Taxes on Gains for Index Funds

This article will speak about potential taxes on index funds. Before speaking about the article, it is important to note that:

  1. We aren’t tax advisors
  2. Tax rules can change
  3. Taxes all around the world are on capital gains. We don’t know of any country which simply taxes an account which is rising in value
  4. Nobody can know what the tax laws will be in 10, 20 or 30 years. So it is best to “cross that bridge when you come to it” and not worry about it on day 1.
  5. We have worldwide clients so this is a general introductory article

If you have questions or are looking to invest, you can email me (advice@adamfayed.com) or use the chat function below.

Index Funds:

‘Index Fund Definition’ – Index Fund, also known by the name ‘Index Tracker’, are the type of funds that are designed in order to track the performance of any other financial market index. Index Funds are known to be an efficient form of passive investment and don’t require to be managed on a regular basis. Index Funds are used by many investors in order to diversify their portfolios.

A few well-known examples for the index funds are ‘S&P 500’, ‘Russell 2000’, ‘Wilshire 5000’, etc. few companies like Charles Schwab, Vanguard, etc. offer index funds that track the total returns of the market indexes. For example, Charles Schwab is known to offer an index fund that tracks the entire market performance of the equity market.

With the help of index funds, investors get access to broader exposure to a group of companies rather than just buying the individual shares of stock in one company.

Creating a diversified portfolio is considered to be one of the main strategies for the people who want to gain profits by investing and index funds are known to represent a multitude of sectors within the indexes they track.

A group of underlying securities in an index fund can be able to protect the investor from major losses, as it doesn’t get heavily impacted even if the price of an individual stock dramatically falls.

Index funds often require lower fees when compared to that of the actively managed mutual funds. This is due to the reason that Index funds require very little trading activity and sometimes no trading activity at all as the funds are designed in order to track a broader index while actively managed funds have a requirement of continuously adding or removing of securities from their portfolios.

The index funds always make an investment in the companies that are owned with the index that they track. For example, an index fund that tracks the DJIA (Dow Jones Industrial Average) would invest in the 30 large companies that are present within that index.

The changes in the portfolios of index funds occur only when their benchmark indexes change. In some cases, where the fund is following a weighted index, the managers of the fund usually rebalance the percentage of different securities, every once in a while, in order to maintain the weight of their presence in the benchmark.

There is a very low chance for the underlying securities of an index fund to have a big impact and often remain the same unless an index decides to remove one of the existing securities from its index. Many index funds require a minimum investment amount that needs to be deposited while creating an account and usually charge different types of fees and charges.

Passive management leading to positive performance and it is often proved to be true over the long term. Within shorter periods of time, actively managed funds (such as mutual funds) are known to perform relatively better than the Index Funds. The statistics and data presented by SPIVA Scorecard state that during the time span of one year, only more than 60% of large-cap mutual funds have been known to provide a performance which was considered to be subsequently lower than that of the S&P 500 index. 

In general words, more than one-third of the mutual funds have been known to have beaten the performance of the S&P 500 index during a shorter time period. In some other aspects as well, actively managed assets have been proven to have more advantages when compared to that of the passively managed assets. For example, approx. 85% of mid-cap mutual funds performed better than the S&P mid-cap 400 Growth Index benchmark, within the time period of one year.

‘Advantages of Index Funds’ – The major benefits to an investor while trading with the index funds are as follows:

  • ‘Diversification’ – Index Funds are known to offer a diversified portfolio and are a great choice for the investors who want to create a diversified portfolio.
  • ‘Low Expense Ratios’ – The Expense ratios are known to directly impact the overall performance of a fund. Actively managed funds that have higher expense ratios are considered to be at a disadvantage when compared to the index funds.
    Actively managed funds often struggle to keep up with their benchmarks in terms of overall return, whereas, Index Funds are known to replicate the market performance with ease.
  • ‘Highly beneficial on long term’ – Investor legend Warren Buffett suggests that index funds can be considered as a haven for savings for the retirement period of life. Instead of picking out stocks individually for investment, he says, it would be more beneficial for the average investor to buy all of the S&P 500 companies for the low price an index fund offers.
  • ‘Good strategy for buy-and-hold investors’ – Index Funds are more beneficial for the investors who are willing to trade on the strategy of buying and holding their assets instead of making day to day trades.

There are also some disadvantages along with the advantages while having to trade with the index funds. They are:

  • Index Funds are highly vulnerable to the swings and crash in the market as they replicate the overall performance of a market.
  • Index Funds are not considered to be a flexible choice of investments.
  • With having no requirement for manual activity, it might be a disadvantage for the investors who want to trade manually.
  • The gains on the Index Funds are limited.

