Choosing the best Vanguard funds for taxable accounts requires a more strategic approach than the process for tax-deferred accounts like IRAs and 401(k)s. It's key to analyze the tax efficiency of the funds, because this affects the performance of the portfolio. You can get the most out of your portfolio by cutting back on fund expenses as well as tax costs if you know how to identify the right funds.
Worst Funds for Taxable Accounts
You should first determine the worst funds for taxable accounts. The best way to win in the long run is often to avoid losing in the short term. The quickest way to lose when you're investing in taxable accounts is by doing so in the types of mutual funds that incur the most in taxes.
Investments held in a regular brokerage account are taxed on capital gains, as well as on interest and dividends. You'll have a gain for which you'll owe tax when you sell a fund at a price (NAV) higher than that for which you purchased it.
Interest income and dividends are taxed as ordinary income, just as if you had received pay from a job.
Capital gains are generated when a fund manager sells shares of securities within the fund. These gains (and the taxes on them) are passed on to the shareholders.
The worst types of funds to hold in a taxable account include actively managed funds with high turnover ratios, funds that pay above average dividends, and most types of bond funds.
Tax-efficient strategies, such as tax-loss harvesting and the "bucket system approach," can be implemented if you need to generate income from mutual funds in taxable accounts.
Best Funds for Taxable Accounts
You can buy municipal bond funds if you're looking for income-generating funds. They're tax-free at the federal level, and sometimes at the state level as well. You can also look at the "tax cost ratio," which tells you how much of a fund's return is reduced by taxes. Look for the lowest tax cost ratio.
Best Vanguard Funds for Taxable Accounts
These are some of the best Vanguard funds for taxable accounts, in no order.
The Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) or the Vanguard Total Stock Market ETF (VTI) might appeal to you if you're looking for a great core holding that's tax efficient. The VTSAX and VTI include small-cap stocks. This tends to boost long term returns and reduce short term taxes from dividends. The expense ratio for VTSAX is 0.04%. The minimum initial investment is $3,000.
Vanguard offers many tax-managed funds, and VTCLX is one that provides the broadest exposure to stocks. The fund invests in mid- and large-cap U.S. stocks, using a unique index investing style that keeps tax costs low and limits its overall expenses. The expense ratio for VTMFX is 0.09%. The minimum investment is $10,000 to start out.
Consider VTMFX to meet your needs if you're looking for a one-fund solution for your taxable account. The fund portfolio consists of about 50% mid- and large-cap U.S. stocks, with the other 50% in federally tax-exempt municipal bonds. The expense ratio for VTMFX is 0.09%. The minimum start-up investment is $10,000.
VWITX invests in high-quality municipal bonds, which are tax-exempt at the federal level. This combination of quality and tax efficiency will provide you with both stability and diversification. The expense ratio for VWITX is 0.17%. The minimum start-up investment is $3,000.
You'll like VTEAX if you're looking for the best bond index fund that provides broad diversification and tax efficiency. It's available as Admiral Shares with an expense ratio of 0.09% and a initial investment of at least $3,000.
Another option is the Vanguard Tax-Exempt Bond ETF (VTEB). The expense ratio for VTEAX is 0.09%. The minimum start-up investment is $3,000.
Vanguard Funds and Tax Efficiency
Index funds are often more tax efficient than actively managed funds. They passively track a benchmark index, which translates to very low turnover, which occurs when securities like stocks and/or bonds are bought and sold within a portfolio.
The low turnover with index funds means that lesser capital gains are produced. Actively managed funds tend to have much higher turnover than index funds. You can look up a mutual fund's turnover ratio.
You may also want to consider Vanguard's exchange-traded funds (ETFs), which are passive investments that track an index. Like index funds, they have very low turnover ratios. They often have very low expense ratios as well, sometimes less than 0.20%, especially the ETFs offered by Vanguard.
Choosing the best mutual funds should begin with your investment objective and risk tolerance. Your search can begin from there when you know which funds are right for your goals.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be right for all investors. Investing involves risk, including the loss of principal.