The Best Investments for Taxable Accounts

I recently wrote about investments that are best left out of investors’ taxable accounts because they have a record of kicking off sizable income/dividend distributions or making large capital gains payouts.

It's a long list. For investors who would like to reduce the drag of taxes on their taxable accounts (that is, nonretirement, non-tax-sheltered accounts), it's wise to downplay taxable bonds and bond funds, allocation (multi-asset) funds, actively managed stock funds, high-dividend-paying stocks and funds, and a host of niche categories like real estate and convertible bonds.

That seems like everything but the kitchen sink, but the good news is that it’s still possible for investors to build well-diversified portfolios that are also tax-efficient. The number of tax-managed model portfolios available to investors is also on the rise. In addition, I’ve developed a series of model portfolios with tax efficiency in mind.

Bear in mind that the investor’s own tax bracket plays a role in the attractiveness of various asset types. While municipal bonds—discussed below—will be close to a no-brainer for investors in higher-income tax brackets (say, 24% and above), those in lower tax brackets may be able to obtain a higher aftertax yield (not to mention better diversification) in taxable bonds. And while I had high dividend payers in my “save for tax-sheltered” bin, investors who are in the 0% tax bracket for qualified dividends and long-term capital gains (under $44,625 for single filers and $89,250 for married couples filing jointly) can go ahead and gorge on them.

Here are some of the key asset classes that make sense for most investors’ taxable accounts:

1. Municipal Bonds, Municipal-Bond Funds, and Money Market Funds
2. I Bonds, Series EE Bonds
3. Individual Stocks
4. Equity Exchange-Traded Funds
5. Equity Index Funds
6. Tax-Managed Funds
7. Master Limited Partnerships

Municipal Bonds, Municipal-Bond Funds, and Money Market Funds

Any interest you earn from a conventional/taxable-bond fund is taxed at your ordinary income tax rate, which means that taxes take a big bite out of a taxable account’s return. By contrast, you won’t have to pay federal income tax on a municipal bond or municipal-bond fund’s payout. You may also be able to skirt state tax by buying a bond from your home state or a bond fund dedicated to that state. Individual bond buyers may also be able to avoid local taxes by buying bonds issued by their own municipalities.

As with taxable bonds, municipal bonds and municipal-bond funds have varying degrees of interest-rate sensitivity and credit qualities. A high-quality short-term muni fund will make sense for goals that are close at hand, whereas a longer-duration and/or lower-quality one could make sense for spending goals that are further into the future.

I Bonds, Series EE Bonds

These bonds, which can be purchased directly from the U.S. Treasury via TreasuryDirect.gov, aren’t quite as attractive from a tax standpoint as munis, but their interest skirts state and local taxes. Moreover, to the extent that an EE-bond owner redeems the bonds for qualified education expenses and their income falls below the thresholds, the interest can skirt federal tax entirely.

Investors have been dashing to I Bonds for their decent real yields. I Bonds are currently paying out 5.27%—their fixed rate of interest plus an inflation adjustment. The big downside is that I Bond enthusiasts are limited in how much they can buy: They can purchase $10,000 per year per Social Security number via Treasury Direct, and an additional $5,000 per year through their federal tax refunds.

Individual Stocks

If you’re inclined to hold individual stocks, your taxable account is a great place to do it, particularly if you trade infrequently. With a mutual fund, you’re on the hook for taxes on capital gains payouts regardless of whether you’ve sold any shares or whether you have any profits on hand to cover the taxes. If you own individual stocks, on the other hand, you don’t have to pay capital gains until you yourself sell a share and lock in a gain. (You will owe taxes on dividend distributions, however, which is one reason why I would maintain that high-income-producing equities are best housed in a tax-sheltered account.)

Holding individual stocks also makes it easier to take advantage of tax-loss selling than with a mutual fund, because you won’t have to wait for the broad market or market segments to sell off to find losses in your portfolio. (Individual stocks exhibit more frequent and dramatic ups and downs than do mutual funds, which are inherently better diversified.) Using the specific share identification method for cost-basis accounting makes it even easier to cherry-pick losing blocks of stock for tax-loss-harvesting purposes.

Equity Exchange-Traded Funds

For investors who like the convenience and built-in diversification of a mutual fund, equity exchange-traded funds can make fine, tax-efficient options for taxable accounts. Most ETFs track indexes, so their turnover is often very low, meaning that capital gains distributions also tend to be few and far between.

Moreover, ETFs sell on an exchange, meaning most trading takes place between shareholders. Individuals cannot redeem their shares for cash directly from the fund company. Because the fund manager doesn’t have to pay off departing shareholders, they won’t be forced to sell shares to raise cash, potentially unlocking a capital gain.

Furthermore, the large institutional shareholders that are permitted to redeem ETF shares directly from the fund company don’t receive cash for exchanging their shares, either. Instead, when they sell, they are given a basket of the stocks held in the ETF’s portfolio. This allows the ETF to continually hand off its lowest-cost-basis shares to redeeming institutions. Taken together, those features enable equity ETFs to be much more tax-efficient than traditional mutual funds.

At the same time, it’s worth noting that bond or other ETFs that crank out taxable current income aren’t especially tax-efficient, even though they benefit from the same basic features. That’s because most of the return that bond investors earn is ordinary income, rather than capital gains, and income from an ETF receives the same tax treatment as income from a traditional mutual fund.

Equity Index Funds

Traditional equity index mutual funds don’t benefit from all of the tax-management bells and whistles that ETFs do, and some index funds have made sizable distributions when they’ve had big outflows or their underlying indexes have changed.

But conventional index mutual funds do share a tax-friendly commonality with ETFs: They’re index funds, meaning that they generally don’t trade a lot. Thus, many index funds have managed to be nearly as tax-efficient as their ETF counterparts, making them a solid option for taxable accounts. Vanguard’s index funds have managed to be particularly tax-efficient because the firm’s ETFs are share classes of its funds.

As with bond ETFs, bond index funds haven’t been especially tax-efficient because most of their returns are income, which is taxed at ordinary income tax rates and which the index wrapper provides no protection against.

Tax-Managed Funds

These funds have gotten overshadowed as ETFs have grown in popularity, but there are still some fine options in this subgroup. Tax-managed funds aim to keep income and capital gains distributions to a bare minimum by actively offsetting any capital gains with losses and shunning investments that generate ordinary income, which is taxed at the highest rate.

Vanguard runs a terrific suite of tax-managed funds for nearly every role in investors’ portfolios, and Vanguard Tax-Managed Balanced VTMFX is a rare multi-asset fund that is a good fit for taxable accounts.

Master Limited Partnerships

This is a niche category, but individual MLPs—partnerships that often operate oil and gas pipelines—are an example of a rare higher-income investment that’s generally better off inside a taxable account than a tax-sheltered one.

The tax treatment of MLPs is complicated, but the big reason to keep individual MLPs out of a tax-sheltered account is that most MLP income counts as unrelated business taxable income, or UBTI. If that income exceeds $1,000 in a year, the owner of an MLP inside an IRA could owe taxes on that income, effectively negating the tax-sheltering effects of the IRA wrapper.

The income from ETFs that buy MLPs doesn’t count as UBTI, which makes ETFs a better fit for tax-sheltered accounts than individual MLPs. Morningstar doesn’t currently have any MLP exchange-traded products on its list of Morningstar Medalists. It’s worth noting that many investors have had a terrible experience with MLPs because they bought into the category at a high point last decade, only to see the group sell off sharply subsequently.