There’s a lot to like about having a taxable brokerage account as part of your investment mix. With no limits on annual contributions and not being subject to early withdrawal penalties or required minimum distributions, taxable accounts make great “bridge” accounts of those looking to retire early or fund non-retirement expenses. The key to getting to most out of your taxable account is to try and make it as tax-efficient as possible.
And that’s where exchange-traded funds (ETFs) come in.
Thanks to their fund structure, most ETFs won’t hit their investors with unexpected and large year-end capital gains distributions, while their creation/redemption mechanism also helps keep taxes low for shareholders. Then their intraday tradability allows investors to be tax sensitive buy selling/holding individual lots.
These features make most ETFs ideal holdings for taxable accounts. Using them should help keep more money in your pocket and less in Uncle Sam’s. With that, here are 5 great taxable account ETFs.
Great Taxable Account ETFs #1: iShares Russell 3000 ETF (IWV)
One of the reasons why ETFs are great for taxable accounts is that they track indexes. Because of this, there is less selling in and out of positions that could generate capital gains. In fact, the only real time they generate capital gains is when a stock falls out of an index. To really eliminate capital gains potential, the idea to is think very broadly with an ETFs underlying index.
And you really can’t get much broader than the iShares Russell 3000 ETF (NYSEARCA:IWV).
IWV tracks the Russell 3000 index. This covers the entire U.S. stock market- from mega-caps like Johnson & Johnson (NYSE:JNJ) all the way down to small-caps you’ve never heard of. All in all, the ETF holds a whopping 2,927 stocks that cover 98% of all U.S incorporated equity securities. This broad mandate makes it a prime way to add a dose of stocks to a taxable account.
And the proof is in the pudding. Except for one quarter in 2005, IWV has never had any capital gains distributions on its holdings. Only low-tax rate qualified dividend distributions.
That makes IWV as tax efficient as they come. And its one of the cheapest as well. Expenses come in at just 0.20% — or $20 per $10,000 invested.
Great Taxable Account ETFs #2: PowerShares QQQ (QQQ)
Want to squeeze even more efficiency out of your taxable account? Reach for growth stocks. Typically, growth stocks do not pay big or any dividends at all. And if you hold them for quite a while, capital gains taxes are lower. That makes them perfect for a long-term taxable account.
The classic growth play continues to be the PowerShares QQQ (NASDAQ:QQQ).
The “Cubes” track the venerable NASDAQ 100 Index — which tracks roughly 100 of the largest U.S. and international non-financial stocks listed on the NASDAQ Index. The NASDAQ is known as a home to some of the biggest tech and growth names in the U.S. As a result, the ETF represents one of the best ways to add growth stock potential to a taxable account.
And while some tech giants like Microsoft Corporation (NASDAQ:MSFT) have started to pay dividends, the QQQ’s yield is a measly 0.86%. That makes taxes on dividends easy to swallow. And with no capital gains distributions for decades, the Cubes are as tax efficient as ETFs come.
For investors looking to add a touch of growth to their portfolio, the QQQ is the only way to go.
Great Taxable Account ETFs #3: SPDR Short Term Municipal Bond ETF (SHM)
Municipal bonds are made for taxable accounts. Issued by local and state government and agencies in order to help fund their daily activities or a special project, munis are free from federal taxes and in some cases, state taxes. Because of this, a taxable account is really the only place that you should hold munis. There’s really no point in placing them in an IRA or 401k.
However, there is really one wrench in muni’s perfection. And that’s the Federal Reserve.
Traditionally, municipal bonds are long-dated bonds 10, 15 or even 30-years in maturity. As a result, the inverse relationship between bonds and rising rates hits them very hard. So as the Fed has been raising rates, muni’s have been falling. The way to get around this is to go short with your duration.
The SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (NYSEARCA:SHM) does this by betting on investment-grade munis with an average duration of just 2.74 years. That shorter duration provides some level of interest rate protection as SHM won’t fall as much as longer-dated muni holdings. Meanwhile, the yield on SHM should rise as its able to roll-over its shorter bonds faster to higher yielding ones.
For investors looking to get some income from their taxable account, SHM is a top choice.
Great Taxable Account ETFs #4: Vanguard High Dividend Yield ETF (VYM)
For investors looking for a bit more income from their taxable accounts have to turn to stocks to find it. The key is finding ETFs that continue to be tax-efficient. The popular Vanguard High Dividend Yield ETF (NYSEARCA:VYM) is a great choice.
VYM tracks the FTSE High Dividend Yield Index — which is a measure of large-cap stocks that pay high dividends relative to the market. While the name can be misleading, VYM is all about the bluest of the blue chips. The portfolio is chocked full of dividend stalwarts like Exxon Mobil (NYSE:XOM) and J.P. Morgan (NYSE:JPM). So, investors shouldn’t be worried about risky high yielding names. This focus on quality dividend payers allows VYM to throw off a decent 3.03% yield.
Where the ETF gets its tax-efficiency from — aside from the fact that it’s indexed — comes down to what it holds. Or in this case, what it doesn’t hold. And that’s real estate investment trusts (REITs). REITs are great for getting a high yield, but their dividends are not considered qualified and get taxed at ordinary income rates. High-income earners will get pinched from holding them in a taxable account.
VYM’s dividends come from qualified sources — meaning they will be taxed at just 15%. That’s a small price to pay to get plenty of income from a portfolio.
Great Taxable Account ETFs #5: iShares Short Maturity Municipal Bond ETF (MEAR)
One of the biggest reasons for having a taxable account is for cash management. With no withdrawal limits, a taxable account is perfect to hold cash and similar assets before you reach full retirement age or another pre-retirement purpose. But even holding cash comes with nasty tax consequences. Interest income is taxable at ordinary rates. Using the iShares Short Maturity Municipal Bond ETF (NYSEARCA:MEAR) could be a great answer to limiting cash-related taxes.
MEAR bets on very short-term municipal bonds with maturities of 180 days to 1.5 years. This provides the ETF with very money-market-like qualities. Even more so when you consider that the share price hasn’t really floated up or down significantly since its launch. And while MEAR is an active ETF, fund managers don’t really trade their bonds and the fund has been quite tax-efficient. Again, MEAR hasn’t paid any capital gains distributions and its muni-based income dividends have been free of taxes.
For investors, MEAR could be the best way to hold cash in a taxable account and improve its tax-efficiency.