Vanguard FTSE All-World ex-US Index Fund tax distributions

The Vanguard FTSE All-World ex-US Index Fund is a very suitable candidate for placement in taxable accounts. The fund is often recommended as a core holding in a simple three-fund or four-fund (Figure 1) portfolio. The fund is also used in combination with the Vanguard FTSE All-World ex-US Small-Cap Index Fund  for investors desiring to establish their own set allocations between international large cap and international small cap stocks. 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 an estimate of the foreign tax credit.

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 Vanguard FTSE All-World ex-US Index Fund has not distributed a capital gains distribution from its inception in 2007. Approximately 75% of dividend distributions have been qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.


 * FY 2007 dividend annualized
 * FY 2011 admiral shares introduced
 * FY 2012 - Elimination of 2% transaction fee on redemptions of shares held < 2 mos.

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.) 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).

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.

Tax analysis
As an index fund containing large and mid cap stocks, the Vanguard FTSE All-World ex-US Index Fund, has to date, as expected, realized low, primarily single digit turnover ratios. The FTSE All-World ex-US Index holds large and mid cap stocks across both developed and emerging markets. Stock migration out of the index can come in two dimensions:
 * 1) An individual company is reclassified as a small cap stock and is removed from the index;
 * 2) An emerging market country is reclassified as a frontier market and is removed from the index.

Shareholders have invested net inflows into the fund over its history. Shareholder turnover in mutual fund shares has settled into the 20% range, suggesting an average holding period of five years. ETF shareholders have been mostly accumulating holdings in the fund, as measured by the very low redemption to sales (R/S) ratio. The transaction and tax efficiencies provided by the ETF shares should continue to provide benefits for the fund.

The fund has netted realized losses over much of its history (see the tab tax attributes in the Table 3. spreadsheet for the net loss figures). The losses accrue into an increasing loss carryforward.

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 from (2010-2012) and under tax regime beginning in 2013 (with dividends and long term capital gains taxed at 0%, 15% and 20% tax rates, and an additional 3.8% ACA Net Investment Income tax rate imposed on high 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 0.14% to the annual tax cost of holding the fund.)

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 9 costs. However, you would not pay the Table 9 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 9; 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.