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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: It's the size of your investment account type that can save you from a big tax bill in certain cases.
Vanguard, the largest target date manager, agreed to pay the amount for alleged “misleading statements” about the tax consequences of reducing the asset minimum for a low-cost version of its target pension funds.
Lowering the asset minimum for its cheaper institutional share class—to $5 million from $100 million—sparked an exodus of investors in these funds, according to the SEC. That created “historically larger capital gains distributions and tax liabilities” for many investors who remained in the higher-priced 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 such as a 401(k) plan or individual retirement accounts do not receive annual tax bills for capital gains or income distributions.
Those who own “tax-inefficient” assets—such as many bond funds, actively managed funds and target-date funds—in a taxable account could be hit with a large unwanted tax bill in any given year, experts said.
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 said.
“Having to take money out of your treasury to pay the tax bill 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 did not admit or deny in its settlement agreement with the SEC.
“Vanguard is committed to supporting the more than 50 million everyday investors and retirement savers who trust 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 serve our investors with world-class investment options.”
Vanguard held about $1.3 trillion in assets in target-date funds at the end of 2023, according to Morningstar.
What is best in a retirement account
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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 an “important consideration” for high earners, Benz said.
Such investors are more likely to reach annual contribution limits for tax-clear retirement accounts and therefore need to save on taxable accounts as well, she said. They are also more likely to be in a higher tax bracket.
While most middle-class savers invest primarily 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 line—for which taxable accounts make more sense, Benz said .
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 mid-to-high income tax brackets, according to recent research from 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 resistance amounting 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 about the findings.
Tax-inefficient assets — which are better suited for retirement accounts — are those 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, rather than preferential capital gains rates. (There are exceptions, such as 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 shareholders of the fund.
- Real estate investment trusts. REITs must distribute at least 90% of their income to shareholders, Adams wrote.
- Short-term companies. 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 aimed at a target 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 the asset location come from two moves: switching to municipal bonds (rather than taxable bonds) in taxable accounts, and switching to index stock funds in taxable accounts and active stock funds in tax-developed Accounts, Adams wrote.
Investors with municipal bonds or municipal money market funds avoid federal income taxes on their distributions.
Traded funds also distribute capital gains for investors more often than mutual funds, and therefore can make sense in taxable accounts, experts said.