Understanding the Tax Implications of Target-Date Funds

As is the case with any investment, individuals need to be mindful of how transaction activity – both by them and the target-date fund – can affect the size of the tax bill that ends up in the government’s pockets in any given year. In this article, we’ll explore this aspect of the target-date funds.

Target-date funds, and mutual funds in general, are required to distribute net realized capital gains and dividends to its shareholders on an annual basis. Fund managers often attempt to realize capital losses at certain points throughout the year in order to offset capital gains, thereby minimizing the tax burden for fund shareholders.

At this point, you should become familiar with the pros and cons of target-date funds.

Net capital gains are grouped into one of two buckets: long term (securities held longer than one year) or short term (held less than one year). The two groups are taxed at the appropriate rate regardless of how long a shareholder has owned the fund. Dividends, accumulated and distributed to shareholders throughout the year, are taxed at an individual’s ordinary income tax rate. You may also want to be aware of general tips on how to save taxes on mutual funds.

Target-date funds work in a similar fashion, wherein they distribute the capital gains and dividends of their underlying fund holdings.

Target-date funds tend to be more tax efficient, in general, because they often use index funds to achieve their target allocations. Index funds are passively managed, tend to do little trading throughout the year and typically generate few capital gain distributions.

The Vanguard Target Retirement 2050 (VFIFX), for example, has made small capital gains distributions in several years since its inception in 2006, often amounting to just a couple pennies per share or less. While target-date funds usually aim to be tax efficient, capital gains distributions are not uncommon.

Since many target-date funds own international stocks and bonds as part of their portfolio, the foreign tax credit may come into play. This credit is intended to reduce the burden of income taxed both in the U.S. and abroad. The 1099-DIV form details any foreign tax paid as part of the fund’s distributions. Qualified dividends – dividends issued by corporations that potentially qualify for the lower long-term capital gains rate – also show up on the 1099-DIV form. The foreign tax credit can be claimed on an individual’s tax return.

Another tax consideration concerns the target-date fund’s glide path, the process in which the fund reallocates its assets as the fund approaches its target date. Target-date funds become progressively more conservative over time, so they’ll need to sell stocks and purchase bonds periodically. This has the potential of generating a taxable capital gain distribution.

To learn more about the glide path of these funds, read how target-date funds work.

While the target-date fund itself makes distributions that affect the shareholder’s tax situation, an individual’s buying and selling of funds also creates taxable events. Fund managers often try to harvest tax losses in order to minimize shareholder tax burden, but individuals can do the same thing. If the value of an account is below its cost basis, investors can sell their shares and claim a capital loss for tax purposes.

Wash sale rules prohibit claiming the loss if shares are repurchased within 31 days of the sale, but claiming capital losses when available can be a great way of minimizing one’s tax burden.

Given how confusing it can be to manage investments in a tax-efficient manner, it’s critically important to maintain clean and detailed tax records for all accounts. Many companies now provide cost basis statements to assist in the tax filing process, but you should always consult a qualified accountant or tax advisor if you don’t feel comfortable.

Several investors assume that money earmarked for retirement is better off in an IRA, 401(k) or some other tax-advantaged account, but that’s not always the case. An individual’s tax rate and how long they plan on staying invested are key in determining what type of account in which the investment should be made.

Target-date funds in a taxable account generally become less tax efficient as the target date approaches. This is due to the increased allocation to bonds that produce more and more income on a regular basis. Target-date funds with high allocations to equities tend to be more tax-efficient (few capital gains and dividend distributions) making them more suited for taxable accounts. Target-date funds with high allocations to fixed income tend to be less tax-efficient (high dividend distributions) and are likely better off in a tax-advantaged account.

Target-date funds with significant allocations to actively managed funds may be tax-inefficient due to the potential for higher capital gains distributions and, thus, may be better off in a tax-advantaged account.

Target-date funds make ideal choices for just about any investor’s portfolio, but it’s always wise to understand the tax implications that can arise with any investment. Individual circumstances will affect how the fund should be managed and where it should be held.

Understanding how these factors affect your investments will help you to get the most out of them.

Be sure to follow our Target-date Funds section to make the right investment decision.