Vanguard Total International Stock Index Fund tax distributions

The Vanguard Total International Stock Index Fund is a very suitable candidate for placement in taxable accounts. The fund is now more attractive as a taxable holding since it is no longer structured as a fund of funds portfolio (which is ineligible for the foreign tax credit). As a fund now directly holding securities, the fund qualifies for the credit. The addition of an ETF shareclass to the fund in 2011 and the 2010 inclusion of the fund in the series of Vanguard Target Retirement Funds should help maintain the fund's overall tax efficiency. The fund is often recommended as a core holding in a simple three-fund or four-fund portfolio.



The following tables provide long term data on the fund's history of both dividend and capital gains distributions. The first table also provides the historical distribution of qualified dividends and an estimate of the foreign tax credit. One should note that the fund has a fiscal year ending in October, so its reported distributions for a year reflect the prior year's December distribution of dividends and capital gains.

The second table provides a database of the fund's accounting figures: the annual level of realized and distributed gains; its level of unrealized gains and loss carryforwards; as well as the annual in-kind redemption gains the fund has realized. These figures highlight the level of a fund's tax liabilities.

Because both manager turnover of securities inside the portfolio and investor turnover of fund shares can affect the level of gains realization, a third table provides historical turnover ratios.

Distributions
The following table provides a view of the fund's historical distributions expressed in terms of yields. We can see that the fund distributed modest levels of capital gains during its first five years of existence, but has not distributed a gain since 2001. Approximately 75% of dividend distributions have been qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.


 * FY 1996 - annualized dividends, fund inception.
 * FY 2000 - annualized dividends, fund changed fiscal years.
 * FY 2002 - MSCI transitions to "free-float" market weighting.
 * FY 2003 - Introduction of 2% transaction fee on redemptions of shares held < 2 mos.
 * FY 2008 - Fund begins transition from fund of funds to direct ownership of securities. Transition completed in March 2009.
 * FY 2010 - Fund introduces admiral shares with lower $10,000 minimum investment.
 * FY 2011 - Admiral shares and ETF shares, dividends annualized.
 * FY 2012 - Elimination of 2% transaction fee on redemptions of shares held < 2 mos.

Accounting data
The accounting figures and associated ratios (tables 3 and 4) can help one visualize some of the major determinants of a fund’s tendency to distribute taxable gains. These determining features include:

Turnover: The rate at which a fund manager sells securities within the fund has a major effect on potential gains realization. Single digit annual fund turnover percentages result in a low rate of realized gains. Similarly, fund shareholders' sales flows have major effects on a fund’s distribution tendencies. Net flows into the fund have the following effects:


 * 1) Constant inflows allow a fund manager to purchase a wide range of price lots for shares. The manager can select high basis shares when forced to sell a stock (this may realize a loss). The manager can also select low basis shares when redeeming a stock in-kind (a non-taxable transaction that can remove an unrealized gain out of the portfolio.) This redemption technique is primarily employed with institutional creation and redemption of ETF shares.  Net inflows mean that shareholders are not forcing the manager to liquidate assets (and realize gains or losses) in order to meet redemptions. Large outflows can force such liquidation.
 * 2) A large and growing net asset base serves to diffuse any realized capital gains across a large base of shareholders and reduces the per share gain distribution. Large outflows have the opposite effect; any gains realized are spread across a smaller asset base and result in higher per share distributed gains.

The level of unrealized gains and carryover realized losses in a fund: Index funds defer gains realization and often accumulate significant unrealized appreciation, which if distributed, would be taxed; thus the unrealized gain/loss figure shows the potential gain (or loss) that would be realized if the portfolio was to be entirely liquidated. Any loss carryovers a fund possesses can be used to offset future realized gains (carryovers have an eight year expiration period).

Turnover statistics
Reference article: Average net assets

Tax rates
Mutual fund distributions will be taxed according to the tax laws governing the investment over the holding period of the investment, which are subject to change. The actual tax imposed will depend upon each individual's tax rate and the timing of purchases and sales. The federal tax rates applicable to mutual fund distributions and investor sales of securities for the period 2013 onward are outlined below. Keep in mind that investment income may also be subject to state and local taxation.
 * 1) Short-term capital gains distributions are made from realized gains on securities held for one year or less. Short-term gains are taxed at ordinary income tax rates up to 39.6%. Mutual fund short-term gain distributions are included in a fund's ordinary dividend distribution; therefore, capital losses may not be subtracted from these distributions when computing taxes.
 * 2) Long-term capital gains distributions are made from realized gains on securities held for more than one year. Long-term gains are taxed at 0% for taxpayers in the 10% and 15% tax brackets, at 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets, and at 20% in the 39,6% tax bracket. They are reported on tax Schedule D along with any other capital gains, and can be reduced by capital losses.
 * 3) Qualified dividends are the ordinary dividends that are subject to the same tax rate that applies to long-term capital gains. They should be shown in box 1b of the Form 1099-DIV you receive.
 * 4) When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both. If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss.
 * 5) The Affordable Care Act imposes a Medicare surcharge of 3.8% on all net investment income (NII) once the taxpayer's adjusted gross income exceeds $200,000 (single) or $250,000 (married); while this tax is not part of the income tax, it has the same effect on investors as a higher tax rate. The NII tax begins to apply to individuals falling in the 33% tax bracket. Thus the top effective marginal tax rate is 23.8% on qualified dividends and long-term gains, 43.4% on ordinary investment income.

