Taxes have a huge impact on investment returns. The Bogleheads Guide to Investing cites a study by Charles Schwab that found that for the 30-year period from 1963 to 1992, $1 invested in U.S. equities would have grown to $21.89 in a tax-deferred account but only to $9.87 in a taxable account for a taxpayer in a high tax bracket.

Index funds are tax efficient in two ways. First, index funds can be bought and held “forever” with high confidence that they will outperform the vast majority of investors, who are presumably chasing performance and buying “hot” funds and selling them when they almost invariably turn cold. Second, the turnover of the index funds is extremely low because changes are made only when stocks are added to the index or when stocks leave the index or when companies merge, are taken over or go bankrupt. Hence, realized capital gains that are distributed to the investor and taxed in her hands are very low.

Consider the Vanguard Total Stock Market ETF (VTI) whose portfolio turnover for the past five years were 4%, 4%, 12% (due to a change in the fund’s target index), 4% and 2% respectively. In contrast, it is impossible to tell what the turnovers for the larger U.S. equity mutual funds in Canada because such information is not available in the prospectus. Leith Wheeler, to their credit, publish such information for their U.S. Equity Fund and reported a turnover of 17% (to June 2007) and 25% in 2006. The Vanguard Europe Pacific Fund (VEA) also has very low turnover: 6%, 4%, 4%, 5% and 9% in the past five years. The low turnovers will result in lower realized capital gains distributed to investors over time and result in higher after-tax returns when compared to actively managed funds.

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This article has 8 comments

  1. Not to mention the horror of getting a capital gain tax form from a fund that lost money. Down $5000, capital gain of $3000, WTF?

    Great site BTW.

  2. darryl –

    if that happens, crystalize the $5,000 you are down by selling or switching out of the fund to a similar fund (you can’t buy it back for 30days, so if you pick one that is close but not identiacal you’ll be hedged against the fund moving back up in the 30 days.

    The $3K capital gain slip raises your adjusted cost base by that amount – now your loss after crystalization is $8K (the $5K you are down plus the $3K distribution from the slip.

    When doing your 2008 return – assuming you have NET losses after mixing all your gains and losses in 2008 , you file form T1A request for loss carry back ( the 2007 one can be found here http://www.cra-arc.gc.ca/E/pbg/tf/t1a/t1a-07e.pdf )

    Fill out section three of this T1A form and you can easily get the tax back from 2007.

    So many people bitch about taxes and this is understandable. But a few simple strategies like this one and an awareness of the rules will improve your tax eficiency considerably. BTW – This strategy applies equally well to ETFs, stocks, and funds.

  3. Can we (meaning Canadians) buy Vanguard funds? If so, how?

  4. As a fan of ETFs, I wonder if you have any thoughts on ultra-ETFs, like SSO?

  5. Canadian Capitalist

    Aleks: We can’t buy Vanguard index funds but with a brokerage account we can buy the Vanguard ETFs.

    Link

    Random: I must confess I haven’t heard about SSO before. I stick to plan vanilla ETFs.

  6. cool I will keep that in mind. Though I think I have a net gain for the year. Hopefully canceled out by losses from the past.

  7. Hey, i’m a new investor looking to buy some index funds – specifically iShares. However, this blog also mentions Vanguard ETFs. I was wondering what are the tax implications or additional costs of buying an American fund?

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