, if the market is meaningfully better than the 4% guideline assumes, you'll have underspent relative to what you might have. And that was really a problem that has been encountered by many retirees over the past couple of decades. That's why many retirees have found that even as they have maintained a stable standard of living in retirement, they've seen their portfolios grow nicely. They're nowhere close to spending all of their funds during their retirement. But again, it's luck of the draw. For new retirees, it's generally better to be safe rather than sorry—to start a little bit more conservatively and potentially give yourself a raise if the market returns turn out to be better than you had expected.

Then another big caveat in the realm of the 4% guideline is that, even though Bengen assumed that retirees wanted something resembling a paycheck in retirement, when we examine the research, we see that retirees don't actually spend this way. This is some research that my former colleague, David Blanchett, did on the topic of how retirees actually spent. And the pattern he observed was that spending tended to trend down throughout the retirement years. It started strong in those pent-up demand years, the early years of retirement, the

go-go years

they're sometimes called, then tapered down in what have been termed the

slow-go years

, really, really declined in sort of the mid-80s, and then trail back up later in retirement to account for healthcare expenses, oftentimes uninsured healthcare expenses. This is a pattern that David Blanchett observed looking at retirees' spending across the in-retirement time horizon. This certainly syncs up with the experience that I've had with older adults in my life, helping them manage their portfolios and their spending, I've definitely observed a pattern along these lines. Arguably, the 4% guideline, in that it assumes that static standard of living, perhaps over-accounts for spending in the mid- to later years of retirement relative to how retirees actually spend.

A couple of key takeaways as you set your retirement spending rate: a key one is that flexibility pays. Pay attention to your portfolio balance. You don't need to use just a fixed portfolio withdrawal, but if you can tune into your portfolio balance and take less in down markets like 2022, that will tend to read down to the benefit of your spending plan. It will tend to lead to a more sustainable spending plan. And the other nice thing about being flexible is that you can take potentially more in good markets. In environments like 2019 through 2021, for example, retirees who saw nice gains in their equity portfolios could potentially take more during those years. Staying flexible is a great takeaway. Even if you're using something like the 4% guideline, planning to make those periodic course corrections is really valuable.

A key point I would make, though, and this is top of mind in 2022's inflationary environment, is if you are taking those downward adjustments, they may not feel great, especially when inflation is high or in those early years of retirement, in those go-go years where you had a lot of plans to do, say, heavy travel or other big outlays, having to take a downward adjustment to account for the fact that your portfolio hasn't performed especially well—that may not feel especially great.

Not Enough Portfolio Diversification

Another pitfall that I've observed in the portfolios that I've looked at is just the lack of diversification. We touched on people coming into retirement with too little in safe assets. I would say that's probably problem number one for many of the portfolios that I look at. But a couple of other issues that I see when I observe portfolios today is too light international exposure, too little in non-U.S. stocks, too much in growth stocks, and a lack of inflation protection. So, we'll just take these one by one.

U.S. stocks on this slide, you can see how well they've performed, growth stocks especially. The red line depicts the Vanguard Growth Index. You can see it's had a little bit of a fall from grace so far in 2022, but it's dramatically outperformed the Value Index. Its value counterpart has lagged badly over the past—this period is like 18 years now. It's been a long dark night for value stocks. Many investors just tend to let their winners ride, and that has led to overexposure to the growth column of the style box. Of course, we've seen growth stocks get knocked down so far this year, but nonetheless, many portfolios do have overly aggressive allocations to U.S. growth stocks.

Another issue we see is that, because U.S. stocks have outperformed non-U.S. stocks, many portfolios are overweighted in U.S. stocks relative to, say, the global market cap or any professional asset-allocation recommendation. And this is an issue because, by many measures, non-U.S. stocks are inexpensive relative to U.S. stocks today. So, valuations are lower. Dividends are higher. Certainly, there are a lot of macroeconomic headwinds for non-U.S. stocks to be worried about, even more worried perhaps than the U.S. market. But thanks to higher dividends and lower valuations, I think investors should revisit the non-U.S./U.S. allocation in their portfolios.

