WSJ: The Huge Tax Bills That Came Out Of Nowhere At Vanguard

Wall Street Journal, The Huge Tax Bills That Came Out of Nowhere at Vanguard:

It’s easy for a small investor to make big mistakes. It would be even easier for giant investment firms to help prevent them—but, sadly, the asset-management industry seems to have other priorities.

Just look at what happened last month to some investors in Vanguard’s Target Retirement funds. They got whacked with huge capital-gains distributions. Those payouts triggered painful tax bills they could easily have avoided if Vanguard had simply warned them not to hold these funds outside of a tax-advantaged retirement account.

Like many investment firms, Vanguard offers target-date funds: bundles of stocks, bonds and cash that automatically become more conservative as investors approach their retirement date.

These funds are tailored for investors in 401(k)s or other retirement plans where taxes are deferred. So target funds aren’t managed to minimize dividends or capital gains. Hold them in a taxable account instead of a retirement plan, and you will owe taxes on those payouts—sometimes much more than you would in other types of funds. ...

Most of the money in Vanguard’s target funds comes from corporate and individual retirement plans, where funds’ gains and income aren’t currently taxable. However, some investors do put nonretirement money into target funds, and in December they got a nasty surprise.

Vanguard’s Target Retirement 2035 and Target Retirement 2040 funds, for example, distributed approximately 15% of their total assets as capital gains—which are taxable outside of retirement accounts.

Fury erupted on Bogleheads.org, a website popular among Vanguard investors. ...

It happened because big clients left little ones holding the bag. Vanguard’s target funds come in more than one format. Smaller clients get the standard version; big customers like corporate retirement plans get an institutional version with identical holdings at a lower fee.

At the end of 2020, Vanguard reduced the minimum investment in its institutional Target Retirement funds to $5 million from $100 million. That set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the institutional equivalents. (Clients have to sell out of one format to buy the other.) ...

As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around. Some had made the mistake of owning these funds in taxable accounts.

Vanguard didn’t have anything to say about how it infuriated the individual investors who have taxable money in these funds.