One of the most common myths about indexing is that all index funds are tax-efficient. Funds that buy the biggest stocks, such as Vanguard 500, do boast terrific tax efficiency: As of April 2011, Vanguard 500's shareholders had kept about 87% of their pretax earnings from the past 10 years. That's because stocks that drop out of the large-cap S&P 500 usually are pretty small players in the index (most companies drop out of the index precisely because they've become too small)—after the 228th stock, none accounts for more than 0.10% of the index. When index funds sell these smaller positions, they don't reap sizable taxable gains.
Don't expect similar tax efficiency from funds tracking other indexes, though. Funds following smaller-cap indexes have to sell stocks that have grown too large to remain in the small-company index; because those are also the funds' largest positions, selling them means realizing large capital gains, which then have to be distributed to shareholders.
You can find out how tax efficient an index fund is by checking out its Fund Report on Morningstar.com.
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