This is just a look at our style box. You can use our X-Ray tool to evaluate your portfolio's growth versus value exposure. What you're looking for is a somewhat equal distribution. I don't think you have to get too into the weeds in terms of calibrating so that it's a third, a third, a third value, blend, and growth. But you're looking for at least a somewhat equal distribution across those three columns of the style box.

In terms of setting your U.S. versus non-U.S. exposure, the global market capitalization, I think, is a starting point. When we look at that today, U.S. stocks compose about 60% of the value of all of the stocks on the globe and non-U.S. compose about 40%. I think that's a starting point. Younger investors especially can use that as a starting point. When we look at target-date funds, I would say that's another good benchmark when setting non-U.S. versus U.S. exposure. The average 2060 fund, so geared toward young people who are expecting to retire in 2060, you can see that that's 64% U.S., 36% non-U.S.—a little higher U.S. allocation for people who are getting close to retirement. And the key reason is that in retirement you will be spending your funds presumably in U.S. dollars. So, you just want less of the foreign-currency fluctuations that typically accompany non-U.S. stocks in your portfolio. So, you might back off of that global market capitalization a little bit when setting your non-U.S. exposure.

When I look at most U.S. investors' portfolios today, I don't see non-U.S. holdings that are anywhere close to what's depicted on this slide. This is something to take a look at, especially if you want to help set yourself up for potentially better returns over the next decade. You would likely want to emphasize non-U.S. because of better valuations and better dividends there.

Inflation-protection is another missing component of many investors' portfolios, or at least it's lacking. So, for long-term inflation protection—and I would tend to take this in two pieces: One is, How do I inflation-protect the long-term component of my portfolio? Well, I do that in a couple of ways. I do that by owning stocks, which over long periods of time have tended to outearn the inflation rate. So, even retirees should have ample equity exposure in their portfolio just to give their portfolio a fighting shot at growing beyond the inflation rate. You might also look at commodities, which I'm a little bit lukewarm on, but we've seen an ability to defend against inflation, at least so far in 2022 and in previous inflationary spikes. Real estate, whether direct real estate ownership or real estate equities, also looks halfway decent from the standpoint of inflation-protection. Those are all categories that I would think about when setting up my long-term portfolio to defend against higher inflation.

For people who are getting close to retirement or in retirement and actively drawing upon their portfolios, I think they want to make sure to add inflation protection to that portion of the portfolio that they'll be drawing upon. There are a couple of key categories that belong in this portion of the portfolio. One would be I Bonds, which are issued directly from the U.S. Treasury. You can buy them from Treasury.gov. You need to set up an account there, but it's well worth doing because they tend to be the purest form of inflation-protection that you can add to protect your purchasing power. Unfortunately, purchase constraints limit you to just $10,000 in annual purchases per taxpayer and then an additional $5,000 through your tax refund, but well worth investigating.

Treasury Inflation-Protected Securities are another category that help protect the purchasing power of your fixed-income portfolio. I've long liked and recommended short-term Treasury Inflation-Protected Securities, in part because they tend to get buffeted around a little less by interest-rate changes, which is what we've had coming on strong in 2022. So, look at Treasury Inflation-Protected Securities, especially short-term. You can buy funds and exchange-traded funds that focus specifically on that area.

When we look at retirement-income funds to help determine, Well, what's the right allocation to TIPS as a component of someone's fixed-income portfolio? Most of them come in in the realm of around 25% of the fixed-income weighting. You wouldn't want to hold all of your fixed-income portfolio in TIPS simply because that's not very diversified. But with a roughly 25%, 20% allocation of the bond portfolio, you do pick up inflation-protection and help protect your purchasing power.

