March 16, 2015 Admin | March 16, 2015 Why are index mutual funds so much more tax efficient than managed mutual funds? Why is this important?
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Index funds have much less turnover than a mutual fund or other investment. Index funds do not buy and sell stocks very often so you do not have much for capital gains. The dividends are also reinvested in to the funds so the dividends are qualified. You can hold a total stock market index outside of a retirement with very little in taxes occurred. You want to know what your taxes will look like when your investing. Day trading can make a very large tax bill if you are not careful. Taxes are just one way that indexing is a better way to invest. You want to pay as little in taxes as you can so own tax efficient investments.
The main reason index mutual funds are more tax efficient than managed mutual funds is because they are passively managed portfolios and so realize fewer capital gains. Capital gains earned on your investment must then be claimed as income on your taxes. Fewer capital gains then means fewer taxes to pay on those investments.
You both nailed this question. Well done! Let’s recap.
(1) Index funds are tax efficient because of the low turnover (less buying and selling) within the fund. Most managed funds are not tax efficient because of the higher turnover within the fund.
(2) An index fund will reduce your yearly taxes when held outside of retirement accounts AND increase your long term capital gains and qualified dividends as well.
(3) Index funds are smart short-term and long-term. Here are two very tax efficient stock index funds at Vanguard.com. The Total Stock Market Index Fund and the Total International Stock Index Fund.
(4) Reducing your taxes will increase the money that comes back to you over time. Awake to the possibilities!