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Investing Specialists

Which Investments to Keep Out of Your Taxable Account

Vanguard's recent target-date fund distribution illustrates a simple fact: Some investments are structurally a poor fit for taxable accounts.

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A big capital gains distribution from Vanguard target-date funds in late 2021 owed to some reshuffling among the firm's funds. But it illustrated a broader point: Some investments are simply a poor fit for investors' taxable accounts.

While it can be hard to see one-off distributions like the Vanguard funds' in advance, it also happens that target-date funds are structurally ill-suited for taxable accounts. That's the case for a host of other investment types as well, from REITs to junk bonds to high-dividend stocks and actively managed funds. That's not to say that investors shouldn't own them, but rather that they should take pains to house them inside of their tax-sheltered accounts, where income and capital gains distributions won't result in a tax bill.

Here's a closer look at some of the key categories to keep out of your taxable accounts.

Taxable Bonds and Bond Funds: Generally speaking, bonds will tend to be less tax-efficient than stocks. That's because most of the return that bond investors earn is income, and that income is taxed at your ordinary income tax rate, which is higher than the capital gains and dividend tax rates that apply to the gains from most stock holdings. The median taxable-bond fund in Morningstar's database has a tax-cost ratio of 1.08% over the past five years, representing a 40% cut of the median fund's return over that time frame. The median tax-cost ratio for all U.S. stock funds was higher--1.9%--but it represents just 15% of the median fund's 13% gain over that period. Moreover, a number of stock funds, especially broad-market index funds and exchange-traded funds, had tax-cost ratios of less than 0.5%.

Certain bond holdings can be a particularly bad idea for taxable accounts. High-yield bond funds, because they tend to generate (relatively) large amounts of current income, are best avoided in taxable accounts. Ditto for funds that hold Treasury Inflation-Protected Securities, because you're taxed not just on these bonds' yields but on the principal adjustment you receive to account for inflation. (If you want to give your taxable portfolio a measure of inflation protection, consider I-Bonds, which enjoy more favorable tax treatment than TIPS.)

But what if you're using your taxable accounts to save for shorter-term, nonretirement goals? From a practical standpoint, that's what many of us do. If you need to hold bonds in your taxable accounts and you're in a higher tax bracket--say, 24% or above--check to see whether municipal bonds would be a better bet on an aftertax basis. Whereas any interest you earn from a conventional bond fund is taxed at your own income tax rate, you won't have to pay federal income tax on a municipal-bond fund's payout; you may also be able to skirt state income tax by buying a muni fund dedicated to your state's bonds. For very short-term assets, you can also find municipal money market funds.

Multi-Asset Funds: Multi-asset funds like target-date funds and balanced funds will also tend to be a poor fit for taxable accounts and are much better off housed in a tax-sheltered account like an IRA or 401(k). That's because they typically hold taxable bonds (see above). Moreover, their asset allocations either stay the same, as is the case with static-allocation funds like balanced funds, or they get more conservative over time, as happens with target-date funds. That can necessitate the sale of appreciated assets like stocks, which in turn can sock investors with capital gains taxes.

It's true that some multi-asset funds have been quite tax-efficient, in part because categories like target-date funds have enjoyed robust asset inflows. That has given these funds the opportunity to rebalance by directing the new assets to whichever asset class needed topping up. Indeed, the median allocation fund in Morningstar's database has a tax-cost ratio of 1.43%, representing just 17% of the median fund's five-year annualized return--not too much worse than what stock funds have ceded to taxes. Yet that need to sell for rebalancing purposes could work against these funds at some point in the future. Investors in search of a balanced holding in their taxable accounts might consider Vanguard Tax-Managed Balanced (VTMFX), which is low-cost and has managed to be exceedingly tax-efficient. Its five-year tax-cost ratio of 0.42% is just 4% of its nearly 10% five-year annualized return.

Actively Managed Equity Funds: I used to equivocate about whether to hold actively managed funds in taxable accounts. But I've seen enough, and the answer is: Don't do it. Yes, some actively managed equity funds have managed to keep their tax bills low, either because their managers employ low-turnover approaches or they've been receiving big shareholder inflows. Both of these factors tend to limit big capital gains payouts. But whether they can continue to do so is an open question. And some active funds have been absolutely awful from a tax standpoint, dishing out large capital gains year after year.

The fact that the stock market has enjoyed a steady upward march for most of the past decade has contributed to funds' tax inefficiency, because fund managers have more gains in their portfolios than losses. Manager changes can be a catalyst for big capital gains distributions: As the new guard tosses out older holdings, it realizes taxable gains in the process. Investors' ongoing preference for index funds and ETFs over actively managed funds has been an even more widespread factor, forcing managers into selling appreciated winners to meet shareholder redemptions. That has led some funds to be serial distributors of large capital gains distributions and has caused tax headaches for the investors who have stuck around. Of course, those distributions increase shareholders' cost basis, assuming they're reinvested, but most investors would prefer to realize capital gains on their own schedules, ideally later rather than sooner. Meanwhile, broad-market index mutual funds and especially ETFs have been much more tax-efficient.

High-Dividend-Paying Equities, Dividend-Focused Funds: Investors love their dividends, and they may become especially attached to them if stocks continue to be volatile. And while dividend payers enjoy relatively favorable tax treatment currently, such stocks and funds are arguably a better fit for tax-sheltered rather than taxable accounts.

The key reason is control. Dividend income, like bond income, isn't discretionary. Whereas stock investors can delay the receipt of capital gains simply by hanging on to the stock, investors in dividend-paying stocks get a payout whether they like it or not. That makes dividend payers, regardless of tax treatment, less attractive than nondividend payers from a tax standpoint.

REITs and REIT funds: Real estate investment trusts are a poor fit for taxable accounts for the reason that I just mentioned. Their income tends to be high and often composes a big share of the returns investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year. Moreover, their dividends typically count as nonqualified, meaning that they're taxed at higher ordinary income tax rates versus the lower tax rates that apply to qualified dividends.

Commodities Futures Funds: Commodities-tracking funds typically use futures to obtain exposure to the commodities market, and futures' tax efficiency is poor. Sixty percent of their gains are taxed at the long-term capital gains rate, and the remaining 40% is taxed at the much higher short-term capital gains rate. (For comparison sake, the long-term capital gains rate for the highest-income investors is 23.8%, versus more than 40% for short-term capital gains.) As a result, the tax efficiency of commodities funds is ugly: The median broad-basket commodities fund has a five-year tax-cost ratio of 2.21%, representing 40% of the median fund's five-year annualized return.

Convertibles (and Funds That Own Them): Gains on convertible bonds are generally taxed at ordinary income tax rates, making them ill-suited to investors' taxable accounts. The median convertible fund in Morningstar's database has a five-year tax-cost ratio of 2.4%, representing a 20% bite out of total return over that time period.

Alternatives Funds: The alternatives group is a broad basket encompassing a lot of different strategies. While tax efficiency hasn't been poor across the board, some of these funds have been quite tax-inefficient, especially when you consider their low return profile. The category's median five-year tax-cost ratio of 0.94% represents 29% of the median return over that time period.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.