With the sting of tax season still fresh on the mind and on the wallet, now is a good time to be sure you’re doing all you can to minimize taxes. A great place to start is with Vanguard funds.
While there are plenty of mutual fund companies that have tax-efficient offerings, Vanguard is arguably the best overall for its selection of tax-managed funds and index funds that are smart for taxable accounts.
Therefore, with a broad range of Vanguard funds that are friendly to taxable accounts, investors can build their own portfolio or they can buy single tax-managed funds for a one-fund solution or a smart core holding.
How to Keep Taxes Low With Mutual Funds
When you hear the term tax-efficient in context of investing, it means that a particular security will generate less taxes relative to other securities. For example, a stock mutual fund that pays dividends or a bond fund that is designed to generate income for the investor will likely be less tax-efficient than a growth stock fund that pays little or no dividends.
Also, when seeking tax-efficiency, investors should look for funds with low turnover. This is important because mutual funds are required to pass along at least 90% of their capital gains to investors, which also means more taxes. The term for this is capital gains distributions. Even if the investor doesn’t sell any shares, they can still owe capital gains taxes from those distributed from the activity of the fund itself. Therefore, if the turnover is low, the capital gains distributions, and thus taxes, are kept to a minimum.
So investors looking to minimize taxes are smart to invest in index funds, which by nature have extremely low turnover. Even better, look for index funds that concentrate more on growth stocks, which will also reduce or eliminate taxable dividends.
Vanguard Funds That Keep Taxes Low
Vanguard offers dozens of index funds and several tax-managed funds. Here are a few that are standouts for investing in taxable accounts:
- Vanguard Total Stock Market Index Fund (VTSMX): Diversification and rock-bottom expenses are not the only advantages with VTSMX, which happens to be the biggest mutual fund in the world. It’s also incredibly tax-efficient. Even though the portfolio holdings include more than 3,500 stocks, the turnover ratio is just 3%. Also the yield is 1.91%, which is slightly lower than that of the S&P 500 Index. And with the exposure to small- and mid-cap stocks in addition to large caps, you get a diversified fund that can outperform the S&P 500 while remaining tax-efficient, all in one fund.
- Vanguard Intermediate-Term Tax Exempt Fund (VWITX): It’s not easy to find a good bond fund that can minimize taxes but VWITX is among the best in the tax-efficient category. The income is tax-exempt at the federal level because the fund holdings are municipal bonds. Munis can also be tax-exempt at the state level if you live in a state with income taxes and you buy a bond fund that holds only your state’s municipal bonds. VWITX is also a top performer in the municipal bond fund category, as it tends to remain in the top third for performance among category peers.
- Vanguard Tax-Managed Balanced Fund (VTMFX): If you’re looking for a solid core holding or a standalone option for your taxable account, you can’t get much better than VTMFX. This five-star fund has a moderate to conservative allocation of roughly 50% stocks and 50% bonds. The expense ratio is a cheap 0.11% and the turnover is just 9%. The portfolio is managed with a focus on tax-efficiency; therefore the stocks don’t kick off much in the way of dividends and the bond holdings are predominately municipal bonds. Capping off the tax-efficiency, the historic performance has VTMFX ranking in the top 1% for the 1-, 3-, 5- and 10-year returns. One slight obstacle for some investors is that the fund has an initial investment minimum of $10,000. But that’s reasonable for a fund that represents most or all of your taxable account allocation.
There are many other tax-efficient index funds, bond funds and tax-managed funds at Vanguard. Just keep these basic rules of tax efficiency in mind and you can build your own portfolio with Vanguard funds in your taxable account.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities, although he holds VTSMX for some client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.