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Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 8:03 am
by KDF
When analysts and authors list out the advantages and disadvantages of owning index funds vs. individual stocks, I have yet to find any information on the clear tax disadvantages of owning index funds. Dividends on common shares are qualified and taxed a top federal rate of 20%, while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more).

This can have a dramatic impact over time. Here is an example:

$100,000 is invested for 25 years in an index fund that pays a 2.5% annual dividend. To illustrate the point let's assume the market is flat for those 25 years. After accounting for taxes the investment will grow to $145,507. However, if the $100,000 was invested in common stocks that provided a 2.5% dividend the investment would grow to $160,844. Pretty dramatic difference!

I know that there are other benefits to investing index funds, but the more efficient tax treatment provides a considerable incentive to pick a diversified basket of stocks. What am I missing?

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 8:08 am
by livesoft
... while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more).
False. The dividends I receive from index funds are qualified and I pay a rate of 0% on them.

You are missing that qualified dividends paid by companies (stocks) that the index fund owns remain qualified dividends to the owners of the index fund shares.

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 8:10 am
by stan1
KDF wrote:
Wed Nov 06, 2019 8:03 am
When analysts and authors list out the advantages and disadvantages of owning index funds vs. individual stocks, I have yet to find any information on the clear tax disadvantages of owning index funds. Dividends on common shares are qualified and taxed a top federal rate of 20%, while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more).

This can have a dramatic impact over time. Here is an example:

$100,000 is invested for 25 years in an index fund that pays a 2.5% annual dividend. To illustrate the point let's assume the market is flat for those 25 years. After accounting for taxes the investment will grow to $145,507. However, if the $100,000 was invested in common stocks that provided a 2.5% dividend the investment would grow to $160,844. Pretty dramatic difference!

I know that there are other benefits to investing index funds, but the more efficient tax treatment provides a considerable incentive to pick a diversified basket of stocks. What am I missing?
Your statement that dividends paid by index funds are non-qualified is not correct. Here is Vanguard's list of qualified dividends for 2019 year to date (final available in Jan or Feb, you can find 2018 if you want):
https://advisors.vanguard.com/VGApp/iip ... yeartodate

Total Stock Market fund qualified dividends are 95.97% qualified.

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 8:33 am
by an_asker
KDF wrote:
Wed Nov 06, 2019 8:03 am
When analysts and authors list out the advantages and disadvantages of owning index funds vs. individual stocks, I have yet to find any information on the clear tax disadvantages of owning index funds. Dividends on common shares are qualified and taxed a top federal rate of 20%, while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more).

This can have a dramatic impact over time. Here is an example:

$100,000 is invested for 25 years in an index fund that pays a 2.5% annual dividend. To illustrate the point let's assume the market is flat for those 25 years. After accounting for taxes the investment will grow to $145,507. However, if the $100,000 was invested in common stocks that provided a 2.5% dividend the investment would grow to $160,844. Pretty dramatic difference!

I know that there are other benefits to investing index funds, but the more efficient tax treatment provides a considerable incentive to pick a diversified basket of stocks. What am I missing?
OP:

You've made a blanket statement that appears to be patently incorrect. Do you have a link or a study to back you up?

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 8:40 am
by tibbitts
KDF wrote:
Wed Nov 06, 2019 8:03 am
When analysts and authors list out the advantages and disadvantages of owning index funds vs. individual stocks, I have yet to find any information on the clear tax disadvantages of owning index funds. Dividends on common shares are qualified and taxed a top federal rate of 20%, while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more).

This can have a dramatic impact over time. Here is an example:

$100,000 is invested for 25 years in an index fund that pays a 2.5% annual dividend. To illustrate the point let's assume the market is flat for those 25 years. After accounting for taxes the investment will grow to $145,507. However, if the $100,000 was invested in common stocks that provided a 2.5% dividend the investment would grow to $160,844. Pretty dramatic difference!

I know that there are other benefits to investing index funds, but the more efficient tax treatment provides a considerable incentive to pick a diversified basket of stocks. What am I missing?
As part of your basket of "total" stocks, you''ll own a bunch of REITs. How are you going to make those dividends 100% qualified? Like with a Total Stock fund you will almost certainly have some dividends that aren't qualified - or not have similar diversification.

Also a lot of us own a substantial portion of our funds in deferred or exempt accounts, so it doesn't matter to us.

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 9:03 am
by Stinky
KDF wrote:
Wed Nov 06, 2019 8:03 am

I know that there are other benefits to investing index funds, but the more efficient tax treatment provides a considerable incentive to pick a diversified basket of stocks. What am I missing?
Do you own any index funds yourself? If so, have you looked at the year end Form 1099 from the mutual fund company and noticed that most of the dividends are “qualified”?

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 9:07 am
by JoMoney
KDF wrote:
Wed Nov 06, 2019 8:03 am
... while dividends paid by index funds are non-qualified and taxed at a top rate of 37% (or more)... What am I missing?
My index fund paid out 100% qualified dividends last year, and that's the norm.
It even includes a small portion of REITs and stocks that would not normally be considered "qualified", but since it's such a small fraction of the over all portfolio it's still considered 100% qualified.
https://personal.vanguard.com/us/insigh ... ncome-2018

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 9:32 am
by snailderby
Also, to quote triceratop from another thread:
triceratop wrote:
Wed Dec 14, 2016 3:27 pm
Vanguard's VTSAX QDI was not 100% last year; it was closer to 95%. However, there is a little-known IRS rule that if a fund has 95% QDI or higher then all of its income can be considered qualified dividend income.

. . . . .

Source: 26 U.S. Code § 854 - Limitations applicable to dividends received from regulated investment company

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 10:48 am
by KDF
Thank you to everyone for their replies. I was wrong on my facts, and value that it was pointed out to me.

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 10:52 am
by bryanm
KDF wrote:
Wed Nov 06, 2019 10:48 am
Thank you to everyone for their replies. I was wrong on my facts, and value that it was pointed out to me.
+1! (You might consider adding an edit to your first post noting that this has been resolved, as others might only read that before replying, and not your follow up.)

Re: Tax Disadvantage of Index Funds

Posted: Wed Nov 06, 2019 11:50 am
by mervinj7
snailderby wrote:
Wed Nov 06, 2019 9:32 am
Also, to quote triceratop from another thread:
triceratop wrote:
Wed Dec 14, 2016 3:27 pm
Vanguard's VTSAX QDI was not 100% last year; it was closer to 95%. However, there is a little-known IRS rule that if a fund has 95% QDI or higher then all of its income can be considered qualified dividend income.

. . . . .

Source: 26 U.S. Code § 854 - Limitations applicable to dividends received from regulated investment company
Interestingly, ITOT had a QDI of 92.85% in 2018. VTI, in 2018, was at 94.1%. So neither met the 95% threshold but Vanguard's was closer.

https://personal.vanguard.com/us/insigh ... ncome-2018
https://www.ishares.com/us/literature/t ... 711553.pdf