[Editor’s Note: This article was updated on March 4, 2020.]
Whether you’re still smarting from preparing your taxes or dreading the results, now is a good time to begin setting yourself up for an easier, less painful tax season next year.
For many investors, myself included, taxable account usage is on the rise. Thanks to their flexibility and the lack of deferred retirement accounts at many jobs, more than $8.5 trillion sits in taxable accounts as of the Investment Company Institute’s latest fact book. That’s a lot of money subjected to Uncle Sam’s icy grasp.
But investors may not need to fret. There are ways to lower your taxes today and into the future. The key comes down to exchange-traded funds (ETFs).
Most ETFs are naturally tax-efficient due to their structure. However, some are better than others. By using them in your taxable account, you can actually reduce and, in some instances, pay nothing on your investments. Given the sheer amount of coin now sitting in taxable accounts, using ETFs is a must.
With that, here are five ETFs that are perfect holdings for your taxable accounts.
Tax-Saving ETFs to Buy: iShares Core Dividend Growth ETF (DGRO)
Expense Ratio: 0.08%, or $8 annually per $10,000 invested
Working is for suckers. At least when it comes to taxes. That’s because wages are taxed at ordinary income rates. However, dividends are taxed much more favorably.
In fact, a couple filing jointly with a taxable income of $78,950 or less will pay a whopping 0% on those dividends. The normal dividend tax rate is 15% to 20% — still better than many folks’ marginal tax rates. This is incredibly advantageous for taxes and portfolios. To quote Professor Jeremy Siegel of The Wharton School of Business, “Dividends matter a lot.”
To that end, anyone just starting out their careers or those in lower tax brackets need a hefty dose of dividends and the iShares Core Dividend Growth ETF (NYSEARCA:DGRO) could be a great choice.
DGRO tracks the Morningstar US Dividend Growth Index. This index follows a basket of large- and mid-cap stocks that have histories of raising their dividend payouts. Better still is that DGRO uses screens for the sustainability of dividend growth and will kick stocks out that have shaky financials and cash flows. Furthermore, with this ETF, investors get a portfolio of top stocks like Microsoft (NASDAQ:MSFT) and Johnson & Johnson (NYSE:JNJ).
The kicker is that DGRO focuses its attention on so-called “qualified dividends.” These are the sort of payments that count toward that lower and more favorable dividend tax rate. By buying and holding the fund, investors can build a stream of income that is taxed at a better rate.
Because of that, DGRO is one of the best ETFs to buy in order to lower what you pay today.
SPDR Nuveen Bloomberg Barclays Municipal Bond ETF (TFI)
Expense Ratio: 0.23%
Do you know what’s better than paying 15% on your income? Not paying a single thing. And with ETFs, you can have that.
The ETFs to buy are those that track municipal bonds. Issued by governments 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, many high-income earners lean heavily on munis to get their income fix. However, even those investors in lower tax brackets can benefit from having a slice of munis in their portfolios.
The only problem with munis is that buying them individually is pretty hard. Most of the supply gets swallowed up by institutional investors and you generally need a big initial investment to even consider buying them. This is why ETFs make a ton of sense for the tax-free security.
A great place to start could be the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA:TFI).
TFI tracks the Bloomberg Barclays Municipal Managed Money 1-25 Years Index. This index aims to provide a total picture of the investment grade, fixed-rate municipal bond world. This a similar, but new index for the ETF. This helped bring down the fund’s duration by a bit. The best part is TFI still hold bonds subject to Alternative Minimum Tax (AMT). Currently, TFI holds nearly 2,900 different munis and yields 2.11%.
But before you balk at that low yield, remember that it’s tax-free. You need to earn about 2.34% to get the same amount of income. That makes TFI a top pick for muni bond exposure.
Vanguard Small-Cap Growth ETF (VBK)
Expense Ratio: 0.07%
Historically, small-cap stocks have been a wonderful place to find long-term growth in a portfolio. After all, it takes a long time for many smaller firms to reach their full potential and it’s much easier for them to grow than a behemoth multinational firm. Taxable accounts are perfect for holding ETFs that track small-cap stocks.
The longer you hold a stock, the better for taxes. That’s because, after a year, the capital gains rate dips to just 15% on shares sold. You basically can defer the taxes on those shares for really as long as you want. Because of this, funds like the Vanguard Small-Cap Growth ETF (NYSEARCA:VBK) can find a home in your taxable account.
VBK follows the CRSP US Small Cap Growth Index. This index tracks all the U.S. small-caps considered growth stocks. In other words, it tracks firms that feature rates of earnings or revenue growth faster than the broader market. VBK tracks 622 firms including Zebra Technologies (NASDAQ:ZBRA) and RingCentral (NYSE:RNG).
The reason why VBK makes sense in a taxable account is that growth stocks typically don’t pay big dividends. VBK yields just 0.62%. This helps reduce yearly taxes owed on owning shares of the ETF. And as a result, the fund has a very low three-year tax cost ratio.
Schwab US Broad Market ETF (SCHB)
Expense Ratio: 0.03%
For many investors, a taxable account is serving as supplemental retirement savings. Here again, ETFs can help reduce taxes as you seek long-term growth of capital. Thinking broad is probably best.
That’s because as index trackers the only real time they generate capital gains is when a stock falls out of an index. So, if your index holds a very broad portfolio of stocks, there’s a very low chance that it will pay any capital gains tax.
With just under 2,500 stocks, the Schwab US Broad Market ETF (NYSEARCA:SCHB) is as broad as you can get.
SCHB tracks the entire U.S. stock market — small-, mid- and large-caps. It’s all in there. And because of that, there’s basically zero chance for internally generated capital gains. Moreover, thanks to the fund’s huge size it can efficiently use ETFs’ creation/redemption mechanism to really prevent capital gains. By using a broad fund like SCHB, investors can still use their taxable accounts as a secondary retirement vehicle.
And as we said above with VBR, holding the fund for a long time will reduce taxes to the lower capital gains rate.
Sector ETFs To Buy
Another reason why ETFs are wonderful for taxable accounts has to do with tax-loss harvesting. Here, investors sell losers to help offset some ordinary income or other taxable gains reported in the current year — up to $3,000. Losses above that can be carried forward into future years to reduce taxes.
The beauty is that ETFs can help you stay invested in certain sectors even after trimming your losses to gain the tax advantages. Say you own shares of energy stock Chesapeake Energy (NYSE:CHK), which has been a disaster. You’d like to sell CHK and book the loss tax savings, but still want to have exposure to the energy industry. You could sell the stock and then purchase the Energy Select Sector SPDR (NYSEARCA:XLE), which tracks the broader energy industry.
The key is that ETFs skirt the so-called IRS wash-sale on substantially significant investments as they do not entirely replicate the initial position.
By doing this, investors can sell losers, get the tax savings and still stay invested in a sector they like. Have a few high-profile cloud/tech losers in your portfolio? Dump them and buy the Technology Select Sector SPDR Fund (NYSEARCA:XLK). Lost a bundle on a biotech stock? Sell it and switch to the iShares NASDAQ Biotechnology Index (NYSEARCA:IBB).
The point is, ETFs can be actively used to stay invested while reducing taxes.
At the time of writing, Aaron Levitt did not hold a position in any of the aforementioned securities.