Vanguard Limited Term Tax Exempt Bond Fund tax distributions

The Vanguard Limited Term Tax Exempt Bond Fund is a very suitable candidate for placement in taxable accounts. In fact the fund is not available in tax advantaged accounts. The fund is often recommended for the following purposes:
 * 1) As a funding vehicle for short-term obligations.
 * 2) John Bogle in Bogle on Mutual Funds suggests using short term bond funds for funding an emergency fund.
 * 3) As the fixed income allocation in an investment portfolio. Larry Swedroe and William Bernstein advocate using short term bonds for such purposes.

Investors holding bonds in taxable accounts can compare expected after tax returns of short term municipal tax exempt bond funds, treasury short term bond funds, and corporate short term bond funds to determine which fund provides the highest after tax returns. Bernstein suggests an investor should simply divide the short term allocation across all three short term bond categories.

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 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 any 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. A portion of the dividend income may be subject to alternative minimum tax. Over the 1994 - present period, the fund has distributed a modest capital gain only once (1994) and has maintained a loss carryforward available to offset realized gains since 1996.

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. Bond funds have higher turnover ratios than stock funds, since the bond manager must buy and sell bonds as they mature, and as the manager maintains the maturity and duration structure of the portfolio. The gains or losses on a bond are primarily determined by changes in interest rates, and in some instances, credit quality.

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 bonds at different prices. The manager can select high basis securities when forced to sell a bond (this may realize a loss). The manager can also select low basis securities when redeeming a bond 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
The fund turnover ratio has been quite low for a short term bond fund. Shareholder turnover in fund has on average been roughly the same as the fund's average duration.

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.

After tax yields
The calculator below (courtesy of the The Financial Buff blog) takes into account all taxable input federal, state, and alternative minimum tax for bond fund after-tax return analysis.

Bond Fund Yield Calculator

Income Tax Rates are available from the following sources:

Federal Tax Rates

State Tax Rates

Certain short-term losses
Special rules may apply if you have a short-term loss on the sale of shares on which you received an exempt-interest dividend or a capital gain distribution. If you received exempt-interest dividends on mutual fund shares that you held for 6 months or less and sold at a loss, you may claim only the part of the loss that is more than the exempt-interest dividends. Report the loss as a short-term capital loss.

Example:

On January 7, 2009, you bought a mutual fund share for $40. On February 4, 2009, the mutual fund paid a $5 dividend from tax-exempt interest, which is not taxable to you. On February 11, 2009, you sold the share for $34. If it were not for the tax-exempt dividend, your loss would be $6 ($40 − $34). However, you must increase the sales price from $34 to $39 (to account for the $5 portion of the loss that is not deductible). You can deduct only $1 as a short-term capital loss.