index funds in taxable accounts

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contractdesign
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Joined: Sat Oct 19, 2013 2:09 pm

index funds in taxable accounts

Post by contractdesign »

I searched the forums and wiki but couldn't find an answer. Apologies in advance if this has already been asked...

Having reached my 401k contribution amounts, I am taking the wiki's advice and buying index funds for my taxable accounts, but I'm having a hard timing estimating potential tax liabilities.

From the wiki, Index funds are tax-efficient, since they aren't churned.

- What happens to the dividends generated by index funds? Are these taxed and then used to repurchase more shares?
- From a tax perspective is there a bad time to buy an index funds (like there is with mutual funds)?
- Any tips on estimating tax liabilities? Ideally, I'm looking for a chart with tax bills for $10k investment for the previous N years.

Thanks, y'all!
livesoft
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Re: index funds in taxable accounts

Post by livesoft »

contractdesign wrote: - What happens to the dividends generated by index funds? Are these taxed and then used to repurchase more shares? One reports dividends as income on Form 1040 Schedule B.

- From a tax perspective is there a bad time to buy an index funds (like there is with mutual funds)? Yes. Index funds may pay dividends on a published schedule. One will not want to 'buy the dividend' in general, so maybe 1-2 weeks before a dividend payment is not the best time to buy a mutual fund which includes index funds. OTOH, if you know the stock market is going to go up in that 2 weeks, then it would be wise to capture that 10% gain by buying right away no matter if the dividend will be paid in 2 weeks.

- Any tips on estimating tax liabilities? Ideally, I'm looking for a chart with tax bills for $10k investment for the previous N years. Sure, create a spreadsheet to calculate the tax costs in past years from the reported historical distributions. It will depend on your personal tax situation. Morngingstar reports a sometimes incorrect tax cost ratio which you can look up.
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CantPassAgain
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Re: index funds in taxable accounts

Post by CantPassAgain »

It depends on what kind of fund and what tax bracket you are in.

Qualified dividends (which include dividends for stock funds) and long-term capital gains are taxed at a lower rate. Currently these are taxed at 0% for those in the 15% tax bracket.

Bond fund dividends are nonqualified and therefore are taxed as ordinary income. The exception are municipal bond funds which are exempt from federal taxation (but have lower yields).
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grabiner
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Re: index funds in taxable accounts

Post by grabiner »

Welcome to the forum!
contractdesign wrote:I searched the forums and wiki but couldn't find an answer. Apologies in advance if this has already been asked...

From the wiki, Index funds are tax-efficient, since they aren't churned.

- What happens to the dividends generated by index funds? Are these taxed and then used to repurchase more shares?
The dividends are distributed to you and taxed (at the lower qualified dividends rate for most dividends from stock funds). You can choose to reinvest them in the same fund to buy more shares, receive them in cash, or direct the distributions to a different fund.
- From a tax perspective is there a bad time to buy an index funds (like there is with mutual funds)?
It is best to avoid buying a fund before a large distribution, as you will pay tax on the distribution but will only have a small time period to benefit from the gains. Most index funds don't have large distributions (0.5% of the value quarterly is typical, which will cost you 0.08% of your investment if the dividend is qualified). If you are investing in an index fund which pays annual dividends, or which will distribute a capital gain, don't buy in the few weeks before that distribution. For a typical distribution, the expected loss in staying out of the market for more than a week is greater than the tax on the dividend.
- Any tips on estimating tax liabilities? Ideally, I'm looking for a chart with tax bills for $10k investment for the previous N years.
Check with the fund provider. Vanguard reports pre-tax and after-tax returns for all of its funds; if a fund reports 10% pre-tax and 9.6% after-tax, then you would lose $40 per year to taxes on a $10,000 investment. (Morningstar reports tax data for all funds but sometimes makes errors, primarily because it doesn't always know about qualified dividends.)
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