Index Funds being the passively managed funds, often don’t try to beat the performance of the market. Instead of this, they try to match the risk and returns of the market. The main theory on which the index funds are based is that the Market would always win.

In the most recent years, many obscure indexes have been created in order to allow the investors, the opportunity to take advantage of the specialized markets. Investors who are willing to make an investment in commodities, foreign currencies, or socially responsible companies can now be able to find the type of assets they want with the help of index funds.

It is true that passive management often leads to positive performance, and it is considered to be even more beneficial over the long term. But when it comes to trading for a shorter timespan, actively managed funds are known to provide better performance. According to the data and statistics of the SPIVA Scorecard, in the time span of one year, only 64% of large-cap funds were unable to reach up to the performance of the S&P 500. In general terms, more than one-third of the investors were able to beat the performance of the S&P 500 in the short term. 

The major aspects of Index Funds that are needed to be taken into consideration are:

  • An Index Fund is created in such a way that it tracks the overall performance of a financial market index so that it matches the risk and return of the market instead of beating the market performance.
  • Index Funds are known to be an efficient form of investment asset as they have lower expense ratios, lower turnover ratios, fees, charges, etc. when compared to the actively managed funds as they are a passive form of investing.
  • As the Index Funds follow a strategy of passive investment, they often require fewer costs as they wouldn’t require professional services such as financial managers, some type of trading costs, etc.
  • In the long term, the Index Funds are known to have better performance when compared to any other type of funds that fall under this category.

Taxes:

‘Definition’ – Taxes are the mandatory contributions that are needed to be made to the government on behalf of the individuals living in a country or state. In simple words, Taxes are the money that is needed to be paid to the government by the people. 

Taxes can be collected from on the local, regional or national levels. The process of collecting taxes from individuals is known as ‘Taxation’.

Taxes are used by the government to manage its expenses. Some of the basic expenses for which the government makes use of the taxes are paying the government employees, building/renovating government infrastructure, etc. Taxes can be applied to different types of income or earnings.

There are different types of taxes that can be applicable for a person/company when they are residing in a country and those taxes differ depending on various types of factors such as country they live, amount of income, way of income, etc. 

The revenues of the central government are generally collected in the form of Income Tax, VAT, National Insurance Contributions, Corporation Tax, and Fuel Duty. some of the few examples for taxes are:

‘Income Tax’ – Income Tax is the type of tax that is paid to the government by an individual on the basis of the income they earn. Income tax consists of the incomes that can be earned in the form of wages (which can either be from employment or self-employment), pensions, bonuses, benefits, etc.

Income tax is considered to be one of the primary sources of revenue for any government. For example, Income tax is said to contribute to about 30% of the overall revenue that is collected by the government of the United Kingdom.

There is a personal tax allowance for all the individuals in some countries and the earnings up to this threshold don’t require taxation. the income tax rates are discounted in the case of some people who come under special categories. Also, the income earned by charitable trusts is exempt from income tax.

‘Inheritance Tax’ – Inheritance Tax is the tax that is imposed upon the ‘Transfers of Value’ (which include estates, gifts within seven years of death, transfers to some types of trusts, etc.). There is no inheritance tax applicable to an individual in many countries up to a certain threshold. 

‘Council Tax’ – The main concept of the council tax is to help the services of the local governments of other countries partially in the form of funds. 

‘Value-added Tax’ – Value-added Tax (VAT) is known to be a type of Consumer Tax and is charged to an individual depending on the value of the goods and services. 

‘Excise Taxes’ – Generally, the excise taxes are the taxes that are applicable to certain products such as Fuel, Tobacco, Alcohol, Gambling, Vehicles, etc. 

‘Stamp Duty’ – this is the tax that is applicable upon the transfer of real property, shares, and some securities. Normally, the rates of Stamp duty vary depending on the asset class.

‘Corporate Tax’ – this is the type of tax imposed upon companies or legal entities for the profits gained by them. It is the fourth largest source of revenue in the United Kingdom. It is also imposed on the profits of the permanent establishments of the non-UK companies which trade in Europe.

Taxes for the profits from Index Funds:

The main types of taxes that we are going to be discussing in today’s article are the taxes that are applicable to the Capital Gains and Dividends. These two are the types of taxes that are applicable to an individual while trading with the Index Funds

‘Capital Gains’ – The increase in the price that asset experiences from its actual price is known to be ‘Capital gain’. The gain cannot be accurately determined until the asset has been sold. 

