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The Tax Advantage of Index Funds

The end of the year tis the season investors usually focus on managing taxes, but you don’t have to scramble for last-minute tax strategies to try to lower your tax bill. The market-tracking structure of index funds can help keep your portfolio tax-efficient throughout the year.

Taxes are one of many possible investment costs that can include fund expenses, management fees, administrative charges and so on.

When you hold a mutual fund in a taxable account, you must pay taxes on the gains. Those taxes are incurred in a few different ways. For one, they can be a consequence of personally selling your shares. Additionally, mutual funds distribute taxes to shareholders. For instance, you pay taxes on the interest and dividend income. Interest is taxed as ordinary income while dividends are taxed at a lower dividend tax rate.

Taxes are also distributed when mutual fund managers create realized capital gains taxes from trading underlying securities. Capital gains for investments held less than a year are short-term gains and are taxed as ordinary income. Investments held for a year or longer are taxed as long-term gains at a lower capital gains tax rate.

The buying and selling, or trading, of securities by a fund manager is known as portfolio turnover. The higher the turnover in a fund, the greater chance for capital gains and the likelihood you’ll be on the hook for taxes. Such frequent trading can also result in higher transaction costs.

Low turnover is another advantage index funds have over actively managed funds.   Since index funds replicate a market index the underlying securities rarely change. Actively managed funds typically shift positions, increasing the possibility of capital gains, most of which are short-term gains.

On average, index funds are cheaper than actively managed funds. The average expense ratio of an index funds is about seven times less than an actively managed fund, according to the 2014 Investment Company Fact Book.

The tax efficiency of index funds adds to that cost advantage. In a study published in the Financial Analysts Journal by Vanguard founder John Bogle, “tax-inefficiency” accounts for 0.75% of all-in fund costs in an actively managed fund. In a comparative index fund, only 0.30% in total costs is a result of taxes, giving it a 0.45% tax cost advantage, according to Bogle.

While it may appear small, that tax cost difference can compound over time. Therefore, by investing in funds with low turnover, you are likely to have less tax gains and more money to spend or invest.

Further, you can control turnover in your portfolio by maintaining a strategic asset allocation. Under this strategy, trading generally occurs through periodic rebalancing. A tactical asset allocation, on the other hand, requires you to shift money to various asset classes, meaning higher turnover and a greater potential for capital gains taxes.

A long-term asset allocation along with index funds in your portfolio, especially your taxable accounts, is a way to practice tax-efficient investing 365 days a year.