Watch Out For Taxes On Vanguard Funds Capital Gains Distributions (2019)

The Secure Act is now law.  And like many other laws with neat-sounding, wholesome-as-apple-pie acronyms, remember the “Affordable Care Act” or the “Pension Protection Act” or the “Patriot Act” etc, the Secure Act will do nothing it promises. 

Apparently, the elites in D.C. believe the reason we have a “Retirement Crisis” is that Americans don’t have enough access to retirement accounts.  This is so silly it’s painful for me to even have to argue this. But here goes:

Only 8% of eligible Americans contribute to an IRA of ANY KIND according to Motley Fool’s look at IRS stats!   Now let’s say a bunch of those people who don’t contribute don’t do so because they’re retired, they’re fully maxing out their employer plans, etc.   That still leaves a whole lot of people who don’t contribute to IRAs and this is not because of a lack of access. Simply type in “Open an IRA” in Google and you will see there are ads on top of ads in the Search Engine Results Page (SERP). 

In fact, if you go to Neil Patel’s UberSuggest you will see that keyword phrase has a cost-per-click (CPC) of nearly $20! That means it costs advertisers nearly $20 for every time someone clicks on their ad.

Now, type in “Social Security” in UberSuggest and you will see the CPC is all of $.35.  Advertisers are willing to pay only 35 cents for a click, even though Social Security is one of the biggest financial keywords in the country.

For fun, type in “buy diapers”. Purchasing diapers online, believe it or not, has a huge contingency of buyers and thus firms competing for sales.  That keyword phrase only yields a CPC of $3.14.  

What does this tell you? Companies are desperate, DESPERATE!, for you to open an IRA. So desperate, in fact, they’ll pay huge fees to advertise their firm in Google and many, many other places. 

Yet, somehow we hear ‘lack of access’ is what’s driving the “retirement crisis”. Just silly.  

Secondly, we need the Secure Act because we are told the “Retirement Crisis” is due to people no longer having defined benefit plans, aka pensions, anymore.  As such, we are left to fend for ourselves with our retirement assets. Oh no! How could grown people possibly know what to do with their own money! We need to hire The Professionals to manage our assets for us! 

Yeah, no thanks. The Professionals track record is FAR from superior to the average Jane or Joe out there.  As Bill Buckley used to say, he’d rather be governed from the first 200 people in the Boston phonebook than all the PhDs at Harvard.  Indeed. Professional money management is certainly a great way to enrich the elite class at our expense. 

Oh, the doomsdayers will also say that without pensions we are not only at the mercy of our own inability to manage our own money but of market volatility too.  And, of course, the market can go crazy. We’ve seen it, time and again. 

So, what’s the solution? Annuities of course!  Since few of us have pensions anymore, the annuity is the next best thing.  Amirite? Or amirite?  And who benefits most from annuities being offered to employees in retirement plans? Insurance companies of course!  It’s like Ned Reyerson was able to convince Congress to give him access to more unsuspecting employees with his insurance pitch.  I can’t wait to watch this “fix” in action. 

Those are the benefits of the Secure Act; Increasing access and more professional management via insurance products.  

Wow. And to hear the media tout this new law you’d think there were major improvements.  Now that’s funny.

Oh, I hear you asking “But Josh, what about the increased age until RMDs are required? That’s a great thing, no?”

BWHAHAHA, have you not been paying attention, my tax-paying friend?  We want you to REDUCE your tax-deferred accounts as quickly as you feasibly can, not delay that!  The longer you wait, the MORE you’ll end up paying to the IRS. For one thing, you’ll have MORE, most likely, in which to withdraw.  

Secondly,  that increased RMD amount can throw your Social Security payments into a taxable situation. 

Thirdly, the more distributions you have from your IRAs the higher, potentially, your tax bracket could be, which could force not only Social Security to be taxable, but also your Long Term Capital Gains AND your Qualified Dividends.  (Man, if only someone wrote a book on this!) 

Fourthly, Heaven forbid you’re married and leave your surviving spouse a widow(er) with a large IRA balance.  Whooowweeee, the IRS is gonna love you!

Oh, and lastly, now the Secure Act removed the Stretch IRA, you certainly will do your kids no favors by leaving them IRA balances that you hoped they’d pay minimal taxes on.  No such luck. They MUST withdraw those accounts in the entirety within 10 years of receipt. And we lucked out there as the Senate bill was for five years! Let’s take our blessings when we can get them, I suppose.

And there, in a nutshell, my friends is the Secure Act. 

Great for Insurance Companies.  Great for the IRS. Not great for everyone else.  Just goes to show the power of the Lobbyists.

Don’t Pay This Tax!

Vanguard just released its preliminary capital gain distribution schedule for its funds.  As expected, in this LONG bull market, many of the actively managed funds will have large capital gains distributions. 

This means more tax for you if you hold these funds in a taxable account.

How You Pay Taxes on Mutual Funds

Mutual Funds hold dozens, even hundreds, of stocks or bonds in their portfolios. Sometimes, throughout the year, the manager will sell a stock or bond for a price higher than what he purchased it for. This results in a capital gain.

That capital gain is paid out the actual shareholders of the fund, typically in December. Those shareholders who receive the capital gain must pay tax on that distribution if the fund is held is held in a taxable account.   (If the fund is held in tax-qualified accounts such as an IRA or 401k you don’t pay tax on the capital gain distribution.)

