Why large cap index fund is more tax efficient than Small cap index fund ?

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pachha
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Why large cap index fund is more tax efficient than Small cap index fund ?

Post by pachha » Wed Jan 02, 2019 9:34 pm

Please help me understand why the large cap index fund is more tax efficient than small cap index funds in a taxable account?
For example, VSMAX(Vanguard small cap index admiral) versus VFIAX(Vanguard 500 index admiral).
Looks like Both have pretty much zero short term/long term capital gains.
Looks like VFIAX has 100% qualified income and VSMAX has 75% qualified income. Is this the only reason that large cap index is more tax efficient than small cap index?
However VFIAX has more dividend income than VSMAX. Doesn't this negate the benefit?
FYI i am in 35% tax bracket.
Thanks

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David Jay
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by David Jay » Thu Jan 03, 2019 3:27 pm

I really can't speak to this with any authority, but let me bump your thread to see if we can get some commentary.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

The Wizard
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by The Wizard » Thu Jan 03, 2019 3:38 pm

I'm pretty sure that VSMAX has had CGDs in the past.
What happens is that small startup companies are owned by VSMAX but those that grow significantly get promoted to mid caps and eventually large cap.
That promotion happens when VSMAX sells all of a particular stock that has tripled in value or better. This sale produces a CG for the fund which must be distributed to the extent it exceeds Capital Losses.

With large cap funds like VFIAX, a company exits when it declines in value a lot, like Sears or GE. So no CG when all of those stocks are sold...
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House Blend
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by House Blend » Thu Jan 03, 2019 10:07 pm

pachha wrote:
Wed Jan 02, 2019 9:34 pm
Please help me understand why the large cap index fund is more tax efficient than small cap index funds in a taxable account?
For example, VSMAX(Vanguard small cap index admiral) versus VFIAX(Vanguard 500 index admiral).
Looks like Both have pretty much zero short term/long term capital gains.
Looks like VFIAX has 100% qualified income and VSMAX has 75% qualified income. Is this the only reason that large cap index is more tax efficient than small cap index?
However VFIAX has more dividend income than VSMAX. Doesn't this negate the benefit?

FYI i am in 35% tax bracket.
As you point out, there are two differences, one that works in favor of VFIAX (100% QDI) and one that favors VSMAX (lower dividend yield).

Which one is more significant depends on the exact numbers as well as your tax rates. For example, if you are in the 12% tax bracket and live in a no tax state, then VFIAX is a clear winner -- your tax cost is 0. In your 35% Fed bracket, they're probably about the same--within a few basis points. Your state tax, if any, might be enough to tilt the scales toward VSMAX.

However, given that you are (or might be) putting Small Caps in taxable, Tax Managed Small Cap (VTMSX) is arguably better than VSMAX for that purpose, both in terms of the index it tracks and its tax efficiency.
The Wizard wrote:
Thu Jan 03, 2019 3:38 pm
I'm pretty sure that VSMAX has had CGDs in the past.
In the distant past maybe. Not at all since 2004--the inception date of the ETF share class (VB).

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danielc
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by danielc » Fri Jan 04, 2019 12:52 pm

Large cap will have less turnover. Therefore, fewer capital gain distributions. In fact, I think iShares and Vanguard both keep the capital gains distributions at about zero, so the only tax is from dividends.

catalina355
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by catalina355 » Wed Oct 09, 2019 2:27 pm

As you point out, there are two differences, one that works in favor of VFIAX (100% QDI) and one that favors VSMAX (lower dividend yield).

Which one is more significant depends on the exact numbers as well as your tax rates. For example, if you are in the 12% tax bracket and live in a no tax state, then VFIAX is a clear winner -- your tax cost is 0. In your 35% Fed bracket, they're probably about the same--within a few basis points. Your state tax, if any, might be enough to tilt the scales toward VSMAX.

However, given that you are (or might be) putting Small Caps in taxable, Tax Managed Small Cap (VTMSX) is arguably better than VSMAX for that purpose, both in terms of the index it tracks and its tax efficiency.
Could you please explain why Tax Managed Small Cap would be more tax efficient than Small Cap Index?

Northern Flicker
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by Northern Flicker » Wed Oct 09, 2019 3:48 pm

The large cap index does not have as many REITs (if any), which distribute unqualified dividends. Total US stock market contains REITs but sometimes achieves 100% QDI because if it is greater than 95% it can be rounded up to 100%. Holding small-caps as part of a market index fund is thus more tax-efficient than holding them as a separate index fund.

