I am a big fan of investing in low cost index mutual funds instead of more expensive actively managed funds. An index fund simply owns all the stocks or bonds in a particular index (S&P 500, Russell 3000, etc.), whereas an actively managed fund has a fund manager trying to identify winners and losers. Because few active managers are right enough of the time to justify the fees they charge to manage the funds and it is practically impossible to know in advance which fund managers will come out ahead over time, I believe that low cost index funds are the best choice. In addition to the lower fees, another advantage of index funds, one less well understood, is that they are more tax efficient than actively managed funds. In this blog, I discuss these tax efficiencies.
Note: This discussion applies to taxable brokerage accounts and not IRAs or 401Ks.
Index funds are more tax efficient because mutual funds must distribute capital gains to their shareholders as they are realized. If an active fund manager sells a stock for a gain, the fund will need to distribute that gain during the year to its shareholders. Even an investor who decides to reinvest those capital gains and does not have access to the cash will still need to pay taxes on the amount distributed. By contrast, because an index fund owns a specific set of stocks that generally does not change, there are rarely capital gains to be distributed. Instead, the capital gains build up inside the fund and will only be realized when the investor sells the fund.
This is favorable from a tax standpoint for two reasons. First, by delaying having to pay the capital gains tax, you benefit from the tax deferral because of the time value of money. Paying $100 in tax today “costs” you more than paying that same $100 ten years from now because you are able to keep that $100 invested and earning income.
Even more valuable, there are ways to avoid paying the capital gains tax on index funds altogether. One way is by making a charitable donation in appreciated securities instead of cash. For example, let’s assume you give $40 per week to your church for an annual donation of $2,080. If instead, you donated to the church $2,080 worth of an index mutual fund that you purchased years ago for $1,000, you would avoid the tax on the $1,080 capital gain. Your charitable deduction is based on the fair market value on the day of the donation, which would be $2,080. (Most non-profits have brokerage accounts established to facilitate donations of securities.)
The other way to avoid the capital gains tax is to pass the index fund to heirs as part of an estate. A fund like the S&P 500 will be a core holding for any portfolio, and some portion of the amount purchased today in a taxable account will likely still be in the portfolio at the end. This is especially true given that you are required to make a minimum distribution from your IRAs after age 70 1/2, making it less likely you will need to tap into your taxable account to fund current cash flow.
Appreciated securities inherited as part of an estate receive what is called a “step up in basis.” This means that whoever inherits the fund would “own” it based on the fair market value at the date of death. The capital gain that had built up over the years would be avoided. The rules are different for gifts made during your lifetime. If you give an appreciated stock or mutual fund to a family member, the recipient would own it based on what you paid for it years ago and would have to pay the full capital gain when sold. If you want to give gifts to your children or grandchildren, it is generally better to give cash and let the appreciated securities stay in the account to be passed along later as part of the estate.
As always, feel free to reach out if you have questions about any of this.