What Are Index Funds and How Do They Work?

An index fund is an investment fund that seeks to replicate or mirror the performance of a financial index. Index funds do not try to beat the average return of the stock market like an actively managed mutual fund does. Instead, the goal of an index fund is to match the performance of the underlying index.  

An index fund is a type of mutual fund, which means that an index fund pools money from many investors and uses that money to buy assets that make up the index it tracks. This might sound confusing, so picture it like this.

Imagine that you are standing in a room full of investors and there is an empty basket in the middle of the room. You and all the other investors could each take $100 and put it in the basket. All the funds collected would then be used by the index fund to buy assets.

The assets that the index fund buys will be based upon what financial market index the fund tracks. A financial market index groups similar types of assets together, such as large cap stocks, and tracks their performance over time.

For example, the S&P 500 is a financial market index that tracks the performance of the 500 largest or most important companies in the US. An S&P 500 index fund would buy the stocks that make up the S&P 500 as that is the index that the fund is aiming to track.

It is important to understand that a financial market index is not an investment itself. It is simply a measuring stick of a particular group of investments. The index fund looks at this measuring stick, and buys assets that the measuring stick tracks in hopes of replicating the performance of the market index.

It is also important to note that when you buy an index fund, you are not directly buying the assets that the fund owns. Instead, you buy a share of the index fund itself. In exchange for being a shareholder, you gain an ownership interest in the underlying assets that the fund holds.  

There are a variety of market indexes that an index fund could track, but we will highlight three of the most popular ones below. Remember, these indexes are not investments themselves. They simply measure the performance of the assets that it tracks.

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 the health of tech stocks.

1) The index fund share price increases

Remember, an index fund simply buys the assets of the financial market index that it is indexing. When the underlying assets that an index fund holds go up in value, so does the share price of the index fund itself - which is what you hold as an investor.

For example, lets say you bought shares of an S&P 500 index fund. If the underlying stocks that make up the S&P 500 have a good year and go up in value, so would the shares of the index fund itself. You can sell these shares to back to the fund itself in exchange for a profit.  

2) Income earned from bonds or dividends

If an index fund holds bonds that earn interest or stocks that pay dividends, you can receive a small stream of income. A dividend is simply a portion of a companies profits that are paid out to shareholders. While you do not directly own stocks or bonds in an index fund, you do get an ownership interest in the income that the fund earns.

The income that a fund earns from bonds or dividends are distributed to you as a shareholder of the index fund on a pro rata basis. Depending upon the index fund, you can expect to receive these distributions monthly, quarterly or annually. You can choose to receive these distributions directly or reinvest them back into the index fund in order to buy more shares.

3) Capital gains distributions

Although it is less common, it is possible for an index fund to have a capital gains distribution. A capital gain is simply an increase in value of a capital asset (stocks, bonds, investment funds, etc.). For example, lets say that an index fund bought a stock for $100 and that stock is now valued at $150. That $50 increase is a capital gain.

If the index fund were to sell the stock and take the $50 profit, it would have a realized capital gain. Similar to dividend and bond income, you are entitled to any realized capital gains that an index fund has on a pro rata basis. These realized gains will be distributed to you at least once per year.

1) Expense ratios - An expense ratio is a fee that is charged by an index fund in order to cover administrative and operational costs associated with running the fund. When it comes to index funds, there is some good news. The expense ratios associated with index funds are much lower than other types of investment funds.

Why is this? Some types of investment funds, such as actively managed mutual funds, have a professional fund manager buying and selling investments. In order to cover this extra cost, the fees have to be higher. Since an index fund is passively managed, expenses are lower, which means fees are lower.

The average expense ratio for a passively managed index fund falls somewhere between 0.2% and 0.02% per year. At a 0.02% expense ratio, you would be charged a $2 fee for every $10,000 you had invested in the index fund.

2) Sales load - Although it is less common than an actively managed mutual fund, some index funds do charge a sales load. A sales load is simply a commission that is charged when you buy shares of an index fund. This commission would go to the broker or advisor that you bought the index fund from.

For example, if an index fund had a 1% sales load, you would be charged a $1 fee if you invested $100 in the fund. These sales loads can be charged on the front end when you buy index fund shares, or on the back end when you sell shares.

