Balanced Index Fund Tax Advantages

by Leslie McClintock

A balanced index fund holds both equities and bonds and maintains a relatively steady allocation to both asset classes regardless of market conditions. This distinguishes them from their close cousins, asset allocation funds, which seek to emphasize one asset class over the other if the fund management believes that either stocks or bonds are generally overvalued as a whole.

Index Funds

An index fund is a fund that tracks an unmanaged selection of securities deemed to be representative of a segment of the securities market. One popular examples of indexes include the Standard & Poor's 500, which consists of the largest 500 publicly traded companies in the United States, weighted by the total value of all their shares of stock traded on the market. It is frequently used as a proxy for the fortunes of all U.S. large cap stocks. An index fund has no management team actively trying to pick and choose stocks that will go up. Instead, the investment company simply buys the securities in the index, weighting them the same way the index is weighted -- generally in order of market capitalization.

Tax Advantages of Index Funds

Index funds tend to be tax efficient compared to actively managed funds that invest in the same kinds of securities. This is because index fund portfolios tend to experience very low turnover. Once a security enters an index, the tendency is that it stays in the index for a long period of time. The fund therefore has no reason to sell the security as long as it remains in the index. If it doesn't sell the security, it never realizes capital gains and therefore never has to issue taxable distributions to fund shareholders.

Tax Characteristics of Balanced Funds

Because balanced funds tend to maintain healthy allocations to bonds, they will typically generate some income tax liability, due to the receipt of interest payments from the bonds they hold within their portfolios. They will also receive dividends from the corporations in their portfolios, which is taxable to the shareholder. An index balanced fund will be somewhat less tax efficient than an index stock fund because of the interest payments. But it will tend to be somewhat more tax-efficient than a pure index bond fund because a pure bond fund, all other things being equal, will generate more in taxable interest payments than a balanced fund with a substantial allocation to equities. This is because qualified dividend payments from U.S. equities receive a lower tax rate than ordinary income payments, and because as of 2011, dividends on stocks tend to be lower than bond yields.

Mutual Funds and Capital Gains Tax

Mutual fund shareholders who do not hold their funds in a tax-advantaged account should be aware that they are taxed at three levels: They pay tax on any dividends or interest payments they receive from the mutual fund, even if they elect to have them automatically reinvested into the fund; they pay their share of any capital gains within the fund portfolio as the fund buys and sells securities; and they pay capital gains tax if they sell fund shares at a profit.


If you hold your mutual funds in a retirement account, such as an IRA or 401k, tax efficiency is not an issue. This is because all income tax and capital gains taxes are deferred in traditional IRAs and 401k plans, and tax free in Roth IRAs provided the money has been in the Roth account at least five years. Tax efficiency is only relevant for mutual funds held outside retirement accounts, where they qualify for favorable long-term capital gains treatment on fund shares held for longer than a year.

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