Another Great Reason to Invest in Index Funds - Capital Gains Taxes
As if you needed another reason to invest in index funds, consider just how much doing so saves you in taxes. It’s capital gains season. Late in the year, mutual funds must distribute their taxable capital gains amongst their investors. Index funds, by their nature, have very little in the way of capital gains.
Unlike an actively managed mutual fund, index funds change their stock holdings very infrequently. As a result, they rarely take any capital gains (or losses for that matter). What that means to you is, assuming you hold the fund in a taxable account, you can save hundreds or thousands of dollars in taxes every year, year after year, compared to an actively managed fund.
According to Lipper Inc., the average actively managed stock fund gave up 1.4% in returns because of taxes. As an investor in an actively managed fund, you’re already behind.
This year might be particularly hard on active funds. According to this Wall Street Journal article, many funds will likely make dramatically higher capital gains distributions this year. It seems many of them have burned through the capital losses they carried forward from earlier in the decade.
Incidentally, year-end distributions mean you should probably not invest in an actively managed fund late in the year. If you do, you’ll just be handed back part of your investment in the form of capital gains. You’ll be paying taxes on gains you didn’t get the benefit of earning. That’s what is known as a sucky deal.
I keep it simple. In our taxable investment account, we hold only an S&P 500 index fund. Last year, we had no capital gains (we did have taxable dividends, however). I’m a big believer in index funds; I recommend them highly.
