Understanding the Tax Implications of Target-Date Funds
David Dierking Jan 06, 2017
Taxation of Mutual Funds
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.
Factors That Affect Target-Date Fund Taxation
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.
Investor Actions That Might Impact Taxation of Target-Date Funds
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.
Allocation in Taxable or Tax-Advantaged Account?
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.
The Bottom Line
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.
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