Know the Tax Effects of Index Funds

(3 of 5)

Know the Tax Effects of Index Funds

One of the most common myths about indexing is that all index funds are tax-efficient. Funds that buy the biggest stocks can boast terrific tax efficiency. That’s because stocks that drop out of the large-cap S&P 500 usually are pretty small players in the index (most companies drop out of the index precisely because they’ve become too small)—after the 225th stock, none accounts for more than 0.10% of the index. When index funds sell these smaller positions, they don’t reap sizable taxable gains.

Don’t expect tax efficiency from funds tracking other indexes, though. For example, funds following smaller-cap indexes have to sell stocks that have grown too large to remain in the small-company index; because those are also the funds’ largest positions, selling them means realizing large capital gains, which then have to be distributed to shareholders.

Where to find more information

Some research firms such as Morningstar can help you see how tax efficient an index fund is.