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Create a Lean, Mean Tax-Efficient Machine

Morningstar's Christine Benz discusses how to improve your take-home return by reducing the drag of unnecessary tax exposure.

Christine Benz: Hi, I'm Christine Benz and welcome back to the final session of our Morningstar Individual Investor Conference. This session is called "Create a Lean, Mean Tax-Efficient Machine," and that machine is your portfolio. I'll talk about how to use good tax management techniques to reduce the drag of taxes on your portfolio's return and improve your take-home return.

Before I get into my presentation, I just wanted to make a couple of quick notes.

First, if you would like to download my slide deck, please use the link below your viewer to do so. Second, we will be taking some questions at the end of my presentation. So if you would like to submit one related to tax management, please go ahead and do so by sending email to That’s

Now I'll get right into my presentation. So, the first thing I want to touch on is why you should even care about the tax efficiency of your investments. And the reason that I always say that investors should pay attention to tax efficiency is that there is so much in our investment lives that is completely out of our control. So while it does have an impact on our portfolios, we're not in a position to influence or even predict some of these important factors. So, I'm talking about things like the direction of the economy, the direction of the stock and bond markets, the direction of interest rates, inflation, and the current rate of inflation, the direction of various foreign currencies, the direction of the dollar. These are all things that as investors we naturally pay attention to. They do influence our portfolios' returns, and being aware of them helps us set our expectations for our portfolios, but we certainly cannot influence them ourselves, and nor are we in a position to make good predictions about them, in my view.

So my thought is that investors should instead focus on that set of factors that they actually do exert some control over. And it's a pretty short list; at the top of the list would obviously be investor savings and spending rates. In retirement, your spending rate is really the main thing; while you're in accumulation mode, your savings rate is the key thing. Your asset allocation--how you apportion your portfolio across stocks and bonds and cash, and maybe other asset classes given your life stage. The quality of the investments that you choose would certainly be on that short list of factors that we investors exert some control over, and certainly that's right within's bailiwick.

The total costs that you pay for your portfolio on an ongoing basis. So this would include fund expense ratios, trading costs, commissions, any advisory fees that you are paying. Those will certainly also have a big influence on your portfolio's return.

And finally tax efficiency. I would put on that list as well, as a key factor that investors do exert some control over. So by using tax-sheltered investment vehicles, by making sure that their portfolios are--their taxable portfolios are as tax-efficient as possible, and by practicing good tax management techniques throughout their accumulation and retirement years. Those are all ways to improve your portfolio's take-home return.

So just a quick roadmap of what I plan to cover in this presentation. I'll start by talking about some of the key tax-sheltered vehicles that investors have available to them. I'll also talk about when you hit that fork in the road, and you are eligible for either Roth or traditional contributions, I'll talk about how to make good choices on that front. I'll talk about building a tax-efficient taxable portfolio. I'll share some model portfolios that are tax-efficient. I've been working on a variety of different model portfolios on; you can actually find a link to a lot of those portfolios on the homepage of, right below my picture, you can see a link to our model portfolios homepage and you can see lots of different flavors of model portfolios. I'll be talking about some that I have developed with an eye toward tax efficiency.

I'll talk about how to practice good tax hygiene on an ongoing basis. So whether you're in accumulation mode or during retirement, how to exhibit behaviors that will tend to reduce tax costs on your portfolio. And I will spend some time talking about how to draw down your portfolio in retirement with an eye toward maximum tax efficiency, because most of us will come into retirement with various account types, with various types of tax treatment. So it's valuable to think about how to sequence those withdrawals from those various account types to make sure that you are preserving the tax-sheltering benefits of some of your accounts while reducing the drag of taxes on other types of accounts.

So before I get into some of the specific types of tax-sheltered vehicles, I'd acknowledge that they are definitely not perfect, and namely, there are some strictures surrounding tax-sheltered vehicles. There are strictures about how much you can put into them. There are strictures in some cases on the income that you earn in order to be able to even to contribute to them in the first place. There are strictures related to the types of investments that you can put inside of them, and people who are participating in some sort of employer-sponsored plan know this well--that you must choose from a preset list of investment options. There are limits regarding how long the money can stay in these accounts. So if you're investing in some type of retirement account, unless you're investing in a Roth IRA, at some point that money has to come out of that account.

And finally, there may be some additional costs that are part of the plan. So if you're participating in an employer-based plan and your employer is small, you may have extra layers of administrative costs. Those can be an additional headwind on your take-home returns.

So certainly not perfect when we look across the array of tax-sheltered vehicles. But the key benefit to investing inside them is that you do pick up some tax benefits from being inside them.

