Which statement about turnover and taxes is accurate for index funds?

• A. Higher turnover reduces capital gains distributions
• B. Turnover has no effect on taxes
• C. Lower turnover reduces capital gains distributions
• D. Index funds always have zero turnover

Answer: (C)

Turnover describes how often a fund trades its holdings. In index funds, turnover is typically low because the goal is to mirror a fixed index rather than try to beat it. When the fund sells investments that have risen in value, it realizes capital gains that are then distributed to shareholders and taxed in taxable accounts. With fewer trades, there are fewer realizations of gains, so capital gains distributions tend to be lower, making the fund more tax-efficient for investors. Of course, turnover isn’t zero—rebalancing to reflect the index, corporate actions, or liquidity needs can trigger trades and some gains. The other statements aren’t accurate because higher turnover would usually increase distributions, turnover does affect taxes, and index funds rarely have zero turnover.