Tune Up Your Taxable Portfolio

In my experience, investors often give short shrift to the question of what to put in their taxable accounts versus their tax-sheltered accounts. They focus almost entirely on asset allocation (finding the right stock/bond mix for a particular goal) and security selection but pay less attention to which types of assets go where, often called asset location.

As a result, they needlessly surrender a big portion of their gains to the tax collector each year. That can be a particularly big problem for young and middle-aged investors. If the government is taking a large cut of your investment returns each year, your savings have less of an opportunity to compound over time.

The Before and After portfolios here show how you can fine-tune a taxable portfolio for maximum take-home returns, by putting more tax-efficient assets in the taxable accounts and steering high-tax investments to the tax-sheltered accounts.

I haven't made substantial shifts in the asset allocations of the two portfolios, because a portfolio's stock/bond split is often driven by considerations that supersede taxes, such as time horizon. Instead, I've focused on security selection as a means of boosting the portfolio's aftertax returns.

Tax-Inefficient Portfolio--Before
Holding %	Security
5	Pfizer (PFE)
5	Stryker  (SYK)
10	Cisco Systems (CSCO)
15	Fidelity Disciplined Equity (FDEQX)
10	Turner Midcap Growth
15	Marsico International Opps (MIOFX)
5	PIMCO Commodity RealReturn Strat
5	Vanguard Inflation-Protected Securities (VIPSX)
5	T. Rowe Price High-Yield (PRHYX)
15	Fidelity Total Bond (FTBFX)
10	Vanguard Short-Term Inv Grade (VFSTX)

 

Tax-Efficient Portfolio--After
Holding %	Security
10	Stryker (SYK)
10	Cisco Systems (CSCO)
30	Vanguard Tax-Managed Capital Apprec (VTCLX)
15	Vanguard Tax-Managed International (VTMGX)
5	I-Bonds
15	Fidelity Intermediate Municipal Income (FLTMX)
10	Fidelity Short-Intermediate Muni Income (FSTFX)
5	Vanguard High-Yield Tax-Exempt (VWAHX)

Bond Dos and Don'ts 
Generally speaking, stocks will tend to be more tax-efficient than bonds, because the income from bonds is taxed at your ordinary income rate, which is higher than the capital gains and dividend rates. For that reason, some planners recommend that you keep your taxable portfolio light on fixed-income assets. But that may not be practical if you're saving for a shorter-term, nonretirement goal.

If you need to hold bonds in your taxable accounts, it pays to see whether municipal bonds would be a better bet on an aftertax basis; the tax-equivalent yield function of Morningstar's Bond Calculator can help you crunch the numbers. Whereas any interest you earn from a conventional bond fund is taxed at your own income tax rate, you won't have to pay federal income tax on a municipal-bond fund's payout; you may also be able to skirt state income tax by buying a muni fund dedicated to your state's bonds. In the portfolios here, you'll see that I've shifted the taxable bond funds into municipal-bond funds with similar credit-quality and interest-rate sensitivity. I prefer muni funds to individual munis because smaller investors often get a raw deal on bid-ask spreads when buying and selling munis; buying a fund also helps reduce the credit risk associated with any one issuer.

It's also worth noting that a couple of the bond funds in the Before portfolio are distinct no-nos for a taxable account. High-yield bond funds, because they tend to generate large amounts of current income, are a poor choice for your taxable accounts. Funds that hold Treasury Inflation-Protected Securities also tend to be a bad bet for taxable accounts because, with them, you're taxed not just on your yield but on the principal adjustment you receive to account for inflation. If you want to give your taxable portfolio a measure of inflation protection, consider I-Bonds, which enjoy more favorable tax treatment than TIPS. (This article discusses the current purchase limits on I-bonds.)

Stocks: Keep It Simple
Your taxable account is also a good place to hold individual stocks. In short, individual stocks give you a lot more control over your tax situation than you'll have with funds. Exchange-traded funds also tend to be more tax-friendly than most mutual funds because the manager doesn't have to sell stocks--and realize capital gains--to meet redemptions. Some stocks are better than others for taxable accounts, though. For example, dividend-paying stocks and stock funds are a better option for tax-sheltered accounts than taxable. Although dividends are now taxed at a relatively low rate, those rates are set to expire in 2013, and in any case, you'll still have to pay some taxes on any dividends you receive. Thus, in the After portfolio, you'll see that I'm suggesting a shift of higher-income  Pfizer (PFE) into the investor's tax-sheltered accounts, but I didn't touch lower-yield equities such as  Stryker (SYK) and  Cisco Systems (CSCO).

If you own stock mutual funds instead of or in addition to individual stocks in your taxable accounts, you'll want to be choosy about them as well. Managers who use high-turnover strategies tend to pay out sizable capital gains along the way. And if the manager trades very frequently, you may have to pay tax on short-term capital gains, which are taxed at your ordinary income tax rate. Mutual funds that use quantitative strategies, such as  Fidelity Disciplined Equity (FDEQX) in the Before portfolio, also tend to be poor choices for taxable accounts, because they too tend to have fairly high turnover. Finally, taxable investors should avoid commodity funds like  PIMCO Commodity Real Return , which uses derivatives to approximate the returns of a commodity index. Such investments can play a valuable supporting role in a portfolio, but they're better off in your tax-sheltered account than in your taxable one.

By contrast, large-company index funds tend to be a pretty good bet from a tax perspective, as do active funds with ultralow turnover. You could also consider a tax-managed fund that's explicitly designed to limit the tax collector's cut. I'm a big fan of Vanguard's tax-managed suite of funds. Thus, I've recommended a switch into  Vanguard's Tax-Managed International (VTMGX) and  Tax-Managed Capital Appreciation (VTCLX)  funds for the individual's stock-fund holdings. These funds have managed to deliver competitive returns on a pretax basis relative to their peers, and they look even better once you factor in taxes.

Caveats
If you're considering undertaking a similar portfolio overhaul, bear in mind any tax and transaction costs you'll incur to make the switch. The costs of making such changes may offset any benefits that you reap by making your portfolio more tax-efficient.

Also plan to limit the trading you do in these accounts in the future. Once you've arrived at a taxable portfolio with a pleasing mix of securities and good tax efficiency, batten down the hatches, trade only on an as-needed basis, and focus any rebalancing efforts on your tax-sheltered accounts rather than your taxable ones.

A version of this article appeared March 16, 2011.

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