Portfolio Sprawl—Having Too Many Retirement Accounts

Another pitfall that I want to cover is what I often call

portfolio sprawl.

This is too many accounts, too many holdings. We see why holdings have a way of stacking up, why people end up with portfolio sprawl. Many people have multiple employers over their careers. If you have two spouses with separate accounts, separate employer plans, that can further compound the number of accounts in the mix. And then, I think there's simply a lot of investment hobbyists out there, people who really enjoy assembling portfolios, enjoy selecting and monitoring investments, and they tend to end up with a lot of individual mutual funds, ETFs, individual stocks.

So, why is this a problem? Because we know diversification is a good thing. But having too many accounts, too many holdings can be problematic because it can obscure the big picture. It can make it hard to keep track of your asset allocation, and more holdings simply require more oversight. That's especially true if you have individual stocks in your portfolio, but it's also true if you have actively managed funds. That's one reason why I tend to encourage investors to try to skinny down the number of accounts, try to skinny down the number of holdings, just gives them less to worry about and makes it easier for them to keep an eye on the big picture.

How do we fix this? The starting point is at the account level. See if you can find a way to consolidate like accounts. So, if you have old 401(k)s, those can be consolidated into a single IRA. It's important to note that those accounts must remain with the individual taxpayer. Even if you're part of a married couple, you can't consolidate 401(k)s or IRAs together. You each must maintain your own separate accounts. But nonetheless, if you have numerous old 401(k)s or multiple rollover IRAs, it's a really great opportunity to see if you can consolidate into a single IRA. Just remember that you need to maintain traditional IRAs and Roth IRAs as distinct accounts. There may be an opportunity to convert traditional IRAs to Roth IRAs, but as long as you have separate traditional and Roth IRAs, they must maintain separate accounts. If you have multiple brokerage accounts, you can consolidate those into a single brokerage account.

And then, within those accounts, you can further reduce portfolio sprawl by using simple building blocks that give you a lot of diversification in one fell swoop. In many of my portfolio makeovers, I do use broad market index funds, broad market exchange-traded funds as a way to capture exposure to a single asset class with a single fund. That's especially important for people who are getting close to retirement where you're trying to figure out where to source your cash flows on a year-to-year basis. Rather than having so many holdings, it's much simpler to have a single fund expressing exposure to a single asset class.

I also like all-in-one funds, especially for smaller accounts. For example, in a recent portfolio makeover that I worked on, a person had a Roth IRA that she intended to leave to her heirs, to some young people in her life. We settled on a globally diversified index fund to reflect her heirs' nice long time horizon. All-in-one funds, whether balanced funds or index funds, can make a lot of sense in the context of smaller accounts, especially where someone isn't actively drawing upon those accounts.

And if you have decided that you want to make changes that involve your taxable account, ideally you would concentrate your energies if you're addressing portfolio sprawl in your tax-sheltered accounts. But if that energy moves over to your taxable accounts, just be sure to mind the tax consequences if you've had long held positions that have gains in them that would result in tax bills. Be sure to do the math on what selling them would cost in terms of taxes. Even though reducing portfolios sprawl is desirable, you just want to make sure that you aren't inadvertently triggering a big tax bill in the process.

High Tax Costs

The final pitfall that I wanted to discuss today is tax inefficiencies where people are paying more for their portfolios than they really need to be. A lot of these tax-inefficiency problems owe to issues with what we call asset location, where someone has the wrong asset in the wrong account type. Among the most frequently spotted tax issues that I observe are someone holding high income producers in taxable accounts, whether dividend-paying stocks or bonds, securities that are kicking off a lot in income, some of which may be taxed at ordinary income tax rates. People also cost themselves taxes by holding active equity funds in taxable accounts. Active equity funds are often distributing big capital gains to their shareholders, which in turn result in tax bills when the fund is held in a taxable account. So, active equity funds are generally not a great idea in taxable accounts. And finally, all-in-one type funds are also not a great idea for taxable accounts. These funds are often rebalancing back to some specific asset-allocation target, often taking money off the table in stocks which have depreciated and adding funds to bonds. That tends to result in tax bills. And so, even though these can be great holdings overall, I typically like to think of them as belonging inside of investors' tax-sheltered accounts.

