An index fund is a type of mutual fund that tracks the performance of a specific market benchmark, such as the S&P 500, as closely as possible. The goal of an index fund is to provide returns that are similar to that of the index the fund is tracking. You might be asking yourself what a stock market index is?
A stock market index is simply a measuring stick for the stock market, or sector of the stock market. For example, the S&P 500 is an index that tracks the performance of the 500 most important companies in the US. Therefore, when you buy an S&P 500 index fund, you are buying the stocks of the 500 most important companies in the US.
The first step to investing in index funds is to open an investing account. Your investing account will simply hold your index funds and other investments. There are a wide variety of
account types available, but we recommend looking at just two.
Option 1 - Brokerage account: A brokerage account is the simplest investing account that allows you to buy and sell a range of assets including stocks, bonds, investment funds, and more. The primary advantage to placing index funds in a brokerage account is flexibility.
There are no limitations on who can have a brokerage account and no limitations on how much you can contribute to the account. You can also access the investments in your brokerage account whenever you need to. In other words, you can buy and sell the investments within your brokerage account whenever you need to.
The downside to holding index funds in your brokerage account is that you are subject to short or long term capital gains tax when you sell your index funds for a profit. If you held an index fund in a brokerage account for less than a year and sold it for a profit, you would pay the same tax rate as you would pay on ordinary income - such as income from your job.
If you held an index fund in a brokerage account for more than a year and sold it for a profit, you would pay 0 percent, 15 percent, or 20 percent capital gains tax. If you decide to hold your index funds in a brokerage account, it is better to hold the funds for at least a year before you sell in order to get a more favorable tax rate.
Option 2 - Roth IRA: An IRA, or individual retirement account, is a tax advantaged investing account specifically designed to help you save for retirement. The Roth IRA is one of the most popular types of individual retirement accounts and works like this.
You make contributions to a Roth IRA with dollars that have already been taxed. However, when you take money out of a Roth IRA when you retire, you don't pay any taxes. If you are a long term investor, or are looking to save for your retirement holding index funds in a Roth IRA can be very beneficial thanks to the tax advantages of the account.
Since the Roth IRA offers tax benefits, the IRS does put some restrictions on the account. First, your income must be below a certain level to open a Roth IRA. If you file your taxes as an individual, your income has to be $138,000 or less if you want to make the full contribution. If your tax filing status is married filing jointly, your income has to be $218,000 or less if you want to make the full contribution. (
Rules for 2022-2023).
Secondly, there are limitations on how much you can contribute to a Roth IRA. You can only contribute $6,500 per year, or $7,500 if you are 50 or older. You can start withdrawing money from your Roth IRA once you are 59 and a half, and have held the account for at least 5 years.
If you try to make an early withdrawal, you can incur a 10% penalty and be subject to pay additional income taxes. The exception to this rule is that you can withdraw the base amounts that you have made to a Roth IRA without incurring a penalty since you have already paid taxes on those dollars. However, you can't make easly withdrawals of any of the profits that you have made from your investments within your Roth IRA.
Related - How Do I Set Up a Roth IRA?Which one of these account should you have?It can be beneficial to hold your index funds in a Roth IRA if you qualfiy. It will allow your index funds to compound and grow tax free, and then you don't have to pay taxes when you pull the money out of the account in retirement. The good news is that you can have both a brokerage account and a Roth IRA at the same time.
If you want to have the flexibility to buy and sell index funds when you want, and withdraw the money at any time, it can also be beneficial to hold some of your index funds in a brokerage account. Keep in mind that you will have to pay either short or long term capital gains tax when you sell your index funds for a profit within a brokerage account.
Where can you open these accounts?You can open both of these account types at almost all
online brokers. The process for opening these accounts if pretty straightforward. Simply go to the website of your chosen broker and click on the option to open an account.
Select to open either a brokerage account or Roth IRA depending upon what you want. From there, you can fill out an application. Expect to have to provide information such as your name, address, contact information, income, social security number, and government ID.
