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By Michael Rawson, CFA

With so much uncertainty in the financial markets, there are few outcomes over which investors have much control. One area where informed decision-making can consistently pay off is tax planning. Investors in high tax brackets or with a lot of money to invest should consider which asset classes and strategies are best held in a taxable account and which are best held in a tax-deferred account. Passive strategies generally are more tax-efficient, but this is not always the case, particularly if an index fund invests in an asset class with high tax costs or tracks an index with high turnover.

Asset-Class Tax Treatment Trumps All Else
Certain asset classes offer better aftertax returns in tax-deferred accounts, such as assets that throw off a large share of their total returns in the form of interest income, which is taxed at ordinary income tax rates. For example, if an investor in the highest tax bracket were to hold iShares Core Total U.S. Bond Market ETF (AGG) in a tax-deferred account, he or she would have earned a 5.78% annualized return for the five years ended Dec. 31. That same investment held in a taxable account would have returned only 4.43% for an investor in the highest tax bracket. When choosing a fund for a taxable account, one would have been better off with the iShares S&P National AMT-Free Muni Bond ETF (MUB), which returned 5.48%. But in the tax-deferred account, the muni fund underperformed the taxable iShares Core Total U.S. Bond Market fund.

Investments that generate nonqualified dividends, such as REITs, are also better held in tax-sheltered accounts because those dividends are taxed at investors' ordinary income tax rates. For example, T. Rowe Price Real Estate's (TRREX) 10-year annualized return of 12.53% drops to 10.99% for an investor in the highest tax bracket once taxes are factored in.

Qualified dividend income, on the other hand, is somewhat tax-advantaged compared with ordinary income. For 2013, the highest ordinary income tax rate is 43.4% when including the 3.8% Medicare tax surcharge on high earners, while the highest tax rate is 23.8% on qualified dividends. Over the long term, dividend-paying stocks have performed well, so risk-tolerant investors with additional money to invest can hold dividend-focused funds in taxable accounts, despite the slight tax disadvantage compared with holding them in a tax-deferred account. Naturally, you would put dividend-paying funds in a tax-deferred account first, but those with large taxable accounts should not necessarily avoid dividend-paying stocks. It is important to remember that it is the total aftertax return that is most important, not necessarily minimizing taxes. For example, while it is true that during the past five years an investor in Vanguard Dividend Growth (VDIGX) paid more in taxes than an investor in a typical S&P 500 Index fund, VDIGX still had a much higher aftertax return.

Strategies Still Play a Role
Although the asset location decision--which asset classes to hold in which account types--is a crucial component of tax management, investors also can help improve their aftertax results by focusing on tax-efficient strategies for their taxable holdings. Exchange-traded funds are often touted as tax-efficient investments because they can gain an edge through the use of an additional tax-fighting weapon at their disposal: the creation and redemption process. Rather than selling stock to meet investor redemptions, ETFs are redeemed through an in-kind transfer with an authorized participant. The in-kind, or shares-for-shares, transfer allows for the elimination of low-cost-basis shares, thus reducing (but not eliminating) the possibility of future capital gains distributions.

But here is the rub: This in-kind creation and redemption mechanism works best for U.S.-stock funds. Once we venture outside of the U.S.-stock asset class, the tax benefits stemming from the in-kind creation and redemption process might diminish somewhat. For example, in the bond market, in-kind creations are more difficult, so cash creations and redemptions are common. During the past five years, both iShares Core Total U.S. Bond Market and iShares iBoxx $ High Yield Corporate Bond (HYG) were no more tax-efficient than comparable index mutual funds.

Investors also should remember all the commonalities between the taxation of ETFs and mutual funds. ETF investors will owe taxes on the distributions of dividends or interest income that an ETF receives and passes through to investors. They also will face capital gains taxes when selling the fund, regardless of whether the fund is an ETF or index mutual fund.

And even for U.S.-equity ETFs, most of their tax efficiency stems from the fact that they are index funds, which typically have low turnover and thus generate fewer capital gains than actively managed funds. There are plenty of ETFs (and conventional index funds, for that matter) that follow higher-turnover, so-called strategy indexes, which might be less tax-efficient than traditional, market-cap-weighted index mutual funds. For example, PowerShares Fundamental Pure Large Core ETF (PXLC) had a five-year tax-cost ratio of 0.63, high by equity ETF standards, likely because the fund has high turnover.

In addition, a handful of tax-managed mutual funds--traditional open-end funds that hew closely to market benchmarks but have active oversight--have achieved tax efficiency by following best practices, such as limiting trading, keeping track of tax lots, and appropriately timing the sale of high-cost-basis shares. In summary, tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs.

Delving Into the Details
Let's look at some specific examples to illustrate the point that ETFs can be more tax-efficient than active mutual funds but are not necessarily more tax-efficient than well-run index mutual funds.

The iShares Core S&P 500 ETF (IVV) had a 10-year pretax annualized return of 7.03% and a post-tax (but preliquidation) return of 6.71%. This results in a tax-cost ratio of 0.30. The tax-cost ratio measures the amount of return lost to taxes, so a lower number in combination with a higher after return is better. A similar ETF, SPDR S&P 500 (SPY) had a 6.99% pretax return and 6.65% post-tax return, for a tax-cost ratio of 0.32. The average tax-cost ratio for actively managed large-blend funds during the past decade has been 0.60, so these two ETFs have been much more tax-efficient.

But a number of index mutual funds and tax-managed funds have also been tax-efficient. The institutional share class of Vanguard Institutional Index (VINIX) had a pretax return of 7.11% and 6.78% post-tax, for a tax-cost ratio of 0.31. This Vanguard index mutual fund was as equally tax-efficient as the two ETFs.

In theory, an equity ETF could be even more tax-efficient than an index mutual fund, but it is hard to find the data to prove it. One reason for that is ETFs have eliminated a large chunk of their index-fund competitors. Back in the year 2000, there were more than 118 index funds in the large-blend category; today, there are 84, despite the fact that indexing has continued to grow in popularity. With the exception of Vanguard's index-fund lineup, all of the interim net new inflows into the category have gone to ETFs, while many index mutual funds have languished. Competition from ETFs has washed out more costly and less efficient competitors in the realm of traditional index funds. The end result is a leaner, less expensive, and more efficient menu for investors to choose from.

Data sourced from iShares, PowerShares, T. Rowe Price, Vanguard, and Morningstar. Tax-cost ratio data reflects five- and 10-year periods ended Dec. 31, 2012.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Tax Considerations For ETFs And Mutual Funds