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Income Tax on Mutual Index Fund

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  • Income Tax on Mutual Index Fund

    I am opening Vanguard Mutual Index Fund.

    I am newbie and trying to learn more. I am worried about income tax or capital gain tax which will make me lose my earnings on investment.

    What would one suggest to minimize these?

    I heard it needs to be rebalanced or I will lose earnings. And I don't know anything about rebalancing other than just reading about it.

    Do I need a financial planner for this? My friend suggested Betterment.


  • #2
    Is this a standard taxable brokerage account? Retirement accounts don't pay taxes on growth while in the account.

    In taxable accounts, you pay taxes on dividends. Qualified dividends, which will be most index funds other than REIT, are taxed at the long-term capital gains rate. REITs pay unqualified dividends, taxed at the full income tax rate. To minimize taxes, choose a fund with low dividends. Most total stock market index funds earn about 2% a year on dividends, so you will lose probably at most 0.4% of gain from those.

    You will realize a capital gain whenever you sell something for more than you bought it. The same goes for if the fund managers sell some of the holdings within the fund. This is called "turnover." This is more common in actively managed funds when the managers are trying to earn as much as possible by changing holdings, so index funds, being passive by nature, tend to avoid this problem for the most part.

    There are "tax-managed" funds which are specifically designed to have minimal dividends and turnover. Here is an example of what essentially amounts to a S&P 500 index fund in that mold:

    If you want to see exactly how a fund does with taxes, research sites like Morningstar have that illustrated as above.

    Don't hold bonds in a taxable account because they earn primarily on dividends. The exception is municipal bonds, from which dividend income is tax-exempt. They are ideal for holding in a taxable account, especially if you live in a state with income tax and you buy that state's municipal bonds.

    On the whole, stock index funds tend to be quite tax-efficient based on their low turnover, so they're fine to hold in taxable.

    I have a feeling you're trying to walk before you crawl...I assure you this isn't all that complicated. Here is a decent explanation about tax efficiency:


    • #3
      Thanks for the reply.

      I learnt from you and Forum -

      Invest in 401K - doing it. And will use 70/20/10 distribution.

      Open Roth IRA

      Opened HSA BANK - TD Ameritrade - will invest in commission free ETFs - now need to see how to do 70/20/10 spread

      Will invest in Vanguard index mutual fund as advised - 70/20/10 spread.

      But before I invest money in HSA Bank and index mutual fund, I heard about paying capital gain taxes if I do not do rebalancing. Hence I asked the question. I don't want to invest first and then find out about these things later. I would rather know now, so I do it correctly and don't lose my gains later.


      • #4
        A few thoughts:

        1. You don't have to be 70 / 20 / 10 in each account. It's typically better to calculate your asset allocation across all accounts. I keep stocks and bonds in my 401(k) and my taxable account is 100% stock.

        2. You can rebalance your portfolio by buying and selling (exchanging) within your 401(k). No capital gains taxes to worry about. You incur capital gains taxes only when you buy and sell in your taxable (a.k.a. post-tax brokerage account).

        3. Also, no worries on taxes in HSA. The only way you could pay tax on that money is by withdrawing for non-eligible expenses, which you can do after age 65.

        I've written about tax drag in a taxable account and how it can be minimized. See also WCI's Advantages of a Taxable Investing Account.


        • #5