One of the commonly overlooked benefits 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 lower tax liability for investors than other funds do. 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.
- If you make a profit by selling an investment that you've held for one year or less, you'll pay a short-term capital gains tax, which is the same as your income tax rate.
- If you sell an investment that you've held for more than a year, you'll pay a long-term capital gains tax at a more favorable rate.
- Index funds are tax-efficient, because they have a low turnover ratio, which is the percentage of a fund's holdings that have been replaced in the previous year.
- Ordinary dividends are taxable as income, and most index funds generally produce lower dividends than actively managed funds.
Short-Term vs. Long-Term Capital Gains
When you sell an investment that you've held for one year or less and make a profit, you're subject to short-term capital gains tax. As of tax year 2021, the short-term capital gains tax rate is the same as your income tax rate. Depending on how much you make, you can either 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 finally 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 will either pay 0%, 15%, or 20% on long-term capital gains.
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If you don't make a profit on the 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, let's assume you invest in two assets: Company A and Company B. If you made $50,000 from selling Company B, but lost $10,000 after selling Company B, you will 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 strategically sell an investment can help save a lot of money on tax bills, especially if you're doing so at a loss.
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 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.
Ordinary dividends from mutual funds are taxable as income, and most index funds generally produce fewer 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 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.