An index is simply a list of companies like the Dow Jones or S&P 500. An index fund is a product that tracks that list. It can take the form of either an ETF or a mutual fund. I will briefly explain their similarities and differences.
Same: Both an ETF and a mutual fund are a kind of basket that can hold stocks or bonds. Both an ETF and a mutual fund have a net expense ratio, which amounts to an ongoing cost of ownership.
Different: An ETF trades like a stock. A mutual fund trades once per day after the market has closed.
When picking stock funds for a taxable account, as opposed to a retirement account, it is almost always more tax advantageous to choose an ETF instead of a mutual fund.
The reason for this is because mutual fund capital gain distributions can cause you to pay taxes on the decisions other people make. Why? Because when an investor sells shares in a mutual fund, the fund has to sell the underlying shares of company stock that were inside your mutual fund shares. If the market has gone up, the fund recognizes a capital gain on the sale. After the mutual fund has sold the share, it distributes the cash to your account. But the capital gain distribution doesn’t just go to you- it goes to everyone in the fund which can create unforced taxes for every shareholder.
ETFs are structured differently. When you buy or sell an ETF share, you’re not selling the underlying companies inside the share. You’re simply trading the share itself with another buyer or seller on the stock exchange. Because the ETF doesn’t have to sell the underlying stocks, there are generally no capital gains generated to be distributed among all the shareholders. As a seller, you’re only responsible for the capital gains generated by your own sale.
Whether you’re looking to use the income-on-demand strategy with your own individual stocks or an index fund, be aware of your total expenses and try to keep them low. Make sure the size of your stock investment is aligned with the needs and solutions identified in your financial plan.
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Jonathan Bird, CFP®
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