Most people think about expense ratios when they’re picking investments… but what they don’t realize is there’s a much bigger cost threatening their portfolios: taxes.
I’ve seen too many investors get blindsided by this. They’ll carefully compare funds with 0.05% versus 0.07% expense ratios, then lose 1% to 2% annually just because they put the wrong investments in the wrong accounts.
For example, your regular brokerage account gets hit with taxes every year on dividends, interest, and capital gains distributions. Your 401(k) and IRA? Those grow tax-free until you withdraw.
According to Russell Investments research, investors in regular mutual funds lost an average of 2.06% of their returns to taxes annually over five years.1 Tax-managed funds? Only 0.54%. That difference compounds to serious money over time.
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What Makes an Account “Taxable”?
Before we get into the specific investments to avoid, let me clarify what I mean by taxable accounts.
Taxable accounts (regular brokerage accounts):
- You pay taxes every year on dividends, interest, and capital gains distributions.
- No contribution limits or withdrawal restrictions.
- When you sell, profits are taxed as capital gains.
Tax-advantaged accounts (401(k)’s, IRA’s, etc.):
- Traditional: Pre-tax contributions and tax-deferred growth, but withdrawals in retirement are taxed.
- Roth: After-tax contributions, tax-free growth, and tax-free withdrawals in retirement.
- Both: No annual taxes on earnings within the account.
Keep it simple: Put tax-efficient investments in regular brokerage accounts, and keep any tax-inefficient investments for tax-advantaged accounts.
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The 5 Investments That’ll Cost You
1. High-turnover mutual funds
Here’s the problem about actively managed mutual funds in taxable accounts. The fund manager is constantly buying and selling stocks, and every time they sell something for a profit, that gets passed through to you as a taxable capital gains distribution. You get a tax bill even though you never sold anything yourself.
According to Morningstar data, the typical large-blend fund had a tax-cost ratio of 1.57% annually over the past decade (based on being in the highest income tax brackets).2 That means for every $100,000 invested, you lost $1,570 per year just to taxes. And that’s assuming you didn’t even touch the fund.
The most famous example recently was Vanguard’s target-date funds. They had such large unexpected capital gains distributions that Vanguard had to pay over $106 million to settle with regulators.3 Investors got hit with massive tax bills they never saw coming.
Better alternatives:
- Index ETFs (Many index mutual funds are strong options as well).
- Tax-managed mutual funds specifically designed for taxable accounts.
- Individual stocks you plan to hold long-term.
» Learn more: Discover the key differences between ETFs and Mutual Funds
2. Bond funds and fixed income
Bond funds are tax nightmares in brokerage accounts. They throw off regular interest payments that get taxed at your ordinary income rate, which can be up to 37% for high earners.
Morningstar found that the typical intermediate-term bond fund returned 1.30% annually over 10 years, but had a tax-cost ratio of 1.06%. If you’re in a high tax bracket, taxes would’ve ate up most of your returns.
Let me put this into perspective. Say you invest $100,000 in a bond fund yielding 3%. In the 37% tax bracket, you keep only $1,890 after federal taxes instead of the full $3,000. State and local taxes make it even worse.
Smart alternatives:
- In taxable accounts: Municipal bond funds (tax-free interest), I-bonds, or high-yield savings accounts.
- In retirement accounts: Regular bond funds where the tax drag disappears.
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3. Real estate investment trusts (REITs)
REITs are required by law to distribute at least 90% of their taxable income to shareholders annually.4 Most of those distributions get taxed as ordinary income, not at lower rates that apply to qualified dividends.
Take Realty Income (O), one of the most popular REITs. It currently yields about 5.4%.5 If you’re in the 37% tax bracket, you’re paying over $1,900 in federal taxes on every $10,000 invested, plus state and local taxes that may apply.
But here’s the thing: REITs can be fantastic investments. They just belong in the right accounts and at the right time. In a Roth IRA, that 5.4% dividend income can be withdrawn completely tax-free in retirement.
4. High-dividend stocks and funds
Every dividend payment creates an immediate tax bill, whether you reinvest it or take it as cash. While qualified dividends get better tax treatment than ordinary income, they still create annual tax drag that slows your compound growth.
Look at JPMorgan’s Equity Premium Income ETF (JEPI). It yields around 8.4% currently.6 Most of that income gets taxed at ordinary rates, creating a significant tax burden for high earners.
There’s an exception for certain dividend-paying investments. If they pay fully qualified dividends and your 2025 taxable income is under $48,475 (single) or $96,950 (married filing jointly), those dividends are taxed at 0% under the long-term capital gains rates. For investors in this bracket, dividend stocks or funds can be a nice option in taxable accounts.
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5. Target-date funds and multi-asset funds
These funds look convenient, but they’re tax disasters in brokerage accounts. They hold both stocks and bonds, and they rebalance regularly. Every time they sell appreciated stocks to buy more bonds (or vice versa), they create capital gains distributions.
The Vanguard settlement I mentioned earlier is a great example to reference here. The funds had to rebalance, which created unexpected capital gains distributions for investors who thought they were being conservative.
Plus, these funds typically hold taxable bonds, which I just discussed are tax-inefficient.
Better approach: Build your own allocation using tax-efficient index funds in your brokerage account. Save the target-date funds for retirement accounts like a 401(k).
The Best Investments for a Taxable Account
Charles Schwab research shows that smart asset location can boost your after-tax returns by 0.14% to 0.41% annually.7 For a couple with a $2 million portfolio split between taxable and tax-advantaged accounts, that’s an extra $2,800 to $8,200 per year.
Focus on these tax-efficient investments:
Equity investments:
- Growth oriented index funds (aim for low dividends). ETFs are our preferred choice.
- Tax-managed funds designed for taxable accounts.
- Growth oriented stocks that reinvest earnings rather than paying dividends.
Fixed income alternatives:
- Municipal bond funds (depending on income and state tax).
- Treasury I-bonds.
- High-yield savings accounts for short-term money (at least better than checking accounts).
The ETF advantage: ETFs are structurally more tax-efficient than mutual funds. In 2024, 80% of mutual funds made capital gains distributions compared to less than 5% of ETFs.8
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The Bottom Line
Before you can grow your wealth efficiently, it helps to take a hard look at where your investments live.
Here’s a quick action plan to help you get started:
- Review your current setup: Look at what you own in your brokerage account. Are you holding any of these five tax-inefficient investments?
- Prioritize tax-advantaged accounts: Always prioritize enough into your 401(k), IRA, or other tax-advantaged accounts before optimizing brokerage accounts.
- Make changes gradually: Don’t sell everything at once and create a massive tax bill. Use new contributions and natural rebalancing from areas like dividends to gradually shift toward into different holdings.
- Consider professional help: If you have a complex situation, a financial professional can help you optimize your asset location strategy. Vanguard is just one of many very credible institutions to offer this.
All in all, building wealth takes more than picking good investments. You need to figure out how to keep more of what you earn. By being strategic about where you hold your investments, you can significantly reduce your tax drag and accelerate your path to financial independence.
» Watch this: The 5 best ways to invest in taxable accounts
