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Even as volatility leaves financial advisors’ clients wondering how to address their portfolios, it’s important to remember that certain choices — such as developing a tax-efficient investing strategy — can make a big difference no matter the market environment.

Christine Benz, Morningstar’s director of personal finance, recently outlined her top investments for taxable accounts in an updated column on the firm’s website, and shared insights with ThinkAdvisor on how financial advisors might approach these decisions with clients.

“There is increasing awareness among advisors that tax management is one of the most valuable services they can provide for their clients,” she told ThinkAdvisor via email. “Advisors can’t control how the markets behave or the rate of inflation, but tax management is an evergreen way to add value.”

The starting point for advisors and clients is a discussion on the eventual goals for the funds, which in turn can determine the right asset mix and the proper tax strategy, she said.

“From there, it’s important to discuss tax bracket — right now and in future years,” she said. “That way, the advisor can develop a holistic, long-term tax strategy — one that aims to limit taxes in the here and now but also the taxes that are eventually due when the client sells the asset.”

Tax bracket is “a crucial consideration,” Benz continued. “If a client is in a lower tax bracket, investments that would otherwise be tax-inefficient, such as taxable bonds or high-dividend-paying securities, might make more sense than would be the case for people in higher tax brackets. Additionally, clients in that situation may want to take advantage of selling appreciated securities at the 0% capital gains rate and even re-buying them, thereby boosting cost basis and reducing the taxes due on the eventual sale.”

Advisors rarely create portfolios from scratch, “so a big part of the discussion will necessarily be about how to transition a portfolio with tax-inefficient investments to one that is more tax-friendly and appropriate for a taxable account,” she added. “Unfortunately, making a portfolio more tax-efficient can bring its own tax bill if it means selling out of something that has appreciated.”

The recommended investments for taxable accounts are fairly constant, regardless of the economy, but financial advisors and clients should pay attention to any changes to the tax code, she said.

“Last year, when we pondered curbs on the amount of assets that would be eligible for a step-up in cost basis upon death, for example, that prompted a major reconsideration of strategies that advisors had been using for many years,” although such changes didn’t materialize, she noted.

Here are six of Benz’s top investment picks for investments for taxable accounts (versus tax-preferred accounts like retirement plans), per her Morningstar column, which notes that investors have access to an increasing selection of tax-efficient model portfolios.

1. Municipal Bonds and Municipal Bond Funds

While interest from taxable bond funds — taxed at the investor’s ordinary income tax rate — can hit returns, that’s not the case with municipal bonds and municipal bond funds, Benz wrote. Muni bonds and funds aren’t subject to federal income tax, and clients also may be able to avoid state or local taxes on municipal bonds or bond funds tied to their state or city, she added.

A client’s tax bracket may play a role in choosing the type of bonds for a taxable account, Benz noted. While municipal bonds and municipal bond funds make sense for those in higher tax brackets — 24% and higher — taxable bonds might produce a better yield for investors in lower tax brackets.

She suggested high-quality, short-term municipal bond funds for near-term goals, and longer-duration or lower-quality funds for longer-term spending needs.

Benz also cited municipal money market funds as an appealing choice for taxable accounts, saying they tend to make sense for higher-income investors who need to maintain liquid reserves on an ongoing basis. “There are broadly diversified municipal money market funds as well as ones that focus on bonds from a specific state; those might be especially attractive for high-income people who live in high-tax states like California,” she told ThinkAdvisor.

(Image: Shutterstock)

2. I Bonds and Series EE Bonds

Municipal bonds are more attractive than these U.S. government bonds when it comes to tax efficiency, but clients can avoid state and local taxes with I bonds and Series EE bonds, according to Benz. Clients with incomes below certain thresholds can avoid federal taxes as well if they redeem EE bonds for qualified educational purposes, she added.

I bonds bought before November 2022 come with a 9.62% interest rate for the six months following the purchase date. Clients can purchase up to $10,000 in I bonds per year on and another $5,000 if they use their federal income tax refund, Benz noted.

(Image: Shutterstock)

3. Stocks

Taxable accounts can be good places to hold individual stocks for clients who choose to invest in them, especially if they make infrequent trades, said Benz. While mutual funds can result in capital gains taxes even if the investor hasn’t sold shares, clients won’t owe capital gains on individual stocks until and unless they sell the securities at a profit, she said.

“Generally speaking, limiting trading is a way to avoid realizing capital gains. However, some of the tax-loss harvesting systems involve more frequent trading — netting gains against losses on an ongoing basis in an effort to reduce the taxes that will be eventually due upon sale. So it's too simplistic to suggest that never trading is always a good way to lower taxes. But it's generally a smart policy,” she explained to ThinkAdvisor.

Benz cautioned that investors will owe taxes on distributed dividends and recommended therefore that they keep high-dividend stocks in tax-sheltered rather than taxable accounts.

That advice doesn’t necessarily apply to clients with more modest incomes, however. Investors in the 0% tax bracket for qualified dividends and long-term capital gains (under $41,675 in taxable income for single filers and $83,350 for married couples filing jointly) “can go ahead and gorge” on high-dividend equities, Benz wrote.

(Image: Shutterstock)

4. Stock ETFs

Exchange-traded funds offer the easy diversification available in traditional mutual funds but are much more tax efficient, Benz wrote, noting that most ETFs track indexes and make limited capital gains distributions.

ETFs' structure and their buying and selling mechanism also tend to make them more tax-efficient. ETF capital gains distributions were far less frequent and much smaller than mutual funds’ distributions over 10 years, another Morningstar researcher wrote this year.

Benz cautioned, however, that bond and other ETFs providing current taxable income aren’t particularly tax-efficient. Most bond investment returns are treated as ordinary income and ETF-generated income is subject to the same tax treatment as mutual funds, she wrote.

(Image: Adobe Stock)

5. Stock Index Funds

While equity index mutual funds may lack the many ETF tax advantages, they do similarly benefit from less frequent trading, according to Benz. Some equity index funds are almost as tax-efficient as comparable ETFs and therefore make a “solid option” for taxable accounts, she wrote.

(Image: Shutterstock)

6. Tax-Managed Funds

These mutual funds are designed to minimize taxes by avoiding holdings that generate ordinary income and by offsetting capital gains with losses, Benz noted. While ETFs have garnered more attention lately, there remain many attractive tax-managed fund choices, she said, including a “rare multi-asset fund” at Vanguard (VTMFX) that fits well in taxable accounts.

Advisors and clients should bear in mind several mistakes to avoid when deciding what investments to place in taxable accounts.

They shouldn’t assume that all ETFs and index funds are “magic tax-efficiency bullets,” Benz told ThinkAdvisor. “They're not. Bond ETFs and index funds will usually be as tax-inefficient as bond mutual funds, because most of your return as a bond investor is ordinary income. Similarly, if an equity ETF or index fund tracks a high-turnover index or sees big outflows, that can lead to high taxable gains.”

They also should remember the role of dividend-paying stocks. While dividend tax rates are lower than ordinary income tax rates, high-dividend stocks “force the taxpayer to pay taxes year in and year out, versus at time of sale for capital-gains-producing investments,” she said.

Advisors shouldn’t overlook doing multi-year tax planning, incorporating the trajectory of the client's tax bracket over time, she added.

“Finally, a key issue is assuming that you're stuck with an investment that is tax-unfriendly — say, a mutual fund with a history of making big capital gains distributions. Because you receive a step-up on those distributions, selling out of it may not cost you as much in taxes as you'd expect.”

(Image: Shutterstock)


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