How Index Funds Minimize Taxes

Tax Efficiency and Passively Managed Funds

money and taxes
You can use index funds to minimize taxes. Getty Images

If you love the low costs, simplicity, diversification, and reliable long-term performance of index funds, you'll love them even more when you learn how they can minimize investment related taxes.

Of course the kind of taxes we'll discuss in this article only refer to the kind possible in a taxable account (and not applicable to tax-deferred accounts like 401(k)s and IRAs).

The term that describes how certain investments produce more or less taxes when compared to others is tax-efficiency.

If a particular mutual fund is tax-efficient, it means that it doesn't produce as much taxes for the individual investor when compared to other funds.

Index funds are said to be tax-efficient funds. Here's why:

Index Funds Have Low Turnover

One key element of index funds that makes them tax-efficient is a low turnover ratio, which is a measurement that expresses the percentage of a particular fund's holdings that have been replaced (turned over) 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%.

What's wrong with high turnover? 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.

What' wrong with capital gains distributions? They produce capital gains taxes!

Therefore high turnover often results in high relative taxes. But by nature, index funds have extremely low turnover -- often as low as 1% or 2% -- while actively-managed funds often have turnover ratios higher than 20% and sometimes as high as 100% or more.

Index Funds Generally Pay Less Dividends

Dividends from mutual funds are taxable as income and most index funds generally produce less dividends than actively-managed funds within the same respective category.

Unless you buy an index fund that is specifically designed to buy and hold stocks that pay dividends or unless you 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 Vanguard Growth Index (VIGRX). Growth stocks don't typically pay dividends (because the companies that issue them reinvest their profits rather than sharing them with investors in the form of dividends).

The bottom line is that if you have a taxable brokerage account, index funds can be a smart holding, assuming you want to keep taxes to a minimum.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice or tax advice. Under no circumstances does this information represent a recommendation to buy or sell securities.