For Taxes, Where You Hold Your Investments Really Matters

The suit says the sequence of Vanguard’s actions is important.

A year after Vanguard set off the mass sales of its retail funds by lowering the institutional threshold, it merged the institutional and retail versions of the funds and lowered fees for all investors to 0.8 percent. (They are cheaper for corporate plans that hold the funds as trusts; at The Times, the fee is 0.65 percent.) But Vanguard could have first merged the funds, then lowered the fees, the suit says. If the process had proceeded in that order, the lawyers argued, there would have been no flood of fund sales and no tax shock for retail investors.

Morningstar has found that other companies’ target date funds also produced hefty capital gains distributions for investors who held them in taxable accounts, though none as large as Vanguard’s. They included:

  • JPMorgan SmartRetirement funds, with an average long-term taxable gain of 10.2 percent.

  • Fidelity Freedom funds, with an average long-term gain of 6.7 percent.

  • T. Rowe Price Retirement investor funds, with an average long-term gain of 6.2 percent.

Kristen Chambers, a spokeswoman for JP Morgan Asset Management, said, “For our target date funds, capital gains are a function of portfolio flows, as well as portfolio turnover at both the target date fund level and the underlying funds held within the target date fund strategies.” Less than 10 percent of JPMorgan’s “investor base holds these funds in taxable accounts,” she said.

Fidelity and T. Rowe Price declined to comment.

In response to these tax surprises, the secretary of the commonwealth of Massachusetts is reviewing target date fund disclosures and interviewing the customers of several fund companies, including those of Vanguard, Fidelity and T. Rowe Price, Debra O’Malley, a spokeswoman, said.

Try to prepare yourself

So what should an investor do?

Until recently, target date retirement funds, especially those constructed from low-cost index funds like Vanguard’s, weren’t on my radar as being tax inefficient. Now, they are.

I think there’s enough evidence for new investors to stay away from them in taxable accounts.

If you already hold them, Ms. Pacholok said, “be aware that you could face further capital gains in the future.” She added that the size of the potential tax liability for Vanguard shareholders this year appeared to be an outlier caused by the reduction in the investment minimum for the institutional funds.

The California investor who contacted me about his Vanguard target date funds said he intended to hold onto them. “Taxes aside, and while I’m angry at Vanguard, I still think these are good funds,” he said. Their automatic rebalancing as he ages “makes them an efficient way to reduce equities as I get older.”

Target date funds continue to be a worthwhile option in workplace retirement accounts. I plan to stick with mine — but to monitor them and Vanguard’s pronouncements much more regularly. All shareholders deserve careful treatment, not just those investing under the shelter of corporate retirement plans.

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