The typical large-blend fund in Morningstar’s database posted an annualized return of 10.98% over the decade ended February 2023. Meanwhile, the median tax-cost ratio of that same group of funds was 1.65%.
That means that an investor in the highest tax bracket who owned an average-performing large-blend fund and held it for a decade in a taxable account would have ceded about 15% of her returns to taxes. And that assumes that the investor didn’t sell at the end of the period but rather simply bought and held; the 1.65% per-year tax-cost ratio was simply her carrying cost for the fund and doesn’t factor in any taxes due upon the sale.
It’s not a good idea to hold taxable-bond funds in a taxable account, and that’s especially true now that yields have gone up to more meaningful levels. That’s because the majority of the return that bonds earn consists of income rather than capital gains, and income is taxed at the ordinary income tax rate versus the lower capital gains rate. The typical intermediate-term core bond fund returned 0.96% over the past 10 years and had a tax-cost ratio of 1.06%. For investors in the highest tax bracket who bought and held a taxable-bond fund in a taxable account (again, usually not advisable), their tax burden would have overshadowed the returns of the fund.
Some investors might assume that paying taxes is simply the cost of earning good returns. And it’s certainly true that good asset location can help reduce the drag of taxes. For example, by holding taxable bonds in their tax-sheltered accounts, investors will only be on the hook for taxes when they pull money out, not for any income their bonds or bond funds kick off during their holding periods. (Investors in Roth IRAs won’t owe any taxes at all upon withdrawal in retirement, provided they’ve minded their p’s and q’s.)
Investors can also help reduce their tax bills by maintaining a tight focus on tax-efficient funds for their taxable accounts. Individual stocks can be a good fit as taxable holdings: The investor will be subject to tax on any dividends the stocks pay out but won’t have to contend with the kinds of capital gains distributions that have bedeviled many investors in actively managed stock funds.
Mutual funds and exchange-traded funds can be quite tax-efficient, too; the key is to choose carefully. For equity investors, traditional index funds and ETFs tend to do a good job at limiting taxable capital gains; tax-managed mutual funds can also be a good choice. On the fixed-income side, municipal-bond funds can be a good fit for the taxable accounts of investors in higher tax brackets, though aftertax muni yields may be less attractive at various points in time, especially when muni demand is strong.
Here’s a rundown of some of our analysts’ favorite tax-efficient funds and ETFs for core equity and bond exposure.
Top Tax-Efficient ETFs for U.S. Equity Exposure
- iShares Core S&P 500 ETF IVV
- iShares Core S&P Total U.S. Stock Market ETF ITOT
- Schwab U.S. Broad Market ETF SCHB
- Vanguard S&P 500 ETF VOO
- Vanguard Total Stock Market ETF VTI
Exchange-traded equity funds have taken off in popularity in recent years, in part because of their ability to limit taxable capital gains. Not all ETFs have the same tax efficiency, but broadly diversified core equity ETFs manage to reduce capital gains distributions thanks to their very low turnover as well as the ETF structure.
Investors could also hold separate small-, mid-, and large-cap ETFs; iShares, Schwab, and Vanguard all field cheap and excellent versions. However, the main reason for holding discrete building blocks for each capitalization band is to rebalance among them, but doing so will tend to trigger more frequent selling—and in turn capital gains realization—than is ideal.
Top Tax-Efficient Mutual Funds for U.S. Equity Exposure
- Vanguard Total Stock Market Index VTSAX
- Vanguard 500 Index VFIAX
- DFA US Core Equity 1 DFEOX
- iShares S&P 500 Index WFSPX
Traditional index funds benefit from the chief factor that is responsible for ETF tax-efficiency, and that’s very low turnover. Thus, most of Morningstar’s favorite core index funds are fine tax-efficient picks, especially Vanguard Total Stock Market Index and Vanguard 500 Index. From a tax efficiency perspective, these funds benefit from the fact that they’re share classes of the firm’s ETFs. DFA US Core Equity 1, which has a Morningstar Analyst Rating of Gold, also has fine long-term tax efficiency numbers. BlackRock also offers fine, tax-efficient index options for U.S. equity exposure.
