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By Jason Stipp | 02-14-2012 02:00 PM

Topnotch ETFs for Taxable Accounts

Morningstar's director of ETF research explains which ETFs offer the most tax efficiency and names some of his favorite low-cost ETFs for building a simple but diversified tax-saving portfolio.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on Morningstar.com, and today we're talking about how to maximize your taxable accounts and the role that ETFs can play.

I'm checking in with ETF director of research Paul Justice to give us some tips about incorporating exchange-traded funds in your taxable portfolio.

Thanks for joining me, Paul.

Paul Justice: Great to be here.

Stipp: We do know that ETFs are a tax-efficient investment type, and I think that a lot of times we'll say that this is a kind of investment that you could put in a taxable portfolio and get a little more efficiency than maybe some other investment types. But it's not exactly clear to a lot of investors why ETFs are more tax-efficient, perhaps, than mutual funds. Can you walk us through that?

Justice: So, really when we're making this assumption, comparing ETFs to mutual funds for tax efficiency, what we're talking about is equity ETFs versus equity mutual funds. It's true that equity ETFs tend to be more tax-efficient. Why is that? Most of them are index funds. Index funds tend to be more passive in nature, have very low turnover. So that's one reason why they are very tax-efficient.

The other one--and this is kind of the cherry on top of all that--is this creation-redemption process that ETFs go through, which causes them to incur fewer capital gains, if any at all, over the lifecycle of the products. So yes, it's true, they are more tax-efficient from a capital gain perspective.

Stipp: The other thing I hear you folks often talk about, however, is that ETFs are a look-through type of investment. So, if you own fixed-income (bonds), if you have dividend-paying stocks, it doesn't mean that you're not going to get taxed on that income, correct?

Justice: Right. These are not Cayman Island funds; these are ETFs. They're just mutual funds giving you access to it in a different way. The IRS is making sure that no matter what you have, you're still going to pay taxes on it according to that asset class. If it's gold, and you sell it, you're going to get taxed like you owned a collectible. If you own futures contracts, you get taxed like you own futures. Hence, owning equities tends to be a very tax-advantaged way to get some good performance over a long period of time because we tax capital gains at lower rates.

Stipp: When you look at, though, a bond ETF, for example, compared with a bond mutual fund--even though you still are going to have to pay tax on that income--do you see that there is still some tax efficiency in the bond ETF versus the open-end fund?

Justice: Not really. So, most of the tax efficiencies go away when you're talking about fixed income. First of all, most of the tax implications are going to come from the fact that you're receiving interest income. So it's not a lot of capital gains most of the time.

Second of all, when there are capital gains, usually the ETF is going to have to incur them in the same way that a mutual fund is. If you're going to target some sort of maturity or duration, you have to keep selling bonds within the fund. That gets gains.

Stipp: You mentioned gold and futures before. I know that there are some other things that you need to keep in mind with specific types of ETFs, and you've talked about this in some articles [on Morningstar.com]. Where might you run into some tax quirks when you are investing in the ETF space?

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