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One of the things we often forget about when making investment decisions is how such decisions will affect our taxes. However, it is important to consider the tax implications of investments that you make. One of the advantages that index funds have over actively managed mutual funds is that there is lower turnover that equates with lower taxes. The Oblivious Investor describes how this works in mutual funds (remember that index funds are types of mutual funds):

With mutual funds (as opposed to, say, shares of individual stocks), you don’t pay taxes only when you sell the fund. You pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

With portfolio turnover in actively managed funds averaging roughly 100% per year, a great deal of the gains end up being short-term capital gains. Because STCGs are taxed at your ordinary income tax rate (as opposed to LTCGs which are taxed at a maximum rate of 15%), investors in actively managed funds end up paying more in taxes than they would with a fund that holds onto its investments for longer periods of time.

This means that you have better tax efficiency with index funds. This is extremely helpful if you are interested in keeping more of your money in your pocket. Use a tax-advantaged retirement account, and you receive these benefits to an even greater degree.

ETFs and tax efficiency

Even though they aren’t mutual funds, ETFs also have some helpful tax advantages. The Oblivious Investor points out that because of how ETFs are created, they normally distribute less frequent capital gains (and smaller gains) to shareholders. This means that you pay less in taxes.

When comparing different investment options, consider taxes as part of your costs. Just as administrative fees and loads are part of the equation, what you pay in taxes should also be considered. If you neglect to factor in taxes, you could be rather unpleasantly surprised.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.