Index Funds Save on Taxes

I had this comment recently left on my post titled Why I Like Index Funds (Updated):

You missed just one advantage of index funds - they are tax friendly. Index funds have not only lower fees, but also save you from taxes (due to the fact that index funds hold the stock longer than the other types of mutual funds) and thus generate higher returns by allowing you to invest those saved money.

Actually, I didn't miss that point -- it was part of the post. It just wasn't broken out individually, it was noted as part of how index funds save on costs (and thus deliver a good return.) It's a good point though, and one worth being clear on.

BTW, since I wrote the post noted above, I have updated it with Why I Like Index Funds, Part 3.

Comments

[beastlike]

FMF

Question-

If you have money invested in a CD or money market, the yearly interest gets taxed at whatever tax bracket you are in each year. Do mutual funds and index funds work the same way or is it only capital gains tax (15%) AND only when you take the money out of the fund?

Thanks!!!

[Edmund]

I once had a dream, in which I was listing the greatest things that I have learned.

I don't remember much of that dream, but I remember having "Calculus" and "Index funds" on my list.

[Rob]

I find it ironic that, on one hand, you encourage paying off a mortgage early, giving up pretty significant gains in potential long-term investment income and yet, advise against people giving up 1% to a good, proven money manager for above market returns, all in the name of saving less than 1% in costs.

Don't get me wrong, I understand your thinking in both regards...I just find them a little contradictory. [This is assuming the money manager used has, again, proven himself to beat the market more often than not. Yes, they are out there if you do your due diligence.]

[Edmund]

Where do you find good money manager that is "proven" to give you that 1% extra return?

[FMF]

Rob --

Yes, on the surface that advice may seem strange, but you know there is much more to it than that. You can't simply take a couple points and compare them -- you have to look at all the issues I've discussed surrounding them.

Plus, I'm with Edmund. Where can you find a "proven" manager?

[FMF]

Beastlike --

Index funds generally have capital gains distributions throughout the year -- when stocks are sold within the fund. Since this is income in this year for you, you pay a capital gains tax on them.

On the fund shares themselves, you don't pay any tax until you sell them and then, of course, only if you make money.

[Kevin]

Beastlike -

To add to FMF's comment, most stock mutual fund's dividends (along with cap gain distributions) get taxed at the "qualified" rate which is the more advantageous capital gains rate. Yet another advantage of dividend income with regards to regular interest.

[beastlike]

Thanks for the comments!

[Rob]

Well, I was referred by someone we know who owns a business and has used this money manager for a long time. I have used him for a few years and have never been disappointed...nor have the people that have used him longer. I think it's cool to do index funds but when you get lucky enough to find someone that is good, might as well go with them. Hasn't hurt us any that's for sure.

Thanks for your input!