Investors consider countless things on a daily basis when it comes to the forms their investments assume. Due to various restrictions on tax-deferred accounts, many investors split investments between tax-deferred and taxable accounts. If you follow this investment pattern, you must decide which type of securities to invest in with both the tax-deferred account and the taxable account. Exchange-traded funds (ETFs) and mutual funds count among the many available investments for these types of accounts.
Taxable Account Investing
Taxable account investing works just like any other type of account investing, though all investment capital earned proves susceptible to taxation. Basically, you place your money in an account created for the purpose of investing and develop an investment portfolio with that account by purchasing securities. Investors often combine taxable account investing with tax-deferred investing because the government limits how much you can invest annually in tax-deferred accounts. Determining whether ETFs or mutual funds prove a better investment with a taxable account comes down to the specifics of the fund.
ETFs and Mutual Funds
Mutual funds are investment pools created by accumulating the contributions of all investors. Fund managers invest the pooled resources in a wide range of securities to generate returns as dividends and capital gains for investors. Generally, mutual funds charge fees to investors before distributing dividends or capital gains. Exchange-traded funds consist of a so-called "basket," or collection, of securities that trades publicly as a single entity and track an index. Tracking an index means that all the securities in an ETF basked belong to the same list, such as the Standard & Poor's 500 Index, a list of the top 500 securities. ETFs generally charge lower fees than mutual funds.
Investment experts like Charles Schwab Foundation president Carrie Schwab-Pomerantz recommend using taxable accounts to invest in funds that pay limited dividends and capital gains. States and the Internal Revenue Service tax dividends and capital gains, leaving those earning both through taxable account income susceptible to extensive taxation. Morningstar analyst Christine Benz asserts that as a general rule, ETFs pay fewer dividends and capital gains than mutual funds, making them more suited to taxable account investing. Furthermore, CNN Money calls ETFs the second-most tax efficient investment for taxable accounts, after individual shares of stock.
Things to Consider
Though ETFs prove a better investment for taxable accounts from a theoretical standpoint, the actual benefits of exchange-traded funds compared to those of mutual funds depend upon the specifics of each fund. While ETFs generally pay fewer dividends and capital gains, some ETFs actually pay substantial dividends and capital gains. Investors should also bear in mind that ETFs only generate capital gains when you cash out, where as a mutual fund generates capital gains every time it sells an asset.
- Morningstar; The Better Investment for Taxable Accounts; Christine Benz; 2005
- Charles Schwab; Where to Invest After You've Maxed Out Your 401k; Carrie Schwab-Pomerantz; 2007
- CNN Money: Which Investments Are Better for Taxable Accounts?
- Bloomberg; Frequently Asked Questions About Exchange-Traded Funds; Sree Vidya Bhaktavatsalam
- Bankrate: Mutual Funds vs. ETFs
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