Vanguard Emerging Markets Stock Index Fund tax distributions

The Vanguard Emerging Market Index Fund is a suitable candidate for placement in taxable accounts. The fund is usually held by investors who wish to hold specific targeted allocations to regional stock markets (Figure 1). Thus, the fund is usually held in combination with the following regional international funds:


 * Vanguard Pacific Stock Index
 * Vanguard European Stock Index

The fund is also held by investors who hold a developed market index and wish to add emerging market exposure (Figure 2). Vanguard developed market funds include:

The following tables provide long term data on the fund's history of both dividend and capital gains distributions. Table 2 also provides the historical distribution of qualified dividends and an estimate of the foreign tax credit.
 * Vanguard Tax-Managed International‎
 * Vanguard Developed Markets Index

Table 4 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.

When dividing international allocations among regional index funds in taxable accounts, an investor will need to occasionally rebalance the allocation in a tax efficient manner, and should remain aware of any opportunities to  harvest tax losses.

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 one capital gains distribution during 1994, its first year of existence, but has not distributed a gain since. Approximately 60% of dividend distributions have been qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.


 * FY 1994 - annualized dividend, fund inception.
 * FY 2002 - MSCI transitions to "free-float" market weighting.
 * FY 2003 - Introduction of 2% transaction fee on redemptions of shares held < 2 mos.
 * FY 2005 - Fund introduces ETF shares, dividend annualized.
 * FY 2006 - Fund transitions to MSCI Emerging Markets Index.
 * FY 2006 - Fund adds admiral shares, dividend annualized.
 * FY 2008 - Fund removed from Total Market fund of funds, transition completed March 2009.
 * FY 2010 - Fund introduces admiral shares with lower $10,000 minimum investment.
 * FY 2012 - Elimination of 2% transaction fee on redemptions of shares held < 2 mos.

Accounting data
The accounting figures and associated ratios (tables 4 and 5) 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). The third tab on the Table 2. spreadsheet shows the data in percentage of total assets form.

In-kind redemption gains are included in the realized gains accounting. The second tab (tax attributes) in the Table 3. spreadsheet shows the true taxable net realized gain /loss for the fund. In kind redemption gains are added to the fund's cost basis.

Turnover
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 indicate that the Vanguard Emerging Market Index Fund annual turnover ratio is consistently higher than the turnover realized by the European and Pacific index funds. Factors driving this higher turnover:


 * 1) The fund has experienced two structural shifts in the fund's underlying tracking index during its history. In 2002 MSCI adopted free float market weighting for its international indexes (2002 turnover 65%). In 2006 Vanguard shifted the fund's tracking index from a proprietary MSCI index to the currently tracked MSCI Emerging Markets Index (2006 turnover 26%).
 * 2) Stock migration in and out of the index affects turnover. As a large and mid cap index, the MSCI Emerging Market Index can have stocks reclassified as small cap stocks and removed from the index. A significant migration also occurs on a country level when a nation is reclassified among developed, emerging, and frontier markets. Table (3) documents the historical migrations into and out of the index. Malaysia (2000) and Argentina (2009) are the only countries to have been reclassified as frontier markets; all other migrations out of the portfolio have been to developed market indexes. Historically, the migration of markets has not resulted in the fund distributing a taxable gain to shareholders. However, a realized gain remains a possibility should one of the heavier weighted markets in the index (China, South Korea, Brazil, or Taiwan) be reclassified as a developed market.

The fund has received net inflows every year of its history. In recent years investors have flocked to the ETF share class of the fund, making it the largest Emerging Market ETF in the ETF market place. The ETF possesses competitive advantages: it has the lowest expense ratio in the market and has exhibited superior tracking error performance since inception.

Shareholder turnover, revealed in the Redemptions/Average Net Assets (R/ANA) metric, shows that prior to the introduction of the the ETF shareholders had historically turned over their holdings in the mutual fund shares at 10%-30% annual rates, suggesting average holding periods of between three and ten years. Since the advent of the ETF share class, the R/ANA ratio for mutual fund shares has increased. One element in this increase is share class conversion activity. Vanguard allows investors to convert mutual fund shares to ETF shares. These conversions are included in the mutual fund's redemption total (although no actual sale has transpired). A similar inflation in the R/ANA ratio takes place with investor share / admiral share conversion.

In 2010, investor share turnover also increased due to the policy decision to transform the Vanguard Total International Stock Index Fund from a  fund of funds to direct ownership of securities. The Emerging market mutual fund shares were removed from the holdings in the fund.

As table (4) indicates, the fund has frequently realized net capital losses during its fiscal years (often during years of positive market gains) and, as a result, has always maintained, and steadily increased, its loss carryforward. [Refer to the second tab (Table 4.) for the actual realized net loss in the fund, adjusted for 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 0.11% 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 close to the long term (1994 forward) fund average yield. The fund distributed capital gains during the 1994-2003 period, averaging 0.00% per annum short term gains, 0.04% 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 8 and Table 11 costs. However, you would not pay the Table 11 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 11; 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.