4 Best Practices for Building a Tax-Efficient Portfolio

Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Tax Relief Week here on Morningstar.com, and I'm joined today by Christine Benz--she's our director of personal finance. We're going to look at four best practices for building a tax-efficient portfolio.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: When we are talking about tax-efficient portfolios, we're usually talking about taxable accounts. Why should investors even consider taxable accounts, given the built-in advantages of an IRA or a 401(k)?

Benz: That's a really good question. The first reason is liquidity or flexibility. You might have some short-term or even intermediate-term goals that you need to finance prior to retirement, and investing in a taxable account will give you, by far, the most flexibility in terms of pulling your assets out. You also have the flexibility to invest in a lot of different investment types, whereas there are some strictures certainly for investing in a 401(k) where you are usually choosing from a preset menu. And even with an IRA, even though you have a huge degree of latitude about what you can choose for that IRA, there are at least some strictures regarding what you can invest in inside of an IRA.

So, flexibility and liquidity would be two key reasons. Another key reason would be simply for higher-income investors who are already maximizing their contributions to those various tax-sheltered account types. The taxable account may be their only option at that point. Finally, I would say, especially for people who are accumulating assets for retirement. There is some advantage to coming into retirement with some assets in a taxable account. The reason is that if you have assets in that taxable account that are eligible for capital gains treatment, that's pretty favorable--especially right now with capital gains rates as low as they are.

So, in fact, pulling money from a taxable account will generally be preferable--in terms of your income tax in a given year--to pulling money from a traditional IRA or a traditional 401(k) where you'll pay ordinary income tax rates on those distributions.

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Glaser: Your first best practice for building out a portfolio like this is that time horizon should really lead the way. Why is that?

Benz: The key reason is that if you need safer assets--if you need cash and bonds in your taxable portfolio--you should own them, regardless of their tax treatment. The income that you receive from cash and bonds is going be taxed at your ordinary income tax rate. But let's face it: Income is pretty low in absolute terms certainly today, so the taxes that investors will owe on that income will not be, generally speaking, especially high in absolute terms.

Another key reason that investors shouldn't get too worried about owning shorter-term securities in their taxable account is that they can own municipal bonds. If they are in a higher tax bracket especially, that's going to be more advantageous than holding either taxable-cash securities or taxable-bond securities in that taxable account. I often point people to the tax-equivalent yield function on Morningstar's bond calculator. They'll want to run the numbers about whether they are better off looking to some sort of a municipal bond or municipal-bond fund versus investing in taxable bonds. You can plug in your tax bracket and a little bit of additional information and see which of those products looks most advantageous once the tax effects are factored in.

Glaser: The second best practice is to make sure that you employ either tax-friendly equity strategies or at least avoid the ones that are the most unfriendly. How do you go about doing this?

Benz: Well, certainly, I think there's a lot of clarity around what are tax-efficient equity strategies. Broad-market index-tracking mutual funds and broad-market exchange-traded funds are, generally speaking, very tax-efficient equity types. I like the category of tax-managed funds. It's a pretty small group at this point. I think Vanguard's suite, in particular, of tax-managed funds is a really good one, and certainly individual equities can be a nice tax-efficient portfolio strategy as well. The reason is that, as an individual-equity owner, you exert a lot of control over when you realize capital gains. So, you exert a lot of control over your tax situation.

When I think about the various model portfolios that I've built, for example, that are maintained and built with an eye toward tax efficiency, I have generally focused on these investment types.

Glaser: You mentioned ETFs. One of the big selling points for years has been their tax efficiency. Do you think this is a little bit overdone? Can you get tax-efficient strategies outside of an ETF?

Benz: You definitely can. When you look at the pairs of exchange-traded finds and broad-market traditional index funds that track the same index, we see that both of these investment types tend to be pretty tax-efficient, and that's mainly because they are index funds. So, their turnover is very, very low. I will say, though, that ETFs do have a little bit of an extra tax advantage due to their structure; but in the case of, say, the Vanguard traditional index funds versus the Vanguard ETFs, when you look at the numbers--when you look at our tax-cost ratios, for example--you see that it's generally kind of a wash, in part, because of Vanguard's particular structure for its ETFs where they are share classes of the traditional mutual funds. But in general, both traditional index funds and exchange-traded funds are really good tax-efficient strategies, provided your fund is tracking some benchmark that doesn't reconstitute itself very frequently.

Glaser: On the flip side, how do you recognize a tax-inefficient fund? Not a lot of them advertise themselves as being tax-inefficient.

Benz: Right. Certainly, high turnover is a big red flag. High turnover is particularly painful from a tax standpoint because if the fund is realizing short-term capital gains, those capital gains are taxed as ordinary income. So, to the extent that you want to own that sort of strategy in your portfolio, you would want to own it in some sort of tax-advantaged account. [The same thing goes for] any sort of fund that tends to own other securities that are taxed at your ordinary income tax rates, even though maybe the fund is predominantly equity. You sometimes see this with equity funds that own dividend-paying equities but may also own a sleeve of convertible and preferred stock; those would tend to be less attractive for a tax-efficient portfolio.

Another category would be funds that prioritize dividends. Even though investors love dividend-paying stocks, because you don't exert control over when you receive those dividends, it would be a good practice to shelter that high dividend-payer inside of a tax-sheltered account--to the extent that you can. And finally, I would say that investors would want to take care with any sort of actively managed equity fund. I think this is a lesson that we've learned over the years, watching these funds be tax-efficient for many years--until they aren't. So, you might have a fund that's tax-efficient because it's got a manager who buys and holds the basket of securities that he or she likes, and then that manager leaves; the new manager comes aboard, switches up the strategy somewhat, and the fund that was once quite tax-efficient is not so tax-efficient anymore.

So, I would say, as a general admonition, investors need to be careful about owning actively managed funds within their taxable accounts, just to be safe. I do think it's better to think about index-tracking products or tax-managed funds.

Glaser: Your third best practice is about not being your own worst enemy. What do you mean by that?

Benz: Well, similar to what I was saying about funds, just as they can incur short-term capital gains that are taxed as ordinary income, so can you as an investor if you are trading around and making changes yourself. You can exacerbate your portfolio's tax inefficiency. You can increase the drag of taxes on that portfolio. So, generally speaking, if you've got a taxable portfolio, a strategy of benign neglect is a good policy for that portfolio. Trading less will tend to trigger fewer taxable events in that account.

Glaser: The first three best practices focus on that accumulation phase, but your fourth is about when you are in drawdown. What should investors keep in mind?

Benz: Well, if investors read up on tax-efficient distribution of their retirement assets, they might see some guidelines about sequencing withdrawals--I have even written about this. What you often see is that if you are age 70 1/2 or older, absolutely you have to take your required minimum distributions from your traditional IRAs. [After that], move on to your taxable accounts, then move on to traditional tax-deferred accounts, and then save your Roth assets for last. But I think it's particularly valuable to try to maintain that tax diversification throughout retirement.

So, it's not like you want to sequentially plough through these accounts, and then at the end be left just with Roth assets. Ideally, you'd maintain that tax diversification, and that allows you to be flexible on a year-to-year basis, depending on what else you have going on with your taxes that year. So, if you find yourself in a particularly high tax year for whatever reason and you need additional assets from your portfolio, maintaining the taxable assets where you may be able to obtain capital gains treatments on some of your withdrawals can be really advantageous. Ideally, retirees would maintain some diversification among these different account types throughout retirement--not just as they are accumulating in the years leading up to retirement.

Glaser: Christine, thanks for your tips today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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