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Improving Your Finances

A Moderate Tax-Efficient Portfolio for Retirees

By Christine Benz | 11-11-10 | 06:00 AM | E-mail Article

"Don't let the tax tail wag the dog." That conventional wisdom is sound advice. For example, if you were considering selling some winning investments in an effort to take advantage of currently low capital gains tax rates, that sale should also make sense from an investment standpoint. At the same time, I can't help but think that managing for maximum tax efficiency is an undervalued aspect of portfolio management, particularly right now. A mediocre or worse stock market during the past decade has no doubt lulled many investors into a false sense of complacency about the impact that taxes can have on their returns. But if stocks continue their ascent and taxes revert to previous levels, investors will wish they had paid closer attention to tax management. Like limiting costs, managing for optimal tax efficiency is one of the few aspects of investing over which investors truly exert some control. In last week's column, I shared a model tax-efficient portfolio for a very conservative, older retiree with a life expectancy of roughly 10-15 years. Many retirees obviously have much longer time horizons than that, however. So this week's column will feature a moderate tax-efficient portfolio for retirees, and next week's will showcase an aggressive version. Today's moderate portfolio is appropriate for very risk-conscious retirees with a time horizon (estimated life expectancy) of 15-20 years. Stability and preserving purchasing power are key goals here, but so is capital appreciation. As with my mutual fund and exchange-traded fund portfolios, users should feel free to customize the allocations and individual holdings as they see fit or simply use them as a guide when benchmarking their own portfolios. The portfolios highlight some of the key concepts to bear in mind when managing a taxable portfolio at any age, not just during retirement. A Moderate Tax-Efficient Retirement Portfolio
Holding Vanguard Tax-Managed Capital Appreciation (VMCAX) Vanguard Tax-Managed Small Cap (VTMSX) Vanguard Tax-Managed International (VTMGX) Fidelity Short-Intermediate Muni Income (FSTFX) Fidelity Intermediate Muni Income (FLTMX) Vanguard Tax-Exempt Money Market VMSXX Allocation % 32 5 11 11 38 3

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Asset Allocation This portfolio, like the previous portfolios, uses Morningstar's Lifetime Allocation Indexes to guide its asset allocation. In keeping with the moderate allocations for a 64-year-old, it maintains a roughly 50/50 split between stocks and safer securities like bonds and cash. Bear in mind that this is just a model; your own risk capacity and the extent to which you have income from other sources will be key determinants of your own stock/bond/cash mix. Asset location and how you're sequencing withdrawals will also play a role in the type of assets you hold in your taxable accounts. For example, the conventional rule of thumb is that you should tap your taxable portfolios first during retirement, the better to stretch out the tax savings associated with IRAs. Moreover, you'll need to let your own spending needs drive your cash allocation. While this portfolio does include a small slice in a municipal money market fund, the cash is there solely to improve the portfolio's risk/reward characteristics rather than to provide current income. Bond Holdings To flesh out the portfolio's fixed-income holdings, I used the same municipalbond funds here that appeared in last week's conservative portfolio: actively managed muni funds from Fidelity, which our analysts like for their sensible management and reasonable costs. (Bogleheads shouldn't despair: Vanguard's lineup of low-expense muni funds is also terrific.) I opted for Vanguard's muni money market for the cash holdings, mainly because its ultra-low costs are a particularly big advantage right now, with money market yields as low as they are. Although potentially higher tax rates will tip the scales in favor of municipal bonds for many investors' taxable portfolios, don't automatically assume that you must hold munis in your taxable account. The tax-equivalent yield function in Morningstar's Bond Calculator can help you quantify whether you're better off, on an aftertax basis, holding munis or taxable bonds. And while I generally favor muni-national funds because of the geographic diversification they provide, those who live in very high-tax states may also consider holding a single-state muni fund instead. As with last week's portfolio, this one forgoes inflation-protected bond exposure, even though the indexes I used as a blueprint call for it. That's because Treasury Inflation-Protected Bonds are a poor choice for taxable investors. And while Ibonds are more tax-friendly, purchasers are limited to $10,000 a year. That's not an impediment for smaller investors, but larger investors will have to get their inflation protection through TIPS and should do so within the confines of an IRA.
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Stock Holdings For a taxable portfolio's equity holdings, investors have several terrific options from which to choose: individual stocks, traditional index funds, ETFs, and taxmanaged funds. Ultimately, I decided that tax-managed funds represented the best combination of low maintenance, diversification, and tax efficiency. Although ETFs are widely touted as the superior investment for tax-sheltered accounts and would be fine substitutes here, tax-managed funds' 10-year aftertax numbers were a touch better than ETFs'. That's because tax-managed funds have the ability to customize their portfolios to suppress dividend payers, whereas most core ETFs have large stakes in income-producing equities. That advantage for tax-managed funds could become an even greater consideration if dividend taxes head back up to the ordinary income tax rate in 2011. (If that happens, I wouldn't be surprised to see a new wave of tax-friendly stock ETFs that don't include dividend payers.) However, as several posters noted below last week's article, Vanguard's tax-managed funds carry redemption fees that make them inappropriate for those who expect to need to tap their money within five years of purchase. See More Articles by Christine Benz New! 30-Minute Money Solutions Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more. Order Your Copy Today--$16.95

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Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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