What Are the Advantages of Tax-Managed Balanced Funds?

A reader writes in, asking:

“Now that tax season is beginning to wind down, I was wondering if you might weigh in on the pros and cons of Tax-managed balanced funds and how they might serve a place in a retirement portfolio for a typical investor? I wasn’t able to understand a lot about the advantages of Vanguard’s VTMFX for example.”

If we compare the Vanguard Tax-Managed Balanced Fund to the Vanguard Balanced Index Fund, the tax-managed fund is supposed to be more tax-efficient for two reasons: it uses municipal bonds rather than taxable bonds and it skews the stock portfolio toward holdings with low dividend yields.

The first point potentially improves tax efficiency because muni bonds are exempt from federal income tax. However, it’s critical to remember that, depending on your marginal tax rate, muni bonds may not be the best choice. Muni bonds offer lower yields than taxable bonds with a similar level of risk, so it only makes sense to use muni bonds when the tax savings outweigh the lower yield. (Said differently, it only makes sense to hold muni bonds if they have a higher yield than the after-tax yield on taxable bonds of a similar risk level.)

Skewing the stock holdings toward low-dividend stocks potentially improves tax efficiency because, if a greater portion of a stock’s total return is made up of capital appreciation rather than dividends, the investor has a greater ability to defer taxation. (That is, dividends are taxed right away, whereas capital appreciation isn’t taxed until shares are sold.)

If, however, you’re in the 15% tax bracket or below, it’s possible that skewing toward low-dividend stocks actually reduces tax-efficiency. In that income range, both qualified dividends and long-term capital gains are taxed at a 0% rate. As a result, you’d prefer that a greater portion of the total return show up on your tax return now as tax-free dividends than show up later as long-term capital gains — because later you may not be in the range where LTCGs are tax-free, or tax law may have changed to eliminate the 0% rate.

When Does It Make Sense to Use a Tax-Managed Balanced Fund?

Personally, I would be reluctant to use an all-in-one fund (even a tax-managed one) in a taxable account. While a tax-managed balanced fund is likely to be more tax-efficient than a normal all-in-one fund, it is still going to be less tax-efficient than a DIY allocation, for two reasons.

First, it allows for fewer opportunities for tax-loss harvesting. With an all-in-one fund, you can only tax-loss harvest if the whole fund goes down. In contrast, with a DIY allocation, there will be many occasions on which the overall portfolio is up, yet there’s an opportunity to tax-loss harvest because one particular piece of the portfolio is down.

Second, an all-in-one fund (even a tax-managed one) gets in the way of an asset location strategy. (Under an asset location strategy, you tax-shelter your least tax-efficient assets by holding them in retirement accounts. And it is only your more tax-efficient assets that you hold in a taxable account — to the extent possible, anyway.) For many investors, rather than holding a tax-managed balanced fund, it makes sense to hold only taxable bonds (in order to get their higher yields) and simply keep them in retirement accounts — and hold only stocks (which are naturally tax-efficient, due to the low tax rates on qualified dividends and long-term capital gains) in taxable accounts.

That said, while I have a low tolerance for hassle, I’m sure there are investors who have an even lower tolerance for hassle. For them, a tax-managed balanced fund could make a lot of sense. In other words, if an investor wouldn’t be bothering to tax-loss harvest or pay attention to asset location in the first place, a tax-managed balanced fund might be just as tax-efficient as a DIY allocation.