Vanguard LifeStrategy Funds tax distributions

The Vanguard LifeStrategy Funds 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 U.S. bond and international bond funds.

LifeStrategy Funds are usually singled out for use in tax deferred (employer provided or individual Traditional IRA accounts) or tax-free (Roth IRA) accounts. The funds are also common investment options in many 529 college savings plans.

In contrast to the Vanguard series of similar one fund diversified portfolios, target retirement funds, which utilize a gradual shifting strategic asset allocation over time, the LifeStrategy funds have a fixed target asset allocation. Vanguard considers the LifeStrategy funds to be target risk funds, in contrast to target date target retirement funds. The table below summarizes the fund's relation to a number of tax factors.

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

Equity capital gains
Vanguard LifeStrategy Funds 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 (see tab 5, CG source in the referenced table below). Historically, the funds have realized substantive gains when they have not had the benefit of loss carryforwards (1994-2001, see tab 6, Loss carryforwards in the referenced table below) and when the underlying funds it invests in have not had loss carryforwards (particularly applicable to the distribution history of the  Vanguard Asset Allocation Fund). The funds' two underlying equity funds are very tax efficient.


 * Vanguard Total Stock Market Index Fund
 * Vanguard Total International Stock Index Fund.

Equity dividends
LifeStrategy 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 LifeStrategy Fund dividend that is qualified depends on the strategic equity allocation of the fund.

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 LifeStrategy Funds distribute capital gains distributions received from underlying bond funds. Currently these funds include, for all funds, the Vanguard Total Bond Market Index II Fund (since 2009; prior to 2009 the funds invested in the Vanguard Total Bond Market Fund). These bond funds occasionally distribute relatively small short term and long term gains. Future long term received gains may be offset by any loss carryforwards the fund possesses. Short term gains cannot be offset by loss carryforwards.

Bond dividends
Vanguard LifeStrategy Funds 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 bond dividend yield, and treasury bond tax preference of a given LifeStrategy Fund is dependent on the fund's strategic asset allocation.

Tax analysis
The following tables examine the tax consequences of holding the Vanguard LifeStrategy Funds in a taxable account. The tables include a 5% state tax rate (which of course may vary according to state). The Funds' current fundamentals include the following.


 * 1) Current fund dividend and interest yields are somewhat lower than the historical average yields.
 * 2) The underlying equity based funds possess tax loss carryforwards that should offset gains realizations through 2017. The funds themselves do not possess loss carryforwards as they enter FY 2014. Any losses realized by the funds (and underlying funds) through 2017 will serve to lengthen the period of gain offsets.

The table examines tax costs under the (2010- 2012) tax regime, using each fund's average non-qualified dividend, average qualified dividend, average government bond dividend, and average capital gain. The table also provides results for the current tax regime( with qualified dividends taxed at 0%, 15%, or 20%, depending on tax bracket, and an additional ACA Net Investment Income tax accessed against higher tax brackets). Keep in mind the table does not include the tax cost should one sell an investment in the fund and realize a gain.

LifeStrategy Income Fund


The LifeStrategy Income Fund invests in other Vanguard mutual funds according to a fixed formula that provides an allocation of 80% of the Fund’s assets to bonds, and 20% to common stocks (14% U.S. equity/6% international equity allocation). Prior to 2012, the fund included a 20% allocation to a short term investment grade bond fund and a 20% allocation to the Vanguard Asset Allocation Fund.

LifeStrategy Conservative Growth Fund


The LifeStrategy Conservative Growth Fund invests in other Vanguard mutual funds according to a fixed formula that provides an allocation of 60% of the Fund’s assets to bond and 40% to common stocks (28% US equity/ 12% international  equity). Prior to 2012, the fund included a 20% allocation to a short term investment grade bond fund and a 20% allocation to the Vanguard Asset Allocation Fund.

LifeStrategy Moderate Growth Fund


The LifeStrategy Moderate Growth Fund invests in other Vanguard mutual funds according to a fixed formula that provides an allocation of 60% (US equity 42%/international equity 18%) of the Fund’s assets to common stocks and 40% to bonds''. Prior to 2012 the fund invested 20% of its assets in the Vanguard Asset Allocation Fund.

LifeStrategy Growth Fund


The LifeStrategy Growth Fund invests in other Vanguard mutual funds according to a fixed formula that provides 80% of the Fund’s assets to common stocks (US equity 56%/ international equity 24%) and 20% to bonds. Prior to 2012, the fund invested 20% of its assets in the Vanguard Asset Allocation Fund.