It’s easy for a small investor to make big mistakes. It would be even easier for giant investment firms to help prevent them—but, sadly, the asset-management industry seems to have other priorities.
Just look at what happened last month to some investors in Vanguard’s Target Retirement funds. They got whacked with huge capital-gains distributions. Those payouts triggered painful tax bills they could easily have avoided if Vanguard had simply warned them not to hold these funds outside of a tax-advantaged retirement account.
Like many investment firms, Vanguard offers target-date funds: bundles of stocks, bonds and cash that automatically become more conservative as investors approach their retirement date.
These funds are tailored for investors in 401(k)s or other retirement plans where taxes are deferred. So target funds aren’t managed to minimize dividends or capital gains. Hold them in a taxable account instead of a retirement plan, and you will owe taxes on those payouts—sometimes much more than you would in other types of funds.
That shows the importance of what financial advisers call “asset location,” the choice of whether to put particular investments in a taxable or nontaxable account.
Most of the money in Vanguard’s target funds comes from corporate and individual retirement plans, where funds’ gains and income aren’t currently taxable. However, some investors do put nonretirement money into target funds, and in December they got a nasty surprise.
Vanguard’s Target Retirement 2035 and Target Retirement 2040 funds, for example, distributed approximately 15% of their total assets as capital gains—which are taxable outside of retirement accounts.
One investor posted there: “I think I’m screwed by Vanguard resulting in an enormous tax bill…. I feel that Vanguard guided me down this path which is frustrating.”
In the Bogleheads area on Reddit, another online forum, an investor posting as “Sitting-Hawk” said he received about $550,000 in distributions in Vanguard’s Target Retirement 2035 fund. So he owes 23.8% in federal tax and 4.95% in Illinois state tax—all told, more than $150,000. “HOW,” he asked in capital letters, “COULD VANGUARD LET THIS HAPPEN??”
SHARE YOUR THOUGHTS
How have you been burned by an unexpected tax surprise in your investment portfolio? Join the conversation below.
“Sitting-Hawk,” who asked me not to disclose his real name, says he put about $1.9 million into the fund in a taxable account in 2015 after he maxed out contributions to his tax-deferred funds. He added more savings; by last year, he had about $3.6 million in taxable money in the fund.
“I didn’t want to be that guy who’s constantly trading,” he says. “I just wanted to set it and forget it and have some peace of mind instead of messing around with it every couple of days.”
“It sucks that this had to happen,” he says.
It happened because big clients left little ones holding the bag. Vanguard’s target funds come in more than one format. Smaller clients get the standard version; big customers like corporate retirement plans get an institutional version with identical holdings at a lower fee.
At the end of 2020, Vanguard reduced the minimum investment in its institutional Target Retirement funds to $5 million from $100 million. That set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the institutional equivalents. (Clients have to sell out of one format to buy the other.)
Last year, assets at Vanguard’s 2035 target fund shrank to $38 billion from $46 billion at year-end 2020; the 2040 fund shriveled to $29 billion from $36 billion.
As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around. Some had made the mistake of owning these funds in taxable accounts.
Vanguard didn’t have anything to say about how it infuriated the individual investors who have taxable money in these funds.
Spokeswoman Carolyn Wegemann said that because the Target Retirement approach seeks to reduce risk over time by automatically trimming stock positions, “these funds are best served in a tax-deferred account.”
Yet nowhere on the funds’ main pages at Vanguard.com does the firm tell investors that the funds aren’t ideal for taxable accounts. The summary prospectus, a document almost no one reads, intones on page 10 of 14 that “distributions may be taxable as ordinary income or capital gain.”
Vanguard is far from alone. Few leading asset managers clearly and simply state which of their funds should be held in a taxable account.
That’s a shame, says Eric Johnson, a marketing professor at Columbia Business School and author of the book “The Elements of Choice.” When an investor in a taxable account seeks to buy a fund that might not belong there, he says, a dialogue box could pop up saying something like: “This may not be the best home for your taxable dollars. Before you trade, click here to learn more.” That would link to more-suitable choices.
A related idea has worked well at Betterment, the online investment-advice company, says Dan Egan, the firm’s head of behavioral science. When clients were about to sell an investment that could trigger taxes, some saw a pop-up prompting them to view their estimated tax liability; others didn’t. Those who saw the pop-up were 15% less likely to enter the sell order.
Little interventions like that could make a big difference to small investors. Those were the people Vanguard’s late founder, John Bogle, championed for decades. In this situation, Vanguard failed them.
—additional reporting by Caitlin McCabe
Write to Jason Zweig at email@example.com
Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8