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I see that index funds are encouraged in fool.com's survey of 401k's. Why would one have a very tax-efficient vehicle in a tax-deferred account? Wouldn't it be better to have index funds outside the 401k and have funds that have higher turnover and short-term capital gains in the 401k?

Thank you for your response.

rlar
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I really don't think tax efficient is a factor. ImO the factor is yield. S&P Index should provide the support level of strong 401k. The average Return on Investment in S&P 500 is solid.
So at the end of the 1 year, 5 year and 10 year period you are looking at ROI and S&P 500 Index give you solid returns.
But you are correct, funds that have large capital gains distributions are better in 401k or IRa.

And if you want to develop a startegy were you do what you suggested, it might be interesting to see the results.
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I agree somewhat with you. Index funds have their place in an investment portfolio, but should not comprise the entire portfolio, and not just for tax efficeincy reasons. The S&P 500 Index funds should be treated as a large cap growth fund when you come down to it. Since the Index is cap weighted, meaning if you invested $500 dollars in the index, you would buy $1 of each company. You dollars would be directed toward the largest companies with the largest capitalization (total outstanding shares x current share price). So the largest company would get more of your dollars then the 2nd largest and so on. Because of this cap weighted function. It is possible for the lower 400 stocks to rise and still lose money if the largest one hundred do not go up.
This will typically be true when small caps start outperforming large caps. The past few years have seen large caps do well which is why everyone is favoring indexing. It has worked well the past 5 or 6 years. Actively managed funds do have their place. As do different asset allocation models such as international, growth, value, small cap etc.

Bill
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Perhaps, I wasn't clear. I am asking about tax implications and whether it would be better to have index funds outside of a tax-deferred accounts rather than inside a 401k or an IRA etc. Index funds are very good vehicles and because they are tax efficient, are they better to use outside these accounts?

rlar
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In short, Yes, sorry for that added response.
If you are investing in both tax deferred and taxable accounts. Definitely invest in the indexes in the taxable accounts. You want the most tax efficiency in the taxable accounts. In 401ks and IRAs the tax implications don't come into play bacause all money is withdrawn at your regular income rate. Long term or short term capital gains do not factor in.
If it helps, more and more mutual funds will begin reporting results on an after tax basis over the next couple of years.

Bill
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If you're going to invest in both index funds and non-index funds, and you're going to invest in taxable and non-deferred accounts, then you typically get better total yield putting making the non-index fund tax-deferred and putting taxed dollars in the index fund.

But those aren't your only two choices. You could invest in an index fund in your 401(k) and in a basket of drip stocks with your taxed dollars for example.

Over the past decade index funds have been slightly better than managed funds in a tax-deferred account because of the lower management fees. Over that same time period index funds have been much better than actively managed funds in a taxable account because of the tax efficiencies.


Here's one way of thinking through this investment allocation situation:

Your 401k is limited to a few choices, most of which are likely to be large cap funds and you can expect them to perform similarly over the long run. So pick the one with the lowest yearly fees, which is probably an index fund.

Your taxable accounts have all sorts of choices but history has shown that buying good stocks and holding them long term is one of the best approaches. This is especially true when the tax rate of long term capital gains is less than the tax rate on interest, dividends, and short term capital gains. (This hasn't always been true and might not always be true in the future.) So pick good stocks and hold them long term. You don't pay a management fee and most of your return will be taxed at long term capital rates.


But above all invest and invest regularly! The difference between two investment strategies is far less than the difference between investing and not investing.

-Michael
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<I see that index funds are encouraged in fool.com's survey of 401k's. Why would one have a very tax-efficient vehicle in a tax-deferred account? Wouldn't it be better to have index funds outside the 401k and have funds that have higher turnover and short-term capital gains in the 401k?

Thank you for your response.>

The primary purpose of investing in an index fund is not tax efficency - it is the efficent market theory.

Specifically, historically few managed funds outperform the market - therefore one should invest in an index to obtain a market return rather than one earned by a managed fund.

It is highly desirable to utilize an index fund in most retirement plan portfolios.

The question you may want to ask - is it best to purchase the index fund inside my 401(k) or my IRA. If your 401(k) uses a vendor which applies asset based fees to supplement billed employer fees to support the cost of the plan you will loose some of the advantage provided by the index fund. You may be better off placing you IRA contribution into the index fund.

Just a thought I how this helped

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