Research summary
A smarter way to build tax-aware portfolios
October 23, 2025
Vanguard Investment Strategy Group has published new research showing how smarter allocation decisions can help improve after-tax outcomes for investors. The findings, detailed in Tax-Aware Portfolio Construction: A Multi-Asset Approach, demonstrate how modeling real-world taxes and balancing municipal and taxable bonds may be able to help investors keep more of what they earn. This work is already being used today at Vanguard in taxable accounts focused on after-tax growth.
Building portfolios with real-world taxes in mind
Taxes can quietly erode investment gains, especially for investors in higher tax brackets. Our research offers a tax-aware portfolio-construction framework—one we're already using with clients—that reflects real-world tax rates and tax policy. This tax-aware approach evolves alongside changes in market conditions and tax laws, with the aim of keeping portfolios tax-efficient over time.
Taxable bonds have a role to play, even in taxable accounts
For decades, the industry default for taxable accounts to reduce tax drag has been to swap out taxable bonds for municipal bonds. Our research reveals that this ad hoc, muni-only substitution approach can introduce additional credit risk and weaken diversification compared with portfolios that also hold credit bonds and Treasuries and have a deliberate nonzero taxable-bond allocation to preserve diversification and reduce concentration risk. Moreover, as household income falls, the benefit of avoiding taxable-bond income diminishes.
The figure that follows illustrates that allocating most of a portfolio’s fixed income component to munis may be optimal (or near-optimal) for very high-income households; however, even at very high income levels, the taxable-bond allocation does not go to zero. For households with more modest incomes, taxable bonds (Treasuries and investment-grade credit) play a much larger role.
Different tax situations call for different mixes
Optimal allocations for various household income levels, using marginal tax rates
Notes: Portfolio optimization results are based on 10-year forward simulation data using 10,000 simulations annually from December 31, 2009, through December 31, 2023. See the Notes section later in this article for more information on the asset-class forecasts. The Internal Revenue Service income brackets for a married household filing jointly and the corresponding federal tax rates as of 2023 were used for the analysis. Percentage totals may not equal 100 because of rounding.
Source: Vanguard.
From research to real-world results: Rigorous, published, and well-documented
Vanguard’s tax-aware methodology isn’t just theoretical. It has been rigorously reviewed and published in The Journal of Portfolio Management, and it is fully integrated into live portfolios that adapt to changes in market conditions, tax laws, and client circumstances.
The outcome? Compared with tax-agnostic construction and ad hoc muni substitutions, Vanguard’s approach is designed to provide the best balance of risk and after-tax growth, helping investors keep more after-tax wealth while maintaining diversification.
The table that follows shows the projected median after-tax total returns of three hypothetical portfolio-construction approaches for a household in the highest income bracket:
- A tax-agnostic approach (roughly 50% bonds/50% equities), in which the fixed income component is made up solely of taxable bonds, has the lowest projected after-tax return of 5%.
- An ad hoc approach (roughly 50% bonds/50% equities), in which the fixed income component is made up solely of munis, has a projected after-tax return of 5.2%.
- Our tax-aware approach (roughly 40% bonds/60% equities), in which the fixed income component is made up of munis and taxable bonds, has the highest projected after-tax return of 5.5%.
For top earners, a tax-aware portfolio may generate superior after-tax returns
After-tax return comparisons for 3 portfolio-allocation approaches
Notes: The portfolios assume the highest tax rates of 20% for dividends and capital gains and 37% for income. Portfolio optimization results are based on 10-year forward simulation data using 10,000 simulations annually from December 31, 2009, through December 31, 2023. Portfolio expectations are represented by the median simulation. See the Notes section later in this article for more information on the asset-class forecasts. Percentage totals may not equal 100 because of rounding.
Source: Vanguard.
Tax-aware portfolio construction can deliver real value
Portfolio construction for taxable accounts shouldn’t ignore taxes or attempt to avoid them entirely. Our research suggests that a smarter approach—one that accounts for different tax rates and balances municipal and taxable bonds accordingly—can significantly improve after-tax outcomes. The bottom line: Thoughtful, tax-informed decisions may help investors keep more of what they earn.
Notes:
The simulations use statistical analysis of historical data, conditional on asset-class valuations as of the stated forecast date. The authors used a probabilistic asset-class forecasting model, rather than point forecasts. The returns are thus shown in a distribution framework with the 5th, 25th, 50th, 75th, and 95th percentiles, representing the width of the returns distribution, as well as the median volatility, displayed as the annualized standard deviation.
The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes.
- U.S. equities: MSCI US Broad Market Index.
- Global equities ex-U.S. (unhedged): MSCI All Country World ex USA Index.
- U.S. Treasury bonds: Bloomberg US Treasury Index.
- U.S. intermediate credit: Bloomberg US 5–10 Year Credit Bond Index.
- Global bonds ex-U.S. (hedged): Bloomberg Global Aggregate ex-USD Index.
- U.S. municipal bonds: Bloomberg Municipal Bond Index.
All investing is subject to risk, including the possible loss of the money you invest.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of December 31, 2023. Results from the model may vary with each use and over time.
The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the US Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
Past performance is no guarantee of future results. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk. Investments in stocks and bonds issued by non-US companies and foreign governments are subject to risks including country/regional risk and currency risk.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
Neither Vanguard nor its financial advisors provide tax advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax advisor about your individual situation.
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