Vanguard 500 Index Fund tax distributions

The Vanguard 500 Index Fund is a very suitable candidate for placement in taxable accounts. The fund, which tracks the S&P 500 Index, is often recommended and used as a large cap blend index in portfolios such as the Armstrong Ideal Indexed portfolio shown in Figure 1. The table below summarizes the fund's relation to a number of tax factors.



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.

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 the 1990 - 2000 decade, a period which coincided with a long bull market. The fund has not distributed a gain since 2000, a period marked by two bear markets. The fund has distributed 100%  qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.In 2010 the fund introduced an ETF share class in the fund. We have data extending back to 1993. The fund was established on 08/31/1976.

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.)
 * 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: A fund which defers gains realization accumulates unrealized appreciation, which when distributed, will 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). The third tab on the Table 3. spreadsheet shows the data in percentage of total assets form.

Turnover
Reference article: Average net assets


 * Shareholder turnover in 2010 is magnified by investor share to admiral share conversion due to the liberalization of the Admiral share program (minimum investment lowered to $10,000).
 * Shareholder turnover in 2007 is magnified by admiral share to signal share conversion due to policy change in Vanguard employer provided plans (the use of signal shares).
 * Shareholder turnover in 2000 is magnified by investor share to admiral share conversion due to creation of admiral shares.

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.

Tax analysis
The annual fund accounting figures show that the Vanguard 500 Index fund, has provided single digit turnover rates (excepting a 12% turnover rate in 2009) over the 1993-2011 period. This low turnover can be attributed to the fact that stock migration out of a large cap index can come in the following dimensions:


 * 1) An individual company becomes relatively smaller and migrates to a mid cap index;
 * 2) An individual company is bought out or merged with a second company.

Shareholder turnover, revealed in the Redemptions/Average Net Assets (R/ANA) metric, shows that shareholders were net buyers of the fund from 1993 to 2003. Starting in 2004, shareholders have been net sellers of fund shares. Shareholder redemption and sales figures are especially elevated by share conversion activity in 2000, 2007, and 2010. Conversion involves no security transactions; it is simply a paper accounting transaction. The fund added an ETF share class in the fund in 2010. Mutual share classes of the fund have reflected an average 5 year holding period in the fund.

A look at realized net gains/losses shows that the fund, beginning in 2000 has realized net losses in eight of eleven years (see the second tab, tax attributes in Table 3 above). These losses have produced a substantial level of loss carryforwards, which were used to offset realized gains in 2009 and 2010.

The following table presents the federal tax cost on the fund's historical distributions (see second tab, table 6.) under two scenarios: the tax rate regime in (2010-2012) and under the current tax regime (with dividends and long term capital gains taxed at tax rates of 0%, 15% or 20%, depending on marginal tax rate, and an additional 3.8% ACA Net Investment Income tax accessed at higher tax brackets). Keep in mind that distributions can also be subject to state and local taxation, with marginal rates ranging from 0% to 12% (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 2004-2012, the period comprising the qualified dividend tax regime. The average dividend yield over this period is slightly higher than the average over the 1993-2011 period. The fund distributed capital gains over the 1993-2000 period: an average 0.08% short term gains distribution, and an average 0.33% long term gains distribution.

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 8 costs. However, you would not pay the Table 8 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 8; 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%). 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.