Investment tax can be the most significant difference between profitable or break-even investments. Fortunately, with tax-efficient investing, you can reduce your tax burden and ensure you get the possible best returns out of your investment.
This article introduces you to the concept of tax efficiency and tax-efficient investment, with a focus on taxable accounts and how they work. Also, as usual, I curated a list of the best ETFs for taxable accounts for incoming retirees or investors who simply want to make profits.
Key Takeaways
Just before we go further, here are the key takeaways from the article:
- Taxable accounts allow investors to invest in assets like mutual funds, index funds, bonds, and stocks, but with more flexibility and less restriction.
- Investors must, however, pay tax on their returns in the form of capital gains at the end of every tax year.
- Tax-efficient investments ensure you save more on taxes, especially if your tax bracket is higher.
- Tax-efficient ETFs help investors minimize capital gains with broadly diversified equity and low turnover.
- The best ETFs for taxable accounts include VTEB, IVV, ITOT, IXUS, SCHB, VXUS, and VEU.
- You can invest in these ETFs by opening a taxable brokerage account with any brokerage firm or reputable financial advisor that offers them.
What Are Taxable Accounts?
We cannot talk about tax-efficient investment or taxable account ETFs without mentioning taxable accounts. Brokerages offer taxable accounts as investment accounts without any unusual rules. Also known as taxable brokerage accounts or taxable investment accounts, investors can use these accounts to invest in assets like exchange-traded funds (ETFs), mutual funds, bonds, and stocks.
The ‘taxable’ in the name means you pay taxes only on your investment gains, including federal and capital gain taxes. There are no tax breaks for putting money into taxable accounts, and the withdrawals are not tax-free. As your assets appreciate according to the performance of the market, you will owe annual taxes on returns from such investments. These capital gains distributions are taxed during the tax year you record them.
Taxable accounts can be useful for investors in a few other ways despite not offering any tax benefits. For example, taxable accounts are more flexible than tax-advantaged accounts like 401(k)s and individual retirement accounts. Taxable accounts do not have the usual limits associated with state or workplace tax-advantaged, where you can only invest in certain funds or sections of the market. Furthermore, Investors can also choose to withdraw their investment and returns at any time without any penalty.
What Are Tax-Exempt ETFs?
We have mentioned that one of the major upsides of using a taxable account is that you can withdraw your investment and gains whenever without any penalty. But that does not automatically translate to holding all kinds of funds in your taxable account. The wrong investment types can skyrocket your tax and leave you with little or no gain in the end.
ETFs are designed to limit taxable capital gains by default. These funds also use a creation and redemption system that minimizes taxes for the shareholders. In addition, they are intraday tradable assets, which means investors can ensure tax sensitivity by selling or holding individual lots.
However, I must mention that not every ETF you see out there is tax-efficient or tax-exempted. But if an ETF has a broadly diversified equity, it will most likely have reduced capital gains distributions due to very low turnover.
What Are the Top ETFS for Taxable Accounts?
You could spend all day looking for the right ETFs for your taxable investment accounts, or just look through my carefully-researched and compiled list of the best seven ETFs for taxable accounts below:
Many ETFs track the S&P 500 Index, and the iShares Core S&P 500 ETF 500 (IVV) is one. Considering the index it tracks, this particular fund is ideal for investors seeking exposure to large-cap stocks, including stocks of several large and popular U.S. companies. Up to 80% of IVV’s funds go into assets in the component securities of its index or those with similar economic characteristics.
IVV launched in 2000 and currently has over $320 billion assets under management. Its weighted average market cap is $680 billion, spread across 500 holdings. The MSCI ESG rating of this fund is 7.76 out of 10, which means it is considerably resilient to long-term risks and opportunities associated with environmental, social, and governance factors.
IVV’s expense ratio is 0.03% and recorded a 24.55% as returns in the previous year.
Here is the second of the tax efficiency ETFs issued by iShares on my list. When the iShares Core S&P Total U.S. Stock Market ETF launched in 2004, it was designed to cover just 90% of the investable U.S. market. However, in 2015, it changed its benchmark index and started tracking the S&P Total Market Index. This index tracks the broad U.S. equity market, comprising small, mid, large, and even microcap stocks. It is a blend of the S&P 500 with the mid-cap (400 stocks) and the small-cap (600 stocks) indexes.
This open-ended fund’s weighted average market cap is over $560 billion. It currently holds 3,622 stocks in its portfolio, which is where it invests its $45 billion assets under its management. The ESG fund rating of ITOT is AA, with a score of 7.31/10. Like IVV, it will hold its own in the face of long-term risks and opportunities from environmental, social, and governance factors.
The expense ratio of this fund is 0.03%, with a 19.81% one-year return.
3. Schwab U.S. Broad Market (SCHB)
The Schwab U.S. Broad Market ETF is designed to track the Dow Jones U.S. Broad Stock Market Index’s total return before the fees and other expenses. Therefore, SCHB invests most of its assets (up to 90%) into the largest 2,500 publicly traded U.S. companies across different sectors covered by this index.
