The Best Investments for Taxable Accounts (2024)

Editor’s Note: A previous version of this article appeared on Aug. 17, 2022.

I recently wrote about investments that are best left out of investors’ taxable accounts because they have a record of kicking off sizable income/dividend distributions or making large capital gains payouts.

It's a long list. For investors who would like to reduce the drag of taxes on their taxable accounts (that is, nonretirement, non-tax-sheltered accounts), it's wise to downplay taxable bonds and bond funds, allocation (multi-asset) funds, actively managed stock funds, high-dividend-paying stocks and funds, and a host of niche categories like real estate and convertible bonds.

That seems like everything but the kitchen sink, but the good news is that it’s still possible for investors to build well-diversified portfolios that are also tax-efficient. The number of tax-managed model portfolios available to investors is also on the rise. In addition, I’ve developed a series of model portfolios with tax efficiency in mind.

Bear in mind that the investor’s own tax bracket plays a role in the attractiveness of various asset types. While municipal bonds—discussed below—will be close to a no-brainer for investors in higher-income tax brackets (say, 24% and above), those in lower tax brackets may be able to obtain a higher aftertax yield (not to mention better diversification) in taxable bonds. And while I had high dividend payers in my “save for tax-sheltered” bin, investors who are in the 0% tax bracket for qualified dividends and long-term capital gains (under $44,625 for single filers and $89,250 for married couples filing jointly) can go ahead and gorge on them.

Here are some of the key asset classes that make sense for most investors’ taxable accounts:

  1. Municipal Bonds, Municipal-Bond Funds, and Money Market Funds
  2. I Bonds, Series EE Bonds
  3. Individual Stocks
  4. Equity Exchange-Traded Funds
  5. Equity Index Funds
  6. Tax-Managed Funds
  7. Master Limited Partnerships

Municipal Bonds, Municipal-Bond Funds, and Money Market Funds

Any interest you earn from a conventional/taxable-bond fund is taxed at your ordinary income tax rate, which means that taxes take a big bite out of a taxable account’s return. By contrast, you won’t have to pay federal income tax on a municipal bond or municipal-bond fund’s payout. You may also be able to skirt state tax by buying a bond from your home state or a bond fund dedicated to that state. Individual bond buyers may also be able to avoid local taxes by buying bonds issued by their own municipalities.

As with taxable bonds, municipal bonds and municipal-bond funds have varying degrees of interest-rate sensitivity and credit qualities. A high-quality short-term muni fund will make sense for goals that are close at hand, whereas a longer-duration and/or lower-quality one could make sense for spending goals that are further into the future.

I Bonds, Series EE Bonds

These bonds, which can be purchased directly from the U.S. Treasury via TreasuryDirect.gov, aren’t quite as attractive from a tax standpoint as munis, but their interest skirts state and local taxes. Moreover, to the extent that an EE-bond owner redeems the bonds for qualified education expenses and their income falls below the thresholds, the interest can skirt federal tax entirely.

Investors have been dashing to I Bonds for their decent real yields. I Bonds are currently paying out 5.27%—their fixed rate of interest plus an inflation adjustment. The big downside is that I Bond enthusiasts are limited in how much they can buy: They can purchase $10,000 per year per Social Security number via Treasury Direct, and an additional $5,000 per year through their federal tax refunds.

Individual Stocks

If you’re inclined to hold individual stocks, your taxable account is a great place to do it, particularly if you trade infrequently. With a mutual fund, you’re on the hook for taxes on capital gains payouts regardless of whether you’ve sold any shares or whether you have any profits on hand to cover the taxes. If you own individual stocks, on the other hand, you don’t have to pay capital gains until you yourself sell a share and lock in a gain. (You will owe taxes on dividend distributions, however, which is one reason why I would maintain that high-income-producing equities are best housed in a tax-sheltered account.)

Holding individual stocks also makes it easier to take advantage of tax-loss selling than with a mutual fund, because you won’t have to wait for the broad market or market segments to sell off to find losses in your portfolio. (Individual stocks exhibit more frequent and dramatic ups and downs than do mutual funds, which are inherently better diversified.) Using the specific share identification method for cost-basis accounting makes it even easier to cherry-pick losing blocks of stock for tax-loss-harvesting purposes.

