Another Capital Gains Season to Forget for Vanguard’s Target-Date

During the winter holidays, many investors celebrate the season of giving by exchanging gifts with family and friends. Still, some may get an unexpected (and unwanted) gift from their mutual funds: a capital gains distribution. This year, those nearing retirement and using Vanguard’s target-date mutual fund will face a larger tax hit than usual. It comes on the heels of the firm agreeing to pay $40 million to settle a class-action lawsuit over capital gains that its target-date series distributed in 2021.

Most of the $3.8 trillion invested in target-date funds is in tax-advantaged accounts like 401(k)s or IRAs, so most people using one don’t have to worry about capital gains taxes. However, about half of Americans don’t have access to a retirement plan through their job, and IRA contribution limits are lower than those for workplace plans ($8,000 versus $30,500 for those 50 and older in 2024). This means some people might need to save for retirement in a taxable account. In that case, target-date funds are a good choice, but they aren’t designed to be tax-efficient. Instead, they aim to balance growing your money when retirement is far away and protecting it as it gets closer.

Vanguard Target Retirement series, which has a Morningstar Medalist Rating of Silver, is one of our top target-date picks. Its rock-bottom costs (0.08% for all investors) and straightforward approach to building the portfolio should help investors reach their retirement goals, regardless of the account it’s used in. But investors in taxable accounts should be prepared for capital gains distributions. This year’s tax bill for Vanguard target-date fund shareholders will be less concerning than the 2021 distributions. The 2021 distributions were unusually high due to a significant shift of money from the retail share class to the institutional share class after Vanguard lowered the investment minimum for cheaper shares. This year’s tax bill, albeit lower, may still feel like getting coal in their stocking for those nearing retirement. The exhibit below shows the last five years of capital gain distributions for Vanguard Target Retirement 2025 VTTVX.

A 4.29% capital gains distribution might not seem like much, especially when some funds are dishing out gains of more than 40%. But if you’re aiming to retire in 2025, your account balance should be near its apex, and 4% can result in a hefty tax bill. The next exhibit shows the impact the capital gains would have on a $1 million investment in Vanguard Target Retirement 2025, assuming the investor is in the highest tax bracket, the gains were long-term and taxed at 15%, and the distribution was reinvested in the portfolio after paying the taxes.

Under these assumptions, the capital gains distribution results in a tax bill of $6,435, and the balance drops from $1 million to $993,570 after the remaining distribution is reinvested. In addition to the forced tax bill, the balance is also lower, so positive returns from stocks and bonds will have a smaller impact on the total account balance.

The distributions don’t have to be reinvested. If a shareholder was planning on withdrawing 4% from the portfolio at the end of the year, they can take the distribution rather than manually making a withdrawal. But not having control over the timing or size of capital gains distributions with mutual funds can leave investors frustrated.

Although no target-date strategy is immune from capital gains distributions, Vanguard’s estimated capital gains distribution is higher than the previous year’s and higher than its largest competitors are expecting this year. The exhibit below shows the estimated capital gains distributions for the 2025 target-date funds of the five largest series this year.

Target-Date Capital Gains: The Causes

Target-date funds take in investors’ cash and invest it, usually in other mutual funds, and give them shares of the target-date fund in return. When target-date managers sell underlying holdings with embedded capital gains and can’t offset them with capital losses from other underlying holdings, they must distribute capital gains to the remaining shareholders.

Two of the most common reasons a target-date manager would sell shares of underlying funds are: Selling stock funds to buy bond funds as the retirement date nears and meeting investor redemptions. For series that use actively managed funds, instead of index funds, they may also receive capital gains distributions from the underlying funds that must be passed on. This is not the case for Vanguard’s Target Retirement series, but each of these factors can contribute to realizing capital gains that have to be distributed.

Target-date funds furthest from retirement tend to keep their allocations to stocks steady, and younger investors with a long time horizon give the funds a steady stream of new cash coming in. That helps explain why the funds furthest from retirement are expected to deliver much lower capital gains distributions, as shown below.

Target-date funds tend to lower the equity allocation more rapidly closer to retirement. The average target-date’s allocation to stocks goes from 63% 10 years from retirement to 53% five years from retirement before landing at 44% at the retirement date. The next exhibit shows how Vanguard’s glide path compares with the average target-date strategy 10 years from retirement through five years after.

Investors in 2025 target-date funds have also been cashing out as the retirement date approaches. For the year to date through October, investors have pulled a net $19.3 billion from 2025 target-date funds and approximately $6.7 billion from Vanguard Target Retirement 2025.

Investors pulling money out increases the chance of triggering capital gains distributions as shares have to be sold to meet those redemption requests, so Vanguard’s large size and, as a result, large outflows contribute to its distributions. After a long bull market for stocks, which markets have experienced over the last decade, there is a higher chance that those shares are being sold at a profit.

The sharp decline in the glide path near retirement paired with the expected outflows for investors approaching retirement, both structural features, suggest that this situation is more likely to happen again in the future.

Target-Dates Are Still Great

Target-date funds are a popular pick for a reason: They simplify investing by taking care of asset allocation, fund selection, rebalancing, and gradually dialing back risk as retirement approaches—all handled by professionals at a relatively low cost. For investors looking for a more hands-off option for saving for retirement, target-date funds—like Vanguard’s—are both easy to buy and smart to hold. Although the Vanguard Target Retirement series has higher expected capital gains than other series, it remains a solid choice for many investors, especially when held in tax-efficient accounts. Those holding it in a taxable account should be wary of potential distributions. Although Vanguard has faced more scrutiny after 2021, elevated levels in 2024 show this could be a potential concern for all retirement savers in taxable accounts.