Vanguard Target Retirement Funds (2005-2025) tax distributions

The Vanguard Target Retirement Funds (TRFs) are questionable candidates for placement in taxable accounts. The funds are often recommended as a simple indexed one fund solution for implementing a four-fund portfolio consisting of total market domestic stock, international stock, and investment grade US bond funds and international bond funds. ( Inflation-indexed bonds] are added to the portfolio mixture during the later stages of a fund's glide path)

TRFs are usually singled out for use in tax deferred (employer provided or individual Traditional IRA accounts) or tax-free (Roth IRA) accounts. The passage of the 2006 Pension Protective Act, establishing target retirement funds as the default option for employer provided contributory retirement plans, has helped increase investor contributions to these funds. Employee contribution allocations to Vanguard TRFs have increased from 2% in 2004 to 20% in 2010. The table below summarizes the fund's relation to a number of tax factors.

Distributions
The following tables provide long term data on each TRF's history of both dividend and capital gains distributions. As fund of funds, TRF's taxable distributions come from two sources:
 * 1) Income and gains distributions received from the TRF's underlying funds.
 * 2) The sales which the TRF makes when rebalancing or retargeting the fund.

The breakdown of annual capital gains distributions in the funds can be found on the second and third tabs of Table 11. Target Retirement Funds Capital Gains Distributions, included in the footnotes.

Target Retirement Income Fund
Note:
 * For current tax attributes and distributions see Vanguard

Target Retirement 2010 Fund
Note:
 * For current tax attributes and distributions see Vanguard

Target Retirement 2015 Fund
Note:
 * For current tax attributes and distributions see Vanguard

Target Retirement 2020 Fund
Note:
 * For current tax attributes and distributions see Vanguard

Target Retirement 2025 Fund
Note:
 * For current tax attributes and distributions see Vanguard

Equity capital gains
Vanguard TRF's can distribute taxable gains if the underlying funds distribute gains and if the fund itself realizes gains when rebalancing or retargeting a fund's strategic asset allocation. In both instances, a TRF has been, and can be expected to remain, tax efficient. The underlying equity funds used by a TRF are tax efficient equity index funds that distribute very few (if any) taxable gains. Historically, the funds employed have included the following funds:


 * Vanguard Total Stock Market Index Fund
 * Vanguard European Stock Index Fund
 * Vanguard Pacific Stock Index Fund
 * Vanguard Emerging Markets Stock Index Fund

In 2010, the regional international index funds were replaced with the Vanguard Total International Stock Index Fund.

Fund rebalancing and retargeting is made easier by the steady investor inflows into the portfolios, augmented by employer provided plans use of the funds as default investment options. In most instances, TRF rebalancing has resulted in the realization of capital losses and the creation of tax loss carryforwards in the funds. The sources of fund capital gains and the level of loss carryforwards can be found on the appropriate tabs on Table 8 below.

Equity dividends
The TRF funds pass along the tax-preferenced qualified dividends distributed by the underlying equity index funds. The Total Market Index Fund distributes 100% qualified dividends; International index funds distribute roughly 75% qualified dividends. The actual portion of the TRF dividend that is qualified depends on the strategic equity allocation of the fund, and how this allocation is reduced by the TRF glide path (see Figure 1.) that gradually reduces the equity allocation over time

Foreign tax credit
As of 2010, the Regulated Investment Company Modernization Act of 2010 allows funds of funds to pass on the foreign tax credit from the individual funds to their shareholders.

Bond capital gains
Vanguard TRF's distribute capital gains distributions received from underlying bond funds. Currently these funds include the Vanguard Total Bond Market Index II Fund (since 2009; prior to 2009 the funds invested in the Vanguard Total Bond Market Fund) and the  Vanguard Inflation Protected Securities Fund. These bond funds occasionally distribute relatively small short term and long term gains. Future received gains are likely to be offset by fund loss carryforwards.

Bond dividends
Vanguard TRF's receive and distribute taxable dividend income from underlying bond funds. This income is taxable at marginal income tax rates. The funds receive a modest tax preference for dividends received from treasury securities, which are exempt from state and local income tax. The dividend yield of a given TRF is dependent on the fund's strategic asset allocation. Bond allocations grow over time according to the TRF glide path (see Figure 1.)

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 following table examines the tax consequences of holding a TRF in a taxable account. A high equity TRF (the 2045 target fund) and the terminal glide path high income fund (Income target fund) are examined to show the outer bounds of tax costs. (The tables account for the tax on distributions; should the fund be sold at a gain, the capital gains tax would be an added tax cost. Capital gains distributions while holding the funds are negligible.) The tables include both the 2010 - 2012 tax regime and the present tax regime commencing in 2013. The tables include a 5% state tax rate (which of course may vary according to state). In general the following conclusions are prudent.
 * 1) Investors in high federal tax brackets over 15% would likely be better off avoiding TRF's in taxable accounts if the after tax returns of municipal bonds exceeds the returns of taxable bonds.
 * 2) Investors in all tax brackets having sufficient tax advantaged space in retirement accounts would likely be better served by holding higher yielding bond investments in the tax advantaged account, and lower yielding stock investments in the taxable account.
 * 3)  Investors in the lower tax brackets (10% - 15%) with limited tax advantaged account options may find holding a TRF fund in the taxable account to be acceptable, especially if the investor places a high premium on the simplicity of holding one diversified fund. The tax cost of holding a taxable TRF account will rise somewhat as the glide path transitions to income oriented portfolios. Should an investor's income rise into a higher tax bracket the tax cost will also increase. Likewise, should investment income distribution increase (bond interest and/or stock dividends), the tax bite will be greater. An additional factor to consider is the greater flexibility provided by holding separate asset class funds compared to a balanced fund. If you have a balanced fund, you can only sell bonds and stocks simultaneously. If you want to sell only bonds, in order to hold fewer bonds or a different type of bonds, you will have to sell the stock as well and likely pay a capital-gains tax.

Appendix
On February 10, 2012, the Target Retirement Income fund acquired all the net assets of Vanguard Target Retirement 2005 Fund pursuant to a plan of reorganization approved by the funds’ board of trustees. The move was consistent with the fund's glide path trajectory, which called for the fund to merge into the Target Income Fund five years after the fund passed beyond its 2005 target date. The fund's historical distribution history is reflected in the table below.