Originally Posted by azoodica
I've been reading up recently on Index Funds as a different way to invest my limited money, instead of letting it collect dust in a bank. I've read about a couple of the larger ones, Fidelity, Vanguard, S&P 500. I'm really just trying to wrap my head around exactly what the specifics of owning an Index Fund. I'm looking to invest a rather small amount (3,000 or so) and also not looking to park it for too long (1-2 years) How much do I get penalized or taxed for taking my gains out? What exactly is an expense ratio and how does it affect my initial costs for owning an Index Fund as well as what it will cost during the life of my investment in an Index Fund. Thanks a lot and if anything needs clarifying I will try to explain better.
If your short parking time is just before you go into an active mutual fund or a managed separate account, that is OK. If you're just loading up on equity risk with your down payment money then that is not a good idea.
Expense ratios are just that: the percentage of your money each year that goes to support the manager. Broad-market equity index funds are usually around 0.1% or less, depending on the share class. ETFs are often a bit more expensive than open-ended funds, but that sort of information can be found on Vanguard.com or Bloomberg.com. By way of comparison, actively-managed mutual funds often carry expense ratios over 1%. So that's a fair hurdle the manager has to meet just to earn his fee.
Gains are taxable in two ways. First is if the fund does any selling of stocks that have gone up. They have to calculate the total realized gain and divide it by the number of shares. You get your pro rata slice and pay taxes accordingly. You don't get this a lot with index funds, since they rarely sell from their portfolio unless they have a lot of redemptions.
The second way is if you sell your shares yourself after they've gone up. Buy in at 53, sell at 57, and you get taxed on the $4 gain. As well as any dividends that get distributed while you own the thing. There is a 1099 report sent to you detailing all this after every 12/31.