Tax-Efficient Portfolios for Fidelity Investors

If you’re a high-income heavy saver, you may still have additional funds to invest, even after you’ve contributed the maximum allowable amounts to all of your tax-sheltered options: company retirement plans, IRAs, and even health savings accounts. For those additional savings, a taxable (nonretirement account) is usually going to be your best bet.

Investments in a taxable account won’t earn a tax break on the way in, as traditional tax-deferred account contributions will, or on the way out, as in the case with Roth contributions. Nor will they be eligible for matching contributions. But with a little bit of care, it’s not that difficult to limit tax bills on taxable accounts on an ongoing basis. And when you eventually sell, assuming you’ve held the position for more than a year, you’ll pay the lower capital gains tax rate on any appreciation. Meanwhile, gains on traditional tax-sheltered accounts are taxed at your ordinary income tax rate. You’ll also have a lot of flexibility with a taxable account: to fund it to whatever level you wish and to pull as much as you want each year without strictures or penalties.

I recently shared some tax-efficient portfolios for Vanguard diehards. This week’s article includes some analogous portfolios for Fidelity investors, both retirees and retirement savers.

All six portfolios consist of index funds for their equity exposure and municipal-bond funds for their fixed-income positions. The good news is that Fidelity fields excellent, low-cost options in all of those categories; nearly every holding in these portfolios earns a Morningstar Medalist Rating of Gold. Investors can also use total market exchange-traded funds for their portfolios’ equity exposure instead of the traditional index mutual funds featured here.

In-Retirement Fidelity Portfolios

Tax-Efficient Bucket portfolios

These portfolios are geared toward retired people who are actively drawing upon their portfolios for living expenses. Thus, they all use a bucket-type strategy that is organized by time horizon: cash for near-term expenditures (Bucket 1), high-quality bonds for short- to intermediate-term spending (Bucket 2), and equities for the longest part of the retiree’s time horizon (Bucket 3). Retirees won’t necessarily spend from the three buckets in exactly that sequence: In a rising equity-market year like 2023, for example, rebalancing out of appreciated equity positions can provide cash flow needs. And in a 2022-style environment—a rare losing year for both stocks and bonds—cash can provide spending money. The key to the bucket setup is that if stocks fall and stay down for an extended period of time, as they did during the 2000s’ so-called “lost decade,” retirees can spend through Buckets 1 and 2 without having to sell depreciated equity holdings.

Notice that the Conservative portfolio has the greatest allocations to Buckets 1 and 2 and relatively less in Bucket 3 (stocks). Meanwhile, the Aggressive portfolio has a larger Bucket 3 allocation and less in Buckets 1 and 2, and the Moderate portfolio falls between the two. Retirees should think through their risk tolerances when deciding on a specific portfolio and asset allocation, but more importantly, they should factor in anticipated portfolio spending. Retirees who are spending more heavily from their taxable portfolios should generally favor the Conservative or Moderate portfolios, while those with more modest spending levels are better suited to the Aggressive version. The Aggressive version assumes a starting annual spending level of 4%, whereas the Conservative version is built around a 6% annual spending level. The Moderate portfolio assumes 5%.

These portfolios use Fidelity’s Gold-rated total stock market index funds for their equity exposure, which feature low expense ratios and fairly low tax costs. While not quite as tax-efficient as ETFs, these index funds will certainly beat most active funds on an aftertax basis. On the bond side, I’ve populated the portfolios with Fidelity municipal-bond funds, which offer income distributions that are free from federal income tax. Investors will want to run the numbers on whether a municipal-bond fund is better than a taxable-bond fund once their own tax rate is factored in, however.

Retirement Saver Fidelity Portfolios

Tax-Efficient Retirement Saver Portfolios

In contrast to the above portfolios, which are geared toward retired investors who are in spend-down mode, these three portfolios are meant for the taxable accounts of people who are still working and saving for retirement. Like the portfolios above, however, these Retirement Saver portfolios vary in their amounts of stock exposure and in turn their risk levels. The Aggressive portfolio is geared toward someone with many years until retirement and a high tolerance/capacity for short-term volatility. The Conservative portfolio is geared toward people who are just a few years shy of retirement. The Moderate portfolio falls between the two in terms of its risk/return potential.

These portfolios lean on the Morningstar Lifetime Allocation Indexes to guide their asset allocations. However, they forgo allocations to some notably tax-inefficient components of those indexes: real estate equities and Treasury Inflation-Protected Securities, for example. Such holdings are best positioned in tax-sheltered accounts, if possible.

The holdings are identical to the Retirement Bucket portfolios above. While I’ve used traditional index funds for their equity exposure, investors could reasonably use ETFs instead.

How to Manage These Portfolios

These portfolios’ holdings will tend to limit taxable income and capital gain distributions, and that will go a long way toward limiting the drag of taxes on their returns. However, investors will also want to practice sound tax management themselves, including maintaining a buy-and-hold mindset, harvesting capital losses (ideally employing the specific share identification method of cost-basis accounting), and realizing gains in low tax years if possible.