Active vs Passive Management: Are Most Mutual Funds Active, and What It Costs a High-Income Family

By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.

Active management means a fund manager picks securities to try to beat a market index. Passive management means the fund simply holds an index, such as the S&P 500, and accepts the index return at very low cost. Most mutual funds are still actively managed: at year-end 2024, index mutual funds held 32% of long-term mutual fund assets, so about 68% sat in active funds (ICI 2025 Investment Company Fact Book). Once ETFs are counted, index funds held the majority at year-end 2024: 51% of all long-term mutual fund and ETF assets.

For a California or Washington household earning $750,000 to $3 million, the choice is less about which style is “better” in general and more about where each fund sits. In a taxable brokerage account funded with sold RSUs, an active fund’s yearly capital gain distributions can cost more than its fee. Inside a 401(k) or 529, only the fee matters. This guide shows the numbers.

Active vs passive mutual funds at a glance

Size tells part of the story. At year-end 2024 there were 8,355 US mutual funds (including money market funds), and only 513 of them were index mutual funds, yet those 513 managed $6.9 trillion. The average index equity mutual fund held $13.6 billion against $2.5 billion for the average active equity fund (same ICI source). A few very large, very cheap index funds hold a big share of the money, while most fund names on a brokerage screen are active.

Why the answer changes by account type

Mutual funds generally pass their net realized gains to shareholders each year as distributions. The IRS says to report these capital gain distributions as long-term capital gains “regardless of how long you owned your shares,” and reinvesting them does not avoid the tax (IRS Publication 550). So a fund that trades a lot can send you a tax bill in a year you sold nothing.

• Taxable brokerage account: you pay the fee and the tax on distributions every year.
• 401(k), 403(b), IRA: distributions are not taxed inside the account, so the fee is the main cost.
• HSA: the same is true federally, but California does not recognize HSAs. The FTB says interest and earnings in an HSA “are taxable in the year earned” for California, so a high-distribution fund in a California family’s HSA still creates a state tax bill (FTB Schedule CA (540) instructions, 2025).
• 529 plan: growth is tax-deferred and qualified withdrawals are tax-free, so again the fee is what you compare.
• UTMA/UGMA account: distributions are your child’s unearned income and can hit the kiddie tax (see below).

For our reader, the rate on those distributions is high. For 2026, long-term gains are taxed at 20% federally once married-filing-jointly taxable income passes $613,700, plus the 3.8% Net Investment Income Tax above $250,000 of modified AGI (Rev. Proc. 2025-32, IRS NIIT). California has no lower rate for capital gains, so they are taxed as ordinary income (FTB).

Worked example: a $1.2 million California household with $2 million from sold RSUs

Assumptions (illustrative, not a forecast): married couple, $1.2 million of W-2 income, California residents, $2,000,000 in a taxable brokerage account built from sold RSUs. Their California marginal rate is 12.3% (the 11.3% bracket for 2025 joint taxable income between $891,542 and $1,485,906, plus the 1% Behavioral Health Services Tax on taxable income over $1 million, per the FTB 2025 rate schedules; 2026 schedules are not yet published). Their combined rate on long-term gains is 20% + 3.8% + 12.3% = 36.1%.

They compare two hypothetical US large-company stock funds:

• Fund A (active): 0.65% expense ratio, distributes 5% of its value each year as long-term capital gains.
• Fund B (index): 0.05% expense ratio, distributes 0.5% a year.

The gap is about 2.2% of the account ($44,490 divided by $2,000,000). In this example, Fund A has to beat Fund B by roughly 2.2 percentage points a year, before the family is even. Two caveats keep the math honest. First, reinvested distributions become part of your cost basis (IRS Publication 550), so that amount is not taxed again when you sell, and part of the gap is tax paid early rather than extra tax; the real loss is the compounding on money sent to the IRS and FTB years too soon. Second, some active funds also distribute short-term gains, which the IRS treats as ordinary dividends, taxed at up to 37% federally for 2026, which would make the gap wider.

The same family in Washington: Washington has no wage income tax for 2026. Assuming no Washington tax applies to the distributions, the rate is 23.8% federal. Fund A’s tax becomes $23,800 against $2,380 for Fund B, and with the $12,000 fee gap the total gap is $33,420, about 1.7% a year. Washington’s 7% capital gains tax applies to long-term gains above an annual standard deduction ($278,000 for 2025, per WA DOR), and a new 9.9% income tax on AGI over $1 million starts in 2028 (WA DOR). DOR’s page does not say whether fund distributions count toward the capital gains tax, and income tax details are still pending DOR guidance, so a Washington household above $1 million may see this gap grow. Confirm the treatment with your tax preparer.

