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: Being mindful of your investment account type can save you from a big tax bill in certain cases.
Vanguard, the largest target-date fund manager, agreed to pay the sum for alleged “misleading statements” over the tax consequences of reducing the asset minimum for a low-cost version of its Target Retirement Funds.
Lowering the asset minimum for its lower-cost Institutional share class — to $5 million from $100 million — triggered 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 where the lesson applies: Those taxes were only borne by investors who held the TDFs in taxable brokerage accounts, not retirement accounts.
Investors who hold investments — whether a TDF or otherwise — in a tax-advantaged account like a 401(k) plan or individual retirement accounts don’t receive annual tax bills for capital gains or income distributions.
Those who hold “tax inefficient” assets — like many bond funds, actively managed funds and target-date funds — in a taxable account may get hit with a big unwelcome tax bill in any given year, experts said.
Placing such assets in retirement accounts can make a big difference when it comes to boosting net investment returns after taxes, especially for high earners, experts said.
“By having to pull money out of your coffers to pay the tax bill, it leaves less in your portfolio to compound and grow,” said Christine Benz, director of personal finance and retirement planning at Morningstar.
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Vanguard neither admitted nor denied 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 e-mailed statement. “We’re pleased to have reached this settlement and look forward to continuing to serve our investors with world-class investment options.”
Vanguard held about $1.3 trillion of assets in target-date funds at the end of 2023, according to Morningstar.
What’s best in a retirement account
The concept of strategically holding stocks, bonds and other assets in certain account types to boost after-tax returns is known as “asset location.”
It’s a “key consideration” for high earners, Benz said.
Such investors are more likely to reach annual contribution limits for tax-sheltered retirement accounts, and therefore need to also save in taxable accounts, she said. They’re more likely to be in a higher tax bracket, too.
While most middle-class savers predominantly invest in retirement accounts, in which tax efficiency is a “non-issue,” there are certain non-retirement goals — perhaps saving for a down payment on a house a few years down the road — for which taxable accounts make more sense, Benz said.
Using an asset location strategy can raise annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors (who invest more in bonds) in the mid to high income tax brackets, according to recent research by Charles Schwab.
“A retired couple with a $2 million portfolio [$1 million in a taxable account and $1 million in a tax advantaged account] could potentially see a reduction in tax drag that equates to an additional $2,800 to $8,200 per year depending on their tax bracket,” 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 — which are better suited to retirement accounts — are ones that “generate regular 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, instead of preferential capital-gains rates. (There are exceptions, like municipal bonds.)
- Actively managed investment funds. These generally have higher turnover due to frequent buying and selling of securities within the fund. They therefore tend to generate more taxable distributions than index funds, and those distributions are shared among all fund shareholders.
- Real estate investment trusts. REITs must distribute at least 90% of their income to shareholders, Adams wrote.
- Short-term holdings. The profit on investments held for a year or less are taxed at short-term capital gains rates, for which the preferential tax rates for “long term” capital gains don’t apply.
- Target-date funds. These and other funds that aim for a target asset allocation are a “bad bet” for taxable accounts, Benz said. They often hold tax inefficient assets like bonds and may need to sell appreciated securities to maintain their target allocation, she said.
About 90% of the potential additional after-tax return from asset location comes from two moves: switching to municipal bonds (instead of taxable bonds) in taxable accounts, and switching to index stock funds in taxable accounts and active stock funds in tax-advantaged accounts, Adams wrote.
Investors with municipal bonds or municipal money market funds avoid federal income tax on their distributions.
Exchange-traded funds also distribute capital gains to investors much less often than mutual funds, and may therefore make sense in taxable accounts, experts said.