Personal finance

Vanguard created big tax bills for target-date fund investors, lawsuit claims

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Vanguard Group and its executives created big tax bills for some investors in its target-date funds, amounting to hundreds of millions of dollars in aggregate, according to a lawsuit filed Monday.

The lawsuit, filed in a Pennsylvania federal court by three investors, claims the investment manager triggered an “elephant stampede” selloff in its TDFs.

The selloff ultimately led to “enormous” tax bills in 2021 for people who owned the funds in a taxable brokerage account, instead of a tax-advantaged one like a 401(k) plan or individual retirement account, the lawsuit alleges.

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Vanguard, as well as executives and fund trustees, therefore violated their legal duties to investors, the lawsuit claims.

The plaintiffs — Valerie M. Verduce, Catherine Day and Anthony Pollock — seek compensation for the alleged harm on behalf of a class of similarly situated investors nationwide.

A Vanguard spokesperson declined to comment on the lawsuit.

Fees and asset location

The heart of the legal claim stems from two types of target-date mutual funds Vanguard makes available to retail and 401(k) plan investors.

TDFs are funds that designed to get more conservative over time as investors get closer to their estimated retirement age.

The lawsuit also concerns “asset location,” a financial-planning principle whereby certain types of investments are better held in tax-advantaged accounts to avoid surprise tax bills.

The two Vanguard Target Retirement Fund suites had the same investment strategy. But investors needed at least $100 million to access the lowest-cost version of the mutual funds before December 2020. That month, Vanguard reduced the threshold to $5 million — fueling an exodus from the higher-cost version.

That flight of money caused Vanguard to sell as much as 15% of the assets in the higher-cost retail funds, according to the lawsuit. Vanguard needed to sell fund assets to raise cash to redeem shares for investors, the suit claims.

Generally, when a mutual fund sells its assets for a profit, it results in a distribution of capital gains to the fund’s shareholders. Investors who own the funds in taxable accounts pay taxes on those capital gains; conversely, those who own them in 401(k) plans, individual retirement accounts and other tax-advantaged accounts can reinvest the gains without a tax bill.

In this case, investors in the higher-cost funds got distributions at least 40 times larger than previous years, according to the lawsuit. The plaintiffs incurred estimated 2021 tax bills ranging from roughly $9,000 to $36,000, they claim.

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