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By Russel Kinnel | 07-10-2014 02:00 PM

3 Fund Ideas for a Tax-Efficient Portfolio

Index funds aren't the only vehicles suitable for taxable accounts, and Morningstar's Russ Kinnel offers three names that can help minimize the tax hit.

Christine Benz: Hi, I'm Christine Benz for Savvy investors focus on what they can control, and one of those factors is putting tax-efficient investments in their taxable accounts. Joining me to share some ideas is Russ Kinnel. He's director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, the no-brainer holdings if you have taxable accounts are broad-market index funds. Let's talk about why index funds can be such a good choice for the equity holdings within your taxable account.

Kinnel: You're right. They're the first place to start when you're thinking taxable account. They're very low-turnover, at least a broad market index fund is. They're low-cost, and there are not a lot of changes going on. So, because there is no manager deciding, "I like these stocks today, and I don't like these," with a market-cap-weighted index in particular, there's very little change going on. So, you have low turnover, and that leads to low capital gains. Many of the better index-fund managers, such as Vanguard, can also manage capital gains in a way that reduces that hit, as well. For instance, they can choose to sell the highest-cost lots and do some tax harvesting, even while staying consistent with the index.

Benz: And broad equity market exchange-traded funds would also have those same benefits?

Kinnel: Exactly. It doesn't really matter too much whether it's an open-end fund or an ETF, just as long as it's a well-run broad fund.

Benz: Stepping away from index funds, which you say are a really solid choice for taxable accounts, you brought a couple of other ideas that you think would also work well within investors' taxable accounts. One is a fund, Vanguard Tax-Managed Balanced. It's explicitly managed to keep taxes down. Let's talk about what that fund is and how it works and how it does reduce tax efficiency.

Kinnel: Right. It's an interesting mix. It's kind of unusual. You don't have a lot of balanced funds that include munis, but this fund is half an index fund and half a municipal-bond portfolio. And, of course, for a taxable account that's ideal because munis have tax-sheltered characteristics. The combination is this really nice one. The managers have to keep the muni stake at just over 50% for tax reasons, but it's a really good dependable fund. I think, if you're in a taxable account, why not look at a balanced fund that's got munis in it?

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