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Index Funds Can Have Major Tax Advantages
June 13, 2012

Index Funds Can Have Major Tax Advantages

Written By: Scott Burns

Q. Just read your article about the costs of variable annuities. Is 0.17 percent a year the only cost for the Vanguard 500 Index Fund? Does this charge reduce my return? Are there any taxes due each year? Do these taxes reduce my net return? By how much? Seems to me that you left quite a bit of info out of your article. — A.R., by email

A. There are a number of sources of funds that replicate the S&P 500 index. Some of them have even lower costs than the 0.17 percent you mention. Vanguard, Fidelity and Schwab, for instance, all offer mutual funds or exchange traded funds (ETFs) with expenses as low as 0.05 percent. The only cost other than the annual expense ratio cost is the cost of transactions, a cost that all funds have. Such transaction costs are tiny for broad index funds compared to typical managed funds. As in all mutual funds, annual returns are calculated net of the annual expense ratio.

Each year index fund investors, like managed fund investors, are subject to income taxes on both dividend income and realized capital gains. Historically, that burden has been light, but that description doesn’t really tell you how tax efficient they are. So consider these figures.

Dividends are now taxed at 15 percent. The S&P 500 index now has a dividend yield of about 2 percent a year. So if you pay a 15 percent income tax rate against that, it will reduce your gross return by 0.30 percent (.15x2.00) of your investment each year.

Capital gain distributions are even less of a concern. Using Morningstar Principia I found that over the 15-year period ending 12/31/12, and based on an initial investment of $100,000, the SPDR S&P 500 index exchange traded fund (ticker: SPY) had distributed $0 in capital gains. The Vanguard 500 Index fund had distributed $1,977 in capital gains over the same 15-year period. That would bring the total tax cost, over 15 years, to about $150 or 0.15 percent or 0.01 percent a year.

In other words, the largest cost of these funds would have taken 0.31 percent a year off the pre-tax return. This is a fraction of the typical 1.00 percent, or more, charged every year for the insurance wrapper of variable annuity funds. As a consequence, the tax burden on a broad index fund doesn't slow down the growth of your money nearly as much as the fee burden of a variable annuity product.

During this long period of major ups and downs the index fund beat about 60 percent of its surviving managed peer group. The word “surviving” is important because mutual funds are quietly buried every day, usually because their track records are poor. So that outperformance figure is understated.

In addition, when you withdraw money from your index fund and realize capital gains by selling some shares, part of the sale will be your cost basis, which is not taxed. Part of it will be capital gains, which are currently taxed at 15 percent. When you take money out of a variable annuity account, all dividend and capital gain income comes out first, original cost basis comes out last. Worse, it is all taxable at ordinary income rates. The only way to avoid high taxes on withdrawals is to have lost money and be retrieving your original principal.

Note that much of this cost advantage is unique to broad index funds. The index funds that duplicate large indexes, such as Vanguard Total Market or S&P 500, have low portfolio turnover, low transaction costs, and very limited capital gain distributions.

This is not the case with index funds that reproduce small and obscure indexes. They have more turnover and more capital gain distributions. Ditto managed funds. They have higher expense ratios, more transactions and related costs, and their higher portfolio turnover reduces their tax efficiency. Many have both short-term and long-term capital gain distributions. This reduces their return.

Some observers have made the case that the higher costs and tax inefficiency of managed funds make the tax deferral features of variable annuities a better choice. I believe that is a long and fruitless discussion because simple, low-cost index fund investing trumps both.

If you would like to learn more, visit my website,, you will find an archive of past columns that go into great detail about variable annuities.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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