Vanguard’s Target Retirement Fund Tax Disaster: Who Did It Hurt The Most?

Vanguard made a decision that cost my friend, Patrick, $7000 in extra taxes. That same decision cost another one of my former colleagues an extra $15,000 in taxes. Some people say this was avoidable: an error in judgement from one of the world’s most respected investment firms.

In many ways, Vanguard’s Target Retirement funds are almost perfect products.  Each of them represents a diversified portfolio of index funds wrapped up in a single fund. Vanguard rebalances the internal holdings so investors don’t have to. And the firm increases their bond allocations over time, as investors age.

For years,  people have argued that investors shouldn’t hold such funds in taxable accounts. Because these funds are designed to maintain a consistent allocation, when the funds sell stocks to buy bonds (for example) it can trigger a capital gain distribution to investors. But because Vanguard often uses deposits from new investors to buy “the lagging indexes” (whether they are stocks or bonds) they can often maintain the target allocation without selling anything.

For example, Morningstar reports that the turnover for Vanguard’s Target Retirement 2030 fund is typically about 6 percent per year. That’s far lower than most actively managed mutual funds. Referencing data from Morningstar’s Michael Laske, Investopedia reports that the typical actively managed fund had a turnover rate of 63 percent in 2019. This means about 63 percent of the holdings at the end of a calendar year weren’t the same as the holdings at the beginning of the year. In some cases, a higher number of the holdings would have remained the same, year-over-year, while a smaller number of shares were traded multiple times. Either way, taxable investors feel the bite. After all, when a fund company sells shares that have increased in price, investors holding those funds (in taxable accounts) are given the tax bill. This is why investors shouldn’t hold actively managed funds in taxable accounts.

This is also why, from a tax perspective, it’s theoretically better to own individual stocks than a mutual fund of any kind in a taxable account. If investors in individual shares don’t trade their stocks, they won’t pay capital gains taxes unless they sell at a profit. But that isn’t always the case for investors in mutual funds (whether they’re indexed or actively managed).

For example, if you held an index fund or a mutual fund in a taxable account, and a stock market drop frightened enough investors into selling, the fund company would need to redeem shares to pay those investors. Assuming such shares were sold at a profit, that hands a capital gains distribution to everyone that owns the fund.

That’s what recently happened with Vanguard’s Target Retirement funds. Vanguard lowered the minimum amount required to invest in its lower-cost Institutional series Target Retirement Funds from $100 million to $5 million. This opened the door for wealthy and institutional investors with more than $5 million to swap their Investors series Target Retirement funds in favour of the lower cost Institutional series equivalents.

Because of the mass exodus, Vanguard had to sell shares to meet redemptions, hitting smaller taxable investors with a capital gains distribution.

On January 21, 2022, The Wall Street Journal’s Jason Zweig published, The Huge Tax Bills That Came out of Nowhere at Vanguard. He said Vanguard’s decision benefited institutional investors while hurting small investors. He also said Vanguard should have told people this was coming, and the firm should have warned investors that they shouldn’t own target retirement funds in taxable accounts. 

However, on January 28, 2022, Morningstar’s Jason Kephart, argued that Vanguard’s decision to lower the entry point for their Institutional Target Retirement funds didn’t hurt most small investors because most investors don’t invest in taxable accounts.

“Only investors fortunate enough to max out annual contributions to 401(k)s ($20,500, or $27,000 for those over 50, in 2022) and IRAs ($6,000, or $7,000 for over 50) and still have significant additional assets to invest face potentially painful tax bills. That’s not a luxury most investors have. Indeed, the median 401(k) balance was $34,000 at the end of 2020, according to a Vanguard study. With that in mind, it’s mostly larger individual investors who need to beware capital gains from target-date funds, not smaller investors, despite what some media reports may have suggested.”

Referencing Vanguard, Jason Kephart added that 99 percent of the money that’s invested in Vanguard’s Target Retirement funds is held in tax-advantaged accounts.

You might wonder, then, about my friend who has to pay an extra $7000 tax bill and my former colleague who has to pay an extra $15,000 in taxes.  These aren’t investors who were fortunate enough to max out annual contributions in tax-advantaged accounts, like IRAs and 401(k)s.  My friend Patrick spent most of his career as a teacher, working overseas. As an expatriate American, he wasn’t able to contribute to an IRA, a 401(k)…or even Social Security. 

He now lives in Washington State.  But most of his money is in taxable accounts, which is much the same with most Americans overseas. This raises the question of whether or not people like Patrick (and other Americans abroad) should have bought Vanguard’s Target Retirement funds.

To be fair, Vanguard’s Target Retirement funds are much more efficient (even in taxable accounts) than most people think. My wife has owned Vanguard’s Target Retirement 2020 fund in her taxable account for 15 years. That isn’t because she maxed out her tax-deferred options. She has worked abroad as an international teacher her entire career. And because her salary was below the foreign income exclusion, she couldn’t contribute to an IRA. However, despite having all of her money in Vanguard’s Target Retirement 2020 fund for the past 15 years, her capital gains distributions were almost non-existent until this year.

The image below shows how unusual the capital gains distributions were for Vanguard’s Target Retirement 2040 fund in 2021, compared to the previous four years.

If you are investing in a taxable account, and Vanguard’s decision resulted in a hefty tax bill, you might be wondering whether to actively manage a portfolio of individual stocks or buy ETFs instead of owning a Target Retirement fund. Both are theoretically more efficient from a taxable perspective.

But real world returns often pay little heed to theory. In 2019, using Morningstar’s data, I wrote How Investors Can Win With Target Retirement Funds. I referenced how investors in such funds don’t typically fall for investment mistakes. Using data from Morningstar’s cash-flow analysis, investors in such funds often beat the posted returns of the funds they own. As Morningstar’s Amy C. Arnott explained on August 30, 2021, that isn’t the case with most investors in ETFs because most of these investors underperform the posted returns of their funds…as a result of speculating more. You can see Morningstar’s data here.

I suspect most investors that own individual stocks speculate even more. In that case, real-world tax-efficiency for investors in target retirement funds would be higher than it would be for investors who buy individual stocks.

That doesn’t mean I don’t feel a touch of anger towards Vanguard. Their decision levied large tax bills on plenty of my friends: good, hard-working people who definitely aren’t rich. I hope Vanguard learns from the big mess they caused.

One minor consolation is that Vanguard recently dropped the expense ratio fee on their Investor series Target Retirement funds. Funds that recently averaged costs of 0.14 percent per year now cost just 0.09 percent per year.

I only wish they lowered those fees last year. And I’m guessing Vanguard wishes that too.

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

This article and or podcast contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.