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5 Picks With a Side of Tax Efficiency

Jeremy Glaser

Note: This video is part of Morningstar's February 2015 Tax Relief Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Tax Relief Week here on Morningstar.com. We talked to several of our top specialists to get their picks for your taxable accounts. 

We start with Russ Kinnel, who shared this idea.

Russ Kinnel: One of my favorite funds for a taxable account is Fidelity Tax-Free Bond (FTABX). The reason is that it's a really good way to tap munis. It's a long-term muni fund. Obviously, that entails some interest-rate risk. So, you have to recognize that you have to hold it for a while because there is some risk there. But Fidelity is really the best muni-investing group out there. They just have great analytics, a great team of managers and analysts, and they have delivered consistent performance.

Unlike some managers, they are very focused on issue selection. So, they are not going to make big interest-rate calls or other big bets. They are not going to shift around a lot. They are just going to try to incrementally add value. So, that means if things are working, they are going to beat their benchmark by a modest amount each year. It probably won't happen that they'll beat it every year; but again, their record shows that they are very good at doing what they do.

Glaser: Morningstar StockInvestor editor Matt Coffina thought that these names would be worth considering.

Matt Coffina: When I think about investing in a taxable account, there are two groups of companies that really stand out as being especially well suited to a taxable account. One would be companies that don't pay a dividend and that you're planning to hold for a very long time. If the company has a high dividend yield, it may be better off in a tax-deferred account so that you can shelter that dividend income from regular dividend taxes. Similarly, if you're planning to sell the stock in six months or a year, it's probably better off in a tax-deferred account so that you don't incur capital gains taxes. 

But if there is a stock that you really want to hold for the long haul and that doesn't pay a dividend yield, a name that comes to mind from our portfolio is Google (GOOG). We own it in our Hare portfolio. Google, I think, has the widest moat in technology. It's a very strong franchise with a dominant position in online advertising and is benefiting from the secular shift to digital advertising. So, advertising dollars, I think, will steadily move away from traditional media--be it newspapers, billboards, and so on. That transition is already well under way. But in the longer run, [advertising dollars are probably moving away] from TV as well and other forms of traditional media in favor of more digital advertising. 

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And really, no one is as well positioned as Google to take advantage of this trend with their core assets of search. Search is very conducive to online advertising. You have consumers who are telling you exactly what they're looking for at that moment, and that's a great time for the advertiser to swoop in with their offering.  And then Google also owning Youtube--which is a great alternative for television in the long run--gives brand advertisers an opportunity to get their video ads out there and really measure the effectiveness of those in time. At the same time, I'd love to see Google pay a dividend, but it doesn't currently and there's probably not much hope for a material dividend in the near term here. So, [Google is] a stock that I'm planning to hold for the long run that doesn't pay any dividend, [which makes it] especially well suited to a taxable account.

The other group of companies that does well in a taxable account would be master limited partnerships. These are companies that for tax reasons you really shouldn't own in a tax-deferred account. First of all, they have an embedded tax deferral already within the structure. So, for the most part, these companies have a lot of depreciation that they're able to use to offset their cash flows. The taxable income that they distribute to their unit holders tends to be much, much lower than their actual cash distribution. So, by owning those in a taxable account, you already benefit from a tax deferral on a lot of the income, whereas if you put them in a tax-deferred account, you'd basically be wasting the capacity of your tax-deferred account to hold other kinds of securities that don't have an embedded tax deferral. 

The second reason not to own MLPs in a tax-deferred account is that you could potentially incur some significant penalties and extra tax expense and a lot of tax complication if you have to file a tax return just for the tax-deferred account. If your unrelated business taxable income is above a certain threshold, that's a requirement. And that would really destroy the tax advantages of MLPs. It could certainly weigh on your returns over the long run. But more importantly, it creates a lot of unneeded and excessive paperwork and tax complications. 

So, two master limited partnerships that I favor right now would be Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP). In general, especially amid the energy-market downturn, but also considering that over the next three to five years, it's going to become increasingly difficult for master limited partnerships to find new incremental investment opportunities as the energy boom in North America starts to mature and new pipeline opportunities are less available, I think it's important for investors to be especially choosy about which master limited partnerships they choose to own. 

The advantage of Enterprise and Magellan is that both are very conservatively financed, very conservatively managed, they have diverse assets, their returns are supported by regulation in some cases, they have long-term contracts with customers, and they have a relatively low degree of commodity-price sensitivity. All of this makes those two partnerships well suited for any environment, but especially well suited for the current environment where investment opportunities may be harder to come by, energy prices are down significantly, and so on. I think those two companies will very likely be able to support their distributions for the foreseeable future and continue to grow those distributions, which also makes them good long-term holdings, which defers any potential capital gains taxes or other kinds of taxes that you might have to pay when you sell.

Glaser: Many investors choose ETFs because of their tax efficiency. Morningstar's Ben Johnson describes where these efficiencies come from and why they are not always there. And he also provides a great low-cost core pick.

Ben Johnson: ETFs' value proposition, from a tax-efficiency perspective, is not air-tight. Equity ETFs--particularly those that track very broad, diversified benchmarks--tend to be extremely tax-efficient. Most that, again, is lent by the fact that they track portfolios, indexes, that tend to turn over about 3% per year. For bond ETFs, that value proposition is somewhat less compelling. And indeed, if you get into more esoteric, niche corners of the market--you move down into small caps, for instance--what you'll see is higher turnover just due to the nature of the benchmark and the potential for less tax efficiency.

I think the biggest pitfall to avoid when it comes to looking at ETFs from a tax point of view is making the simplifying assumption that the tax-efficiency proposition is air-tight. It is also incumbent that investors understand that there still will be tax consequences to their ETF ownership. ETFs, be they equity ETFs or fixed-income ETFs, will spit out either regular dividend payments or coupon payments. And those are taxable, as they would be in any context. You will continue to experience capital gains taxes when you sell an ETF that has appreciated in price relative to your cost basis over a long period of time.

The best option if you are looking for a good long-term core U.S. equity holding, from a tax-efficiency point of view, would be the Vanguard Total Stock Market Index fund (VTI). This is an uber-low-cost way to access a very broad cross-section of U.S. equities in a very diversified, extremely liquid, and extremely tax-efficient manner.

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