Is This Another Reason to Beware Target-Date Funds?

Target-date funds are designed to lower your investment risk as you age, giving you one less thing to worry about in life.

As your target retirement date nears, the fund asset allocation automatically changes such that lower-risk investments like bonds comprise an increasingly larger portion of the fund while higher-risk investments like stocks comprise an increasingly smaller portion.

But some investors are getting a big and unhappy tax surprise from at least one fund company that offers target-date funds.

The Wall Street Journal reports that some investors who keep Vanguard Group target-date funds in a taxable account received a rude shock in December upon learning they were on the hook for a major tax bill.

Vanguard paid out large capital-gains distributions to those holding its target-date funds — 15% of total assets in the Target Retirement 2035 and Target Retirement 2040 funds, for example. As a result, many investors now find themselves owing a substantial amount to Uncle Sam and their state government.

How substantial? The WSJ picks up the story of someone who goes by the username “Sitting-Hawk” on Bogleheads.org, an online forum popular with many Vanguard investors:

“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??”

WSJ columnist Jason Zweig — who broke the story about Sitting-Hawk’s unhappy fate — talked to the investor, who asked that his real name not be revealed. Zweig learned that Sitting-Hawk chose target-date funds because he was looking for an investment where he could “set it and forget it” and avoid constantly trading.

In exchange for convenience, Sitting-Hawk ended up with a huge tax bill. As he lamented to Zweig: “It sucks that this had to happen.”

Although few Vanguard investors are likely to owe as much as Sitting-Hawk, many invested in target-date funds still likely now owe more in taxes for 2021 than they had been expecting.

Fortunately, there is a way for investors to avoid this type of tax nightmare. By keeping target-date funds in a tax-advantaged account — such as 401(k) or IRA — you steer clear of having to pay taxes annually based on a mutual fund’s capital gains distribution.

If you put target-date funds in a traditional retirement account, for example, you will not owe taxes on the gains until you start withdrawing from the account in retirement. If you use a Roth account, you will never owe taxes on the gains — a big part of the beauty of Roths.

If Sitting-Hawk’s portfolio — all $3.6 million of it — had been sitting in one of these retirement accounts, his 2021 tax bill for the $550,000 capital gains distribution would have dropped from more than $150,000 to $0.

Another solution would be to avoid target-date funds altogether and to choose a tax-friendlier alternative, such as an index fund that passively tracks a stock market index. As we have noted before, target-date funds are far from perfect. To learn more, check out “This Wildly Popular Investment Has 2 Costly Flaws.”

Finally, it is important to remember that while Money Talks News is a place for you to educate yourself about money, we do not provide financial advice. As with any investment, target-date funds have their pros and cons.

If you are uncertain about whether they are the right investment for you, stop by our Solutions Center and find a great financial adviser.