If you are looking for a tax-efficient ETF for a core holding of a long-term hold portfolio, SCHB should be on your list of considerations. It is well-spread rather than heavy at the top, and at a 0.03% expense ratio, it is one of the cheapest on my list. The MSCI ESG Score is 7.3/10 – A.A.
It holds over $24 billion worth of assets under management, spread across over 2,500 stock holdings. In addition, investors with a Schwab account can trade SCHB free of fund commission on the platform.
The third iShares ETF on my list is the iShares Core MSCI Total International Stock ETF (IXUS), and it tracks the MSCI ACWI ex USA IMI Index. According to iShares, the issuer, IXUS seeks to track the investment results of an index that comprises small-, mid-, and large-cap non-U.S. equities. Therefore, it offers a broad and unbiased coverage of the global equities market and a considerable level of diversification.
Since its launch in 2012, IXUS has amassed over 4,000 stocks in its portfolio and currently invests $32 billion net assets of funds into these stocks. IXUS also has an MSCI ESG rating of A.A. or 7.76/10, which is quite good. The fund’s total return over the past five years is 60.84 (before tax), and 46.97 over the past three. It did 8.52% in returns over the past year.
The 0.09% expense ratio may be somewhat higher for a taxable account ETF. But the impressive returns sure make up for this.
5. Vanguard FTSE All-World ex-US (VEU)
Now to the options from Vanguard, starting with the Vanguard FTSE All-World ex-US ETF (VEU). This fund is excellent for investors seeking broad exposure across emerging and developed non-US equity markets. As an international large blend fund, it tracks the performance of the FTSE All-World ex-US index.
VEU’s total net assets are worth over $54 billion, spread across 3599 stock holdings. The ten largest holdings of this fund account for just 10.7% of the net assets. So, it is not top-heavy. 41.50% of the VEU’s portfolio is invested in Europe, with the Pacific accounting for about 27% and the emerging markets roughly 25%.
Since its inception in 2007, VEU has recorded a 4.01% return, 6.60% in the last ten years, and 5.32 in the previous year. The expense fee is 0.08%, and it is available on Vanguard and several other reputable brokerage services providers.
6. Vanguard Total International Stock Market Index (VXUS)
Next is the Vanguard Total International Stock Market Index ETF (VXUS). VXUS seeks to track the performance of the FTSE Global All Cap ex-U.S.index. It is one of the best options for investors with taxable accounts seeking broad exposure to equity markets outside the U.S., both in the developed and emerging markets. It allocates a small part of its portfolio to small-cap companies located outside the United States.
It debuted in 2011, and since then, it has amassed over $53 billion assets under its management spread across over 8,000 holdings. Its weighted average market cap is over $85 billion. The MSCI ESG rating is 7.75/10 or A.A., indicating that its portfolio is resilient against issues associated with environmental, social, and governance factors.
The expense ratio is 0.08%.
7. Vanguard Tax-Exempt Bond ETF (VTEB)
I’m rounding up this list of tax managed funds with the Vanguard Tax-Exempt Bond ETF (VTEB). The benchmark index of VTEB is the S&P National AMT-Free Municipal Bond, which estimates the investment-grade section of the U.S. municipal bond market. In addition to randomly selecting its investments, 80% of VTEB’s holdings go into securities held in the index, which are exempted from federal income taxes and the federal alternative minimum tax.
VTEB is one of the many bond funds you can consider, especially for tax conscious investors. It has around $16 billion total net assets under its management, spread over 6,000 bonds. The expense ratio is 0.06%, making it the cheapest of the three Vanguard tax-efficient ETFs on my list.
Importance of Tax-Efficient Investing
Returns on investment are affected mainly by asset allocation and investment selection. However, keeping the amount of taxes payable on your investment at the minimum also helps in the long run. This is because taxes reduce your gains, which could have made you more money if you had retained it in your portfolio.
If paying tax is a must on your investment in taxable brokerage accounts, then it is only logical that you only use it to trade assets that are tax-efficient or tax-exempt. These include actively managed funds like exchange-traded funds (ETFs), bonds, mutual funds, and index funds that ensure you pay the minimum capital gains and retain most of your profits.
Final Verdict
Every investor knows there is no 100% expense-free investment – the costs must be somewhere in the picture. With that knowledge, everyone looks out for options that take the least minimum off their returns on investment. But taxable brokerage accounts and tax-efficient investments can help minimize costs and maximize gains if properly harnessed.
The first step is to identify the taxable account actively managed funds you are interested in. As mentioned earlier, not all ETFs are not tax-efficient, and not all tax-efficient ETFs are suitable for your taxable account portfolio. That is why I recommend that you take your time to assess every option on my list on your own, with emphasis on your investment goals and preferences.
Are you doing this for the long term or short term? What part of the market do you want to expose your portfolio to? What is your tax bracket – high or low? What is the level of tax efficiency of your tax managed funds? Your answers to these questions will go a long way in helping you make the correct decision.
Good luck!