When you’re looking into investment opportunities or trying to make your money work well for you, you should be making an effort to look for the most tax-efficient solutions available to you if you want to make the most of your income in the long term.
This is especially important for high-income investors, as tax brackets can change drastically and affect your income drastically.
The thing to look out for is ways to minimize your taxable investment portfolio, whilst still spreading out your assets in a safe and tax-efficient way, so all of your proverbial eggs aren’t in one basket.
If you are looking to minimize your portfolio’s tax burden, you’ve come to the right place.
In this article, we’ll be discussing some of the best ETFs for taxable accounts, and see what suits your needs best, along with an introduction to what you should be looking for when trying to find a good ETF that maximizes your long-term total return in the process.
Let’s get into it.
- 1 What Is An ETF?
- 2 Why Get Into ETFs?
- 3 Creating A Tax Efficient Portfolio With ETFs
- 4 What Are The Best ETFs For Taxable Accounts?
- 5 Factors That Make ETFs The Best Choice For Taxable Accounts
- 6 Final Thoughts
What Is An ETF?
Back to basics: ETF stands for Exchange Traded Fund. This is a financial product that is usually structured to mirror a specific segment of the market.
That means they are funds traded on exchanges that are generally tracking a specific segment index in the market.
When you are investing in an ETF, you are basically getting a bunch of assets that you are able to buy and sell during trading hours.
This can help you to lower your risk potentially, whilst diversifying your portfolio and using your money wisely and with a more cautious approach to the market.
ETFs operate much in the same way as a mutual fund as they are both involved in tracking a particular index or asset, though, unlike a mutual fund, ETFs can be sold the same way that regular stock is sold on the stock exchange.
ETFs are a popular way to get into trading as they are easy to buy and sell, and they have low transactional costs which makes them an efficient way for people to diversify their investment portfolio.
Another main reason why ETFs are popular is that they are tax-efficient.
Though, in order for them to be tax-efficient, investors should wise up to the taxation of ETFs so that they can make smart strategic decisions when buying and selling so that they don’t lose out on any perks.
ETFs have a much less stringent tax treatment than that of mutual funds due to their structure.
Because ETFs create and redeem shares within the transactions, these don’t count as sales, therefore they are not taxed. However, if you were to sell an ETF, this would count as a taxable event as would a mutual fund.
We’ll discuss this more in-depth below.
Why Get Into ETFs?
ETFs have a reputation as being particularly tax-efficient, however, the way they are taxed is pretty complex.
As previously mentioned, ETFs are a lot like mutual funds. The main difference in terms of taxation is that they tend to not distribute a lot of capital gains.
This is partly because ETFs passively track the index performance without any input or selling of stocks, which means that they generally only rebalance their holdings when the underlying tax index changes its constituent stocks.
A mutual fund on the other hand has to be actively managed, with each transaction incurring taxation costs.
What your ETF is best for will depend on what its focus is.
For example, if you have a dividend focused ETF, the stocks will be spread between shareholders a few times a year, whereas regular EFTs tend to give out to their shareholders only once a year.
In terms of taxation, the IRS taxes any dividends or interest payments from ETFs in the same way that it taxes the underlying stocks or bonds.
You must report this income therefore on your 1099 statement.
What we’ll be looking at today is ETFs that are held in taxable accounts, such as your brokerage account, rather than in a tax-different account such as an IRA.
The reason ETFs are a good thing to get into is that they are less likely to surprise you. They also manage themselves more than a mutual fund, meaning you can just let it do its thing.
Unlike investing in currencies and commodities, when you invest in stocks and bonds through ETFs, it’s far more simple, which makes it perfect if you either want to balance your portfolio or you are not too sure about getting into more risky ventures in the trading game.
Creating A Tax Efficient Portfolio With ETFs
Whether you are looking for a quick in and out investment, looking to make your income work for you, or investing for your retirement, a lot of the time you’ll have to use taxable accounts.
