Taxes are costs too
How trading inside a fund creates tax bills, and why Bogle counts taxes alongside fees.
FinanceBogle ch. 6About 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain turnover and how it creates realised capital gains
- Show why paying tax later beats paying it now
- Explain why tax rules depend on the country and the kind of account
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
Common-sense investing: the case for index funds: lesson 5 of 12
- Costs and the market
- Investors as a group earn the market minus costs 7 min
- Bogle ch. 2
- Where stock returns come from 5 min
- Bogle ch. 3
- Owning the whole market 4 min
- Bogle ch. 5
- Fund returns versus investor returns 6 min
- Bogle ch. 6
- Taxes are costs too 5 min
- Bogle ch. 7
- When future returns are lower 5 min
- Bogle ch. 8–9
- Why past winners rarely repeat 5 min
- Costs and the market
- Is advice worth paying for? 7 min
- Bogle ch. 11–12
- Costs go on forever 5 min
- Bogle ch. 13
- Bonds and money-market funds 4 min
- Bogle ch. 14–15
- New indexes and ETFs 5 min
- Bogle ch. 16–18
- Graham, the arithmetic, and a plan 5 min
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Pairs with Bogle, The Little Book of Common Sense Investing (2007), chapter 6, "Taxes Are Costs, Too"
What it is
When a fund sells a share for more than it paid, it realises a capital gain. In some countries, including the U.S. in Bogle's examples, funds pass those gains on to their investors, who may owe tax on them that year, even if they didn't sell anything themselves.
Turnover measures how much of its portfolio a fund buys and sells in a year. A turnover of 100% means, on average, it replaces its whole portfolio once a year. Bogle's 2006 figures: about 100% for the average actively managed stock fund (counting each fund once), or 61% weighted by fund size. A broad index fund trades very little, so it realises few gains.
Bogle estimates that, for 1980–2005, federal taxes took 1.8 points a year from the average active stock fund's return, against about 0.6 points for an index fund.
The yearly tax on realised gains only arises in taxable accounts. Money in tax-sheltered accounts (pensions and similar accounts, whose names and rules vary by country) isn't taxed on these gains each year.
Quick check
Tap an answer to check it.
A fund has a turnover of 50%. Roughly what does that mean?
- Turnover is about trading, not returns
Show answer
It replaces about half its holdings in a year. Turnover = how much of the portfolio is bought and sold in a year.
Why it matters
Tax paid now is money that can no longer grow. Tax paid later, when you finally sell, lets the whole amount keep compounding until then. So two funds with the same pre-tax return can leave a taxable investor with quite different amounts.
Worked example
10,000 grows at 8% a year for 20 years. Suppose gains are taxed at 20% (an illustrative rate, not any real country's).
Fund A realises all its gains every year, so the investor pays tax each year and the money grows at 8% × (1 − 0.20) = 6.4% a year: 10,000 × 1.064²⁰ ≈ 34,600.
Fund B realises nothing until the end. It grows at 8%: 10,000 × 1.08²⁰ ≈ 46,610. The gain of 36,610 is taxed once at 20% (7,322), leaving about 39,290.
Same return, same tax rate. Paying later leaves about 4,700 more, simply because the tax money stayed invested.
Common mistake
Comparing funds only on their pre-tax returns when the money is in a taxable account. A fund that trades heavily can hand you a tax bill each year that its advertised return doesn't show. (Bogle also notes a twist: an index fund pays out more of its dividends, because its low costs eat less of them, so it can look less tax-efficient on dividends while being more tax-efficient overall.)
Key terms
- capital gain
- the profit when something is sold for more than it cost
- realised gain
- a gain that has been locked in by selling (often taxable)
- turnover
- how much of a fund's portfolio is traded in a year
- tax-efficient
- arranged so that as little tax as possible is due before you sell
- taxable account
- an account where gains and income are taxed as they arise
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| capital gain | the profit when something is sold for more than it cost |
| realised gain | a gain that has been locked in by selling (often taxable) |
| turnover | how much of a fund's portfolio is traded in a year |
| tax-efficient | arranged so that as little tax as possible is due before you sell |
| taxable account | an account where gains and income are taxed as they arise |
Practice
Work it through
10,000 grows at 6% a year for 10 years. Gains are taxed at 25% (illustrative). Fund A is taxed every year; Fund B only at the end.
- 6 × (1 − 0.25)
- 10,000 × 1.045¹⁰
- 10,000 × 1.06¹⁰
- 10,000 + 0.75 × 7,908
Quick quiz
Tap an answer to check it.
Why can an index fund be more tax-efficient than a busy active fund?
- Index funds pass on dividends too
- The same tax rules apply to both
Show answer
It trades little, so it realises few capital gains each year. Low turnover means fewer realised gains.
Two funds return 8% before tax. In a tax-sheltered account, which leaves you more?
- In a sheltered account, yearly gains aren't taxed
Show answer
Neither, as far as tax goes: both return the same. The yearly tax on realised gains only arises in taxable accounts.
In short
- Selling at a profit realises gains, which may be taxed that year.
- High turnover → more realised gains → bigger yearly tax bills.
- Paying tax later lets the money keep compounding.
- Rules depend on the country and account: this lesson teaches the idea, not any country's law.
Mastery check
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Check yourself
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What is turnover?
Show answer
How much of a fund's portfolio it buys and sells in a year.
Why does paying tax at the end beat paying it every year, at the same rate?
Show answer
The money that would have gone in tax keeps growing until the end.
When do these differences not matter?
Show answer
In tax-sheltered accounts, where gains aren't taxed each year.
Further reading
- John C. Bogle, The Little Book of Common Sense Investing (John Wiley & Sons, 2007), chapter 6.
- Investor.gov: Mutual Funds, the U.S. SEC's plain-language page on mutual funds (a U.S. example).
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