3) 12 b-1 fee -  A 12 b-1 fee is a fee that is charged to cover annual marketing and distribution costs. A large portion of this fee is also typically used to pay brokers or advisors who sell the fund. This fee can cost you between 0.25% and 0.75% per year depending upon the index fund. However, since index funds aim to be cost effective, the fees are usually not this high and are included in the expense ratio of the index fund.

Index funds are taxed based upon capital gains which can occur in three different places. These rules are applicable if you buy index funds through a taxable brokerage account. You can avoid some of the taxes associated with index funds by buying them through tax advantaged accounts (see item 5).  

1. Taxes on income earned from stock dividends and bonds

If you invest in an index fund that earns income from stock dividends or bonds, your portion of the income earned is subject to taxes. The income that you earn from bonds is taxed at your ordinary income rate. The income that you earn from dividends will be taxed at your ordinary income rate if it is a nonqualified dividend.

The income you earn from dividends will be taxed at long term capital gains rates (more on that below) if it is a qualified dividend. You will typically be sent an IRS Form 1099-DIV that will show how much income you earned. You are required to report this income when you file your taxes.

2. Taxes on capital gains distributions

If an index fund incurs a capital gain by selling investments within the fund for a profit, your portion of these profits (distributions) are subject to capital gains tax. You will typically be sent an IRS Form 1099-DIV that will show how much you earned through capital gains distributions.

You are required to report this income when you file your taxes. Keep in mind that capital gains distributions in index funds do not occur that often as the goal of an index fund is to buy and hold the assets of the underlying market index it is tracking.

3. Taxes when you sell shares of your index fund

Thirdly, you can incur capital gains tax when you sell shares of your index fund for a profit. The price of index fund shares typically increase when the underlying assets the fund owns increase in value. If you want to sell your index fund shares you are able to do so. When you sell shares, the index fund buys the shares back from you in exchange for a cash profit.

4. What are capital gains and their tax rates?
‍
For clarity, a capital gains tax is simply a tax on the profit you make when you sell an asset. If you sell an asset at a loss, you have a capital loss and do not owe any taxes. You can incur either a short or long term capital gains tax.

A short term capital gains tax occurs when you hold an asset for less than a year before selling it. Short term capital gains tax rates are the same as your ordinary income. A long term capital gains tax occurs when you hold the asset for more than a year before selling it.

Long term capital gains rates are more favorable as you will pay 0%, 15% or 20% depending upon your tax filing status and income. You can use the chart below to get an idea of what long term capital gains rates could look like. Simply find your tax filing status and corresponding income to see what rate you could incur.

(Accurate for 2024).

5. Strategies to reduce index fund taxes

a) Hold index funds in tax advantaged accounts

The easiest way to reduce the taxes associated with index funds is to buy index funds through tax advantaged accounts. The most popular of these accounts for the typical investor would be IRAs (individual retirement accounts), and employer sponsored 401(k)s.

These account types offer either tax deferred or tax free benefits. A Traditional IRA and 401k offer a tax deferred benefit. Essentially, you don't pay taxes on the dollars you invest today, but wait or defer the taxes until you pull the money out in retirement.

So, if you bought index funds through a tax deferred account, you would not owe any taxes on any of the income, capital gains, or increases in share price until you pulled the money out in retirement, at which point you would incur taxes at your ordinary income rate.

On the other hand, a Roth IRA and 401k offer tax free benefits. You contribute to these accounts with dollars that have already been taxed, but then the investments within your account grow tax free and when you pull the money out in retirement you don't owe any taxes.

So, if you bought index funds through one of these accounts, you would pay taxes on the dollars you contributed to the account, but you would not owe any taxes on any income, capital gains, or increase in share prices when you pull the money out of the account in retirement.

Learn more about these accounts

b) Wait for more than a year before selling shares

In order to get a more favorable capital gains tax rate, you can wait until you have held shares of your index fund for a minimum of 1 year. This will get you into the lower tax rates of 0%, 15% and 20% as opposed to being taxed at your ordinary income tax rate. Again, this applies if you hold your index funds in a brokerage account.

c) Understand what your index fund invests in

If your index fund is highly invested in assets that produce income such as dividend stocks and bonds, you might want to avoid that fund if your goal is to reduce taxes. This is not really a problem if you buy index funds through a tax advantaged account.  

d) Seek out tax experts

Most importantly, you need to seek out tax experts. Taxes associated with index funds can get confusing. It is important that you understand the tax implications of your investments, as well as how to be tax efficient. You can speak with a CPA or financial advisor for more clarity.