‘Capital Gains Tax’ – Capital Gains tax is the type of tax that is generally levied upon the profits that have been earned from the capital gains of an asset. Most commonly the capital gains taxes are applicable to the sales of assets such as stocks, bonds, real estate, property, precious metals, etc. Capital Gains Tax can either be applied on the valuable items or the assets that have been sold in order to gain profit.

‘Dividends’ – Dividends are the small amounts of money that are paid by a company from its profits to the shareholders of that respective company. 

‘Taxes on Dividends’ – The taxes that have to be paid for the dividends earned by an individual are known as Dividend taxes. 

‘Taxes on Index Funds’ – Dividends and Capital Gains are the two types of income generated from an Index Fund. People who are attracted to the long-term performance, lower expense ratios, diversified portfolios, etc. of an Index Fund would be even more fascinated and like to invest in them if they can get to know about the reduced tax rates for the index funds.

The Index Funds are considered to be more tax-efficient when compared to most of the other types of assets. Because of tax-efficiency that index funds provide, investors who are holding funds in a taxable account can be able to reduce the taxes by investing in these passively managed funds (index funds).

‘Low Turnover ratio’ – One of the major aspects of index funds that makes them tax-efficient is their Low Turnover Ratio. Low Turnover Ratio is a measurement that indicates the percentage of a particular fund’s holdings that have been replaced during the before year. 

For example, if an index fund is known to be investing in 100 different stocks and 30 of those stocks were replaced, then the turnover ratio would be 30% for that specific index fund. 

People might get a doubt that what would happen if they have higher turnover ratios. Higher turnover ratios would lead to an interesting series of events described as follows. Higher turnover ratios caused in mutual funds would often lead to an increase in the activity of buying and selling. When the buying and selling activity of a mutual fund increases, they are required to sell a few securities for a higher price than the actual price. 

When they are sold at a price that is higher than the actual price it would lead to capital gains. These capital gains should be distributed among investors. At this point, people might be wondering why would capital gains not be beneficial to anyone? This is due to the capital gains taxes that occur and are required to be paid by the investors.

Hence, Index Funds, which are known to be having lower turnover ratios such as 1% or 2% require a low amount of taxes when compared to the actively managed funds, where the turnover ratio can subsequently higher than the index funds such as 20%. In some cases, the turnover ratio of an index fund can be as high as 100% which would create more taxes.

‘Less Dividends’ – Index Funds often pay fewer dividends to the shareholders when compared to many of the actively managed funds. Dividends from Index Funds are taxable just like they are taxable for many other types of actively managed funds. 

Dividends can be more in some cases, where the investor buys an index fund that has been created specifically in order to be useful for the investors trading on the buy-and-hold strategy stocks that pay significantly higher dividends. Another case is where the investor buys a Bond Index Fund where the investor can become subject to taxes that can arise from the dividends and interest.

If an investor who is known to have enough risk tolerance and an excellent investment strategy, they can choose to make an investment in a growth index fund. For example, if a person chooses to make an investment in a growth index fund, such as the ‘Vanguard Growth Index’, the dividends are not directly paid to the customer. 

Instead of directly paying those dividends, the growth index funds usually make use of those dividends to reinvest in their assets. This could generate an increase in the underlying assets for an investor while lowering the tax rates for the dividends and other types of profits.

The main thing that needs to be taken into consideration is that investors having a brokerage account with tax benefits can be able to hold their index funds very efficiently, by saving the amount that needs to be paid in the form of taxes.

It is very popularly known by most of the investors that making an investment in assets such as Index Funds, Small-cap growth funds, etc. might be very beneficial to them as the taxes that need to be paid can be reduced for these assets when compared to many other types of assets that come under this category. 

Conclusion:

In general terms, index funds are known to be more tax-efficient when compared to the actively managed funds because index funds are managed passively. This actually means that index funds, which passively track a benchmark index, often lead to an extremely low turnover when compared to that of the actively-managed funds. 

Turnover is when securities are bought and sold within an existing portfolio of an index that is tracked by the respective index fund. The low turnover ratio that can be taken advantage of with the index funds means that the capital gains generated are relatively less when compared to actively managed funds. Actively managed funds are known to have a much higher turnover than that of the index funds. 

Having said that, it is suggested to any investor that index funds, even though as good choice for making an investment, can be sometimes riskier for the investors (especially for the beginner level investors). 

Thus, it is better to get familiar with all the terms related to the specific asset that an investor is willing to make an investment in and create a good strategy for gaining profits by discussing with a good financial advisor (like us), investors might be able to gain more benefits from all their investments.

Although a person can be able to make an investment on their own, it is better to take the help of a financial expert so that they can be able to guide you with all your doubts and queries related to making an investment. 

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