tax implications

[bicyclekick]

I didn't have time to really understand but my grandma was trying to explain the difference between getting a standard mutual fund and an index fund. She said that when individual stocks are traded in a mutual fund you have to pay capital gains taxes on them but in an index fund you do not.

How does this work and effectively how much does it cost you?

I was able to find this link now after typing this up so I think i may have answered my question to an extent but a little more understanding would help. For example, if you invested 10k in an index fun and 10k in a regular fund, where does it become even % difference wise of gains over 10 years for instance.
http://finance.yahoo.com/etf/education/06

[DesertCat]

This article explains why ETFs should be slightly more tax efficient than index mutual funds, which isn't what Grandma was telling you (but i'll explain that at the end). ETF's are specially structured funds that as the article explains, have some ability to defer taxes that a normal mutual fund structure used by index funds don't have.

But I think the article may overstate the benefits, for three reasons. First, is they are counting capital gains distributions, not taxes. Your tax rate on those distributions are likely to be between 15%-25%, i.e. 15% federal capital gains (long term rate) plus your state tax rate. So the 5.87% distributions works out to somewhere around 1% per year in taxes you would pay.

So ETF's are 1% per year better than index funds? Not exactly. The second problem is that the ETFs will owe similar taxes when you sell them, i.e. over a five year ownership period the index fund owner is paying 1% per year, but at the end the ETF owner will pay the 5% all at once. The ETF is still better off because they deferred these taxes, but not as much as the 1% number.

Lastly, the article used a very short period to compare, that might be very misleading. Personally I doubt the difference is 1% per year, my guess is that the typical index fund generates less than 1% per year in capital gains distributions total per year. But I don't have the facts in front of me so that's just my guess from my previous readings. Maybe someone who's a better expert can provide some detail here.

So essentially indexed mutual funds and ETFs are very similar, and if they cover the same index (own the same stocks) you might want to choose the ETF because of it's slightly more tax efficient. I don't think anyone would disagree with that statement.

But Grandma was talking about the difference between actively managed mutual funds and index funds. An actively managed fund has a manager who picks stocks to buy, while an index just owns every stock in an index (a basket or list of stocks, the S&P 500 is a list of the largest 500 U.S. stocks). The index fund is "passive", the only time a stock is sold or bought is when the index is "rebalanced" which doesn't happen very often, and typically very few stocks are added/deleted.

The active manager is trying to beat the market. Typically this involves lots of buying and selling stocks, generating commissions and other costs. So the active managers fund is usually much less tax efficient than an index fund.

Whereas the index fund might sell only 5% of it's stocks in a year, the active manager could easily sell over 100%, turning over his entire portfolio in less than 12 months. This means that gains in the active fund are much more likely to be short term capital gains (less than 12 months) which are taxed at your personal rates, usually much higher than long term capital gains. And, since capital gains taxes aren't triggered until you sell, the excess turnover creates more taxable events.

And I'm not sure if grandma mentioned this, but even if you ignore the tax advantages of index funds, it's so hard for an actively managed fund to beat the market that 90% trail index funds over long periods. Essentially it's the higher costs of active funds give the managers too big a hurdle to overcome.

One of the great strengths of passive investing (index and ETF funds) is tax efficiency. Investing in an index fund outside of a tax deferred account such as an IRA or 401k is almost as efficient as doing it inside. Last time I looked I guessed the difference was less than .5% per year, but it all depends upon your assumptions on future gains and turnover.

[gull]

A big difference between index funds and ETFs is tax-loss harvesting.

http://etf.seekingalpha.com/article/15259

[DesertCat]

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A big difference between index funds and ETFs is tax-loss harvesting.

http://etf.seekingalpha.com/article/15259

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Thanks for the interesting article. Because of wash sale rules this is almost impossible to do with individual stocks, so I never think about it, but ETFs open yet another door.

['Chair]

[ QUOTE ]
...
One of the great strengths of passive investing (index and ETF funds) is tax efficiency. Investing in an index fund outside of a tax deferred account such as an IRA or 401k is almost as efficient as doing it inside. Last time I looked I guessed the difference was less than .5% per year, but it all depends upon your assumptions on future gains and turnover.

[/ QUOTE ]

DC - thanks for the info. question though...why do ppl recommend Vanguard/Fidelity index funds for Roths if you want your tax-inefficient investments protected in these. I'm dumb so feel free to use basic terminology.

[DesertCat]

[ QUOTE ]

DC - thanks for the info. question though...why do ppl recommend Vanguard/Fidelity index funds for Roths if you want your tax-inefficient investments protected in these. I'm dumb so feel free to use basic terminology.

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Since Roths are tax deferred, they are a vehicle for long term investments, and you want your highest return investments in them. For most people, the highest long term return investments they can choose are index funds. Even without the tax advantages index funds beat 90% of active funds over long periods, basically because of the lower costs.

As you get closer to retirement and you want to put some of your portfolio into less volatile investments (bonds, money market accounts), it might make sense to keep those in the Roth since they are less tax efficient, and keep your money outside of the roth in index funds.