Best ETFs for Taxable Accounts

Invest in the best ETFs for taxable accounts with Interactive Brokers.

Discover how to boost your investment returns and keep more money in your pocket with tax-efficient funds. These specially designed funds offer minimal taxable income and capital gains distributions, which means you can lower your tax liability and increase your after-tax returns. 

This article explores some of the best exchange-traded funds (ETFs) for taxable accounts, including top mutual funds, while discussing key factors to consider when selecting them.

Top Investments for Taxable Accounts

With tax consequences in mind, invest in top ETFs and mutual funds based on your risk tolerance, investment goals and tax situation.

Tax-Efficient ETFs for Non-U.S. Equity Exposure

Foreign mutual funds or individual stocks may be subject to withholding taxes by the foreign government and income taxes by the U.S. government, resulting in a higher tax burden. To avoid double taxation, consider investing in ETFs that are domiciled in the U.S. but track foreign indexes. These ETFs reinvest dividends or interest in the fund, allowing you to pay taxes only on capital gains when selling the ETF. This approach can result in a lower tax rate compared to ordinary income.

• Vanguard FTSE All-World ex-US ETF (VEU) 
• Vanguard Total International Stock ETF (VXUS)
• Schwab International Equity ETF (SCHF)
• iShares Core MSCI Total International Stock ETF (IXUS)
• iShares ESG Aware MSCI EAFE ETF (ESGD)

Tax-Efficient ETFs for U.S. Equity Exposure

These ETFs invest in stocks of companies in the U.S. They can help minimize taxable income or capital gains distributions by using strategies such as holding stocks for longer periods, avoiding dividend-paying stocks or tracking indexes with low turnover or tax optimization. 

• iShares Core S&P 500 ETF (IVV)
• iShares Core S&P Total U.S. Stock Market ETF (ITOT)
• Vanguard Growth ETF (VUG)
• Vanguard Tax-Exempt Bond ETF (VTEB)
• Vanguard Intermediate-Term Treasury ETF (VGIT)
• iShares ESG Aware MSCI USA ETF (ESGU)

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

Tax-efficient mutual funds that provide exposure to non-U.S. equities are funds that invest in stocks of companies outside the U.S. They help investors diversify their portfolios, access growth opportunities in foreign markets and reduce tax bills. These funds achieve tax efficiency by buying and holding stocks over long periods. They also pay qualified dividends that are taxed lower than ordinary income and may be eligible for foreign tax credit which allows investors to offset some or all of the taxes they pay on their dividends and interest income.

• Vanguard Total International Stock Index (VTIAX)
• Vanguard FTSE All-World ex-US Index (VFWAX)
• Fidelity International Index (FSPSX)

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

If you prefer mutual funds over ETFs, tax-efficient mutual funds that offer exposure to U.S. equity may be more to your taste. These funds employ tax-efficient strategies similar to the ETFs, including avoiding dividend-paying stocks, tracking indexes with low turnover or tax optimization and using tax-managed techniques to reduce capital gains distributions. 

• Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX)
• T. Rowe Price Tax-Efficient Equity Fund (PREFX)
• DFA US Core Equity 1 (DFEOX)

Tax-Managed Funds for U.S. Equity Exposure

Tax-managed mutual funds can provide tax efficiency for taxable accounts. These funds use strategies like avoiding dividend-paying stocks, tracking low-turnover or tax-optimized indexes, reducing capital gains distributions through tax-managed techniques or investing in municipal bonds exempt from federal income taxes to minimize the tax impact of their investments.

• Vanguard Tax-Managed Small Cap Fund Admiral (VTMSX)
• T. Rowe Price Tax-Efficient Equity Fund (PREFX)
• Vanguard Tax-Managed Capital Appreciation Fund Admiral (VTCLX)
• Russell Tax-Managed U.S. Mid & Small Cap Fund (RTSCX)

Tax-Efficient Mutual Funds for Bond Exposure

These funds can lower your tax liability and increase your after-tax returns by investing in bonds exempt from federal income taxes, such as municipal bonds or bonds with low interest rates, and Treasury bonds or inflation-protected securities. These mutual funds may be worth considering to gain exposure to bonds while also being tax-efficient. 