Equity Exchange-Traded Funds

For investors who like the convenience and built-in diversification of a mutual fund, equity exchange-traded funds can make fine, tax-efficient options for taxable accounts. Most ETFs track indexes, so their turnover is often very low, meaning that capital gains distributions also tend to be few and far between.

Moreover, ETFs sell on an exchange, meaning most trading takes place between shareholders. Individuals cannot redeem their shares for cash directly from the fund company. Because the fund manager doesn’t have to pay off departing shareholders, they won’t be forced to sell shares to raise cash, potentially unlocking a capital gain.

Furthermore, the large institutional shareholders that are permitted to redeem ETF shares directly from the fund company don’t receive cash for exchanging their shares, either. Instead, when they sell, they are given a basket of the stocks held in the ETF’s portfolio. This allows the ETF to continually hand off its lowest-cost-basis shares to redeeming institutions. Taken together, those features enable equity ETFs to be much more tax-efficient than traditional mutual funds.

At the same time, it’s worth noting that bond or other ETFs that crank out taxable current income aren’t especially tax-efficient, even though they benefit from the same basic features. That’s because most of the return that bond investors earn is ordinary income, rather than capital gains, and income from an ETF receives the same tax treatment as income from a traditional mutual fund.

Equity Index Funds

Traditional equity index mutual funds don’t benefit from all of the tax-management bells and whistles that ETFs do, and some index funds have made sizable distributions when they’ve had big outflows or their underlying indexes have changed.

But conventional index mutual funds do share a tax-friendly commonality with ETFs: They’re index funds, meaning that they generally don’t trade a lot. Thus, many index funds have managed to be nearly as tax-efficient as their ETF counterparts, making them a solid option for taxable accounts. Vanguard’s index funds have managed to be particularly tax-efficient because the firm’s ETFs are share classes of its funds.

As with bond ETFs, bond index funds haven’t been especially tax-efficient because most of their returns are income, which is taxed at ordinary income tax rates and which the index wrapper provides no protection against.

Tax-Managed Funds

These funds have gotten overshadowed as ETFs have grown in popularity, but there are still some fine options in this subgroup. Tax-managed funds aim to keep income and capital gains distributions to a bare minimum by actively offsetting any capital gains with losses and shunning investments that generate ordinary income, which is taxed at the highest rate.

Vanguard runs a terrific suite of tax-managed funds for nearly every role in investors’ portfolios, and Vanguard Tax-Managed Balanced VTMFX is a rare multi-asset fund that is a good fit for taxable accounts.

Master Limited Partnerships

This is a niche category, but individual MLPs—partnerships that often operate oil and gas pipelines—are an example of a rare higher-income investment that’s generally better off inside a taxable account than a tax-sheltered one.

The tax treatment of MLPs is complicated, but the big reason to keep individual MLPs out of a tax-sheltered account is that most MLP income counts as unrelated business taxable income, or UBTI. If that income exceeds $1,000 in a year, the owner of an MLP inside an IRA could owe taxes on that income, effectively negating the tax-sheltering effects of the IRA wrapper.

The income from ETFs that buy MLPs doesn’t count as UBTI, which makes ETFs a better fit for tax-sheltered accounts than individual MLPs. Morningstar doesn’t currently have any MLP exchange-traded products on its list of Morningstar Medalists. It’s worth noting that many investors have had a terrible experience with MLPs because they bought into the category at a high point last decade, only to see the group sell off sharply subsequently.

What to Have on Your Tax Radar for 2024

Tax- and retirement-planning expert Ed Slott discusses SECURE 2.0 provisions and potentially higher income and estate tax rates in 2026.

11m 44s

The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.

The Best Investments for Taxable Accounts (2024)

FAQs

The Best Investments for Taxable Accounts? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

Why are ETFs better for taxable accounts? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

Should I hold REITs in taxable accounts? ›

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 that investors earn from them, as REITs must pay out a minimum of 90% of their taxable income in dividends each year.

Should I hold treasuries in a taxable account? ›

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they're exempt from state and local income taxes. 89 But corporate bonds don't have any tax-free provisions, and, as such, are better off in tax-advantaged accounts.

Should I hold dividend stocks in a taxable account? ›

4. Stocks and Funds That Pay Dividends. Dividends are not a bad thing, but they are considered taxable income in the year you receive them. If you're invested in stocks or funds that generate a lot of dividend income, your current-year tax bills may be high.