Secondly, you need to pick a type of index that you want your index fund to track. Remember, a stock market index is not an investment itself. Instead it is simply an index that measures or tracks the performance of a particular basket of stocks that represent a particular market or sector.
When you buy an index fund, you are investing in the stocks that the underlying fund tracks. There are hundreds of indexes that you can track using index funds, but we recommend starting with just a few.
1) The S&P 500: The S&P 500, or Standard and Poor's 500 index, tracks the performance of the top 500 companies in the US. The S&P 500 is the most popular index and is often used to gauge how the entire stock market is doing as a whole.
2) The Dow Jones Industrial Average: The Dow Jones Industrial Average index is a stock market index that tracks 30 of the larges companies in the US. The index was created in 1896 making it one of the oldest stock indexes. The DJIA includes stocks from most market sectors which is why it is often used to gauge the health of the entire US stock market.
3) Nasdaq Composite: The Nasdaq Composite is a stock market index that tracks the performance of stocks that are listed on the Nasdaq stock exchange. The Nasdaq Composite is a representation of most, not all, of the companies listed on the Nasdaq stock exchange.
This index has a high concentration of companies in the technology sector. For this reason, the Nasdaq Composite is used to gauge both the overall stock market, and more specifically how tech stocks are doing.
Which of these indexes should you start with?
Ultimately buying index funds that track each of these indexes can be beneficial, but it is arguably best to start with an S&P 500 index fund. It is the most popular index and is a good place to start. Keep in mind that each of the indexes we listed track the performance of large US stocks.
There are also indexes such as the Russell 2000 and S&P Small Cap 600 that track the performance of small US stocks. Additionally, there are indexes that track the perfomance of specific sectors such as healthcare and real estate. It is best to start with one of the indexes listed above, but you should be aware that there are a wide variety of indexes you could track using index funds.
Choosing an index to track can help you narrow down the index funds that you should invest in. For example, lets say that you decide that you want to use the S&P 500 as your benchmark index. This means that you are only going to look for index funds that track the performance of the S&P 500.
You can find index funds through your online broker that you opened your investing account with back in Step 1. The good news is that almost all online brokers offer free research tools to help you find good index funds. With that being said, there are a few things that you should look at for.
1) Expense ratios: The majority of index funds charge a fee that is called an expense ratio. Even though index funds are not actively managed by professional investors, there are still costs associated with buying and selling the investments the fund holds. You want to look for index funds that have low expense ratios so that the fees do not eat into your return.
The average expense ratio for an index fund is 0.2% per year. This means that a $0.20 fee would be subtracted each year from your returns for each $100 you had invested. Although 0.2% is an average expense ratio, there are index funds that have even lower expense ratios.
2) Minimum investments: There are many index funds that don't have a minimum investment required in order to buy the index funds. However, there are some index funds that do have a minimum investment required. It is good to be aware if there is a minimum investment required as you are looking at potential index funds to invest in.
3) Tracking error: Although index funds aim to track the performance of an underlying market index, they don't always track it perfectly. When an index fund does not perfectly track its underlying market index, it is known as a tracking error.
If a fund has a high tracking error, it can eat into your overall return. It is almost impossible for an index fund's tracking error to be zero, but in general you want to look for index funds that most closely track the performance of the underlying benchmark index such as the S&P 500.
Once you have chosen a few index funds that you want to invest in, you can buy shares of those index funds. The first step to doing this is to transfer money from your bank account to your investing account - whether that be a brokerage account or Roth IRA.
After your funds are in your investing account, you can search for the index fund that you want to buy through the website or platform of your online broker. Once you pull up the fund that you want to invest in, you simply enter the number of shares that you want and click the buy button.
The bottom line is that index funds are great low costs investment options. You can invest in them by opening an investing account, picking a type of index, choosing an index fund that tracks your chosen index, and then buying shares of that index fund.
If you have any hesitation to investing in index funds, legendary investor Warren Buffet says that the every day American would be better off buying them if they don't have time to research their own investments. If you want more of a big picture on investing, you can check out our guide on
how to start investing as a beginner.