VTMSX tax-managed small-cap is more tax-efficient than an S&P600 small-cap index fund because it can give tax considerations priority over index tracking. Over medium and long-term periods it will track the S&P600 smallcap index as well as a true S&P600 index fund but in the short-term it may have a little higher tracking error. You can see from the following comparison of VTMSX and IJR that index tracking variance with VTMSX has not been a concern:

http://quotes.morningstar.com/chart/fun ... 2%3A955%7D
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MotoTrojan
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by MotoTrojan » Wed Oct 09, 2019 5:17 pm

catalina355 wrote:
Wed Oct 09, 2019 2:27 pm
As you point out, there are two differences, one that works in favor of VFIAX (100% QDI) and one that favors VSMAX (lower dividend yield).

Which one is more significant depends on the exact numbers as well as your tax rates. For example, if you are in the 12% tax bracket and live in a no tax state, then VFIAX is a clear winner -- your tax cost is 0. In your 35% Fed bracket, they're probably about the same--within a few basis points. Your state tax, if any, might be enough to tilt the scales toward VSMAX.

However, given that you are (or might be) putting Small Caps in taxable, Tax Managed Small Cap (VTMSX) is arguably better than VSMAX for that purpose, both in terms of the index it tracks and its tax efficiency.
Could you please explain why Tax Managed Small Cap would be more tax efficient than Small Cap Index?
Lower dividend yield perhaps. I’d prefer it anyways due to S&P600 index (smaller medium market cap).

catalina355
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by catalina355 » Wed Oct 09, 2019 7:13 pm

Northern Flicker wrote:
Wed Oct 09, 2019 3:48 pm
The large cap index does not have as many REITs (if any), which distribute unqualified dividends. Total US stock market contains REITs but sometimes achieves 100% QDI because if it is greater than 95% it can be rounded up to 100%. Holding small-caps as part of a market index fund is thus more tax-efficient than holding them as a separate index fund.

VTMSX tax-managed small-cap is more tax-efficient than an S&P600 small-cap index fund because it can give tax considerations priority over index tracking. Over medium and long-term periods it will track the S&P600 smallcap index as well as a true S&P600 index fund but in the short-term it may have a little higher tracking error. You can see from the following comparison of VTMSX and IJR that index tracking variance with VTMSX has not been a concern:

http://quotes.morningstar.com/chart/fun ... 2%3A955%7D
I am looking for a completion index for Large Cap Index and the CRSP Small Cap Index would be the obvious choice. Do you have a link to the tax cost of Small Cap Index versus Tac Managed Small Cap in a particular Federal and State tax bracket.

Thank you for the explanation.

Northern Flicker
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by Northern Flicker » Wed Oct 09, 2019 10:13 pm

The Vanguard Small-cap index fund is the actual market completion index fund for the Vanguard Large Cap Index fund. If you want to hold both in a taxable account, just hold the total market index fund. Otherwise when stocks move between the two indices tour portfolio will be selling the stock in one fund and buying it in the other, incurring transaction cost for you to hold the same aggregate portfolio.

If you want a small cap tilt in a taxable account hold VTI/VTSAX and VTMSX. If you want a small-cap value tilt, hold VIOV instead of VTMSX.
Index fund investor since 1987.

catalina355
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by catalina355 » Thu Oct 10, 2019 7:08 am

Northern Flicker wrote:
Wed Oct 09, 2019 10:13 pm
The Vanguard Small-cap index fund is the actual market completion index fund for the Vanguard Large Cap Index fund. If you want to hold both in a taxable account, just hold the total market index fund. Otherwise when stocks move between the two indices tour portfolio will be selling the stock in one fund and buying it in the other, incurring transaction cost for you to hold the same aggregate portfolio.

If you want a small cap tilt in a taxable account hold VTI/VTSAX and VTMSX. If you want a small-cap value tilt, hold VIOV instead of VTMSX.
I agree but I can't make that change now. Do you know where I can find information about the tax cost of holding Small Cap Index versus Tac Managed Small Cap?

Northern Flicker
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by Northern Flicker » Thu Oct 10, 2019 11:46 am

You can find QDI data for 2018 here:

https://personal.vanguard.com/us/insigh ... ncome-2018

You can also lookup prior years.

iShares data is here:

https://www.ishares.com/us/literature/t ... 711553.pdf
Index fund investor since 1987.

catalina355
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Re: Why large cap index fund is more tax efficient than Small cap index fund ?

Post by catalina355 » Thu Oct 10, 2019 12:00 pm

Northern Flicker wrote:
Thu Oct 10, 2019 11:46 am
You can find QDI data for 2018 here:

https://personal.vanguard.com/us/insigh ... ncome-2018

You can also lookup prior years.

iShares data is here:

https://www.ishares.com/us/literature/t ... 711553.pdf
Thank you. I will run this in Turbo Tax.

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