Mutual fund distributions will be taxed according to the tax laws governing the investment over the holding period of the investment, which are subject to change. The actual tax imposed will depend upon each individual's tax rate and the timing of purchases and sales. The federal tax rates applicable to mutual fund distributions and investor sales of securities for the period 2008 - 2012 are outlined below. Keep in mind that investment income may also be subject to state and local taxation.
 * 1) Short-term capital gains distributions are made from realized gains on securities held for one year or less. Short-term gains are taxed at ordinary income tax rates up to 35%. Mutual fund short-term gain distributions are included in a fund's ordinary dividend distribution; therefore, capital losses may not be subtracted from these distributions when computing taxes.
 * 2) Long-term capital gains distributions are made from realized gains on securities held for more than one year. Long-term gains are taxed at 0% for taxpayers in the 10% and 15% tax brackets and at 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets. (These tax rates are mandated for 2008-2012.) They are reported on tax Schedule D along with any other capital gains, and can be reduced by capital losses.
 * 3) Qualified dividends are the ordinary dividends that are subject to the same 0% or 15% maximum tax rate that applies to net capital gain. They should be shown in box 1b of the Form 1099-DIV you receive. Qualified dividends are subject to the 15% rate if the regular tax rate that would apply is 25% or higher. If the regular tax rate that would apply is lower than 25%, qualified dividends are subject to the 0% rate.
 * 4) When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both. If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss.

Tax analysis
The annual fund accounting figures show that the Vanguard Total International Index fund turnover ratio usually stays in single digits. The rise in turnover during fiscal years 2009 and 2010 was likely due to the fund's transformation over the period from a fund of funds into a fund directly holding securities, and during FY 2010 from its change of index benchmarks to the MSCI ACWI ex USA IMI Index which added allocations to the Canadian stock market and small cap stocks to the fund portfolio. The MSCI ACWI ex USA IMI Index, being a total market index, can be expected to exhibit low, single digit turnover in future years. This low turnover can be attributed to the fact that stock migration out of a total international market index can come in only two dimensions:
 * 1) An individual company goes bankrupt and is delisted from the stock exchange;
 * 2) An emerging market country is reclassified from its status as an emerging market and is placed into a frontier market index.

Neither event is likely to generate large capital gains.

Shareholder turnover, revealed in the Redemptions/Average Net Assets (R/ANA) metric, shows that shareholders have historically turned over their holdings in the fund at 10%-20% annual rates, suggesting average holding periods of between five and ten years.

The fund has received net inflows every year of its history. The heavy inflows in FY 2010 partly reflect the policy decision to include the fund in the allocation of Vanguard Target Retirement funds. From 2010 onwards, the fund will receive inflows from investors adding to these fund of funds (the fund has always been a holding in some of the Vanguard Life Strategy funds). Assuming continual net investment in these retirement accumulation portfolios should result in the continuance of future net inflows into the fund.

A look at realized net gains/losses shows that the fund realized net losses during the 2000-2001 and 2008-2009 bear markets. These losses produced loss carryforwards. Low fund and shareholder turnover has retained most of these carryforward losses as offsets to potential future gains. The introduction of ETF shares to the fund should also help increase its future tax efficiency, as the fund sees an increase in its realization of in-kind redemption gains.

The following table presents the federal tax cost on the fund's historical distributions (see second tab, table 6.) under two scenarios: the current favorable tax rate regime (2010-2012) and under a higher tax regime (with dividends taxed at marginal rates and long term capital gains taxed at a maximum 20%). Keep in mind that distributions can also be subject to state and local taxation, with marginal rates ranging from 0% to 10.3% (an average 5% state tax rate will add an approximate 0.10% to the annual tax cost of holding the fund.) The average is based on the results from 2004-2010, the period comprising the qualified dividend tax regime. The 2004- 2010 average dividend yield is roughly 0.5% higher than the long term (1996 forward) fund average yield. The fund distributed capital gains during the 1996-2003 period, averaging 0.02% per annum short term gains, 0.13% per annum long term gains.

The table does not include the capital gains cost associated with selling the fund at a gain. This table indicates the additional cost for the capital-gains tax when you sell, assuming that you pay taxes on the distribution and reinvest the after-tax portion of the distribution; since it is a one-time cost, the effect is annualized. For example, if you hold an investment for 30 years and lose 10% to taxes when you sell, that is equivalent to losing 0.35% every year. Thus, if you sell the fund, your cost will be the sum of the Table 6 and Table 9 costs. However, you would not pay the Table 9 cost on any stock which you either leave to your heirs or donate to charity, and thus may not pay that cost on your full investment. In particular, you might estimate your total tax cost by using the low-return line in Table 2; if stock returns are high, you will have a large taxable account and will reduce the tax cost by taking longer to deplete it or by not spending it all during your lifetime.

Taxes are computed at a tax rate of 15% on long-term gains (except in the "rate rises to 20% column", which applies if that tax reduction is allowed to expire), and on qualified dividends (except in the "no QDI" column, which applies if the tax reduction on qualified dividends expires and the rate is 35%). The foreign tax credit is added to the dividend yield before computing taxes; for example, if a fund had $100 withheld in foreign taxes on dividends, and you pay $20 in taxes on the withheld dividends, you get a $100 credit for a net benefit of $80. Although not tabulated, keep in mind that investors in the lower tax brackets (15% or lower) pay lower federal tax rates on investment income for the period 2003 - 2012, and reap higher after-tax returns, outside of tax-exempt municipal bonds, in all asset classes.