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ETF Specialist

Fact or Fiction: Exchange-Traded Funds Are More Tax-Efficient Than Mutual Funds

ETFs can offer better tax efficiency, but mainly in the domestic-equity realm.

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With so much uncertainty in the financial markets, there are few outcomes over which investors have much control. One area where informed decision-making can consistently pay off is tax planning. Investors in high tax brackets or with a lot of money to invest should consider which asset classes and strategies are best held in a taxable account and which are best held in a tax-deferred account. Passive strategies generally are more tax-efficient, but this is not always the case, particularly if an index fund invests in an asset class with high tax costs or tracks an index with high turnover.

Asset-Class Tax Treatment Trumps All Else
Certain asset classes offer better aftertax returns in tax-deferred accounts, such as assets that throw off a large share of their total returns in the form of interest income, which is taxed at ordinary income tax rates. For example, if an investor in the highest tax bracket were to hold  iShares Core Total U.S. Bond Market ETF (AGG) in a tax-deferred account, he or she would have earned a 5.78% annualized return for the five years ended Dec. 31. That same investment held in a taxable account would have returned only 4.43% for an investor in the highest tax bracket. When choosing a fund for a taxable account, one would have been better off with the  iShares S&P National AMT-Free Muni Bond ETF (MUB), which returned 5.48%. But in the tax-deferred account, the muni fund underperformed the taxable iShares Core Total U.S. Bond Market fund.  

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