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Investing Specialists

Morningstar's Top Fund Picks for Taxable Portfolios

Traditional mutual funds and ETFs for tax-efficient exposure to domestic and international stocks as well as bonds.

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Note: An earlier version of this article appeared on Jan. 29, 2020.

The typical large-blend fund in Morningstar's database posted an annualized return of 17% over the past decade ended November 2021. Meanwhile, the median tax-cost ratio of that same group of funds was 1.45%.

That means that an investor in the highest tax bracket who owned an average-performing large-blend fund and held it for a decade in a taxable account would have ceded about 9% of her returns to taxes. And that assumes that the investor didn't sell at the end of the period but rather simply bought and held; the 1.45% per year tax-cost ratio was simply her carrying cost for the fund and doesn't factor in any taxes due upon the sale. The fact that many actively managed equity funds have been seeing redemptions has exacerbated capital gains tax bills for many investors, jacking up tax-cost ratios.

Granted, it's not a good idea to hold taxable-bond funds in a taxable account if you're a high-income investor, but the tax-efficiency statistics are even worse for bond funds. That’s because the majority of the return that bonds earn consists of income rather than capital gains, and income is taxed at the ordinary income tax rate versus the lower capital gains rate. The typical intermediate-term core bond fund returned 2.8% over the past 10 years and had a tax-cost ratio of 1.11%. That means that for investors in the highest tax bracket who bought and held a taxable-bond fund in a taxable account (again, usually not advisable), nearly 40% of their returns would have gone to taxes.

Some investors might assume that paying taxes is simply the cost of earning good returns. And it's certainly true that good asset location can help reduce the drag of taxes. For example, by holding taxable bonds in their tax-sheltered accounts, investors will only be on the hook for taxes when they pull money out, not for any income their bonds or bond funds kick off during their holding periods. (Investors in Roth IRAs won't owe any taxes at all upon withdrawal in retirement, provided they've minded their p's and q's.)

Investors can also help reduce their tax bills by maintaining a tight focus on tax-efficient funds for their taxable accounts. Individual stocks can be a good fit as taxable holdings: The investor will be subject to tax on any dividends the stocks pay out but won't have to contend with the kinds of capital gains distributions that have bedeviled many investors in actively managed stock funds.

Mutual funds and exchange-traded funds can be quite tax-efficient, too; the key is to choose carefully. For equity investors, traditional index funds and ETFs tend to do a good job at limiting taxable capital gains; tax-managed mutual funds can also be a good choice. On the fixed-income side, municipal-bond funds can be a good fit for the taxable accounts of investors in higher tax brackets, though aftertax muni yields may be less attractive at various points in time, especially when muni demand is strong.

Here's a rundown of some of Morningstar analysts' favorite tax-efficient funds and ETFs for core equity and bond exposure.

Top Tax-Efficient Funds for U.S. Equity Exposure

ETFs: Exchange-traded equity funds have taken off in popularity in recent years, in part because of their ability to limit taxable capital gains. Not every ETF is tax-efficient, but broadly diversified core equity ETFs manage to reduce capital gains distributions thanks to their very low turnover as well as the ETF structure. Among Morningstar's top tax-efficient core ETFs are iShares Core S&P 500 ETF 500 (IVV), iShares Core S&P Total US Stock Market ETF (ITOT), Schwab U.S. Broad Market (SCHB), Vanguard S&P 500 (VOO), and Vanguard Total Stock Market (VTI). Investors could also hold separate small-, mid-, and large-cap ETFs; iShares, Schwab, and Vanguard all field cheap and excellent versions. However, the main reason for holding discrete building blocks for each capitalization band is to rebalance among them, but doing so will tend to trigger more frequent selling--and in turn capital gains realization--than is ideal.

Traditional Index Funds: Traditional index funds benefit from the chief factor that makes equity ETFs tax-efficient, and that's very low turnover. Thus, most of Morningstar's favorite core index funds are fine tax-efficient picks, especially Vanguard Total Stock Market Index (VTSAX) and Vanguard 500 Index (VFIAX). From a tax-efficiency perspective, these funds benefit from the fact that they're share classes of the firm’s ETFs. Schwab S&P 500 Index (SWPPX), which has a Morningstar Analyst Rating of Gold, also has fine long-term tax-efficiency numbers, as does the Silver-rated DFA U.S. Core Equity (DFEOX).

Tax-Managed Funds: Although they've been eclipsed by "popular kid" ETFs in recent years, the small subset of tax-managed funds have historically done a terrific job of limiting taxable capital gains. Vanguard's suite of tax-managed funds, including Vanguard Tax-Managed Capital Appreciation (VTCLX), Vanguard Tax-Managed Small Cap (VTMSX), and Vanguard Tax-Managed Balanced (VTMFX), is a standout in this small group. Its funds closely track indexes and benefit from low turnover; they also layer on additional tax-management techniques such as tax-loss harvesting and downplaying dividend-payers. Their expense ratios are ultralow, and their tax-cost ratios are on par with or even lower than comparable ETFs. I used Vanguard Tax-Managed Capital Appreciation and Vanguard Tax-Managed Small Cap in my core model tax-efficient Bucket portfolios for retired investors.

Top Tax-Efficient Funds for Non-U.S. Equity Exposure

ETFs: Foreign-stock ETFs have all of the structural tax-efficiency benefits that U.S. stocks do, but their tax-cost ratios tend to be a bit higher for one key reason: Foreign companies often pay higher dividends than U.S. companies, and those year-in, year-out payments lead to higher tax bills. For example, iShares Core MSCI Total International Stock ETF (IXUS) has a 12-month dividend yield of 2.1%, versus 1.2% for iShares Core Total S&P U.S. Stock Market. Accordingly, foreign stock ETFs' tax-cost ratios are higher than U.S. ETFs. Even so, broad foreign-stock ETFs are appreciably more tax-efficient than actively managed funds. Among Morningstar's favorite foreign-stock ETFs are Vanguard FTSE All-World ex-US (VEU), Vanguard Total International Stock Market Index (VXUS), Schwab International Equity ETF (SCHF), and iShares Core MSCI Total International Stock ETF (IXUS).

Traditional Index Funds: Many of the same caveats that apply to foreign-stock ETFs also apply to foreign-stock index funds. They generally enjoy low tax-cost ratios relative to actively managed products but usually have worse tax-cost ratios than U.S. index funds and ETFs because of higher dividends on foreign stocks. Among Morningstar's favorite core international index funds are Vanguard Total International Stock Market Index (VTIAX), Vanguard FTSE All-World ex-US (VFWAX), and DFA International Core Equity (DFIEX).

Top Tax-Efficient Picks for Bond Exposure

Municipal-Bond Funds: For investors in higher tax brackets (over 32%) who want to hold bonds in their taxable accounts, a municipal-bond fund can be a good fit. (At the same time, it's worth noting that aftertax yields on munis won't always be higher than those of taxable bonds with similar risk attributes.) While index funds dominated the preceding discussions of tax-efficient equity investing, Morningstar's analysts tend to favor low-cost active management for the municipal-bond space. Fidelity's muni funds have long rated among Morningstar's favorites, including Fidelity Intermediate Municipal Income (FLTMX), Fidelity Municipal Income (FHIGX), and Fidelity Tax-Free Bond (FTABX). T. Rowe Price's municipal funds also earn high ratings, including T. Rowe Price Summit Municipal Income (PRINX) and T. Rowe Price Tax-Free Income (PRTAX). Vanguard Intermediate-Term Tax-Exempt (VWIUX) is another favorite.

Christine Benz has a position in the following securities mentioned above: VWIUX. Find out about Morningstar’s editorial policies.