Capital Gains Tax
The other advantage of an index fund over a typical managed fund—and this can be major—is that most mutual funds are set up so that if there’s a capital gain when they sell a stock, that gain is passed through to the investors. At the end of the year the fund will pay you (or reinvest in the fund, your choice) all the realized capital gains they’ve acquired that year. Whenever a mutual fund has a capital gain distribution, it also reduces the NAV by the price of the capital gain. Let’s say that you’ve invested in a mutual fund with a NAV of $10, which itself has a capital gain distribution of $1. If you have chosen not to reinvest capital gains, you’ll get $1 for every share you own, and you’ll have to pay tax on it. If you have decided to reinvest the capital gains, then the fund will buy you as many shares as that capital gain allows, but you’ll still have to pay tax on this amount. In addition, in both cases the NAV of the mutual fund has now been reduced to $9 a share.
Maybe this doesn’t sound so bad, but depending on how much money you have in the fund, you may be unpleasantly surprised to see what this capital gain distribution does for you if it happens to come in a year when you’re in a high tax bracket to begin with. It’s definitely a drawback in a managed mutual fund that you have no say or way to plan in its decision whether or not to take a large gain in a given year. All that fund cares about is making the greatest return for you, which is fair enough. They don’t care whether it’s a convenient year for you to pay taxes on a capital gain.
Happily, this isn’t as big a problem with an index fund. Since index funds buy the whole index, they do not in general distribute capital gains. Why? Because they don’t sell with such planned regularity. They buy and sell when only one of the stocks of the index is removed and a new stock takes its place. Since a fund that matches the S&P 500 index is meant to track the stocks in the index, it las to make these appropriate changes as necessary. But these trades occur with nowhere near the frequency they do with a managed fund. So if the idea of paying taxes on unexpected capital gains worries you, this should be taken into consideration before you decide on a managed fund or an index fund.
Remember, it’s not how much you make that counts. It’s how much you get to keep.