My Money Blog

Vanguard Target Retirement Funds are a huge series of “all-in-one” mutual funds, now with over $1 trillion in total assets. I don’t hold them myself, but I have advised my parents to invest their IRAs in them. I appreciate that they are low-cost, diversified, and rebalanced automatically to maintain a reasonable asset allocation, meaning that I don’t have to actively monitor them myself.

However, due to a mix of factors, it is important to know that these Target Retirement 20XX funds tend to make larger capital gains distributions than an equivalent mix of index ETFs. This can cause unexpected tax bills, especially for those with large balances and near retirement. Inside a 401k or IRA, none of this matters. But you should avoid owning them in a taxable brokerage account unless you accept these disadvantages as a price of their ease of ownership.

Back in 2021, these made large capital gains distributions due to a mishandling of mutual fund expense changes by Vanguard. Vanguard eventually had to settle a class action lawsuit for $40 million. This 2022 Morningstar article has more details: Lessons From Vanguard Target-Date’s Capital Gains Surprise.

The Vanguard Target Retirement 2025 and 2020 funds again announced a higher capital gains distribution amount than its peer funds in its 2024 estimate report. The 2025 TDFs for American Funds, Fidelity, and T. Rowe Price were all in the 0.53% to 2.10% range, and American Funds are actively-managed! The Fidelity Freedom Index 2025 Funds only distributed 0.53%.

Assuming a $1 million balance in Vanguard Target Retirement 2025, the 4.29% capital gains distribution would work out to $42,900 in additional, likely unexpected income. At a long-term gains rate of 15%, that’s a tax bill of $6,435.

This could all happen again and again. Why? For one, Vanguard’s steeper glide path at this age period means they are selling stocks for bonds faster than other funds. Second, folks have been selling their shares, either because they need the money for retirement expenses or because they are part of the larger trend of selling to switch to ETFs. Either way, these two things are expected to continue in the foreseeable future.

ETFs have inherent structural advantages over mutual funds that help them to avoid creating capital gains. I suspect that it is only a matter of time before Vanguard introduces a line of Target Retirement ETFs, which would be able to minimize capital gains distributions. Of course, that could mean even more people selling their Target Retirement Mutual Funds if they can’t figure out how to make converting a non-taxable event, which would result in even more capital gains distributions! I’m not saying this would happen for sure, but it is a possibility that may create a spiral of increasing capital agains.

The actionable move here is to avoid buying into the Target Retirement Funds in a taxable account right now. If you are a younger investor, a Target Retirement Fund is 90% stocks anyway, essentially split into 60% VTI (Total US Stock) and 40% VXUS (Total International Stock). I’d just buy those two core building-block ETFs if you manage to have extra money to invest after 401k/403b/457/TSP and IRAs. If you wanted to be more exact, you could buy 55% VTI, 35% VXUS, and 10% BND.