Inside a 401(k) or 529, compare only the fee

Suppose the same couple holds $600,000 across two 401(k)s. Moving from an active fund at 0.65% to an index fund at 0.05% in the plan menu would save $3,600 in the first year, and that saving compounds. No distribution tax applies inside the plan, so the tax argument above disappears. That is why many families keep any active funds they like inside tax-deferred accounts and hold index funds in taxable accounts. Our guides on how fund fees affect your return and target date fund fees walk through plan menus in more detail.

Active funds in a child’s UTMA account and the kiddie tax

For 2026, a child’s first $1,350 of unearned income is tax-free, the next $1,350 is taxed at the child’s rate, and unearned income over $2,700 is taxed at the parents’ rate (Rev. Proc. 2025-32; Form 8615 instructions). A $150,000 UTMA in Fund A above would distribute about $7,500, so $4,800 of it would be taxed federally at the parents’ rate. The same balance in Fund B distributes about $750 and stays under the tax-free amount. For grandparent or parent gifts into a child’s name, a low-turnover index fund usually keeps the child’s tax return simple.

When an active fund can still make sense

• Inside a 401(k) where the plan offers no low-cost index option for that asset class.
• In areas where you want a manager’s judgment on credit or interest-rate risk, such as some municipal bond funds, if the after-fee record against the benchmark holds up.
• When you already hold a large single-stock position (for example, years of unsold employer RSUs) and want the rest of the portfolio to deliberately avoid that sector, which a broad index cannot do.

Before buying any active fund, open its prospectus. SEC Form N-1A requires the fund to show its returns next to a broad market index over 1, 5 and 10 years, and to report its portfolio turnover rate (SEC Form N-1A). If the fund has trailed its index after fees and turns over much of its portfolio each year, the case for holding it in a taxable account is weak.

Common mistakes we see with high-income families

• Buying an active fund in a taxable account late in the year, just before its capital gain distribution, and paying tax on gains you never earned.
• Judging an active fund on pre-tax returns when it sits in a taxable account at a 36% marginal rate.
• Holding the same active fund in both the 401(k) and the brokerage account, so the tax cost lands where it hurts most.
• Owning five funds that all track US large companies, which adds fees without adding diversification.

Write down the family’s fund rule for your kids

The decision itself is small. Writing down why you made it is what your children can use later. A one-page note covering which accounts hold index funds, when you would accept an active fund, and the fee and turnover you consider too high gives your kids a rule they can test and apply on their own. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.”

Frequently asked questions

Are index funds the same as passive funds?

In practice, yes. An index fund buys all, or a representative sample, of the securities in a published index and changes holdings only when the index changes. “Passive” describes that style. Some ETFs are actively managed, so the wrapper (mutual fund or ETF) does not tell you the style. Read the fund’s stated objective and benchmark in the prospectus to confirm which one you own.

Do index mutual funds ever pay capital gains distributions?

They can. Index funds sell holdings when the index changes or to meet redemptions, and those gains must be passed to shareholders. Broad index funds tend to distribute less than active funds because their turnover is low, but “less” is not “never.” Check the fund’s distribution history before buying it in a taxable account, especially in November and December.

Should we sell our active funds and switch to index funds?

Not automatically. In a 401(k) or IRA you can switch without tax. In a taxable account, selling can trigger capital gains, taxed in California at up to 13.3% (2025 top rate) on top of federal tax. The answer depends on the embedded gain, the fund’s ongoing distributions and fees, and whether you have losses elsewhere to offset it. Model it before you sell.

Next step

Pull the last year’s Form 1099-DIV for your taxable accounts and look at box 2a, total capital gain distributions. If that number is large relative to the account, list which funds produced it and whether they would sit better inside a 401(k) or be replaced over time. If you want a second set of eyes on the full picture, our investment risk management and tax management work at the Age Five Family Office™ starts with a Tax & Wealth Assessment. You can also read how much you should pay in investment fees and HYSA vs brokerage account.

This is general education, and the right move depends on the family’s full picture.

Written by

Kevin Luu

Co-Founder and Chief Learning Officer, Bright Advisers

Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.

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