The classic minimalist portfolio consists of three funds: one broad-market U.S. stock index fund, one broad-market international-stock index fund, and a total bond market index fund. Such a portfolio, the likes of which I wrote about last week, is cheap, well-diversified, and low-maintenance.
But as effective as it is, such a portfolio is not necessarily tax-efficient, especially for investors in higher tax brackets who have significant allocations to bonds and hold the funds in a taxable (that is, nonretirement) account.
That's because even though index funds (including exchange-traded funds) do a good job of limiting taxable capital gains, any income distributions from bonds or bond funds you hold inside your taxable account are what they are; they're taxed at your ordinary income tax rate. That's true even if you reinvest them back into your holdings rather than spend them.
Managing for tax efficiency is especially important for more-affluent retirees for several reasons. First and most obviously, higher-income people pay taxes at a higher rate than lower-income folks. In addition, high earners are more likely to have significant assets in taxable (nonretirement) accounts. They've often made the maximum allowable contributions to IRAs and 401(k)s and still have assets to set aside for savings; the only real landing place for those assets is in taxable accounts. Finally, those supersavers often find their tax bills are somewhat out of their control once required minimum distributions commence at age 70 1/2; managing taxable assets for maximum tax efficiency is a way to reduce the drag of taxes on that portion of the portfolio, at least.
My new suite of model portfolios is designed with such investors in mind. (Later this week, I'll introduce similar portfolios geared toward still-working people's taxable portfolios.) The portfolios are also meant to be as streamlined as they can be while also offering diversification. And because taxable assets are often a smaller portion of investors' portfolios than their tax-sheltered accounts, these portfolios are designed to require little to no oversight on an ongoing basis, save for potential tweaks to asset allocation to account for planned spending.
Finding tax-efficient equity funds is a cinch: ETFs that track broadly diversified indexes of U.S. stocks fit the bill nicely. Because total market index funds have ultralow turnover, usually in the low single digits, they tend to make few capital gains distributions; to the extent shareholders owe taxes on such holdings, it's because of dividend distributions. In contrast with capital gains distributions, which funds can avoid paying out by keeping turnover low and other strategies, funds must distribute dividends from their underlying holdings. You'll owe taxes on those distributions, whether you reinvest or spend them.
ETFs have more tools in their tool kits to keep a lid on taxable capital gains than traditional index funds, so I've used them to supply equity exposure. Traditional index funds tend to be pretty tax-efficient, too, so they can be solid choices for investors who prefer the format. For U.S. equity exposure, I've employed Vanguard Total Stock Market ETF (VTI). IShares Core S&P Total U.S. Stock Market ETF (ITOT) and Schwab U.S. Broad Market ETF (SCHB) are also superb low-cost options. I'm also a fan of tax-managed funds for tax-efficient U.S. equity exposure and have used them in my other tax-efficient portfolios. However, the best core tax-managed option, Vanguard Tax-Managed Capital Appreciation (VTCLX), has scant exposure to small-cap stocks, so it's less appropriate as the sole U.S. stock fund in these minimalist portfolios.
I took a similar tack with the portfolios' international-equity exposure, employing Vanguard Total International Stock ETF (VXUS) as the sole foreign-stock fund. Vanguard FTSE All-World ex-US ETF (VEU) has been a better performer and more tax-efficient, but its portfolio lacks exposure to smaller stocks and is therefore less appropriate as a sole international holding. IShares Core MSCI Total International Stock ETF (IXUS) and Schwab International Equity ETF (SCHF) are also solid options. Note that international-equity ETFs tend to be less tax-efficient than their U.S. counterparts, mainly because of foreign stocks' higher dividends. Thus, to the extent that these funds cede returns to taxes, it will largely be due to that component of the portfolio.
I wrestled with which holding to employ for the portfolios' fixed-income exposure; there are several solid options. While there are a few excellent municipal ETFs on the market, including Vanguard Tax-Exempt Bond (VTEB) and iShares National Muni Bond (MUB), the ETF format doesn't confer the same benefits to bond funds as it does to stock funds. That's because most of the return you earn as a bond investor, whether in a taxable-bond or municipal-bond fund, comes from income payouts, not capital gains. And as an ETF investor, that income flows through to you just as it would to an investor in a traditional fund. (In fact, you may even get more income because index fund/ETF expenses can be so low!) Because municipal-bond income is free from most federal taxes, and in some cases state and local tax, too, both actively managed and indexed municipal bonds tend to be extremely tax-efficient. Ultimately, I opted for Fidelity Intermediate Municipal Income (FLTMX), a risk-conscious option with reasonable costs, a solid management team, and a Morningstar Analyst Rating of Gold. The fund has historically had some exposure to bonds subject to the Alternative Minimum Tax, but that's apt to be less important for many households thanks to the new tax laws, which sweep many fewer taxpayers into the AMT column. Vanguard Intermediate-Term Tax-Exempt (VWITX) is another solid option for investors who would like to keep all of their holdings at Vanguard.
Because these portfolios are designed for people who are actively tapping their portfolios, I've also included a cash component to serve as a short-term parking place for near-term expenditures. (If you're not actively tapping your taxable portfolio, you can skip the cash.) Investors should run the numbers to determine whether a taxable or municipal cash option is the better bet for them; the tax-equivalent yield function on Morningstar's Bond Calculator can help with that job. The yield advantage of one category versus another will tend to ebb and flow over time, but right now, taxable money market funds offer substantially better yields than municipal money markets, even factoring in the higher tax haircut associated with the taxable products.
Aggressive Tax-Efficient Portfolio for Minimalist Retirees
Time horizon/life expectancy: 25-30 years
Baseline asset allocation: 60% equity/40% bonds and cash
Current yield: 2.20%
32%: Fidelity Intermediate Municipal Income
40%: Vanguard Total Stock Market ETF
20%: Vanguard Total International Stock ETF
Moderate Tax-Efficient Portfolio for Minimalist Retirees
Time horizon/life expectancy: 20-25 years
Baseline asset allocation: 50% equity/50% bonds and cash
Current yield: 2.16%
40%: Fidelity Intermediate Municipal Income
35%: Vanguard Total Stock Market ETF
15%: Vanguard Total International Stock ETF
Conservative Tax-Efficient Portfolio for Minimalist Retirees
Time horizon/life expectancy: 15 years
Baseline asset allocation: 40% equity/60% bonds and cash
Current yield: 2.11%
48%: Fidelity Intermediate Municipal Income
30%: Vanguard Total Stock Market ETF
10%: Vanguard Total International Stock ETF
Investors should use their spending plans for their taxable assets to help identify an appropriate asset allocation. With the Aggressive portfolio, for example, the assumption is that the investor would consume about 4% of his or her portfolio per year; it includes an allocation to cash amounting to two years' worth of portfolio withdrawals. The Conservative portfolio, by contrast, is designed for older investors who are using a higher spending rate of 6% per year. Investors who aren't tapping their taxable assets at all can forego cash altogether and instead employ a fully invested version of the above portfolios.
While these portfolios should require little in the way of ongoing maintenance, they'll require at least some oversight to ensure that their asset allocations are tracking with your goals. It's also wise to factor in your own tax rate to determine the appropriateness of municipal versus taxable bonds. Investors in lower tax brackets may be better off with taxable bonds, even on an aftertax basis, than they will with munis.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.