Target date funds in
A taxable account can
Cause big tax trouble

Tax planning is a great place to start a financial plan. The reason for this is that the tax code changes often. If you own a business, are an independent contractor, work a side hustle, hold income-producing real estate, have high earnings, or own a taxable investment account, it’s worth getting a second set of eyes on your taxes to make sure you aren’t paying more than you have to. There may new rules that apply to you, or old ones that have been changed.

Tax planning failures recently led to expensive problems for Vanguard account owners.

To understand what happened at Vanguard, you first must understand Target Date Funds and where they belong in your portfolio.

Target Date Funds, sometimes called LifeCycle Funds, are actively managed funds that hold a mixture of stocks, bonds, and cash. The idea is that the investor buys a fund with a target year close to the year they want to retire. Then, over time, a fund manager decreases the risky stock holdings in the account in favor of less risky bond holdings. When an investor first buys into the fund, it may be invested aggressively. By the time the investor is retired, the fund will hold a more conservative balance of stocks and bonds.

In order to make these changes, fund managers must sell out of those risky stock positions to buy more bond positions. If a stock position has been held for several years, there’s a good chance that position will have appreciated during that time. In order to sell that stock to buy bonds, the fund manager will have to realize capital gains in the process.

Unfortunately for mutual fund owners, those realized capital gains are distributed to the shareholders who own the fund. The reason these funds work this way has to do with how mutual funds are regulated.

According to the Investment Company Act of 1940, mutual funds are considered Open End Investment Companies. The “Open End” part refers to the fact that mutual funds have a continuous offering of new shares. No matter how many people invest in one of Vanguard’s famous index mutual funds, for example, there will always be new shares available for new investors.

Open End Investment Companies are taxed as pass-through entities. In this way they are taxed similar to an S Corp, or a Limited Partnership. These entities pass earnings to shareholders or limited partners, respectively, and in doing so avoid paying corporate taxes on those earnings.

In order for a Mutual Fund to maintain its pass through tax status, it must distribute 90% of its income to shareholders. When a fund realizes capital gains on the sale of underlying investments like risky stocks in a target date fund, the shareholders must foot the bill for at least 90% of the capital gains.

In an IRA or 401k account, this is not a problem. These accounts are tax-deferred. The capital gain liability generated by the target date fund vanishes within the tax-deferred status of the IRA or the 401k and the investor goes on his or her merry way.

In a taxable investment account, though, mutual fund capital gains can become a major problem.

This is what happened in 2020 when Vanguard reduced the minimum investment required for the lower cost version of its institutional mutual funds from $100 million to $5 million. Money started pouring out of the higher cost funds, forcing those funds to liquidate assets. This in turn generated huge capital gains bills. In one instance a single target date fund generated capital gains at a rate of 15.1%.

That means that if an investor had $1,000,000 in that fund, they would see $151,000 of capital gains on their taxes. Assuming a 15% tax rate on those gains, that hypothetical investor saw a tax bill of $22,650 just from the activity within that fund. This would happen by simply owning the fund in a taxable account. The hypothetical investor may not have placed a single trade all year, but they would still see that tax bill.

Target Date Funds may be a reasonable idea for investors looking to have professional help for risk management and rebalancing in a tax-deferred account. However, from a tax standpoint, using these funds in a taxable account is probably a mistake. While the fees on these funds may be low, the tax bill may not be.

Taxable accounts can be extremely powerful tools in a portfolio. Built the right way, they can generate annual tax benefits through tax harvesting. They have no limits on how much you can invest in them per year. There are no age-based withdrawal penalties. They are taxed using capital gains rates, which are lower for some taxpayers than the ordinary income tax rates we all pay on IRA and 401k withdrawals.

Investing in a taxable account is a great way to take advantage of the benefits of the capital gains tax code in your portfolio. But holding actively managed funds like Target Date Funds inside a taxable account will likely help the IRS more than it will help you.

If you want to talk about using taxable accounts in your financial plan, we’re here for you.