So I just wanted to use a simple example here to illustrate those tax benefits. So let's assume that we have Emily here. She's been an assiduous saver throughout her investing career and she has managed to save $15,000 on an ongoing basis within her company 401(k) plan, and she has earned a 6% return. So she is contributing to a traditional 401(k) plan. She is making pretax contributions. So those contributions go straight in without taking the haircut of taxes. She's earning a 6% return. Income tax and capital gains taxes she pays on that account on a year-to-year basis don’t factor in. So she enjoys tax-deferred compounding as long as money stays within that account.

Then when it comes time to take withdrawals in retirement, she will pay ordinary income tax on those withdrawals. So Emily, the assiduous saver within the 401(k) plan, has managed to amass about $1.19 million over that 30-year period, assuming a 6% return on her portfolio. She does take a haircut as I said when she begins to withdraw the money in retirement. So her in-retirement withdrawals, assuming a 25% income tax bracket, would shrivel to about $890,000.

So that illustrates the virtue of investing inside of a tax-sheltered wrapper. In particular, she's getting that big benefit of being able to put in those pretax contributions and enjoying that tax-deferred compounding.

So let's assume another investor--let's call her Kathy--goes a different route and forgoes the company retirement plan route and instead goes straight to a taxable account. So she, too, is saving $15,000 of her salary per year, but she takes a haircut on her contributions to that taxable account, because she has no choice but to contribute aftertax dollars. So once you factor in maybe a 25% tax bracket, which is what I've used in my example, her $15,000 in salary goes down to $11,250. We're assuming generally the same earnings, investment earnings on her contributions as Emily earned. But she has to take a little bit of a haircut, because she is not enjoying tax-deferred compounding.

So if her portfolio kicks off income or capital gains distributions in the 30 years that she holds that taxable portfolio, she'll be on the hook for those income and capital gains distributions that are made. So she'll owe taxes on those distributions even if she reinvests them back into the account. So, we will give her return a little bit of a haircut, we'll take it down to 5.5% from the 6% return that our tax-deferred saver was able to enjoy.

So what we see is that after a 30-year period, assuming she has invested inside of a taxable account, her balance is actually even lower than what Emily was able to earn in that tax-sheltered account. So she has about $815,000. She does enjoy a little bit more favorable tax treatment here. So she is not taxed again on her contributions. She's already been taxed on that money, but she is taxed on any appreciation in her accounts when she begins pulling the money out.

So after those taxes are factored in, that takes her balance down to about $740,000, about $150,000 below what Emily was able to earn by using her tax-sheltered account.

So that's just a very basic illustration of why investors who are in accumulation mode should pay attention to amassing assets within these tax-sheltered accounts.

So I'll just quickly cycle through some of the key account types that investors can use. Employer-provided plans, whether 401(k)s or 403(b)s or 457s, have a couple of advantages. For one thing, there are no income limits, and the contribution limits are currently pretty generous. So $18,000 is the maximum allowable contribution for folks who are under age 50, and $24,000 is the contribution limit for people who are 50-plus. There are two contribution types that are available to investors. The first would be the traditional tax-deferred option that we just talked about in my Emily illustration. So that would be money that is pretax, tax-deferred compounding, then ordinary income tax upon withdrawal.

The other option that is enjoying increasing uptake among plans--in fact, roughly half of plans offer some sort of Roth option currently--is the Roth option for a 401(k). And there the tax treatment is basically the exact opposite. So you do pay taxes on your contribution; you are putting aftertax dollars into the plan. You are enjoying tax-free compounding on your money and then the withdrawals in retirement are tax-free as well. So those are the two key flavors.

The key thing to know about 401(k) plans, 403(b) plans, 457 plans is that there are required minimum distributions. So the money must begin being withdrawn once the participant edges past age 70.5. Another thing to keep in mind with these company-provided plans is that matching contributions have the potential to enhance take-home returns; that was one thing I didn't factor in with my Emily example. But it certainly does have the potential to enhance take-home returns, and also some company-provided plans offer pretty nice automatic features.

So one of the most basic of course is that you can have your contribution extracted directly from your paycheck. That's a pretty effective way to invest, but plans also have in many cases, additional automatic features. So automatic rebalancing, automatic escalation where a higher percentage of your paycheck goes into the account if you get a raise, those are just a couple of the automatic features that employer plans are increasingly using.

I wanted to just take a quick step away from those traditional and Roth 401(k) contributions, and talk about aftertax 401(k) contributions, because this is actually kind of a third flavor of 401(k) contributions. If you read the fine print you can see that you can actually contribute a full $53,000 to employer-provided plans in 2016. That additional money is accounted for by the ability to make aftertax 401(k) contributions. There's a lot of confusion about what these are and who they are good for, who should consider them.

