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Investing Specialists

3 Tax-Efficient Bucket Portfolios for Retirees

Our model portfolios are designed to facilitate in-retirement cash flows--and to limit Uncle Sam's take.

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One of the easiest things you can do to improve your portfolio's take-home return is to pay attention to tax efficiency, and it's arguably never been more important. 

Sure, capital gains and dividend tax rates continue to be pretty low. But continued strong market performance and outflows from actively managed funds mean that many mutual funds have made significant capital gains distributions in recent years. And while it's hard to get excited about bond income, period--before or after the haircut of taxes--taxes exact just as big a toll, if not larger, in percentage terms as they ever did. The Medicare surtax that went into effect in 2013 creates an added incentive for high-income investors to pay attention to tax efficiency. In an era in which returns could be constrained going forward, paying a tax-cost ratio of 1% or 2%--not uncommon among many mutual funds that are not explicitly managed for tax efficiency--will be a significant drag on take-home returns.

Of course, an obvious way to limit taxable capital gains and income distributions is to stash investments inside of tax-sheltered accounts. But once those receptacles are full, investors have no choice but to save inside of taxable accounts. And building assets in taxable accounts can even be desirable, especially in retirement. By saving in each of the main types of tax wrappers during the accumulation years--tax-deferred, Roth, and taxable--a retiree can exercise at least some control over the taxes she pays in retirement.

My original Bucket portfolios--time-segmented portfolios geared toward aggressive, moderate, and conservative retirees--were created with tax-sheltered accounts in mind. The three original portfolios consist of traditional mutual funds, while the other three are composed exclusively of exchange-traded funds. But those same portfolios can readily be adjusted to make them more tax-efficient, as we've done with today's series of model portfolios.

Higher Equity Positions
For these three tax-efficient Bucket portfolios, I employed the same general asset-allocation parameters that I used with the other Bucket portfolios. Specifically, I carved out a cash component to cover a retiree's near-term expenses--the linchpin of the Bucket system--and relied on Morningstar's Lifetime Allocation Indexes to help guide the long-term portfolios' exposures.

It's worth noting, however, that these portfolios feature slightly higher equity positions than is the case with my other retiree bucket portfolios. The reason is that I avoided some of the higher-risk/higher-income fixed-income types that appeared in my other portfolios--for example, high-yield and emerging-markets bonds. Because their income distributions are taxed at investors' ordinary income tax rates, they're a better fit for tax-sheltered accounts. These investments have risk/reward profiles that fall between equities and bonds, so it's reasonable to nudge up the tax-efficient portfolios' equity exposures to compensate for the fact that they're missing here. (A retired investor could reasonably employ a small stake in high-yield municipal bonds in lieu of some of the high-quality exposure featured in this portfolio; T. Rowe Price Tax-Free High Yield (PRFHX) is a favorite.)

Retirees will want to be sure to "right-size" the components of these portfolios based on their spending plans and other considerations. If they're prioritizing withdrawals from their taxable portfolios over other account types--in line with tax-efficient withdrawal-sequencing considerations--they may want a larger cash component than is outlined here. (I typically recommend that retirees hold one to two years' worth of planned expenditures in true cash instruments.) Moreover, retirees will want to take into account their own time horizons, risk tolerance, and investment goals when setting their allocations. As with the other retiree Bucket portfolios, the asset allocations shown here assume that the retiree will spend all of his or her assets, which may not be the case for those who would like to leave a bequest to loved ones or charity.

A Tax-Efficient Makeover
Despite having asset allocations that are similar to the other Bucket portfolios, the specific holdings differ. On the equity side, 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 ultralow-cost foreign-stock index fund, which also features very strong tax efficiency.

On the fixed-income side, I eschewed bond funds with higher incomes and, in turn, higher tax costs. Instead, I employed municipal-bond funds--in this case, from Fidelity. I stuck with the firm's short- and intermediate-term core muni funds to help protect against interest-rate-related volatility.

For the cash piece--Bucket 1--it's important to shop around for cash instruments that provide the right balance of income and security. High-income investors who are in high tax brackets might also look to a municipal money market fund instead of a taxable option, though muni yields are quite low currently.

Aggressive Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 20-25 Years | Risk Tolerance/Capacity: High | Target Stock/Bond/Cash Mix: 60/30/10

10%: Cash 
10%:  Fidelity Limited Term Municipal Income (FSTFX)
20%:  Fidelity Intermediate Municipal Income (FLTMX)
10%:  Vanguard FTSE All-World ex-US (VFWAX) (the  exchange-traded fund (VEU) is fine, too)
40%:  Vanguard Tax-Managed Capital Appreciation (VTCLX)
10%:  Vanguard Tax-Managed Small Cap (VTMSX)

Moderate Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 15-Plus Years | Risk Tolerance/Capacity: Average | Target Stock/Bond/Cash Mix: 50/40/10
10%: Cash 
15%: Fidelity Limited Term Municipal Income
25%: Fidelity Intermediate Municipal Income
10%: Vanguard FTSE All-World ex-US (the exchange-traded fund is fine, too)
30%: Vanguard Tax-Managed Capital Appreciation 
10%: Vanguard Tax-Managed Small Cap

Conservative Tax-Efficient Bucket Portfolio
Anticipated Time Horizon: 15 Years or Fewer | Risk Tolerance/Capacity: Low | Target Stock/Bond/Cash Mix: 35/55/10
10%: Cash 
20%: Fidelity Limited Term Municipal Income
35%: Fidelity Intermediate Municipal Income
5%: Vanguard FTSE All-World ex-US (the exchange-traded fund is fine, too)
25%: Vanguard Tax-Managed Capital Appreciation
5%: Vanguard Tax-Managed Small Cap

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.