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There’s an important lesson for investors in Vanguard Group’s recent $106 million settlement with the Securities and Exchange Commission over its target-date funds: Taking the type of investment account into account can save you a big tax bill in some cases.
Vanguard, the largest target-date fund manager, agreed to pay the amount due to alleged “misleading statements” about the tax implications of lowering the asset minimum for a low-cost version of its Target Retirement Funds.
Lowering the asset minimum for the cheaper institutional share class – from $100 million to $5 million – caused an exodus of investors to these funds, according to the SEC. That created “historically larger capital gains distributions and tax liabilities” for many investors who remained in the more expensive investor share class, the agency said.
Here’s the lesson: These taxes were only borne by investors who held the TDFs in taxable investment accounts, not in retirement accounts.
Investors who hold investments – whether TDF or otherwise – in a tax-advantaged account, such as a 401(k) plan or individual retirement accounts, do not receive annual tax bills for capital gains or income distributions.
Those who hold “tax-inefficient” assets — such as many bond funds, actively managed funds and target-date funds — in a taxable account could face a large, unwanted tax bill in any given year, experts say.
Placing such assets in retirement accounts can make a big difference when it comes to increasing net after-tax investment returns, especially for high earners, experts say.
“Having to take money out of your treasury to pay your tax bill leaves less in your portfolio to build and grow,” says Christine Benz, director of personal finance and retirement planning at Morningstar.
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Vanguard did not admit or deny wrongdoing in its settlement agreement with the SEC.
“Vanguard is committed to supporting the more than 50 million everyday investors and retirement savers who entrust us with their savings,” a company spokesperson wrote in an emailed statement. “We are pleased to have reached this settlement and look forward to continuing to provide our investors with world-class investment options.”
Vanguard had about $1.3 trillion in assets in target-date funds at the end of 2023, according to Morningstar.
What’s best in a retirement account?
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The concept of strategically holding stocks, bonds, and other assets in certain types of accounts to increase after-tax returns is known as “asset location.”
It’s an “important consideration” for high earners, Benz said.
Such investors are more likely to reach annual contribution limits for tax-sheltered retirement accounts, and therefore also need to save in taxable accounts, she said. They are also more likely to fall into a higher tax bracket.
While most middle-class savers invest primarily in retirement accounts, where tax efficiency is not an issue, there are certain non-retirement goals — perhaps saving for a down payment on a house in a few years — for which taxable accounts make more sense, Benz said .
According to recent research from Charles Schwab, using an asset allocation strategy can increase annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors (who invest more in bonds) in the middle to high income tax brackets.
‘A retired couple with a two million dollar portfolio [$1 million in a taxable account and $1 million in a tax advantaged account] could potentially see a reduction in tax burden amounting to an additional $2,800 to $8,200 per year, depending on their tax bracket,” says Hayden Adams, a certified public accountant, certified financial planner and director of tax and wealth management at the Schwab Center for Financial. Research, wrote of the findings.
Tax-inefficient assets — better suited for retirement accounts — are assets that “regularly generate taxable events,” Adams wrote.
Here are some examples, according to experts:
- Bonds and bond funds. Bond income is generally taxed at ordinary income tax rates, rather than preferential capital gains rates. (There are exceptions, such as municipal bonds.)
- Actively managed investment funds. These generally have a higher turnover as a result of the frequent purchase and sale of securities within the fund. Therefore, they tend to generate more taxable distributions than index funds, and those distributions are shared among all fund shareholders.
- Real estate investment funds. REITs must distribute at least 90% of their income to shareholders, Adams wrote.
- Short-term investments. Gains on investments held for one year or less are taxed at short-term capital gains rates, to which the preferential tax rates for ‘long-term’ capital gains do not apply.
- Target date funds. These and other funds that seek targeted asset allocation are a “bad bet” for taxable accounts, Benz said. They often hold tax-inefficient assets, such as bonds, and may have to sell appreciated securities to maintain their target allocation, she said.
About 90% of the potential additional after-tax returns from asset location come from two moves: the move to municipal bonds (rather than taxable bonds) in taxable accounts, and the move to index stock funds in taxable accounts and active stock funds on tax-advantaged accounts . accounts, Adams wrote.
Investors with municipal bonds or municipal money market funds avoid federal income taxes on their distributions.
Exchange-traded funds also pay out capital gains to investors at a much lower rate than mutual funds, and therefore may make sense in taxable accounts, experts said.