First I would say they're different from Roth 401(k) contributions. So even though both entail aftertax dollars, the key difference is that if you're making a Roth 401(k) contribution, you are immediately earning the ability to enjoy tax-free compounding on your money. The difference with a Roth 401(k) contribution is, yes, you are putting aftertax dollars in, too, but the earnings that accumulate on that aftertax 401(k) contribution are going to be taxable. They will be tax-deferred, but they will be eventually taxable. So you are only able to get those aftertax contributions over into a Roth IRA if you leave your employer for some reason. So if you've left your employer or separated from service, if you've retired or if your plan allows what are called in-service distributions from the plan, then you're able to get that money rolled over into a Roth IRA.

So the big virtue of being able to make these aftertax contributions is to be able to get more assets into that Roth IRA column eventually, not right away as long as the money is within that employer-provided 401(k) plan. But eventually when it's rolled over what will happen is that those aftertax 401(k) contributions will be eligible for rollover into a Roth IRA, and the investment earnings that have accumulated on them will be eligible for a rollover into a traditional IRA.

So that's something to think about in terms of these aftertax 401(k) contributions. They've generated a lot of interest when we've talked about them on, and I think there is still a lot of confusion about them.

Just a couple of caveats. As you may have guessed, the aftertax 401(k) contributions will be generally less advantageous than making traditional 401(k) or traditional IRA or any type of conventional IRA or 401(k) contribution. The tax benefits are simply less than you have with those other types of accounts. In fact, investors should think about maxing out their IRAs and 401(k) conventional contributions before they even think about aftertax contributions. In fact, they may even want to think about maxing out their health savings account contributions before they think about aftertax 401(k) contributions.

There is also some concern that aftertax 401(k) contributions could face legislative risk in the years ahead. So one thing that we saw in President Obama's budget proposal for fiscal year 2017 was a proposal that would limit the conversion of dollars to Roth IRAs to pretax dollars. So aftertax dollars would no longer be eligible for conversion to a Roth IRA, in which case making these aftertax 401(k) contributions would be much less advisable than is the case today.

Finally, I would note that at this point a lot of plans don't offer aftertax 401(k) contributions. So you need to read the fine print on your company's plan to see if this is even an option for you.

SoI'll spend a little bit of time talking about IRAs. This is obviously the other key retirement funding vehicle. The nice thing about IRAs is that they are open to anyone with earned income. The 2016 contribution limit is $5,500 for people who are under age 50, and $6,500 for those who are 50-plus. And here again, people will hit that fork in the road where you can invest in Roth or traditional. One nice thing about IRAs is that, in contrast with 401(k)s, where you've got to choose from that preset menu of choices. The difference with IRAs is that you really do have almost open architecture; you can invest in almost anything. There are a few limitations, but very few. And the tax treatment of traditional and Roth contributions are identical to what I just outlined for 401(k) plans.

Just a quick overview of Roth IRAs. One thing to keep in mind is that income limits may apply to contributions, so for single filers in 2016 in order to make at least a partial Roth IRA contribution, you'd need to have had less than $132,000 in modified adjusted gross income. For people who are part of a married couple filing jointly, your modified adjusted gross income would need to be less than $194,000 for you to be able to make at least a partial Roth IRA contribution.

One of the big attractions of Roth IRAs is that there aren't currently any required minimum distributions. In fact, this is the only retirement funding vehicle where you can leave the money in as long as you like. There is some concern that that may eventually go away--that at some point there will be RMDs on Roth IRAs. But for now it is a vehicle that is safe from required minimum distributions. Another thing I like about Roth IRAs is that they give participants a lot of flexibility. So the contributions, because they are aftertax dollars that go into a Roth IRA, they can be withdrawn at any time and for any reason. That's one reason I find Roth IRAs really easy to recommend for young accumulators who are just getting started in their retirement savings program. If they are, say, trying to build an emergency fund, at the same time they are trying to save money for retirement, that Roth IRA lets them hedge their bets. They can pull the contributions out without any taxes or penalties, but if they don't need that money it can continue to grow for their retirement. So I think it's a nice multitasking vehicle for that reason.

In terms of traditional IRAs that are deductible, the deductible income limits are even lower here than was the case for Roth IRAs. So if you are not participating in a company retirement plan at work, your income doesn't matter. Anyone who is not eligible to participate in a company retirement plan at work, or their employer doesn't have one, can make a deductible traditional IRA contribution. For everyone else who has that employer-provided plan, there are income limits, and they are even lower than is the case for Roth IRAs.

So in 2016, if you're a single filer with modified adjusted gross income of less than $71,000, you can make at least a partially deductible traditional IRA contribution. If you are part of a married couple filing jointly, you can have modified adjusted gross income of up to $118,000 and still make that deductible IRA contribution. Required minimum distributions do apply to this type of account, in contrast with Roth IRAs.

Just a few words about nondeductible IRAs. This is often the IRA of last resort for people who are in the enviable position of having incomes that are too high to enable them to contribute to either Roth or a traditional deductible IRA. Anyone of any income level, provided they have earned income, can make a contribution to this IRA type.