• Vanguard Tax-Exempt Bond ETF (VTEB)
• Fidelity Intermediate Municipal Income (FLTMX)
• T. Rowe Price Summit Municipal Intermediate (PRSMX)

Understanding the Tax Efficiency of ETFs

Investors aim to minimize the tax consequences of their investments by choosing tax-efficient options that either defer taxes or avoid them altogether. Because of their low turnover, ETFs are a popular choice for tax-efficient investments. This attribute means that ETFs buy and sell securities less frequently than actively managed funds, reducing the likelihood of realizing capital gains that must be distributed to shareholders and taxed. Index funds, which most ETFs are, tend to have low turnover as they only trade when the index changes or to maintain their tracking accuracy. 

ETFs also have a unique mechanism to create and destroy shares without buying or selling securities. This system is known as an in-kind transaction and allows ETFs and their shareholders to avoid triggering capital gains.

In contrast to ETFs, mutual funds are less tax-efficient as they have to buy and sell securities to meet investor flows, resulting in taxable capital gains distributions. By selecting tax-efficient ETFs over mutual funds, investors can defer capital gains taxes until they sell their ETF shares, potentially lowering their tax bills and reinvesting more earnings. 

Benefits of Tax-Efficient Investing for Taxable Accounts

Tax-efficient investing can offer several benefits for taxable accounts, including:

• Reducing your tax liability and increasing your after-tax returns
• Preserving your capital and compounding your growth
• Aligning your investment goals and risk tolerance with your tax situation
• Enhancing your portfolio diversification and flexibility

Factors to Consider When Choosing ETFs for Taxable Accounts

When choosing ETFs for taxable accounts, you may want to consider the following factors.

Expense Ratio and Management Fees

ETFs charge costs for their operation and administration, which are deducted from the fund's assets and reduce the investor's return. ETF expense ratio and management fees vary depending on type, size and complexity. Generally, passive ETFs that track an index have lower costs than active ETFs that try to beat the market. Investors should compare the expense ratio and management fees of similar ETFs to choose the ones that provide the best value for their performance.

Tracking Error and Index Replication 

ETFs are evaluated based on how accurately they mirror their underlying index or benchmark. Tracking error is the difference between the ETF's and index's returns over time. ETFs use index replication to match the composition and weightings of the index. Some ETFs use full replication, which means they hold all the securities in the index, while others use sampling, which means they contain a subset of securities that are representative of the index. The ETF's risk, return and tax efficiency are affected by tracking error and index replication. Choose ETFs with low tracking error and high index replication.

Trading Volume and Liquidity

Trading volume is the number of shares traded during a given period. Liquidity refers to the ability to execute a trade quickly and at a fair price. High trading volume and liquidity indicate a high demand and supply for the ETF, which leads to a lower bid-ask spread (the difference between the buying and selling price) and better price discovery (the process of determining the market value of an asset). Conversely, low trading volume and liquidity imply a low demand and supply for the ETF, which results in a higher bid-ask spread and impaired price discovery. Trading volume and liquidity also impact the ETF's transaction costs, market efficiency and price volatility. Most investors aim to choose ETFs that have high trading volume and liquidity.

Distribution Frequency and Reinvestment Options

Investors should consider an ETF's distribution frequency and reinvestment options to ensure optimal cash flow, compounding and tax efficiency. Distribution frequency refers to how often dividends or interest income are distributed, while reinvestment options allow shareholders to reinvest their distributions into the ETF. Choose an ETF with distribution frequency and reinvestment options that align with one's income needs, investment goals and tax situation.

ETF Structure (Open-End vs. Closed-End)

ETFs can operate under two legal forms — open-end and closed-end. Open-end ETFs are the most prevalent type, and they create and redeem shares on demand based on investor flows. Closed-end ETFs issue a fixed number of shares that can be bought and sold on an exchange, similar to stocks.

The ETF's structure significantly impacts its supply and demand, pricing mechanism and tax efficiency. Investors should look for ETFs with a structure matching their risk tolerance, liquidity preference and tax bracket.

Leveraging ETFs for Higher After-Tax Returns

Investing in a tax-efficient manner can significantly increase your post-tax returns. Because of their low turnover, in-kind redemption mechanism and tax optimization, ETFs can be great options for taxable accounts. They offer the potential to improve your portfolio, lower your tax obligations and align your investments with your tax situation. Consider expense ratios, tracking error, trading volume and distribution frequency when choosing suitable ETFs.

Frequently Asked Questions