A Conservative Tax-Efficient Portfolio for Retirees

Investors don't get a lot of gimmes, namely simple, low-risk, or no-risk ways to boost our take-home returns. But one of the key ones is managing your portfolio for optimal tax efficiency, thereby (legally) reducing Uncle Sam's cut of your return during the life of your portfolio. Banks and brokerage firms hire armies of lawyers to help wealthy individuals and families limit the taxes they pay on their investments, but they often charge a steep fee for their services. Basic tax-management techniques are a cinch to practice on your own.

Staying attuned to tax efficiency is particularly crucial for those nearing or in retirement. For one thing, most retirees are in drawdown mode, and some strategies for tapping your accounts for income incur fewer tax-related costs than others. Moreover, there's only so much money you can shelter in tax-protected vehicles, so many people come into retirement with substantial shares of their portfolios in taxable accounts. (The higher the level of wealth, the more this is the case.) Finally, retirees and pre-retirees are generally steering ever-larger shares of their portfolios into bonds and cash investments, and income from these asset classes is taxed at a higher rate than is the case for withdrawals from equity accounts.

Proper asset location, which determines the types of investments best-suited for particular accounts, and sequencing withdrawals from your various retirement accounts are key components of tax management for retirees and pre-retirees.

And to the extent that you hold retirement assets in your taxable accounts, it's prudent to concentrate the most tax-efficient investments there while reserving less-tax-friendly investments for your IRA or company retirement plan.

With that in mind, here's an example of what a conservative retiree's taxable portfolio might look like. It's appropriate for very risk-conscious retirees with a time horizon (estimated life expectancy) of 10-15 years. Thus, stability and preserving purchasing power are key goals for this portfolio. 

However, individuals with that same time horizon might have higher or lower equity weightings, depending on their specific financial and family situations. Investors should feel free to customize the allocations and individual holdings as they see fit or simply use them as a guide when benchmarking their own portfolios.

A Conservative Tax-Efficient Retirement Portfolio

Holding                                                                                       Allocation % Vanguard Tax-Managed Capital Appreciation                                     20 Vanguard Tax-Managed Small Cap (VTMSX)                                                   5 Vanguard Tax-Managed International (VTMGX)                                               5 Fidelity Short-Intermediate Muni Income (FSTFX)                                           13 Fidelity Intermediate Muni Income (FLTMX)                                                   50 Vanguard Tax-Exempt Money Market VMSXX                                                   7 Total                                                                                                       100

 
Asset Allocation
As with the previous portfolios, I've relied on Morningstar's Lifetime Allocation Indexes to guide the portfolio's asset allocation. However, your own taxable assets may be more or less stock-heavy than the portfolio featured here. And while the portfolio includes a small cash position, it's there to improve the portfolio's overall risk/reward profile rather than to cover an investor's near-term cash needs.

Your own positions in more liquid assets like cash and bonds may well be larger. That's because the conventional wisdom on sequencing in-retirement withdrawals calls for tapping any taxable accounts early on, the better to stretch out the tax-savings benefits of tax-sheltered vehicles.

Fixed-Income Holdings
Municipal bonds and bond funds will make sense for the fixed-income component of many investors' taxable portfolios because income will be free of federal and, in some cases, state tax (provided you stick with bonds issued by municipalities in your state). Use the Tax-Equivalent Yield function on Morningstar's Bond Calculator to determine whether you're better off in taxable bonds or munis once you factor in taxes.

For this portfolio's fixed-income portion, I've relied on actively managed Fidelity municipal-bond funds because they're well-managed and their costs are reasonable. In terms of specific funds, Vanguard's suite of municipal bond funds is also very good and features even lower costs, and therefore would serve as a worthwhile substitute. Morningstar's exchange-traded fund analysts are also keeping an eye on a new wave of municipal-bond ETFs, including some that carry set maturity dates--that is, all of the bonds in a portfolio mature on a given date. But given that indexing the muni space is more complicated than other market segments as a result of fragmentation and a huge number of issuers, Morningstar fixed-income analyst Eric Jacobson tells me that he would feel more comfortable recommending an active fund like those from Vanguard or Fidelity before jumping into a muni index fund or ETF at this time. For the cash component of the portfolio, I'm switching to Vanguard's municipal money market fund; in a low-return world, its rock-bottom costs give it a meaningful edge over other funds, including Fidelity's, which is fairly low-cost itself.

Note that in contrast with my past mutual fund and ETF portfolios, this one does not feature inflation-protected bonds. Yes, inflation protection is important for retiree portfolios, but Treasury Inflation-Protected Securities are a bad bet for taxable portfolios. I-bonds, meanwhile, are more tax-friendly, but investors are limited in their purchase amounts, crimping their appeal for larger investors.

Stock Holdings
Taxable investors have even more choices on the equity side. Building a portfolio composed of individual stocks gives investors the maximum level of control over when they realize capital gains and losses, though many retirees prefer the low maintenance of mutual funds. On the funds side, traditional index funds, exchange-traded funds, and tax-managed funds all do a good job of limiting the tax collector's cut of investor returns. Ultimately, I decided to populate the portfolio's equity component with tax-managed funds after perusing the various vehicles' tax data for the past decade. Owing in part to their ability to limit the role of dividend payers in their portfolios, tax-managed funds have exhibited tax-cost ratios that are equal to or lower than comparable ETFs or traditional index funds.

I also like the fact that tax-managed funds can adjust their strategies to suit the current tax climate, giving them an element of flexibility that traditional ETFs and index funds do not have. For example, they could avoid dividend-paying stocks if dividends are once again taxed at investors' ordinary income tax rates. Bear in mind that  Vanguard Tax-Managed International (VTMGX) levies a 2% redemption fee if you sell shares that you've held for fewer than two months. If your holding period is shorter than that (and I hope it's not), you're better off in an exchange-traded fund or another vehicle without such a stricture.

A version of this article appeared March 16, 2011.

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