Prior to 2010 I would say that the traditional nondeductible IRA was a big "Why bother?" In most cases the tax benefits didn't warrant some of the strictures. So specifically, if you invest in a traditional nondeductible IRA, you can't deduct your contribution, obviously. You do enjoy tax-deferred compounding on your money, as long as it stays within the IRA. But then when you pull the money out in retirement, your investment appreciation is subject to your ordinary income-tax rate. And that's less advantageous than the capital-gains rate that prevails for gains in a taxable account.

2010, though, changed all that. The key reason is that income limits were lifted on conversions from traditional IRAs to Roth, and that's where the backdoor Roth IRA was born. And essentially what the backdoor Roth IRA does is that it lets people who earn too much to contribute to either a traditional nondeductible IRA or a Roth IRA to get some money over into Roth column. So the basic idea is that you open this traditional nondeductible IRA, you wait a while, and financial experts do differ a little bit in how long you need to wait. Some say that you should wait as long as year; others say a shorter time horizon. But you wait at least a little period of time and then you convert those assets to Roth. There are no income limits on those conversions.

So that allows the high-income earner who had been previously shut out of those other IRAs to get some money over into the Roth IRA column. So financial planners have been very excited about this maneuver; high-income individuals have been excited about this maneuver. It can make a lot of sense for some investors. 

The problem is--well, there are couple of problems. One is that if you have other IRA assets--say you rolled over IRAs from an employer-based plan, rolled over 401(k)s from an employer-based plan--you will not want to engage in this backdoor Roth IRA maneuver. And the reason is that the IRS uses what's called the pro-rata rule to calculate the taxation of your IRAs and to calculate the taxation of the conversions that you might undertake with those IRAs. So I've used a simple example here to illustrate how this pro-rata rule works in real life.

So let's assume Rosa has been shut out of a Roth IRA. Nor can she make a traditional deductible IRA contribution because she earns too much. So she wants to do this backdoor Roth IRA. She funds her nondeductible traditional IRA. But lo and behold, she also has some other assets in an IRA that she rolled over from an employer-provided plan. None of that money has ever been taxed before. So she made pretax contributions to that plan. Her money earned investment earnings and those earnings were tax-deferred, so she's got this $45,000 in that kitty that has never been taxed. That dwarfs the amount of money that she has in her brand-new IRA. So unfortunately, when she undertakes the conversion of her little $5,000 IRA, that's 90% taxable.

So she'd want to be very careful. In fact, she'd want to avoid the backdoor Roth IRA maneuver because she will trigger a tax bill in most cases. It's also worth noting that many financial-planning experts think the clock is ticking on this backdoor Roth IRA contribution. It's a loophole; Congress did not necessarily intend to leave this loophole open, so there is some concern that the loophole could close down the road.

Most planners agree that it would not affect assets that have already gotten into Roth IRAs via the back door, but it could affect high-income investors' ability to undertake future backdoor Roth IRA conversions. So it's something to keep in mind if you're thinking about using this maneuver, if you're one of those high-income people who has not been able to contribute to an IRA and certainly not able to make a Roth IRA contribution to date.

So I just want to spend a few minutes talking about investors who hit that fork in the road. This certainly happens a lot for people with employer-provided plans where you have that ability to make either traditional or Roth contributions. In the case of IRAs, some of the income limits we've discussed may make your decision for you. But in any case, if you're one of those people who is in a position of being able to make traditional contributions to these accounts or Roth contributions to these accounts, the key thing you need to think about is when you need the tax break the most. 

So if you are someone who is just at the beginning of your career, you expect that your earnings trajectory will really take off, and you'll begin to amass significant assets for retirement as the years go by. For someone like that, their taxes may in fact be at a low ebb relative to what they could be for the rest of their lives, and certainly in retirement, in which case making Roth contributions are pretty advisable. It's better to take the haircut on your contributions, pay taxes on your contributions in exchange for tax-free compounding that you get within the vehicle, as well as the tax-free withdrawals in retirement.

For other folks the calculus isn't so clear at all. So I would say for people, especially for those who have not accumulated significant assets for retirement, maybe are getting a little later in their investment careers, and they're able to make either traditional deductible IRA contributions, or traditional 401(k) contributions, taking that tax benefit when their income and, in turn, their tax bracket is higher, may be the more advantageous thing to do. So I think through that. For a lot of people, they might just throw up their hands and say, "I have no idea what my tax rate looks like now relative to what it might be in the future." In that case, I think it can make a lot of sense to split the difference. So you can steer some of your contributions to the Roth accounts and some to the traditional accounts to kind of hedge your bets.

