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Top U.S. Equity Funds for Your Taxable Account

These offerings combine low tax-cost ratios and strong performance in the same package.

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One of the biggest advantages of investing in a tax-sheltered account, such as an IRA or 401(k), is the freedom it brings with regard to picking stocks, bonds, and funds. Because account holdings grow tax-free (and distributions may also be tax-free if held in a Roth account), the investor doesn't need to worry about the tax efficiency of each holding.

When investing in a taxable account, however, it's a whole other ballgame. Here, dividends, interest, and capital gains--including those generated by a fund's manager and over which the investor has no control--can add to the investor's tax bill each year. That's why it's so important for investors with taxable accounts to understand what makes some funds more tax-efficient than others.

For equity funds, the prime culprits are dividends and capital gains--the latter of which can vary greatly from year to year depending on the amount of trading a fund does and the degree to which the holdings it sells have appreciated in value. A fund that is more tactical in nature, trying to take advantage of temporary price discrepancies in the market and selling shortly after prices correct, might generate more short-term capital gains for its shareholders than one that tends to take a buy-and-hold approach. For shareholders, those short-term gains are taxed as ordinary income rather than at lower long-term capital gains rates, which apply only after a security has been owned for at least a year.

What has made matters worse for some investors is that many funds that had banked capital losses during the last bear market, which ended in 2009, have used them up, meaning they can no longer use them to offset more recent gains. (See this article for a list of funds that passed along particularly hefty capital gains distributions in 2014.)

One way for equity-fund investors who use taxable accounts to keep capital gains distributions in check is by choosing funds with low turnover ratios. The less a fund trades, the fewer capital gains it generates and the more likely those gains are to be of the long-term variety. Index funds are particularly tax-efficient because holdings are bought and sold only when required to match the weighting of a given index or to meet redemptions, not as part of an active strategy designed to take advantage of market conditions. Also, with an actively managed fund, a manager change could trigger portfolio changes that generate heavy capital gains--a risk that doesn't exist with index funds.

To check tax-efficiency metrics for a given fund, click on the Tax tab on its fund page. There, you'll find both the pretax and tax-adjusted return for the fund over various time periods as well as its tax-cost ratio--an estimate of how much of the fund's return was lost to taxes (based on shareholders in the highest tax bracket). Plus, you'll find information on the fund's potential capital gains exposure--an estimate of the percentage of the fund's assets that represent gains, based on its most recent portfolio disclosure. The larger the number, the more capital gains are embedded in the fund's holdings.

To help identify U.S. equity funds that are both among the most tax-efficient and best performing of their type, we used the  Premium Fund Screener tool. We limited our search to non-institutional share classes of funds that are currently open to new investors and that have five-year tax-cost ratios of no more than 0.5%, meaning that shareholders in the top tax bracket would have lost no more than half a percentage point of performance to taxes each year, on average, over the time frame. To ensure that those funds didn't owe their low tax-cost ratios to low returns, we also limited our search to funds that were in the top 25% of performers in their category over that same time frame. Last of all, we stuck with funds that have earned Morningstar Analyst Ratings of Gold, Silver, or Bronze to ensure that only funds vetted for quality were included.

Premium Members can click  here to see the full screen, which includes some duplicate share classes of the same funds. Three of those funds are shown below.

 Vanguard Total Stock Market Index (VTSMX)
Analyst Rating: Gold | 5-Year Tax-Cost Ratio: 0.44%
An obvious choice, perhaps, but it bears repeating that index funds tend to be more tax-efficient than actively managed funds and, therefore, are a good choice for taxable accounts. Both this fund and its ETF counterpart,  Vanguard Total Stock Market ETF (VTI), hold nearly every publicly traded U.S. stock, weighted by market cap. The fund provides great diversification across the market-cap spectrum and all for the low price of 17 basis points (the ETF is even cheaper at just 5 basis points). A 4% turnover rate helps keep capital gains distributions to a minimum. And another plus unique to Vanguard index mutual funds is that their corresponding ETFs are technically share classes of the fund, allowing the firm to use the ETFs to off-load low cost-basis stock shares when ETF shareholders take in-kind distributions, which adds to the tax efficiency. (For more, see this video.)

 Wasatch Core Growth (WGROX)
Analyst Rating: Silver | 5-Year Tax-Cost Ratio: 0.18%
Small-cap funds--even those that track an index--face special tax challenges because high-performing holdings may outgrow the fund's mandate, requiring that they be sold, often at hefty gains. This fund is less inclined to jettison winners, however, resulting in a portfolio that often includes a strong mid-cap presence. Morningstar analyst Dan Culloton describes Wasatch's investing style as "building compact portfolios of stocks with defensible economic advantages and consistent economic returns across market styles." This fund's two seasoned managers run a relatively compact portfolio of 50 to 60 names. Below-average turnover helps with tax efficiency, although a hefty capital gain of $7.80 per share in 2007 is worth noting. However, the fund's three-, five-, and 15-year tax-adjusted returns all land in the top quintile of the small-growth category.

 Weitz Partners Value (WPVLX)
Analyst Rating: Gold | 5-Year Tax-Cost Ratio: 0.15%
This fund's sizable cash stake (currently at one quarter of the portfolio) has resulted in lagging short-term performance as stocks have continued to climb ever higher, but it also puts managers Wally Weitz and Brad Hinton in a position to scoop up bargains should prices fall. Turnover is on the low side at 19% of the portfolio as management tends to invest with a three- to five-year time horizon. This fund has grown less contrarian and more conservative since getting burned by financial stocks in 2007-08.
Also, tax-loss carryforwards from that time period likely deserve some credit for the fund's low five-year tax-cost ratio.

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.