While investors are often urged to focus on their tax-sheltered accounts for their retirement savings, there are many good reasons to stash assets in a taxable account, too.
A key reason to do this is if you’re a supersaver who has maxed out the available tax-sheltered vehicles and still have assets to invest. Once you’ve made all of those 401(k) and IRA contributions, investing in a taxable account may be your only option. (Just be sure to investigate whether health savings accounts and/or aftertax 401(k) contributions might be an avenue, too.)
You’ll also want to employ a taxable account if you expect to tap the account prior to retirement. Whereas tax-sheltered retirement-savings vehicles generally carry at least some strictures to pulling your money out early (save for withdrawals of Roth IRA contributions, which are always tax- and penalty-free), you can come and go as you please in a taxable account. You may pay transaction costs and capital gains taxes as you trade, but there are no penalties for early withdrawals.
Because many people use taxable accounts for near-term spending needs as well as a retirement funding vehicle, the asset allocation of that account may be a bit of a barbell--very safe assets as well as longer-term assets earmarked for retirement.
The right amount to hold in safe securities is highly individualized; it depends on your desired emergency-fund size as well as any planned near-term outlays, such as the property-tax bill that’s due next month or the amount that you’re saving for a new car. Because cash yields have finally started to compel, it’s worthwhile to shop around for cash holdings that balance income production with risk controls.
If you’re still working, you can obviously afford to take more risk with taxable assets that you have earmarked for retirement. How much risk depends, first and foremost, on your proximity to retirement, as well as your ability to handle the volatility that will inevitably accompany a portfolio with a significant allocation to equities.
No matter what asset allocation you opt for, there’s a strong case to be made for building a taxable portfolio that’s both streamlined and tax-efficient. After all, your taxable holdings aren’t likely the largest component of your retirement portfolio, so it doesn’t make sense to overcomplicate it with too many holdings. And by ensuring that your streamlined portfolio is also tax-efficient, you’ll improve your take-home returns.
Earlier this week I introduced three tax-efficient Bucket portfolios for minimalist retirees--people who are already retired and actively drawing upon their portfolios for living expenses. Now let’s take a look at some model portfolios for the taxable retirement assets of people who are still working. In contrast with the in-retirement portfolios, these portfolios don’t have dedicated cash holdings; this article discusses how to right-size your cash holdings. You can also adjust the portfolio holdings based on your own provider preferences.
As with the tax-efficient Bucket portfolios geared toward minimalist retirees, the tax-efficient Minimalist Saver portfolios are anchored by equity exchange-traded funds that track broad-market indexes. Such funds tend to make limited capital gains distributions; to the extent that shareholders will owe taxes on these holdings, it will be because of the dividends they pay out. Because foreign funds tend to have higher dividend payouts than U.S., the Aggressive portfolios, which include larger allocations to foreign stocks, will tend to be less tax-efficient than the Conservative portfolios.
For U.S. equity exposure, I've employed Vanguard Total Stock Market ETF (VTI). IShares Core S&P Total US Stock Market ETF (ITOT) and Schwab US 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. But the best core fund of that ilk, Vanguard Tax-Managed Capital Appreciation (VTCLX), focuses on large-company stocks and is therefore less suitable as a stand-alone U.S. equity holding. Finally, investors could quite reasonably use traditional index funds instead of the ETFs shown here; Vanguard, Schwab, and Fidelity all field fine total market trackers.
I took a similar tack with the portfolios' international-equity exposure, employing Vanguard Total International Stock ETF (VXUS) as the sole foreign-stock fund. Investors could reasonably use Vanguard FTSE All-World ex-US ETF (VEU), iShares Core MSCI Total International Stock ETF (IXUS), and Schwab International Equity ETF (SCHF). Here again, a traditional index fund supplying broad foreign-market exposure could work.
For the portfolio’s fixed-income exposure, I opted for Fidelity Intermediate Municipal Income (FLTMX), a longtime Morningstar Medalist with a Morningstar Analyst Rating of Gold. It benefits from low costs, a sensible process that emphasizes risk controls, and a solid management team. Worthy alternatives include Vanguard Intermediate-Term Tax-Exempt (VWITX), Vanguard Tax-Exempt Bond ETF (VTEB), and iShares National Muni Bond ETF (MUB). The latter two funds are ETFs, but it’s worth noting that 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. Because municipal-bond income is free from most federal taxes, and in some cases state and local taxes, too, both actively managed and indexed municipal bonds tend to be extremely tax-efficient.
I've based the portfolios' asset allocations on the Morningstar Lifetime Allocation Indexes. However, I'd recommend that investors take into account their own situations when setting their asset allocations or work with a financial advisor to help them do so. For example, investors who are close to retirement but expect to derive most of their needed income from Social Security and/or a pension are apt to find the Conservative portfolio too meek for their needs. Meanwhile, younger retirees who haven't yet lived through a bear market (and therefore don't know how they'll respond when one eventually surfaces) may want to opt for fewer stocks than are reflected in the Aggressive portfolio.
Aggressive Tax-Efficient Saver Portfolio for Minimalists
Estimated retirement date: 2055
Baseline asset allocation: 95% equity/5% bond
Moderate Tax-Efficient Saver Portfolio for Minimalists
Estimated retirement date: 2035
Baseline asset allocation: 75% equity/25% bond
45% Vanguard Total Stock Market Index
30% Vanguard Total International Stock Market Index
25% Fidelity Intermediate Municipal Income
Conservative Tax-Efficient Saver Portfolio for Minimalists
Estimated retirement date: 2025
Baseline asset allocation: 55% equity/45% bond
35% Vanguard Total Stock Market Index
20% Vanguard Total International Stock Market Index
45% Fidelity Intermediate Municipal Income
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.