Tax-Efficient Retirement-Bucket Portfolios for ETF Investors
These tax-efficient portfolios are geared toward retirees who are seeking simplicity and balance.
My original tax-efficient portfolios featured traditional mutual funds, not exchange-traded funds. And it’s true that ETFs aren’t the only game in town when it comes to limiting the drag of taxes on a taxable portfolio. Tax-managed funds, traditional index funds that track broad equity indexes, and old-fashioned municipal bond funds can all be tax-efficient, too.
But ETFs—especially equity ETFs—have some advantages that make them particularly good choices for investors concerned with tax efficiency. For one thing, the vast majority of ETF assets are in funds that track market indexes with very low turnover. Additionally, most ETF shares are traded in the secondary market among ETF buyers and sellers. Both of those features mean that that an ETF manager rarely, if ever, has to sell appreciated securities from the portfolio, unlocking taxable capital gains. In addition, for larger investors transacting in the primary market, ETFs’ “in kind” creation and redemption mechanism helps further enhance tax efficiency.
Those last two features—the fact that ETF investors trade with one another and the creation/redemption mechanism—make ETFs an even better bet for taxable accounts than traditional equity index mutual funds, which are pretty tax-efficient themselves. Moreover, the advent of good-quality municipal-bond index ETFs makes it simple to assemble a well-diversified portfolio that consists exclusively of ETFs.
About the Portfolios
As with all of the other portfolios geared toward people in retirement, I used a bucket framework to guide how much to deploy into each asset type. The bucket approach assumes that the investor holds cash-type assets to meet near-term spending needs in bucket 1, intermediate-term assets like bonds and balanced-type funds in bucket 2, and long-term investments, mainly stocks, in bucket 3.
The Conservative portfolio has more in cash and bonds, whereas the Aggressive portfolio is heavy on equities. The Moderate portfolio falls in the middle. I used broad-market ETFs for equity exposure, and I focused the portfolios’ bond exposure on high-quality municipal bond funds.
To populate the portfolios, I worked with Morningstar’s passive strategies research team to identify low-cost ETFs that earn Morningstar Medalist ratings of Bronze or better. My aim is to make few changes to the portfolios on an ongoing basis; I’ll generally only make a change if an ETF is no longer a medalist or if there’s a substantive change to the fund’s fundamental characteristics—for example, an expense-ratio hike.
How to Use Them
These portfolios are meant to be used within the confines of investors’ taxable accounts; for retirement accounts like IRAs and 401(k)s, there’s no need to pay any attention to tax efficiency. These portfolios, in contrast, are designed to limit income and capital gains distributions and in turn investors’ tax bills.
As with all of my Bucket portfolios, I’d recommend that retirees use their own portfolio spending and personal situations (goals and risk tolerance/capacity) to determine how much they hold in each bucket. Many investors use their taxable accounts to store money to meet ongoing obligations or emergency expenses, so their liquid reserves in those accounts (Bucket 1) may be higher than is the case with their tax-sheltered accounts. In addition, many retirees are spending more aggressively from their taxable accounts than their tax-advantaged accounts, in keeping with tax-efficient withdrawal sequencing. 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.
To use a simple example of how a retiree can use her own spending to determine the allocations to each bucket, let’s assume a retiree has a $200,000 taxable portfolio, from which she's spending $10,000 a year. She'd use that spending amount to arrive at how much to park in Bucket 1, and in turn Buckets 2 and 3. Using the Moderate version of the portfolios below, she'd hold six months' to two years' worth of portfolio spending in cash ($5,000-$20,000), another eight years' worth of expenditures ($80,000 in high-quality short- and intermediate-term municipal bond ETFs), and the remainder of the portfolio (half or nearly half of the assets, in this case) in stocks.
Aggressive Tax-Efficient Retirement-Bucket Portfolio for ETF Investors
Anticipated Time Horizon: 20-25 Years
Risk Tolerance/Capacity: High
Target Stock/Bond/Cash Mix: 60/32/8
- 8% Cash
Moderate Tax-Efficient Retirement-Bucket Portfolio for ETF Investors
Anticipated Time Horizon: 15-Plus Years
Risk Tolerance/Capacity: Average
Target Stock/Bond/Cash Mix: 50/40/10
- 10% Cash
- 35% Vanguard Total Stock Market ETF VTI
- 15% Vanguard Total International Stock Market Index
Conservative Tax-Efficient Retirement-Bucket Portfolio for ETF Investors
Anticipated Time Horizon: 15 Years or Fewer
Risk Tolerance/Capacity: Low
Target Stock/Bond/Cash Mix: 40/48/12
- 12% Cash
- 28% Vanguard Total Stock Market ETF VTI
- 12% Vanguard Total International Stock Market Index
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.