Top Tax-Managed Funds for U.S. Equity Exposure
- Vanguard Tax-Managed Capital Appreciation VTCLX
- Vanguard Tax-Managed Small Cap VTMSX
- Vanguard Tax-Managed Balanced VTMFX
Although they’ve been eclipsed by “popular kid” ETFs in recent years, the small subset of tax-managed funds has historically done a terrific job of limiting taxable capital gains. Vanguard’s suite of tax-managed funds, including Vanguard Tax-Managed Capital Appreciation, Vanguard Tax-Managed Small Cap, and Vanguard Tax-Managed Balanced, is a standout in this small group. Its funds closely track indexes and benefit from low turnover; they also layer on additional tax-management techniques such as tax-loss harvesting and downplaying dividend payers. Their expense ratios are ultralow, and their tax-cost ratios are on par with or even lower than comparable ETFs. I used Vanguard Tax-Managed Capital Appreciation and Vanguard Tax-Managed Small Cap in my core model tax-efficient Bucket portfolios for retired investors.
Top Tax-Efficient ETFs for Non-U.S. Equity Exposure
- Vanguard FTSE All-World ex-US ETF VEU
- Vanguard Total International Stock ETF VXUS
- Schwab International Equity ETF SCHF
- iShares Core MSCI Total International Stock ETF IXUS
Foreign-stock ETFs have all the structural tax efficiency benefits that U.S. stock ETFs do, but their tax-cost ratios tend to be a bit higher for one key reason: Foreign companies often pay higher dividends than U.S. companies, and those year-in, year-out payments lead to higher tax bills. For example, iShares Core MSCI Total International Stock ETF has a 12-month dividend yield of 2.4%, versus 1.6% for iShares Core S&P Total U.S. Stock Market ETF. Accordingly, foreign-stock ETFs’ tax-cost ratios are higher than those of U.S. ETFs. Even so, broad foreign-stock ETFs are appreciably more tax-efficient than actively managed funds. Among Morningstar’s favorite foreign-stock ETFs are Vanguard FTSE All-World ex-US ETF, Vanguard Total International Stock ETF, Schwab International Equity ETF, and iShares Core MSCI Total International Stock ETF.
Top Tax-Efficient Mutual Funds for Non-U.S. Equity Exposure
- Vanguard Total International Stock Index VTIAX
- Vanguard FTSE All-World ex-US Index VFWAX
- Fidelity International Index FSPSX
Many of the same caveats that apply to foreign-stock ETFs also apply to foreign-stock index funds. They generally enjoy low tax-cost ratios relative to actively managed products but usually have worse tax-cost ratios than U.S. index funds and ETFs because of higher dividends on foreign stocks. Among Morningstar’s favorite core international-equity index funds are Vanguard Total International Stock Index, Vanguard FTSE All-World ex-US Index, and Fidelity International Index.
Top Tax-Efficient Mutual Funds for Bond Exposure
- Fidelity Intermediate Municipal Income FLTMX
- Fidelity Municipal Income FHIGX
- Fidelity Tax-Free Bond FTABX
- T. Rowe Price Summit Municipal Income PRINX
- T. Rowe Price Tax-Free Income PRTAX
- Vanguard Intermediate-Term Tax-Exempt VWIUX
For investors in higher tax brackets (over 32%) who want to hold bonds in their taxable accounts, a municipal-bond fund can be a good fit. (At the same time, it’s worth noting that aftertax yields on munis won’t always be higher than those of taxable bonds with similar risk attributes.) While index funds dominated the preceding discussions of tax-efficient equity investing, Morningstar’s analysts tend to favor low-cost active management for the municipal-bond space. Fidelity’s muni funds have long rated among Morningstar’s favorites, including Fidelity Intermediate Municipal Income, Fidelity Municipal Income, and Fidelity Tax-Free Bond. T. Rowe Price’s municipal funds also earn high ratings, including T. Rowe Price Summit Municipal Income and T. Rowe Price Tax-Free Income. Vanguard Intermediate-Term Tax-Exempt is another favorite.
A version of this article appeared on Oct. 19, 2022.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.