What percentage of yearly gains on an index mutual fund is lost on tax?

Question

Background about me: I am a foreign national living in the United States. I am in my late 20s, and have begun thinking about long term investing. Having read Get A Financial Life by Beth Kobliner, I understand pretty clearly the benefits of tax-advantaged accounts like IRAs, Roth IRAs, etc. The problem is that my medium term status in the United States is uncertain: I do not have permanent residency, and may, in a few years, return to Europe. It seems that in my situation tax-advantaged retirement plans are a risk: if I stay in the US long term, they will be extremely beneficial, but if I leave the US in a few years I could lose significant investment gains from withdrawal penalties.

The issue: the benefit of tax-advantaged plans is that they increase your growth rate slightly (maybe 1% or 2%, from not having to pay tax on your gains), but because of compounding this small 1% or 2% change results in huge increases in your investment over the long run.

But, on the other hand, I have read that passively managed index funds (like Vanguard Total Market Admiral VTSAX) actually do relatively little trading (they have low portfolio turnover), so even though the value of your investment is increasing all the time you're not paying that much capital gains or income tax. In the absence of long term residency certainty, it would seem to make sense to place my long term investments in such funds rather than an IRA. While I still would have to pay some tax yearly, it should be relatively low, and so the total loss from not having an IRA would not be gigantic.

My questions:

1. Does my overall reasoning here check out? Or do the taxes on index mutual fund gains still tip the scales towards an IRA in my situation?

2. Can you give a ballpark figure of about what percent of the gain on a passively managed index fund will go on tax? If the fund goes up by 10%, how much of the 10% is lost on tax? Capital gains is 15%, which would give 1.5% loss, but as I said, it seems that you don't pay tax on all the gains as relatively few taxable events occur within the fund. If someone had personal experience with this and was willing to share, I would love to hear it.

(Alternatively, I'm not put off by the idea of drilling through a mutual fund prospectus or annual report to make the calculations myself as I have a quantitative background. I just wouldn't know where to start. So some advice on how to use the prospectus and annual report to make the calculations would be very gratefully received!)

Answer 1

First of all an IRA is a type of account that says nothing about how your money is invested. It seems like you are trying to compare an IRA with a market ETF (like Vanguard Total Market Admiral VTSAX), but the reality is that you can have both. Depending on your IRA some of the investment options may be limited, but you will probably be able to find some version of a passive fund following an index you are interested in. The IRA account is tax advantaged, but you may invest the money in your IRA in an ETF.

As for how often a non-IRA account is taxed and how much, that depends on how often you sell. If you park your money in an ETF and do not sell, the IRS will not claim any taxes from it. The taxable event happens when you sell. But if you gain $1000 in a year and a day and you decide to sell, you will owe $150 (assuming 15% capital gains tax), bringing your earnings down to $850. If your investments go poorly and you lose money, there will be no capital gains tax to pay.

Answer 2

Money isn't lose on a mutual fund due to tax; you only pay capital gains when you sell, based on the difference between your buy price and your sell price. Instead, money in a fund is lost due to the fund's expense ratio, which is the operating cost of the fund.

Expense ratios vary by fund, and can range from very high (2%) active managed funds to very low (0.05%) index funds. This is regardless of whether you're investing in a 401k, IRA, or just on your own.

The large advantage of 401ks and IRAs is that they are tax advantaged -- either allowing you to bypass paying taxes on money you're putting in (traditional), or bypassing paying capital gains on money that you are taking out (Roth). The disadvantages to them are their contribution limits, and that they restrict when you can withdraw your money without paying penalties. There's no reason you would have to withdraw your money if you left the US (you could easily just leave it in your account), and if you are ok with that then the tax advantages can be significant.