Another thing to keep in mind is that as long as there are no required minimum distributions on Roth IRAs, for people who have more than enough assets for their own retirements, and are mainly saving in order to let the money compound for their heirs, the Roth can be attractive because they will not have to take out that money during their own lifetimes. That can be an attractive set of assets to leave for their heirs. It can grow beyond RMD age.

So those are just a few things to keep in mind if you are trying to decide between tax-deferred traditional vehicles and Roth vehicles.

So I want to spend a little bit of time before we leave tax-sheltered investment vehicles to talk about health savings accounts. This is another topic that when we've written about it on or raised the issue in our comments boards, we've generated a lot of interest. People love their HSAs. So, a couple of things to know about these health savings accounts. One is that you are only eligible to contribute to an HSA if you are contributing to some type of high-deductible healthcare plan, and the IRS has specific guidelines about what constitutes a high-deductible healthcare plan. So, provided you are contributing to or participating in a HDHP, you are eligible to contribute to an HSA. And the contribution limits are currently $3,350 for single filers or for single individuals participating in HDHPs. And it's $6,750 for people who are part of a family plan, so $6,750 in HSA contributions for folks who are participating in a family HDHP plan.

So the reason that people love their HSAs is that it's the only triple tax-advantaged vehicle in the whole tax code. So the government really wants us to invest inside of HSAs. You are able to put in pretax contributions. You are able to enjoy tax-free compounding, as long as the money stays inside of the HSA. And you are able to enjoy tax-free withdrawals for qualified healthcare expenses.

Once you reach age 65, your HSA essentially functions like an IRA. So, if you are using the money for qualified healthcare expenditures those withdrawals are all tax-free. If you are using the money for other things beyond healthcare expenses those withdrawals are taxed at your ordinary income-tax rate. So it's a pretty attractive vehicle from the tax standpoint, and so I would say at a minimum people who are participating in an HDHP need to at least think about putting enough in the HSA to cover what they anticipate will be their out-of-pocket healthcare costs in the year ahead.

People who fall into the camp of the healthy and wealthy--and I think that this describes a lot of our users, judging from your comments--might use the HSA instead as a savings vehicle that they hold onto for many years, so they might instead choose to pay their healthcare expenses not from the HSA, but from their taxable accounts. The better to preserve those great tax features of the HSA. So you pay out-of-pocket for your healthcare costs, fund the HSA to the extent that you possibly can, and then leave the money in to compound for your use during retirement. That's how the healthy and wealthy are thinking about the HSAs; that’s why a lot of affluent investors really like this vehicle.

The problem is that many people are contributing to HSAs, to some sort of a captive HSA provided by their employers. If you are contributing to your own high-deductible plan you are able to choose any HSA you want. So if you're someone who is independently employed, for example, and contributing to an HSA, you can choose the best HSA you can find. A lot of people who are having pretax contributions come out of their paychecks, though, because they are participating in employer-provided HSAs, may find that their employer-provided HSAs are not that good. So unfortunately it's kind of the Wild West when it comes to HSAs at this point. We've got a lot of HSAs that have very heavy fees, transaction costs. Sometimes the fund choices aren't very good, or they are expensive. So there are a lot of different layers of fees that accompany these HSAs.

One thing I've written about on is that there is a pretty good workaround. And that is, you can go ahead and contribute to that employer-provided HSA. So have your pretax contributions come right out of your paycheck and steered into the HSA, and then periodically throughout the year, you can transfer the HSA assets to the HSA of your own choosing. So you can obtain that payroll deduction and get into the HSA of your choice.

I also wanted to mention a nifty feature that accompanies HSAs, which is that even if you are one of those healthy and wealthy people who is paying out of your taxable account to cover your healthcare costs as you incur them--so you are leaving that HSA in place to compound to enjoy the tax benefits there--you still have a little bit of an escape hatch. So in my example below, let's say Tim incurred $2,500 in healthcare costs in 2015. He paid them out-of-pocket. He didn't touch his HSA; even though he contributed to his HSA, he didn’t touch it at that time. Lo and behold, in 2016 he incurs or comes up with some expenses--non-healthcare-related expenses--that he needs to fund, and he doesn't have a ready source of assets in his taxable account. Well, as long as he saved his receipts for those 2015 healthcare expenses, he can actually take the money out of his HSA and use those 2015 receipts to justify the expenditure.

So you are actually allowed quite a bit of flexibility here. This is one reason why planners really like HSAs, because they do give you that escape hatch if it turns out that you shouldn't have tapped your taxable assets after all. So I just wanted to spend a little bit of time on HSAs, and why and how they can be so attractive for investors.