But why not just stick to investing in IRAs where the tax is much less intrusive? Well, IRAs are great for a high-dividend-yield fund, metals, or actively managed mutual funds.
These actively managed funds have a high turnover which means that they are constantly buying and selling within the funds, making them tax-inefficient and better in an IRa or similar account.
ETFs are much more attractive if you are looking into tax-efficient investing. However, not all ETFs are the same.
When you are building up your portfolio of ETFs for taxable accounts, you want to be looking for ones that have a tax-efficient structure, require little to no management, have a low capital gains distribution, low overall costs, and a low dividend yield overall.
To break it down even further, you’re looking for the following:
- Municipal Bonds- debt securities issued by government entities
- Treasury Bonds- fixed-rate government debt securities with a maturity year of 10-30 years.
- Broad Core Stock Funds- an investment that tracks a large index.
- Growth Stock Funds- investments focused on companies with above-average growth rates that focus on capital appreciation rather than dividend payout.
What Are The Best ETFs For Taxable Accounts?
Below are some of the best ETFs for taxable accounts available right now. Let’s have a closer look at them.
What Is It?: Selected by the S & P committee, the 500 index is a group of the 500 largest companies currently in the US.
The IVV tracks the market-cap weighted index of these 500 large and midcap stocks.
Insights: This is one of several ETFs that track the S&P 500 Index. It delivers large-cap exposure to the market.
Though many assume the 500 is just the market exposure to the US economy, it can also actually exclude certain companies, and it reaches further down the spectrum of companies.
Though, in general terms, the fund offers great coverage across the market, making it a more secure and favorable stock to buy and hold as dividends.
It also shows its daily market position which is useful if you like to stay on top of these things.
The expense ratio sits at 0.03% with a Max LT/ST Capital Gains rat of 20%/39.6%
What Is It?: Another option if you want broad exposure over the US market, ITOT from iShares offers you broad diversification, low fees, and low turnover.
ITOT from iShares is a low-cost way of getting access to the total US market, with the fund containing over 3500 stocks.
It passes the S&P minimum liquidity criteria and constituents are weighted by their market cap which gives them a high level of easily traceable information and liquidity.
This means new information is quickly incorporated into their prices.
Insights: In terms of safety, the broad diversification of these shares makes them a great and safer option for investment in taxable accounts.
They have a low turnover and low fees which is essential if you want to prevent excessive spending when getting into the market.
The index is incredibly varied, meaning there is much less unnecessary turnover or uncertainty. The limited risk factor limits the potential growth here, with an expense ratio of 0.03%
What Is It?: IXUS tracks a market-cap weighted index of global stocks that covers 99% of the global market outside of the US.
With another broad portfolio option of international equities, IXUS tracks the same index used for the segment benchmark in the US.
IXUS is a good indicator of the global markets and tilts are relatively negligible even though the portfolio itself has fewer holdings.
Unlike others on this list that focus on broad-cap exposure, IXUS is an example of a tracker that provides a comprehensive small-cap exposure that captures the market well.
Insights: The fund has a securities lending program that strips back some of the expenses, and remains to have broad and unbiased coverage of the markets.
It has an expense ratio of 0.07%, and like ITOT, IXUS is a low-cost way to get exposure to a huge market whilst remaining relatively tax-efficient in the process in terms of access to the international stock funds.
The fund tracks the MSCI ACWI ex USA IMI Index.
The next three ETFs for taxable accounts are all from Vanguard- one of the largest issuers of mutual funds in the world, and the second-largest issuer of ETFs.
AS they focus on Index funds with low fees, they are a great way to get into an investment with a lower risk of capital and unnecessary spending on fees and constant sales taxes for most investors.
VUG – Vanguard Growth ETF
What Is It?: VUG tracks the CRSP US Large-Cap Growth Index, which is made up of selected large and mid-cap stocks that have six watched growth factors.
It is a sensibly constructed large-growth fund that has low fees and curbs turnover.
VUG is great if you’re in a tax environment where a high yield would create an unsustainably high tax burden.
