The target-date fund settlement of $106 million that the Vanguard Group had to cough up on Friday is a lesson for all investors. The Securities and Exchange Commission (SEC) slammed the investment asset giant with a $106.41 million fine in the third week of January. Vanguard’s error? In 2020, the asset manager changed its minimum investment requirement for institutional target-date funds. The SEC’s order then pointed out that Vanguard did not fully disclose the potential outcome of such changes to their clients.
Subscribers to the Investor Target Retirement Fund (TRF) who failed to migrate to the institutional version suffered shortfalls in returns on their long-term investments. Now, the essence of the fine is to get Vanguard to distribute the $106.41 million to all its investors affected by the disinformation. So, tax experts suggest understanding the tax implications of subscribing to any type of investment account. Failure to carry out this due diligence may result in substantial tax bills on investment and stifling your returns.
Why Vanguard Had to Part Ways With a $106 Million Target-Date Fund Settlement
Reports have it that Vanguard eventually agreed to pay the hefty fine for alleged “misleading statements.” Of course, many of the investors only put their money down and went to sleep in anticipation of massive yields. Instead, something dramatic happened in 2020 after Vanguard reduced the minimum investment in its institutional share class from $100 million to $5 million. Naturally, investors swooped in to take advantage of the significant drop in asset minimum.
However, this portfolio rebalancing led to “historically larger capital gains distributions and tax liabilities” for old-time investors who remained in the expensive share class. Let’s break it down. The new subscribers to the low minimum asset accounts are largely retirement investors and 401 (k) plans. By implication, these accounts enjoy considerable tax waivers.
Consequently, all the tax burden on investments with Vanguard was distributed to investors with target-date funds in taxable brokerage accounts. So, after the 2020 change by Vanguard, the tax bill of brokerage account operators puffed up considerably. By implication, this is a heads-up to investors with “tax-inefficient assets.” Operating such target-date funds or bond funds, besides being subject to market volatility, is likely to attract unsolicited and hefty tax bills.
So, to avoid such pitfalls, the advisable investment strategy is to place such assets in a retirement funds account. This will allow you to earn higher returns and experience rapid compounding.
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More Tax Lessons From the Target-Date Fund Settlement
Such tax-inefficient practices like those in Vanguard can greatly harm your investment portfolio. Christine Benz of Morningstar, an expert in retirement planning and personal finance, shares a similar opinion. She said, “By having to pull money out of your coffers to pay the tax bill, it leaves less in your portfolio to compound and grow.”
So far, Vanguard has remained mum about its innocence or guilt regarding the SEC’s allegations. An e-mailed statement by a spokesperson simply read, “Vanguard is committed to supporting the more than 50 million everyday investors and retirement savers who entrust us with their savings.” According to Morningstar, Vanguard maintained assets worth approximately $1.3 trillion as of December 2023.
Things To Look Out for in a Retirement Account
Asset allocation is a term that covers the investment strategy deployed in holding bonds, stocks, and similar financial assets in dedicated accounts. Such active investment management boosts your after-tax returns, shortens fund maturity, and makes risk management easier. If you are a high-income earner, it is highly recommended that you practice asset allocation. Doing this will prevent target-date funds from spilling over into a taxable account after the tax-advantaged retirement account exceeds annual contribution limits.
Hayden Adams is a Schwab Center for Financial Research director and an expert in financial planning. He has some advice for people looking to invest their assets in a retirement account. If you are a high-income earner or a retiree looking to invest in target-date funds, Adams recommends splitting your investment fund into multiple units as part of an asset allocation strategy.
For example, a retired couple with a $1.8 million portfolio could split it into $900k portions. They can then place one portion in a tax-advantaged account and the other in a taxable account. This portfolio rebalancing move will aid capital preservation on the total asset, as lesser amounts go to tax, and the overall investment compounds faster.
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Management of Tax-Inefficient Assets
If you are bent on holding tax-inefficient assets in your retirement accounts, we have some recommendations for advisable ones to go for. You are better off with these asset classes because tax events on them are fairly predictable. Common examples of such easy-to-manage assets are:
- Target-date funds
- Short-term holdings
- Real estate investment trusts
- Actively managed investment funds
- Bonds and bond funds
We have identified the risks of investing in a target-date fund without considering the modalities of the account type. You don’t get target-date fund settlements every day, so endeavor to ask questions of a financial planning expert before proceeding with such a capital preservation investment. In addition to the market volatility of bonds and equities, it is essential to ask for details about the investment’s fund maturity and risk management strategy.