A Moderate Tax-Efficient Portfolio for Retirees
This portfolio balances capital preservation with growth potential.
Investing Specialists
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report. A version of this article appeared Feb. 28, 2013.
"Don't let the tax tail wag the dog."
That conventional wisdom is sound advice. For example, if you were considering adding exchange-traded funds to your taxable portfolio to improve its tax efficiency, those holdings should also make sense from an investment standpoint.
At the same time, I can't help but think that managing for maximum tax efficiency is an undervalued aspect of portfolio management, particularly right now. The bear market of 2007-09 limited taxable capital gains and no doubt lulled many investors into a false sense of complacency about the impact that taxes can have on their returns. But given stocks' gains since the market bottomed in early 2009--and the fact that many mutual funds made big payouts in 2013--many investors may wish in hindsight that they had paid closer attention to tax management. Like limiting costs, managing for optimal tax efficiency is one of the few aspects of investing over which investors truly exert some control.
In another column, I shared a model tax-efficient portfolio for conservative retirees with life expectancies of roughly 10-15 years. Many retirees obviously have much longer time horizons than that, however. So our moderate portfolio is appropriate for risk-conscious retirees with time horizons (estimated life expectancies) of 15-20 years. Stability and preserving purchasing power are key goals here, but so is capital appreciation. 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. For example, they might readily swap in ETFs to stand in for the tax-managed mutual funds that I've included here. The portfolios highlight some of the key concepts to bear in mind when managing a taxable portfolio at any age, not just during retirement.
A Moderate Tax-Efficient Retirement Portfolio
Holding Allocation % Vanguard Tax-Managed Capital Appreciation (VTCLX) 32 Vanguard Tax-Managed Small Cap (VTMSX) 5 Vanguard Developed Markets Index (VDMIX) 11 Fidelity Limited Term Muni Income (FSTFX) 11 Fidelity Intermediate Muni Income (FLTMX) 38 Vanguard Tax-Exempt Money Market (VMSXX) 3 Total 100
Asset Allocation
This portfolio, like the previous portfolios, uses Morningstar's Lifetime Allocation Indexes to guide its asset allocation. In keeping with the moderate allocations for someone nearing retirement, it maintains a roughly 50/50 split between stocks and safer securities like bonds and cash.
Bear in mind that this is just a model; your own risk capacity and the extent to which you have income from other sources will be key determinants of your own stock/bond/cash mix. Asset location and how you're sequencing withdrawals will also play a role in the type of assets you hold in your taxable accounts. For example, the conventional rule of thumb is that you should tap your taxable portfolios first during retirement, the better to stretch out the tax savings associated with IRAs. That may argue for holding more in steady asset classes like bonds and cash in your taxable accounts.
Moreover, you'll need to let your own spending needs drive your cash allocation. Although this portfolio does include a small slice in a municipal money market fund, the cash is there solely to improve the portfolio's risk/reward characteristics rather than to provide current income. That helps explain why its cash stake is lower and its total equity allocation is higher than is the case with my model bucket portfolio for moderate investors; the bucket portfolio includes a sizable cash stake to meet near-term cash needs.
Bond Holdings
To flesh out the portfolio's fixed-income holdings, I used the same municipal-bond funds here that appeared in the conservative portfolio: actively managed muni funds from Fidelity, which our analysts like for their sensible management and reasonable costs. (Bogleheads shouldn't despair: Vanguard's lineup of low-expense municipal-bond funds is also solid.) I opted for Vanguard's muni money market fund for the cash holdings; even though its yield, like that of most money market funds, is barely positive right now, its low costs should be a long-term competitive advantage. However, cash yields are so low right now--and the associated taxes are, as well-- that investors might reasonably invest in nonmunicipal cash holdings instead.
Although potentially higher tax rates will tip the scales in favor of municipal bonds for many investors' taxable portfolios, don't automatically assume that you must hold munis in your taxable account. The tax-equivalent yield function in Morningstar's Bond Calculator can help you quantify whether you're better off, on an aftertax basis, holding munis or taxable bonds. You'll also need to gauge your comfort level with municipals: Some investors may obtain peace of mind by holding a mix of taxable and municipal bonds, even if doing so results in a lower aftertax return.
As with the conservative portfolio, this one forgoes inflation-protected bond exposure, even though the indexes I used as a blueprint call for it. That's because Treasury Inflation-Protected Bonds are a poor choice for taxable investors. And while I-bonds are more tax-friendly, investors are limited in their purchases. That's not an impediment for smaller investors, but larger investors will have to get their inflation protection through TIPS and should do so within the confines of an IRA.
Stock Holdings
For a taxable portfolio's equity holdings, investors have several terrific options from which to choose: individual stocks, traditional index funds, ETFs, and tax-managed funds. Ultimately, I decided that tax-managed funds represented the best combination of low maintenance, diversification, and tax efficiency for the portfolio's domestic-equity exposure. I used a Vanguard index fund for international exposure.
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