What is the best investment for a taxable account? ›

The Best Investments for Taxable Accounts
  • Municipal Bonds, Municipal-Bond Funds, and Money Market Funds.
  • I Bonds, Series EE Bonds.
  • Individual Stocks.
  • Equity Exchange-Traded Funds.
  • Equity Index Funds.
  • Tax-Managed Funds.
  • Master Limited Partnerships.
Dec 28, 2023

Which ETF is best for a taxable account? ›

25 Top Picks for Tax-Efficient ETFs and Mutual Funds
  • Vanguard Interm-Term Tx-Ex Adm. (VWIUX)
  • Vanguard Tax-Managed Small Cap Adm. (VTMSX)
  • Vanguard Total Stock Mkt Idx Adm. (VTSAX)
  • Schwab International Equity ETF™ (SCHF)
  • iShares Core MSCI Total Intl Stk ETF. (IXUS)

What is the best account to hold a REIT in? ›

If you invested in the REIT outside of your Roth IRA, the dividends would be taxed as income. In many ways, investing in REITs in your Roth IRA is the ideal way to invest in a REIT. Their dividends greatly compound over time and you won't have to pay taxes on them when you reach retirement age.

Are REITs better in taxable or tax deferred accounts? ›

It's not necessarily a bad idea to own REITs in taxable brokerage accounts. But because of complex REIT taxation rules, they certainly make more sense in IRAs. This way, the REITs avoid taxation on the corporate level and you can defer or avoid taxes on the individual level, as well.

What are the advantages of REITs in a taxable account? ›

REIT Tax Advantages

There are no wage restrictions or caps on the deduction, and taxpayers don't need to itemize their deductions to receive the QBI deduction. Therefore, in a REIT structure, the QBI deduction can benefit high-net-worth individuals, as non-REIT structures may have income limitations.

Why buy a CD over a treasury bill? ›

CD and Treasury bill rates offer similar rates for terms of one to six months. CDs are paying higher rates than Treasury bills and Treasury notes for terms of one to five years. Treasuries are exempt from state income taxes, which is an important advantage when rates are nearly the same.

Are treasuries safer than CDs? ›

CDs and Treasuries Offer a High Degree of Safety

Both CDs and Treasuries are considered extremely safe investments. Treasuries are backed directly by the federal government, while CDs are covered by FDIC insurance – which is also backed by the federal government.

Which is better, CD or Treasury bond? ›

Key Takeaways. Both certificates of deposit (CDs) and bonds are considered safe-haven investments with modest returns and low risk. When interest rates are high, a CD may yield a better return than a bond. When interest rates are low, a bond may be the higher-paying investment.

When to invest in taxable accounts? ›

Here are some examples of times when you might use a taxable brokerage account: You have short-term investment goals: If you have short-term investment goals, such as saving for a down payment on a home or purchasing a car, a taxable brokerage account may be a good option.

How do you avoid dividends in taxable accounts? ›

Avoiding all income taxes on dividends is more complicated, though. Options include owning dividend-paying stocks in a tax-advantaged retirement account or 529 plan. You can also avoid paying capital gains tax altogether on certain dividend-paying stocks if your income is low enough.

Is an ETF better than an index fund for taxable accounts? ›

If you're investing in a taxable brokerage account, you may be able to squeeze out a bit more tax efficiency from an ETF than an index fund. However, index funds are still very tax-efficient, so the difference is negligible. Don't sell an index fund just to buy the equivalent ETF.

Are index funds or ETFs better for taxes? ›

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.

Are ETFs better than mutual funds in IRAS? ›

ETFs are often considered more tax-efficient as their structure minimizes capital gains distributions to investors. Meanwhile, mutual funds can generate capital gains within the portfolio which are distributed to investors, potentially resulting in taxable events.

What is an ETF for tax purposes? ›

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.

Top Articles
Latest Posts
Article information

Author: Kelle Weber

Last Updated:

Views: 6079

Rating: 4.2 / 5 (73 voted)

Reviews: 88% of readers found this page helpful

Author information

Name: Kelle Weber

Birthday: 2000-08-05

Address: 6796 Juan Square, Markfort, MN 58988

Phone: +8215934114615

Job: Hospitality Director

Hobby: tabletop games, Foreign language learning, Leather crafting, Horseback riding, Swimming, Knapping, Handball

Introduction: My name is Kelle Weber, I am a magnificent, enchanting, fair, joyous, light, determined, joyous person who loves writing and wants to share my knowledge and understanding with you.