Let's talk about taxable accounts, because they also belong in investors' toolkits. One of the key advantages to taxable accounts is that you do have a lot more flexibility than you have with any of those tax-sheltered vehicles. So you truly can put anything inside of a taxable account; you can invest any amount you like. There are no contribution limits. There are no income limits. There are no required minimum distributions. So no strictures regarding when the money needs to come out of those accounts. So a lot of flexibility. They also can be good accounts if you have highly appreciated assets or assets that you expect to appreciate highly over the years. Those can be really nice assets to leave to heirs or to charity because you can effectively get that appreciation out of your taxable estate.

When your heirs inherit assets from you, their cost basis steps up to the security's price at the date of your death. So it effectively washes out that tax burden. So they can be really nice estate planning tools.

Finally, I would point out that long-term capital-gains rates are still quite low relative to historic norms. So folks who are in the 10% and 15% income-tax brackets currently pay a 0% capital-gains tax rate, and people who are in the middle bands pay a 15% long-term capital-gains rate. Folks who are in the 39.6% tax bracket pay a 20% long-term capital-gains rate.

So tax treatment of taxable assets. I talked about long-term capital gains. Income from taxable accounts is taxed at your ordinary income-tax rate. So that would be taxable bond income; that would be nonqualified dividends. That would be short-term capital gains from fast-trading strategies. Those would all be subject to your ordinary income-tax rate.

Qualified dividends have the same tax treatment as long-term capital gains and most U.S. securities do qualify--to the extent that they kick off dividends--do qualify for that low dividend tax treatment currently.

So I just wanted to make a quick note about mutual funds and capital gains. This has been a hot topic among users. We've seen some funds spin off pretty high capital gains in recent years. In part because some funds have been stuck in this unlucky position where they have had redemptions, and managers have had to sell securities to meet redemptions and those gains in turn get paid out to shareholders.

So this is something to watch out for to the extent that you have mutual funds in your portfolio. The bad thing about these capital-gains payouts is that they won't necessarily align with your profits. So the mutual fund may make a capital-gains payout, but you may not have had a particularly good year in the fund yourself. So it's something to watch out for if you do have funds in your portfolio. Broad-market index equity funds tend to be quite tax-efficient because they have very low turnover, they tend not to make a lot of these capital-gains distributions. Exchange-traded equity funds to the extent that they track broad-market indexes are also really nice, tax-efficient holdings. Even though actively managed funds can be less tax-efficient, ETFs and broad-market index funds tend to be quite tax-efficient.

So tax-friendly investments. I've talked about a couple. Individual stocks I would also add to the list, in part because the investors' profits are perfectly aligned with the realization of capital gains. So you control when you realize capital gains. That makes individual stocks generally quite tax-friendly. Under that heading I would also add tax-managed mutual funds. These are funds that are managed to reduce the drag of taxes. Most of them use quasi-index exposures as their baseline, but they might use additional tax-managed techniques to reduce the drag of taxes.

For fixed-income investors, municipal bonds are the way to go to reduce the drag of taxes on your portfolio. Master limited partnerships are also a rare income-producing security that is better housed within a taxable account than in some sort of tax-sheltered vehicle. They tend to be quite tax-friendly. Their performance hasn't been so good recently, but they tend to be quite tax-efficient on an ongoing basis.

So, in terms of investments to keep out of your taxable accounts and inside your tax-sheltered accounts, any security that's kicking off a high level of ordinary income, so high-yield bonds, emerging-markets bonds, multi-sector bonds or bond funds, securities that pay nonqualified dividends (like REITs), like some preferred stocks, high-turnover mutual funds I would put under this heading, and commodities funds, where your gains are taxed 60% as long-term and 40% as short-term. Those would all be categories that to the extent that I owned them, I would want to keep them housed within my tax-sheltered accounts.

So, in terms of active equity funds, I've hit on some of the risks that you can have by putting these investment types within your taxable accounts--these unwanted capital-gains distributions. So I've listed here just a few funds that have very low turnover, and they are actually all really good funds, but for one reason or another, their recent tax histories have not been great for investors who have held them inside of their taxable accounts. They have made a lot of capital-gains distributions despite the fact that they have very low turnovers. So, while turnover can sometimes be a proxy for how tax-efficient a fund is, not necessarily always.

And at the bottom part of this slide I've just got a short list of the tax-cost ratios for some index-tracking and a tax-managed mutual fund as well. So, you can see that their tax-cost ratios, which are meant to be sort of equivalent to an expense ratio, but they're meant to capture the tax burden a given fund has incurred for investors who owned it in a taxable account and were in the highest tax bracket. You can see that the tax-managed fund and some of the broad-market index funds and exchange-traded funds have had much lower tax-cost ratios.

