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Vanguard Group’s recent settlement of $106 million with the U.S. Securities and Exchange Commission highlights a critical lesson for investors: Awareness of your investment account type can significantly influence your tax obligations.
As the leading manager of target-date funds, Vanguard reached this agreement in response to allegations of making “misleading statements” regarding the tax implications of lowering the asset minimum for a cheaper version of its Target Retirement Funds.
The reduction of the minimum investment for the lower-cost Institutional shares from $100 million to $5 million led to many investors migrating to these funds, according to the SEC. This shift resulted in “historically larger capital gains distributions and tax liabilities” for those who remained invested in the more costly Investor shares.
Here’s the core takeaway: Only investors holding these target-date funds in taxable brokerage accounts faced these tax repercussions, while those in retirement accounts were spared.
Individuals holding investments, whether in the form of target-date funds or others, within tax-advantaged accounts like 401(k)s or IRAs are not subject to annual tax bills for capital gains or income distributions.
In contrast, investors with “tax inefficient” assets—such as many bond funds, actively managed funds, and target-date funds—held in taxable accounts may encounter significant tax liabilities each year, according to financial experts.
For high-income earners, placing these types of assets into retirement accounts can lead to significant enhancements in net returns after accounting for taxes. Christine Benz, director of personal finance and retirement planning at Morningstar, notes, “When you have to withdraw funds to cover a tax bill, it diminishes the amount left in your portfolio to earn compound interest.”
Important Insights on Personal Finance:
Major changes for inherited IRAs are on the horizon in 2025
This period presents a great opportunity to reassess retirement savings
Free filing options may be available for investors this tax season
In its settlement with the SEC, Vanguard did not admit to any wrongdoing. A spokesperson for the company stated, “Vanguard is dedicated to supporting the over 50 million everyday investors and retirement savers who trust us with their savings. We are pleased to have reached this resolution and look forward to continuing to provide exemplary investment options for our clients.”
As of the end of 2023, Vanguard managed approximately $1.3 trillion in target-date fund assets, according to Morningstar.
Optimizing Your Retirement Accounts
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The strategy of holding stocks, bonds, and other assets in specific account types to maximize after-tax returns is known as “asset location.” This approach is particularly important for high earners, according to Benz.
These investors are often more likely to reach the contribution limits in tax-advantaged retirement accounts, necessitating an additional savings strategy in taxable accounts, especially as they usually fall within higher tax brackets.
For many middle-class savers, retirement accounts serve as the primary investment vehicles, meaning that tax efficiency tends to be less of an issue. However, for certain non-retirement objectives—like saving for a future home down payment—taxable accounts can sometimes present a better option.
Employing an asset location strategy can enhance annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors in mid to high tax brackets, based on recent research from Charles Schwab.
According to Hayden Adams, a CPA, CFP, and director of tax and wealth management at the Schwab Center for Financial Research, a retired couple with a $2 million portfolio split evenly between taxable and tax-advantaged accounts could see their tax burden reduced by as much as $2,800 to $8,200 annually, depending on their tax bracket.
Assets that are deemed tax inefficient, which are ideally placed in retirement accounts, include those that generate regular taxable events, as noted by Adams.
Some examples include:
- Bonds and Bond Funds: The interest from bonds is typically taxed at ordinary income rates rather than preferential capital gains rates, although municipal bonds are an exception.
- Actively Managed Investment Funds: These funds often have higher turnover rates, which leads to more taxable distributions compared to index funds, impacting all shareholders.
- Real Estate Investment Trusts (REITs): To meet tax regulations, REITs must distribute at least 90% of their income to shareholders, increasing tax exposure.
- Short-Term Holdings: Profits from investments held for one year or less are subject to short-term capital gains tax rates, which lack the advantages of long-term capital gains rates.
- Target-Date Funds: These funds, designed to maintain a particular asset allocation, can be detrimental in taxable accounts due to containing tax-inefficient assets like bonds and occasionally requiring the sale of appreciated securities.
Roughly 90% of the potential additional after-tax returns from asset location can be achieved through two key strategies: utilizing municipal bonds in taxable accounts instead of taxable bonds, and opting for index stock funds in taxable accounts while reserving actively managed stock funds for tax-advantaged accounts, according to Adams.
Investors holding municipal bonds or municipal money market funds can avoid federal income tax on their distributions.
Additionally, exchange-traded funds tend to distribute capital gains to investors much less frequently than mutual funds, making them another viable option for those with taxable accounts.
