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How Index Funds Trim your Tax Bill

How Index Funds Trim your Tax Bill

Here’s a plus for passive investingover active: lower taxes.

Taxes knocked an average of 0.96 percentage point a year off the returns of about 2,000 actively managed U.S. stock mutual funds over the 15 years ended in September 2014, if they were held in taxable accounts rather than tax-sheltered retirement plans, according to research by Vanguard Group.

By contrast, taxes reduced the returns of 130 broad-based U.S. stock index funds by an average of 0.69 percentage point a year over the same period—about one third less. The S&P 500’s annualized return was 2.91% during this period.

The tax efficiency of passive funds is due partly to the fact that they trade less than actively managed funds. By law, funds must pay most of their realized gains to investors each year, so less trading generates fewer annual capital-gains payouts that erode investors’ principal during the time they hold a position.

“Taxes affect investment returns at least as much as fees, and sometimes more,” said Joel Dickson, an expert on taxes and investing with Vanguard.

At some actively managed funds, the tax hit has been higher than average in recent years. According to Morningstar, taxes cost investors holding the popular Schwab Core Equity Fund 2.4 percentage points a year of their 13.46% total annualized return for the five years ended Aug. 31. At Fidelity’s Dividend Growth Fund, the annual tax cost was 2.2 percentage points of the 12.34% return for the same period.

Meanwhile, the tax cost for each firm’s S&P 500 index fund was about 0.6 percentage point a year for the same period.

Morningstar’s calculations, which use methodology prescribed by the Securities and Exchange Commission, estimate the annual tax cost to an upper-bracket taxpayer of holding an investment and aren’t intended to reflect returns if an investor sells the holding. Investors can check this statistic for many funds on Morningstar’s website.


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