So, just a couple of seconds on some model tax-efficient portfolios. As I mentioned, you can find all of these model portfolios on This is a portfolio for accumulators. So, you can see, it's got just a little smidge in bonds, in a municipal-bond fund, and our analysts really like Fidelity's muni funds. It has a global ex-U.S. stock market index-tracker for the foreign stock exposure, and then I've used tax-managed funds for the U.S. equity exposure, a little bit of Vanguard Tax-Managed Capital Appreciation as well as Vanguard Tax-Managed Small Cap. There investors could reasonably use broad-market index funds or ETFs in lieu of the tax-managed funds. So, these are portfolios geared toward people with long time horizons, a roughly 20-year runway to retirement. So, this is quite an equity-heavy portfolio.

This next one is one of my bucket portfolios geared toward investors investing in taxable accounts. You can see that it has a much larger weighting in safe securities. So it has that bucket one, which is the cash piece of the portfolio. It also has a short-term municipal-bond fund. It has an intermediate-term municipal-bond fund and then has similar equity positions just in a lower proportion of the total portfolio. So, this is geared toward an investor with a much shorter time horizon. It's targeting a roughly 50% equity, 40% bond, 10% cash weighting. It's a much more conservative portfolio.

In terms of managing taxable portfolios on an ongoing basis, some best practices. One of the top would be to reduce your own trading. Try to reduce the extent to which you're realizing capital gains on an ongoing basis, to the extent that you are investing inside of a taxable portfolio. Also periodically seeing if you can't find tax-loss selling opportunities. That's one of the silver linings that sometimes comes up when we have lousy stock-market environments, investors can prune their losers from their taxable accounts. They can use those losing securities to offset capital gains elsewhere in their portfolio, or if they've exhausted their capital gains up to $3,000 in ordinary income. It's important to remember that the wash-sale rule is in effect for our investors engaging in tax-loss selling. So, as nice as it would be to be able to re-buy the same security right away after you've sold it, you do have to wait 30 days to re-buy the same security. But you can maintain similar economic exposure. So, for example, you can sell a losing security, a losing stock, for example, and buy another company in that same industry, or you can sell an actively managed fund and buy an index fund that tracks that same market segment.

Another thing to keep in mind if you are an investor who is in the 10% or 15% tax bracket is that you might consider what's called tax-gain harvesting. So, the idea there is that you are periodically harvesting gains in your portfolio, you're selling securities that have appreciated and you are re-buying that same security, and what happens is that your cost basis steps up to the new purchase price. And if you're ever in a higher tax bracket in the future, you are able to calculate your cost basis using that new, higher cost basis. So, this is something to keep in mind if you're an investor who is in the 10% and 15% tax bracket.

So, I'm just going to stop right there. My colleague Jason Stipp is joining me on the stage here, and I think he has brought some questions from some users. It's been a lot of information and I'm sure there are some good questions coming in. I hope it's not too dull for everyone here today.

Jason Stipp: Well, Christine, as I said at the beginning, there are a lots of ways that we don't control our investments, but taxes are one of those ways. So, maybe not the most explosively interesting topic, but it can certainly save investors a lot of money.

Before we get started, I just want to let everyone know, yes, it is snowing in Chicago. It looks like we're filming this in February. I promise you, it is April, and we are dealing with this here in the Midwest.

But a few questions for you, Christine. There is one question about RMDs. So, RMDs are required minimum distributions. These are what the government requires you to take out of tax-deferred accounts like traditional IRAs and 401(k)s because eventually, that money has not been taxed, the government will want to get their tax cut. And this is something that for folks who have saved up a good amount of money and don't need RMDs necessarily, can be problematic for them because they are forced to take that money, they are forced to pay the taxes. But they are a fact of life. We have a question here about what are the best funds within a retirement account to draw upon for an RMD. So, if you have to draw out of it, obviously, you don't want to be in a fund that could be really volatile. So how should you--what kinds of investments should you have in your account, knowing that you have to draw that money out?

Christine Benz: That's a really great question, Jason. And think there are a couple of ways to think about this. One thing you could do is simply have that cash piece of your tax-deferred account that you've earmarked to satisfy your RMDs in the year ahead. Another thing to think about, though--and I help my mom with her RMDs each December and we have to figure out where the money comes from, and one thing we often do is use her required minimum distributions to help also achieve the portfolio-related goal. So, invariably, she's got one holding in her portfolio that has performed much better than everything else. That's usually where I go to do the trimmings, so the nice thing is that you can use your RMDs to reduce risk in your portfolio, because invariably the securities that shot up the most are the ones where there maybe is a little more risk than there was the year prior. So, I would see investors being able to do it either way. Just meeting dedicated cash piece that you periodically refill, or just harvesting those gains from highly appreciated positions.

Jason Stipp: I think that you had a little bit of information in your presentation that maybe you didn't quite get to, but how to deal with sequencing of withdrawals in retirement, and the same reader actually had a follow-up then. Given that I have to take money out of those RMDs, if I still have more money I need to take for living expenses, how should I decide where to take that money that's a most tax-efficient way to do that?

