Do index funds pay capital gains?
All mutual funds, including index funds, are required to pay out any realized gains to shareholders on a pro-rata basis at least once a year. Typically, actively managed equity mutual funds do so annually in the form of short-term and long-term capital gains.
Contribute to Your Retirement Accounts
Investing in retirement accounts eliminates capital gains taxes on your portfolio. You can buy and sell stocks, bonds and other assets without triggering capital gains taxes. Withdrawals from Traditional IRA, 401(k) and similar accounts may lead to ordinary income taxes.
For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.
These funds buy or sell very few shares each year, so most generate very little in terms of taxable capital gains, if any. But there are usually taxes due on S&P 500 funds' dividends. The exact amount of taxes varies by taxpayer, though.
Gains earned from index funds are subjected to long-term and short-term capital gains tax as explained below: Short-term capital gains: Gains earned from an index fund held for up to 12 months are taxed at 15%. Long-term capital gains: Gains earned from an index fund held for more than 12 months are taxed at 10%.
Wealthy investors can afford investments that average investors can't. These investments offer higher returns than indexes do because there is more risk involved. Wealthy investors can absorb the high risk that comes with high returns.
While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index. Tracking error may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc.
Index mutual funds & ETFs
Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
What are the tax implications of an index fund if you don't sell it, but just reinvest dividends every quarter/year? If the fund is held in a taxable account, the dividends and possibly some distributed capital gains are reported as taxable income each year even if they are reinvested and nothing is withdrawn.
That's because mutual funds must distribute any dividends and net realized capital gains earned on their holdings over the prior 12 months. For investors with taxable accounts, these distributions are taxable income, even if the money is reinvested in additional fund shares and they have not sold any shares.
What is the ETF tax loophole?
Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.
When APs redeems shares, the ETF issuer doesn't typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind”—delivering the underlying holdings of the ETF itself. No sale means no capital gains.
If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.
Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds. The primary con of index funds when in comparison to 401(k) plans is the lack of any tax advantage.
While index funds provide diversification, there's still a risk of losing money. Market downturns, economic recessions, or unexpected global events can lead to significant declines in index fund values.
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
Financial Advisors' Fees Are Too High to Use Index Funds
We looked at the overwhelming body of research that points to the low-odds of outperforming the market over the long run using stock-picking or market-timing strategies.
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
Is now a bad time to invest in index funds?
Is now a good time to buy index funds? Any time is good for investing in index funds when you plan to hold the fund for the long term. The market tends to rise over time, but not without some downturns along the way, thanks to short-term volatility.
Lack of Global Diversification
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
The index fund or ETF owns the stock. You own a share in the fund or ETF. So while you have indirect exposure to the stock, you are not a shareholder for legal purposes. In other words, as far as ExxonMobile, GE or Apple are concerned, their shareholder is Vanguard or iShares.
Although not as liquid as exchange traded funds, index funds can be bought and sold at the end of each trading day. Many investors choose to buy and hold their index funds for months or years.
However, if you have noticed significantly poor performance over the last two or more years, it may be time to cut your losses and move on. To help your decision, compare the fund's performance to a suitable benchmark or to similar funds. Exceptionally poor comparative performance should be a signal to sell the fund.
