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Tax Efficiency of Index Funds and ETFs

When discussing index funds as opposed to actively managed funds, I tend to focus primarily upon their lower expense ratios and lower turnover costs. But for those of you investing in taxable accounts, index funds (and ETFs) offer an additional advantage over actively managed funds: They’re decidedly more tax efficient.

Increased Turnover Means Increased Taxes

As compared to actively managed funds, index funds and ETFs allow you to:

  1. Pay less taxes, and
  2. Defer your taxes.

With mutual funds (as opposed to, say, shares of individual stocks), you don’t pay taxes only when you sell the fund. You pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

With portfolio turnover in actively managed funds averaging roughly 100% per year, a great deal of the gains end up being short-term capital gains. Because STCGs are taxed at your ordinary income tax rate (as opposed to LTCGs which are taxed at a maximum rate of 15%), investors in actively managed funds end up paying more in taxes than they would with a fund that holds onto its investments for longer periods of time.

Also, the longer holding period for shares within an index fund’s portfolio allows you to defer taxation for a greater period of time (thereby allowing your money to grow more quickly).

ETF Tax Efficiency

In addition to the above tax benefits, Exchange Traded Funds (ETFs) have a significant tax advantage due to the way in which they’re created.

When a typical index fund needs to raise cash (due to investors liquidating their holdings), it must sell investments from within its portfolio. If these investments were sold for more than their cost basis, the transaction triggers a capital gain, which must be paid for by remaining shareholders.

In contrast, when large ETF shareholders want to redeem their shares, they’ll often simply exchange them (with the ETF sponsor) for shares of the underlying companies owned by the ETF. The ETF sponsor makes it a point to distribute the shares that have the lowest cost basis, thereby minimizing unrealized capital gains within the ETF’s holdings.

The end result is that ETFs tend to distribute smaller, less frequent capital gains to their shareholders–thereby allowing shareholders to defer the majority of taxation until they actually sell their shares.

Taxes Are Costs Too.

After considering expenses, the majority of actively managed funds underperform their respective indexes. When you factor in the impact of taxes, the results become even more dramatic. In fact, some studies have shown that the likelihood of an actively managed fund outperforming its index on an after-tax basis is less than 10%.

Why take those odds?

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Comments

  1. “The ETF sponsor makes it a point to distribute the shares that have the lowest cost basis, thereby minimizing unrealized capital gains within the ETF’s holdings.”

    Interesting, related point: Vanguard’s ETFs are actually a share class of their mutual funds. In theory, particularly as ETFs gain popularity, a fund’s non-ETF shareholders will benefit from this tax management as well.

  2. Thanks for bringing that up, Dylan. Very cool.

    I remember hearing some talk a while back about whether Vanguard would be licensing other firms to use its ETF-as-a-share-class structure. Seems like a good idea to me…

  3. Great points Mike. I think that Index funds are the perfect way to invest for the long-term. They force me to practice disciplined personal finance.

  4. Mike, Great blog! Have been reading it for a week or so now. This topic brings a few questions that had been in back of my mind for some time now. Its on Taxes on capital gains from mutual funds. I am about to start investing in vanguard index funds in a taxable account after fully funding the retirement accounts – 401K/IRA. When you open an account with Vanguard, it gives you an option for Dividends to Reinvest or take a distribution. If I choose to reinvest my dividends in my taxable accounts, do I still pay taxes? Other part of the question is about capital gains. Since I have not owned any mutual funds outside of my retirement accounts, I have not seen any capital gains distributions. How often they are distributed and where can I find some historic data on capital gains distributions for a vanguard index fund?

  5. Hi GoYanks.

    Thanks for the kind words about the blog. I hope you continue to enjoy it. 🙂

    As to dividends: Yes, you’ll pay taxes even if you reinvest them. By the way, I know some people who elect not to reinvest dividends in taxable accounts for recordkeeping purposes. (If you reinvest dividends, you end up with fractions of shares purchased at a multitude of different prices.)

    As to the question about historical capital gains distributions, if you head to Vanguard’s funds page, then select any given fund, you can click the “distributions” tab to find some information. The prospectus of each fund will have more information.

  6. Taxes are my least favourite cost when investing. It seems almost spiteful that after I’ve risked my hard-earned tax income to the vagaries of the market, the taxman can share in my winnings.

    The bright side of the bear market – this year I generated a tax loss. Hurrah! (Erm…)

  7. “The ETF sponsor makes it a point to distribute the shares that have the lowest cost basis, thereby minimizing unrealized capital gains within the ETF’s holdings.”

    Mike,

    This is good information I am not aware of. Do you have a reference or a source?

    Michael

  8. TIF: I have no firsthand experience of it. I simply read it in Rick Ferri’s The ETF Book (starting on page 64). My general assumption is that if he says it, it’s true. 🙂

  9. Hi,
    If I am investing with a buy and hold strategy in index and etfs in taxable accounts how does a person budget for captial gains taxes realized in the in the funds in the portfolio that may come at the end of the investment year?

    How much money can we be talking about with say $100,000.00 in etfs and index funds in a taxable account?

    What a nightmare… to invest wisely and at the end of the year have a tax bill you cant pay because your money is tied up in what you invested in.
    Kind regards, Capt. Mike

  10. Information about past capital gains distributions is widely available for most funds. (There’s no guarantee, of course, that future distributions will be close to past distributions, but it can give you some sort of ballpark idea.)

    For example, if you head to Vanguard’s page for their Total Stock Market Index Fund, then click the “distributions” tab, you can see the size of past capital gains distributions.

    Many people like to set their funds to not automatically reinvest dividends in taxable accounts. This is generally done to make tracking of cost basis easier, but it would also allow for a little cash balance to build up to pay taxes on distributions.

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