D3 Logo | Moment | Getty Images
Vanguard investors learn important lesson Recent $106 Million Settlement Communicating with the SEC About Target-Date Funds: Pay Attention to Your Investment Account Type can save you Large tax bills can be waived under certain circumstances.
largest vanguard group target date funds The manager agreed to pay the fee for what it called “misleading statements” about the tax consequences of lowering the minimum assets for a lower-cost version of the Target retirement fund.
According to the SEC, lowering the asset minimum for the low-cost institutional stock class from $100 million to $5 million triggered an influx of investors into these funds. The agency said this created “historically larger capital gains distributions and tax liabilities” for many investors who remained in more expensive investor share classes.
This is where the lesson applies: These taxes are borne only by investors who hold TDFs in taxable brokerage accounts (not retirement accounts).
Investors who hold investments (whether TDFs or otherwise) in a tax-advantaged account such as a 401(k) plan or an IRA do not receive an annual tax bill on capital gains or income distributions.
Experts say those who hold “tax-inefficient” assets in taxable accounts, such as many bond funds, actively managed funds and target-date funds, could be hit with a large and unwelcome tax bill in any given year.
Experts say putting such assets into retirement accounts can have a significant impact in improving net after-tax investment returns, especially for high-income earners.
“Because money has to be taken out of the coffers to pay taxes, you have less money in your portfolio to compound and grow,” said Christine Benz, director of personal finance and retirement planning at Morningstar.
More from Personal Finance:
‘Major changes’ coming to inherited IRAs in 2025
Now is an ‘ideal time’ to reassess your retirement savings
Investors may be able to file taxes for free this season
Vanguard neither admitted nor denied wrongdoing in its settlement with the SEC.
“Vanguard is committed to supporting the more than 50 million everyday investors and retirement savers who entrust their savings to us,” a company spokesperson wrote in an emailed statement. “We are pleased with the settlement and look forward to continuing to serve our Investors are offered world-class investment options.”
Vanguard held about $1.3 trillion in target-date funds at the end of 2023, according to Morningstar.
What’s Best in a Retirement Account?
Loden Riverton | Electronic+ | Getty Images
The concept of strategically holding stocks, bonds, and other assets in certain account types to increase after-tax returns is called “asset positioning.”
Benz said this is a “key consideration” for high-income earners.
Such investors are more likely to hit 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 be in higher tax brackets.
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 home in a few years — for which Bentz says one should A tax account makes more sense.
According to recent research from Charles Schwab, for conservative investors in middle and upper income tax brackets (who invest more in bonds), using an asset allocation strategy can increase annual after-tax returns by 0.14 to 0.41 percentage points.
“A retired couple with a $2 million portfolio ($1 million in a taxable account and $1 million in a tax-advantaged account) might see a reduction in tax drag equivalent to an additional $2,800 to $8,200 per year. , depending on their tax bracket,” said Hayden Adams, CPA, Certified Financial Planner, and Director of Tax and Wealth Management at the Schwab Center for Financial Research, wrote the results of the investigation.
Tax-inefficient assets — better suited for retirement accounts — are assets that “generate periodic taxable events,” Adams wrote.
Here are some examples, according to experts:
- Bonds and Bond Funds. Income from bonds 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 funds typically have higher turnover rates due to the frequent buying and selling of securities within the fund. Therefore, they tend to generate more taxable distributions than index funds, and these distributions are shared among all fund shareholders.
- Real Estate Investment Trust. REITs must distribute at least 90% of their income to shareholders, Adams wrote.
- Short term holding. Profits from investments held for one year or less are taxed at short-term capital gains rates. The preferential tax rates for “long-term” capital gains do not apply.
- Target date funds. Bentz said these funds and others designed to target asset allocations are a “bad choice” for taxable accounts. They often hold tax-inefficient assets such as bonds and may need to sell appreciated securities to maintain their target allocations, she said.
About 90% of the potential additional after-tax return for Asset Location comes from two moves: a shift to municipal bonds (rather than taxable bonds) in taxable accounts, a shift to index stock funds in taxable accounts and a shift in tax-advantaged active stock funds Adams wrote.
Investors who hold municipal bonds or municipal money market funds can avoid federal income taxes on their distributions.
Exchange-traded funds also distribute capital gains to investors Much less than mutual fundsso it might make sense in a taxable account, experts say.
