An insightful takeaway for investors emerged from Vanguard Group’s recent $106 million settlement with the Securities and Exchange Commission concerning its target-date funds. The core message here is about the importance of knowing the type of account in which you hold your investments, as this can significantly influence your tax liabilities.
As the leading manager of target-date funds, Vanguard faced allegations from the SEC of making misleading statements about tax implications tied to the asset minimum reduction for a cost-effective variant of its Target Retirement Funds. When Vanguard slashed the asset minimum for its Institutional share class from $100 million to $5 million, it resulted in a significant investor shift to these funds. The SEC highlighted that this shift led to “historically larger capital gains distributions and tax liabilities” for those who stayed with the pricier Investor share class.
Here’s the crucial lesson: these taxes only affected investors holding the Target Date Funds (TDFs) in taxable brokerage accounts, not retirement accounts.
Investors should note that holdings in tax-advantaged accounts, like 401(k) plans or IRAs, do not incur annual tax bills for capital gains or income distributions. But those with “tax inefficient” assets, such as many bond funds, actively managed funds, and target-date funds, in taxable accounts could face hefty tax bills, as experts caution.
Placing these assets within retirement accounts can substantially enhance net investment returns after taxes, which is especially beneficial for high-income individuals. Christine Benz, director of personal finance and retirement planning at Morningstar, explains, “Having to dip into your funds to cover tax bills reduces the money available in your portfolio to compound and grow.”
Furthermore, Vanguard neither accepted nor denied any wrongdoing in the settlement. A company spokesperson reiterated Vanguard’s commitment to serving the 50 million everyday investors and retirement savers who rely on their services, expressing satisfaction with the settlement outcome and eagerness to continue offering top-tier investment options.
At the close of 2023, Vanguard’s target-date funds managed about $1.3 trillion in assets, based on data from Morningstar.
Understanding where to best position your assets within a retirement account is another key consideration. This strategy of allocating stocks, bonds, and other assets in certain accounts to optimize after-tax returns is referred to as “asset location.” Benz emphasizes its importance for high earners, who are likely to hit their retirement account contribution limits and thus also need to save in taxable accounts. These investors also often fall into higher tax brackets.
Middle-class investors typically focus on retirement accounts where tax efficiency isn’t as pressing. However, taxable accounts can be more appropriate for specific goals outside of retirement—such as saving for a future home down payment, Benz notes.
Asset location strategies can raise annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors in mid to high income tax brackets, according to research from Charles Schwab.
“A retired couple with a $2 million portfolio, split between taxable and tax-advantaged accounts, could potentially reduce tax burdens by $2,800 to $8,200 per year, depending on their tax bracket,” explains Hayden Adams, CPA and director of tax and wealth management at the Schwab Center for Financial Research. Tax inefficient assets are those that “generate regular taxable events,” he adds.
To illustrate, bonds and bond funds generally incur ordinary income tax rates, as opposed to the favorable rates associated with capital gains. Actively managed funds tend to have higher turnover, resulting in more taxable distributions than index funds. REITs are mandated to distribute 90% of their income, leading to significant taxable events. Additionally, profits from short-term holdings attract higher tax rates, and target-date funds often hold tax inefficient assets like bonds.
Adams details that roughly 90% of potential after-tax return enhancements using asset location stem from transitioning to municipal bonds in taxable accounts and opting for index stock funds in taxable versus active stock funds in tax-advantaged accounts.
It’s worthwhile for investors to consider municipal bonds or money market funds as they avoid federal income tax on distributions. Also, exchange-traded funds tend to distribute capital gains less frequently than mutual funds, making them more suitable for taxable accounts.
