Vanguard Value Index Fund tax distributions



The Vanguard Value Index Fund is a suitable candidate for placement in taxable accounts. The fund is recommended for portfolios that employ a value tilt, such as the Schultheis "Coffeehouse" portfolio illustrated in Figure 1.

In addition, John Bogle has stated that Vanguard created style index funds with tax consequences as the paramount factor that should guide investors: I expect that the new style indexes will greatly assist investors in meeting their particular investment objectives. In the accumulation phase of your life, you might be well served by a relatively low dividend yield to minimize your taxes. At retirement and in the distribution phase of your life, you would presumably be better served by a higher yield. (Bogle On Mutual Funds: New Perspectives for the Intelligent Investor ISBN 978-1556238604, p. 184.)

...when Vanguard created the industry's first Growth Index Fund and Index Value Fund in 1992, the former was designed for younger investors who focused on wealth accumulation, were seeking tax-efficiency, and were willing to assume larger risks. The latter was designed for older investors who focused on wealth preservation, were seeking higher income, and were happy to reduce their risks. Alas, while the original idea was strong, the ensuing reality was weak. What followed their introduction was a classic case of performance chasing. (The Little Book of Common Sense Investing ISBN 978-0470102107, pp. 133-34.)

The following tables provide long term data on the fund's history of both dividend and capital gains distributions. The first table also provides the historical distribution of qualified dividends.

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 following table provides a view of the fund's historical distributions expressed in terms of yields. We can see that the fund distributed considerable levels of capital gains during its first decade of existence, a period which coincided with a long bull market. The fund has not distributed a gain since 2001, a period marked by two bear markets, and which saw the introduction of an ETF share class in the fund. The fund has distributed 100%  qualified dividends, whichunder the current tax regime, are taxed at lower capital gains tax rates. The higher taxable dividend yields distributed by value index funds make them less tax efficient than lower yielding blend and growth index funds.


 * 2000 admiral dividend annualized
 * The fund made a minor change of benchmark on 05/16/2003, moving from the S&P 500/Barra Value Index to the MSCI US Prime Market Value Index.
 * The fund introduced ETF shares on 01/26/2004.

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.)
 * 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.

Table 3.

Turnover
Reference article: Average net assets

Table 4.

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 show that the Vanguard Value Index fund, since its 2003 change to the MSCI benchmark, has provided turnover ratios inhabiting a range between 20% to 30%. This moderate turnover can be attributed to the fact that stock migration out of a large value index can come in the following dimensions:


 * 1) An individual company becomes relatively smaller and migrates to a mid cap index;
 * 2) An individual company migrates to a growth index;
 * 3) An individual company is bought out or merged with a second company.

Shareholder turnover, revealed in the Redemptions/Average Net Assets (R/ANA) metric, shows that shareholders have tended to chase performance in the fund. The fund received moderate inflows during the 1990's, a period marked by growth stocks outperforming value stocks; the fund saw net redemptions in 2002, at the conclusion of the 2000-2002 bear market. The fund has realized higher levels of inflows during the 2001-2008 period when value stocks outperformed growth stocks.

A look at realized net gains/losses shows that the fund realized net losses in the 2000-2001 and 2008-2009 bear markets (see the second tab, tax attributes in Table 3 above). These losses produced loss carryforwards. These carryforward losses have been used to offset realized gains during ensuing periods of market recovery. One should remain cognizant of the fund's tendency to distribute higher levels of taxable gains absent carryforward losses, although this risk is mitigated by the creation and redemption process central to the fund's ETF shareclass.

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 0.14% 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 very close to the life of fund average yield. The fund distributed capital gains during the 1992-2000 period, averaging 0.94% per annum short term gains, 2.63% 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 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%). 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.

Table 6.

John Bogle's original insight into the relative tax inefficiency of value index funds vs. growth index funds is evidenced in the following table of relative yields:

Table 7.