By law, every time a mutual fund sells shares at a profit, it must distribute those capital gains to the fund’s shareholders, who then pay tax on the earnings. That happens pretty often in the typical stock fund, because their managers are active traders. But since index funds simply hold stocks that match a market index such as the S&P 500, the portfolio looks pretty much the same over time, with few stocks bought or sold. That means shareholders’ capital gains are, in essence, deferred, in much the way IRAs operate. When you decide to sell out of the fund, the IRS moves in.
If many index-fund holders decide to get out at the same time, there may be another tax surprise. Index funds hold very little cash, so if more investors leave a fund than come into it, the fund manager may have to sell holdings to raise the money owed to the departing shareholders. For the moment, that’s unlikely. So far this year, more money has flowed into than out of index funds, says AMG Data Services.
But any shareholder in a fund tied to the S&P should be watching for a gain or loss in the near future. That’s when the S&P will update its 500 index by replacing Syntex with Microsoft. Index funds will have to rejigger their portfolios accordingly, and holders could owe tax on the results.
