How Index Funds Minimize Taxes

One of the commonly overlooked aspects of passive investing is the potential tax benefits of index funds. If you enjoy the low costs, simplicity, diversification, and reliable long-term performance of index funds, you'll appreciate them more when you learn how they can minimize investment-related taxes.

"Tax-efficiency" describes the way certain investments produce tax liability as compared to others. If a particular mutual fund is tax-efficient, it produces a lower tax liability for investors than other funds. Because of tax efficiency, investors holding funds in a taxable brokerage account can reduce taxes by using passively managed funds. That is why index funds are said to be tax-efficient funds.

Short-Term vs. Long-Term Capital Gains

When you sell an investment that you've held in a taxable account for one year or less and make a profit, you're subject to short-term capital gains tax. The short-term capital gains tax rate is the same as your income tax rate. Depending on how much you make, you'll pay 10%, 12%, 22%, 24%, 32%, 35%, or 37%.

If you hold an asset for more than a year, you'll be subject to long-term capital gains tax whenever you sell it. Long-term capital tax rates are much more favorable than short-term rates because the IRS wants to incentivize long-term investing. Depending on your income and filing status, you'll pay 0%, 15%, or 20% on long-term capital gains.

If you lose money on the sale of an asset, it counts as a capital loss. Luckily, you can use capital losses to offset your capital gains and lower your tax bill. For example, assume you invest in two assets: Company A and Company B. If you made $50,000 from selling Company A but lost $10,000 after selling Company B, you would only be taxed on capital gains of $40,000. If your overall losses happen to exceed your profits, you can deduct the difference on your tax return, up to $3,000 per year. Learning when to sell an asset strategically can help save a lot of money on taxes, especially if you're doing so at a loss.

Low Turnover

One key element of index funds that makes them tax-efficient is a low turnover ratio. This ratio is a measurement that expresses the percentage of a particular fund's holdings that were replaced during the previous year. For example, if a mutual fund invests in 100 different stocks, and 20 of them are replaced during one year, the turnover ratio would be 20%.

The problem with a high turnover ratio is that when mutual funds have more buying and selling activity, they're bound to sell some securities at a higher price than the fund manager bought them. This means there is a capital gain, and when mutual funds have capital gains, they pass along those gains to investors in the form of capital gains distributions. Those capital gains distributions then trigger capital gains taxes. High turnover often results in higher taxes. By nature, index funds have extremely low turnover, while actively managed funds regularly have higher turnover ratios.

Fewer Dividends

Ordinary dividends from mutual funds are taxable as income, and most index funds generally produce fewer dividends than actively managed funds within the same category. Unless you buy an index fund that is specifically designed to buy and hold dividend-paying stocks or buy bond index funds, you aren't likely to hold an index fund that produces income tax from dividends or interest.

Even better, if it suits your risk tolerance and investment objectives, you could buy growth index funds, such as the Vanguard Growth Index Fund Admiral Shares (VIGAX). Growth stocks are often newer companies that have not reached full form but are headed in the right direction—and seemingly fast. They don't typically pay dividends, because they reinvest the profits to help fuel growth.

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