Christine Benz: Yeah, great question and it's one that addressed in the slide deck, so for people who want to download it, they should do so. But the thing to think about is that the sequencing guidelines that you often hear tax advisors talk about is definitely first satisfying those RMDs because you'll pay a big penalty for foregoing them. Then if you need additional assets, [you'll] generally want to look to your taxable accounts for those additional withdrawals. The reason is your tax-deferred vehicles, as Harold Evensky mentioned in one of the earlier sessions, they are giving you those tax benefits as long as the money is within those accounts. So, if you need additional assets, consider pulling it from the taxable accounts first, because you will pay income and capital-gains taxes on any distributions from those accounts on an ongoing basis. So they're less valuable to you from a tax standpoint than are those tax-deferred and certainly the Roth accounts. You want to leave Roth accounts to last, generally, in the queue.

Jason Stipp: There was a reader question about the Roth account. I think we've discussed how some government changes or some proposed changes could make RMDs applicable to the Roth account. So, right now, there is no RMD. So, a reader asked, well, what's the problem if that happens, because I won't have to pay tax on it. It would be tax-free. But the fact that the government's requiring you to take money out is what you really don't want, because then you lose that tax deferral within that account, right?

Christine Benz: That's exactly right, Jason. So, I guess, the key constituent for whom this would be a big deal would be the person who was earmarking Roth assets, specifically as part of their estate plan. Not money that they intended to spend themselves or during their lifetimes, but the people who had earmarked that Roth IRA to be there for their kids, knowing that they weren't going to have to pull money out at any point. And any time you talk to estate-planning attorneys, they love Roth assets because they can be very advantageous estate-planning tools. That would be less the case if there were RMDs from Roths.

Jason Stipp: Time for two more quick questions. The first one is from Karen and she said that her husband--she is having a conversation with her husband about potentially converting some money prior to age 70.5, which is when RMDs come in, and you've written about how there can be a sweet spot here after folks are retired but before RMDs kick in, and it could be for some folks a good time to convert. Why is that?

Christine Benz: Well, the reason is that if you are no longer earning an income, you have a little more control over your income than you do--so in the years, say you retire at 65 and then RMDs commence at age 70.5, you have that five-year window where you do exert some control over the income you draw from your portfolio. No one is mandating how much you take out of that portfolio. So those are often thought of as good years to think about doing some of those conversions, if you can keep your income down during those years, to go ahead and think about converting some of your assets during that time. It may also be a good period to actually spend some of those are tax-deferred assets, so even if you don't intend to convert them, to actually maybe prioritize some of them over the taxable accounts in order to winnow down the size of the balance. 

So, it's one of those things, though, where I think it sounds really good on paper--the math looks good, the math seems sound--but when you think about the years between 65 and 70, that's often time a retiree is very active, happy, great quality of life, travel, you name it, maybe kids' weddings coming up, whatever it might be. Those might be high spending years. It may be difficult to control spending because of some of those quality-of-life considerations.

Jason Stipp: Last question is on taking RMDs from Paul, and he says, is there any advantage or disadvantage taking your RMD all at once as one lump sum, versus maybe having a monthly distribution from taxable accounts, or tax-deferred accounts that would be taxable at that point?

Christine Benz: I think it's a matter of personal preference. I don't feel strongly that retirees do it one way or another. One thing I often hear from retirees is that they use their income distributions from the securities that they have within their tax-deferred accounts; they have them sent over to their cash account to try to satisfy those RMDs. That seems like a sensible strategy to me. But I think ultimately it won't be hugely impactful whether you wait until year-end or use sort of a reverse dollar-cost averaging type scenario.

Jason Stipp: Christine, always insightful to hear everything you have to say about portfolio planning, especially in retirement. Thanks for that great presentation today, very useful.

Christine Benz: Thank you, Jason.

Jason Stipp: Before we go today, I have a couple of things that I'd like to share with you about the conference. First of all, thank you all for tuning in. It's really been great to have you. We hope that you had as much fun watching the conference as we did putting it on for you. This is an event that we do every year. We really look forward to it and having a chance to really spend a lot of good quality time with you on what turned out to be a snowy Saturday today.

A couple of things to keep in mind: replays. So, we will have replays of all of the sessions that you've seen today. We're going to start to roll those out on on Monday April 11. Those replays will also include transcripts. So all the investment ideas and other things mentioned, you'll have both in a written form, and you can watch again in case you missed something or just want to see a session again.

Also, keep an eye an out to your email inbox. We will be sending you a survey. In fact, I think it may be going out right now. We really, really want to hear your feedback about this conference--things that you liked, some topics that maybe you'd hoped we'd cover but didn't have a chance to--that can help us make this event better.

On that note, thanks again for tuning in. We've really enjoyed having you. Have a great day and we look forward to seeing you on I'm Jason Stipp, site editor for Morningstar.