The Vanguard Growth ETF selects its stocks based on these six factors: 3-year historical EPS (earnings per share) growth, expected long-term growth in EPS, expected short-term EPS growth, current investment-to-asset ratio, 3-year historical growth in SPS (sales per share), and current return on assets.
Insights: Because this portfolio of stocks is carefully chosen based on these six factors, and also dips into the midcap market space, it can cross over to your other investments if you are also looking at midcaps in the rest of your portfolio.
As with most Vanguard portfolio ETFs, they do not give your daily data (as you would get with some of the previous ETFs on this list), but rather disclose their holdings on a monthly basis.
In terms of efficiency, VUG has an expense ratio of 0.04% and a low risk of fund closure.
VTEB – Vanguard Tax-Exempt Bond ETF
What Is It?: Offering a broad portfolio of tax-exempt municipal bonds at a good price, VTEB is a good way to keep bond funds whilst keeping them in your taxable account.
Usually, bonds are best off in a tax-advantaged account, but these ones chosen in VTEB are tax-free at local, state, and federal levels.
VTEB tracks a market-weighted index of investment-grade debt issued by the government and state agencies. Interest accrued on these is US income tax and AMT exempt.
If you are a high-earner in a high tax bracket, investing in a VTEB portfolio can be a great idea.
VTEB is Vanguard’s foray into the municipal bonds index fund and competes directly with the MUB from iShares, both tracking the same S&P index.
Insights: Only securities that meet the minimum standards from maturity and size are included in the index, and as we see with all of the ETFs available to invest through Vanguard, the holdings are only disclosed monthly to investors.
The VTEB ETF expense ratio is 0.05%.
VGIT – Vanguard Intermediate-Term Treasury ETF
What Is It?: Much like the debt interest tracked by VTEB, the interest from treasury bonds is exempt from taxation at both local and state levels.
In general, treasury bonds tend to have a lower correlation to their stocks than municipal bonds, thus making them likely to be a more distinguished hedge.
Vanguard’s Intermediate-Term Treasury ETF tracks a market-weighted index of fixed income securities issued by the US government.
This excludes inflation-protected bonds, and they have a maturity of between 3 and 10 years.
VGIT provides exposure to the treasury debt market, and as a result, VGIT has a much larger average maturity and duration which results in higher yields.
The downside of this, of course, is that it is more sensitive to interest rate changes thus making it a little bit riskier in terms of ETF investment.
Insights: The funds hold a range of securities that have the same risk and return as the underlying index.
VGIT may not appeal to investors that are looking to have just a short period of exposure or want a more controlled risk ratio. The expense ratio of VTIG is 0.04%
Factors That Make ETFs The Best Choice For Taxable Accounts
To round up, these are the main factors that make ETFs a good choice to invest in from taxable accounts:
- Taxable accounts give you more flexibility and less restriction when you choose to invest in certain assets such as mutual funds, index funds, bonds, and stock.
- If you are using taxable accounts, investors must pay tax on their returns in the form of capital gains at the end of every tax year.
- You can invest in these ETFs by opening a taxable brokerage account with any brokerage firm or reputable financial advisor that offers them.
- Tax-efficient investments ensure you save more on taxes, especially if your tax bracket is higher.
- The best ETFs for taxable accounts include, but are not limited to IVV, ITOT, IXUS, SCHB, VXUS, and VTEB.
- Tax-efficient ETFs help investors minimize capital gains with broadly diversified equity and low turnover.
It’s a good idea to keep an eye on these accounts to make sure they are still delivering the same kind of returns, as with everything, the market is ever-changing.
However, if you like the idea of minimizing your risk, and having some money set aside that you don’t need to constantly manage and check up on, an ETF is the way to go for a taxable account.
Be aware of the laws surrounding capital gains and be sure to take advantage of when you should make the switch to another account, along with how you need to declare any ETFs on your portfolio when it comes to income tax.
These ETFs for taxable accounts are good ways to go if you want a solid investment, and whilst there is always risk involved in the market, these are some of the more stable options to go for.