1) Lower fees than actively managed investment funds - Index funds are not managed by an investing professional. Instead the index fund simply buys assets in the financial market index that it is tracking. Due to this, index funds are much more affordable than actively managed funds, such as mutual funds.  

2) Easy to invest in and understand - You do not have to be an investing wiz to understand and invest in index funds. You simply find a market index that tracks assets that you like, and then buy shares of an index fund that tracks that market index.  

3) Stable returns over time by reducing risk - Index funds are inherently less risky than buying individual stocks as you gain an ownership interest in lots of stocks when you invest in an index fund. This means that you are not reliant on the performance of a single asset to accomplish your goals. This concept is known as diversification.

Over time, an index fund can average around a 10% annual return. Keep in mind that positive returns do not happen every year. If an index fund is primarily built with stocks, and the stock market crashes, so will the index fund.

However, if you hold onto these funds for 10, 20 or 30 years, they tend to bounce back from these crashes and provide stable returns. Keep in mind that average returns will often differ from actual returns.  

4) No need to choose individual investments - One of the arguments against index funds is that the fund will only ever provide you an average return of the market index it is tracking. In other words, there is no potential to achieve above average returns in an index fund.

While this is true, there is an upside to this. You do not have to choose any individual investments. For most every day investors, building an investment portfolio is a challenging and time consuming endeavor. Index funds overcome this problem by allowing you to gain exposure to a wide variety of assets in a matter of minutes.

1) No chance to beat average returns - Investors that are in the anti index fund camp will always point out that it is not a good idea to invest in index funds as you are only ever going to capture average returns. This is true.

An index fund simply buys assets in a particular market index. Due to this, the index fund will never outperform the market index. Factor in the fees of index funds and the best return you can expect from index funds is the average return of the market index.

2) Lack of flexibility - Index funds are less flexible than other investments. You do not get to choose the assets that the index fund holds as it simply buys assets of the market index it tracks. If flexibility is important in your investments, you might need to learn how to invest in individual stocks.

There is not necessarily a "best" investment. A better question to ask yourself is if index funds are a good investment for you? The answer to that will vary greatly. Most investors who opt to use index funds have long term investing goals and prefer a set it and forget it investment.

Index funds are not going to provide flashy returns or be particularly exciting as you invest in them. However, what they can do is provide an easy, low cost investment vehicle that will provide stable returns over time if you hold onto them.

If you want an investment that has the potential to get above average returns, index funds are not going to be your best bet. Instead, you could look at investing in an actively managed mutual fund.  However, if all you want is an easy way to build wealth for your future, index funds might be the way to go.

At the end of the day, index funds may or may not be a good investment for you. It really depends on what type of investor you are, as well as your financial goals. If you need help choosing investments, it is always a good idea to speak with a financial advisor.

The process of buying index funds is quite simple. You can do it through an online broker. The first step is to open an investing account through your chosen broker. (You can check out our list of the best online brokers if you need help finding one).

Once you have chosen a broker, simply go through an online application for an investing account. At a bare minimum, you will need a brokerage account, but it might be better to buy mutual funds through an IRA to avoid some of the tax problems. (Check out our list of the best investing accounts for more information.)

After your account is approved, transfer funds from your bank account to your investing account. From there, you can research index funds that you want to invest in. Most brokers offer free tools to help you compare the best index funds.

Once you find a index fund that you want to invest in, you need to execute a trade. This might sound complicated, but it is not.  You simply need to search for the ticker symbol of the fund you want to invest in, select a dollar amount to invest, and execute the trade.

A ticker symbol is simply just a series of letters and numbers that represent a particular investment. For example, the Fidelity 500 Index Fund ticker symbol is SWPPX. If you wanted to buy this fund, you could search for the ticker symbol and execute a trade.

An index fund is an investment fund that seeks to replicate or mirror the performance of a financial index. Index funds are a low cost investment option for many investors who want to lower risk and access stable returns over long periods of time. Keep in mind that index funds are not the right investment for every investor.

Index funds will never beat the average return of the market index that it is tracking and lack the flexibility that other investments offer. At the end of the day, index funds may or may not be a good investment for you depending upon your goals and investing style.