Tax-Efficient Bucket Portfolios for Vanguard Investors

My original model bucket portfolios geared toward Vanguard investors were designed with tax-deferred accounts like IRAs in mind. Tax efficiency takes center stage this time around, with three bucket retirement portfolios geared toward Vanguard investors' taxable accounts.

Many investors don't pay too much attention to tax efficiency, assuming the taxation of their investments is out of their hands or not that big a deal; other investors operate with the assumption that limiting the drag of taxes on their investment returns is extraordinarily complicated. None of this is true. When investing inside of taxable accounts (that is, non-tax-advantaged retirement accounts), sensibly employing a few basic investment types can help limit taxable capital gains and taxable income distributions on an ongoing basis.

As with Fidelity's lineup, it's a cinch to create model tax-efficient portfolios that use Vanguard funds. The firm boasts a low-cost, no-nonsense lineup of municipal bond funds, as well as a number of tax-efficient equity offerings: index funds, exchange-traded funds, and the fund world's best lineup of tax-managed funds. I anchored these portfolios with tax-managed equity funds, but index funds or ETFs would contribute to a very tax-efficient portfolio, too.

Bucket Overview A basic bucket strategy is pretty straightforward and is, at heart, a total-return approach versus one that is strictly income-centric. The retiree sets aside near-term living expenses in true cash instruments (bucket one) and uses that money to fund ongoing living expenses. Meanwhile, assets that will be used for later retirement years are parked in investments with higher long-term growth and income-production potential. Knowing that living expenses are set aside in bucket one gives the retiree peace of mind to deal with the inevitable fluctuations that accompany longer-term investment assets.

The retiree then periodically refills the cash bucket--bucket one--with income and capital gains distributions from stock and bond investments. Regularly rebalancing can also help refill bucket one if income and capital gains distributions fall short. Current income production is not the overarching goal; rather, building a portfolio with strong risk/return characteristics is.

As with all of the retirement bucket portfolios, I used Morningstar's Lifetime Allocation Indexes to guide the allocations here. (For more detail on the indexes, see pages 60-63 of the most recent issue of Morningstar magazine.) However, the allocations shown here are by necessity just approximations; it's important that retirees right-size the various buckets based on their anticipated spending needs. Say, for example, a retiree expects to spend 3% of her portfolio per year. Her bucket one (cash) would hold 6% of her portfolio (two years' worth of living expenses), her bucket two might hold another 24% of her portfolio (3% of her portfolio times eight years), and the remainder of her assets would go into bucket three.

Withdrawal sequencing is also in the mix here, because most retirees hold their assets in both tax-deferred and taxable accounts. If required minimum distributions from IRAs (and Social Security and/or a pension) supply most of a retiree's spending needs, the taxable portfolio could well be more aggressively positioned than what is depicted in these models.

To help populate the portfolios, I relied heavily on

, emphasizing those that have historically been tax-efficient and stand to be so in the future, too. As of early September 2015, 78 Vanguard funds receivee ratings of Bronze or higher, the highest Medalist count of any single fund family. Nor does that figure encompass exchange-traded funds, so I had plenty of options to choose from. As with my other tax-efficient portfolios, I omitted some diversifying fund types that do not have good tax efficiency, such as Treasury Inflation-Protected Securities. I employed the lowest-minimum share classes throughout these portfolios, but investors who are eligible for lower-expense share classes, such as Admiral shares, should certainly use them instead.

Finally, it's important to note that the goal of the model portfolios is to depict sound asset-allocation and portfolio-management principles during retirement, not to blow the doors off of any other retirement portfolio ever devised. As such, I won't jockey among asset classes or employ higher-octane actively managed funds for these portfolios; the goal is to keep things simple.

Aggressive Bucket Portfolio Anticipated Time Horizon: 25 or more years

Bucket 1: Years 1-2 8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

As noted above, a retiree's spending needs should dictate the percentage allocation in bucket 1, which holds various cash instruments. (Online savings accounts will tend to have some of the highest cash payouts available today.) A retiree who is drawing more heavily from her taxable portfolio than the 4% per annum spending I've assumed here would necessarily have a higher percentage of that portfolio in bucket one, while one who is using RMDs to fund most ongoing living expenses (and downplaying taxable portfolio withdrawals) would have a much smaller allocation. Of course, cash yields are extremely modest right now, so it's important not to stake too much in bucket one; the long-term opportunity costs are too great.

Bucket 2: Years 3-10

10%:

22%:

This portion of the portfolio is also focused on stability and downside protection, but it does step out a bit on the risk spectrum in search of slightly higher income production. Because income from municipal bond funds is largely exempt from federal tax, I've favored two municipal bond funds for this portion of the portfolio. Vanguard fields two fine short-term muni funds, Short-Term Tax-Exempt and

Bucket 3: Years 11 and Beyond

35%:

10%:

15%:

The growth engine of the portfolio, bucket three steps out on the risk spectrum. I employed tax-managed funds for U.S. equity exposure and a core index fund for non-U.S. exposure. While tax-managed funds, index funds, and exchange-traded funds all tend to distribute fewer taxable capital gains than most active funds, tax-managed funds are explicitly managed to reduce the drag of taxes. Because Vanguard no longer offers a tax-managed international fund, I employed an ultra-low-cost foreign-stock index fund, which also features very strong tax efficiency. Investors could reasonably employ an all-index or all-ETF lineup with this portion of the portfolio, however; Vanguard's index funds and ETFs are obviously topnotch.

Moderate Bucket Portfolio Anticipated Time Horizon: 20 or more years

This portfolio contains the same holdings as the aggressive Vanguard portfolio, differing only in its allocations to them. Its cash stake is the same, but because it's geared toward retirees with shorter time horizons, it includes larger positions in high-quality short- and intermediate-term bonds and smaller positions in equities.

Bucket 1: Years 1-2 10%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

Bucket 2: Years 3-10 15%: Vanguard Short-Term Tax-Exempt 25%: Vanguard Intermediate-Term Tax-Exempt

Bucket 3: Years 11 and Beyond 35%: Vanguard Tax-Managed Capital Appreciation 5%: Vanguard Tax-Managed Small Cap 10%: Vanguard FTSE All-World ex-US

Conservative Bucket Portfolio Anticipated Time Horizon: 15 Years

In contrast with the aggressive and moderate portfolios, both of which emphasize growth to varying extents, this portfolio is geared toward older retirees with shorter time horizons/life expectancies. As such, its focus is on preserving purchasing power and funding living expenses; capital appreciation is secondary. Because its growth prospects are relatively low, it would not be appropriate for younger retirees unless they are extremely risk-averse and--more importantly--have more than enough money to last throughout their retirement years. Also note that I've eliminated this portfolio's dedicated small-cap stake; with a shorter time horizon, this retiree would have less time to benefit from small caps' potential outperformance. The tax-managed fund also supplies a dash of small-cap exposure.

Bucket 1: Years 1-2 12%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate)

Bucket 2: Years 3-10 20%: Vanguard Short-Term Tax-Exempt 28%: Vanguard Intermediate-Term Tax-Exempt

Bucket 3: Years 11 and Beyond 30%: Vanguard Tax-Managed Capital Appreciation 10%: Vanguard FTSE All-World ex-US