So, how do we improve a portfolio's tax efficiency? At the top of the heap would be to take advantage of all of the tax-sheltered receptacles that you have available to you when you're in accumulation mode. That would be IRAs, that would be 401(k)s and other company retirement plans, health savings accounts, 529 college savings plans. The whole gamut of tax-sheltered receptacles are worth considering as you are accumulating assets for retirement. And the key benefit of them is that they effectively shield you from owing taxes on those accounts. As long as the money stays inside those accounts, you won't owe taxes on them. That's the key benefit, the key reason, to take advantage of all those tax-sheltered receptacles.

And then, within those accounts, it's really helpful to shelter those investments that are inherently tax-inefficient inside of those accounts. I referenced high income producing securities, whether stocks or bonds—hold them inside your tax-sheltered accounts. To the extent that you have active equity holdings in your portfolio, especially those that kick off a lot of turnover and, in turn, capital gains, you'd want to hold them inside of your tax-sheltered accounts. And similarly, funds that rebalance back to a target. We talked about balanced funds and target-date funds, all-in-one type funds that typically are taking equity exposure out of their portfolios as the years go by, those tend to be tax-inefficient choices, so they are great options for your tax-sheltered accounts.

In terms of how to position your taxable accounts, so if you have nonretirement, non-HAS, non-529 assets, just plain-old taxable brokerage accounts, you want to focus on making those accounts as tax-efficient as you possibly can. So, for equity exposure, index funds and exchange-traded funds, especially those that track broad market indexes, tend to be superb tax-efficient choices. Individual stocks are also great options for your taxable account because they give you a lot of control over your capital gains realization in the way that you don't necessarily have with active equity funds.

If you're in a higher tax bracket and you are holding fixed-income investments inside of your taxable account, you'd want to think about municipal bonds. Run the numbers to see if you're actually ahead on an aftertax basis with a municipal-bond fund or municipal bonds, but in many cases, higher-income investors will indeed be better off by holding municipal bonds versus taxable bonds if they are actively holding bonds within their taxable accounts.

It's also important to pay attention to your cost basis when you're repositioning. The nice thing about the current down market is that some investors may have the opportunity to do a little bit of repositioning because their holdings have dropped in value. But if you've had positions in your account for many years, you probably still have gains in them. If you are doing repositioning, just pay attention to your cost basis. You don't want to trigger a big tax bill without thinking through the implications. Just bear that in mind when you're repositioning your taxable account.

And finally, in retirement, I think there's a great opportunity for thinking through how you might alleviate the tax bill as you're withdrawing from your account. I think it's super helpful to develop a year-by-year plan for where you will go for your withdrawals. So, not just thinking it through how much you'll take out of your portfolio each year, but also look across your total plan and determine where you'll go for those cash flows on a year-to-year basis. This is a great spot to get some help from a financial advisor or a tax advisor who can help you figure out how to source your withdrawals with an eye toward reducing the tax bills associated with them.

It can also be a great idea to consider conversions of traditional IRA assets to Roth, and to do that conversion, especially in the early years of retirement shortly after retirement has commenced but before required minimum distributions have come on board, so before you're age 72. That's a great period to do some strategizing about how you might reduce your future tax bills, and I mentioned it's really important to get some help in this area as well, because this can all get very complicated very quickly when you think about taxes on Social Security and taxes on Medicare.

Thanks so much for watching today. Hope you found some good food for thought in this discussion, and I hope you're able to find some takeaways in our Annual Portfolio Makeover Week that resonate with your own situation. Thanks for watching. I'm Christine Benz from Morningstar.