So, even if you’ve never sold any shares of your fund, even if you are actually DOWN in value on YOUR investment in the fund, you will still have a taxable distribution because of those capital gains 

Let me give you an example. 

You buy fund ABCDE for $100,000 in 2017.  At the year end of 2019, the value has dropped to $98,000.  You are down $2,000. Well that stinks. But that’s the nature of investing in mutual funds, right?

But then, in January 2020, you receive a 1099 showing the fund paid out a Capital Gain distribution of 5% of its assets in December 2019.  This means YOU will have to pay tax on that $5,000 capital gain, even though you are down in the portfolio!

“Wha, wha, what???? How the heck does this happen?” You ask. It’s simple really. If the fund has been around for any period of time, it’s got some serious UNREALIZED CAPITAL GAINS built up in it.  

Unrealized Gains on Capital Opportunity fund

The image above shows the Vanguard Capital Opportunity Fund has nearly $10.5 BILLION of unrealized gains! And that is as of Sept. 2018, wait until the new annual report comes out given the huge market gains in 2019. The amount of unrealized gains will probably grow another 10-15%. 

SOMEONE has to pay tax on those gains when they are realized, i.e., when the fund managers decide to sell a position that has increased in value relative to the price they paid for it.  That someone is YOU, the fund shareholder. And you’ll pay tax on that capital gain regardless if your individual holding is up, down or sideways. 

I can’t even begin to tell you how many times people have complained to me that they have to pay tax on their mutual funds even though they are down on the total balance of their account.  Welcome to the double taxation of Mutual Funds. Fun, isn’t it? 

Of course not.  But being ignorant of the tax treatment of mutual funds doesn’t absolve you of having to pay the tax.  So, best be forewarned

Vanguard Capital Opportunity Fund (VHCAX, VHCOX)

This fund, run by the folks who run the highly-regarded PrimeCap fund, will pay 5.58% of its portfolio as taxable capital gain distributions.  This means for every $10,000 you own you’ll receive a taxable distribution of $558.  

Now, don’t think you’re out of the woods just yet, either. 

Last year this fund had a dividend distribution of .93% of the Net Asset Value.  Thus if you owned $10,000 in the fund you’d have to add another $93 to your taxable distribution as a dividend. 

In fact,  last year your total distributions were more than 12% of the portfolio value:

That means on that $10.000 position you owned in Capital Opportunity you’d receive total taxable distribution of $1,200!

Vanguard Diversified Equity Fund (VDEQX)

This fund-of-funds, in that it invests in other Vanguard actively managed funds, will pay out 6.71% of its assets  by year end. That means for every $10,000 you own, you’ll receive a taxable distribution of $671. And that is just the capital gains alone.  Last year it ALSO paid dividend distributions of around 1.25%. 

Vanguard Health Care Fund (VGHAX, VGHCX)

A perpetual rock star of Vanguard’s funds, run by the good folks at Wellington, this fund will pay out 6.82% of its assets by year end.  Oh, but the good times don’t end there. It also paid 4.15% back in March as a Supplemental distribution to shareholders. Thus, all told, investors will receive over 11% in 2019 as taxable distributions. 

Don’t forget the dividend too.  Last year it paid out $2.18 per share. 

Vanguard Mid-Cap Growth (VMGRX)

Whooooweee!  This fund is going to pay out 11.14% of its assets as taxable capital gain distributions.  That is on top of the nearly 14% it paid out last year. This fund is generating some serious taxable distributions.  Thankfully, it only has a dividend yield of .33%. So the dividend won’t add much to your taxable distributions.

Vanguard Primecap (VPMCX)

Another of Vanguard’s actively managed rock stars.  This fund will pay out just under 6% of its total assets in taxable capital gain distributions. So, for every $10,000 you own, you’ll have to declare $580 as taxable capital gain income 

Add another 1.26% for the dividend and you’re looking at over a 7% taxable distribution.

Scary thing about this fund is that 55% of the portfolio is unrealized gains.  That means unless we hit a serious market skid, this fund will continue to pay heavy distributions for as far as the eye can see.   

Nothing wrong with that of course. Taxes means you made money, right?  Well, not in the wonderful world of mutual funds as I mentioned at the beginning of this blog post. 

Vanguard Selected Value (VASVX)

I’m not familiar with this fund, or its management team.  But familiarity is irrelevant if you own this fund as you’ll still get hit with a 6.06% capital gain distribution. 

Throw in the 1.65% dividend yield and you’re coming up on nearly an 8% total taxable distribution.

Vanguard Windsor (VWNEX)

Another of the stellar line up of Wellington funds, Windsor has been around a LONG time. RIP to its long serving manager John Neff who died this year.

This fund will pay out 8.37% of its asset base as capital gains.  Add in the 2.09% dividend yield, you’ll receive around 10.50% taxable distributions!  YIKES!

Vanguard Windsor II (VWNAX) 

Another of the Vanguard stalwarts, though this actively managed fund is not run by the Wellington team.  Windsor II will pay out 8.17% in capital gains distributions come December. Add to that nearly a 2% dividend yield, and you’re looking at taxable income of $1,000 per every $10,000 you own in this fund. 

Where are the Index Funds?

Notice anything missing from this list?  Yes, indeed, there are no index funds paying out capital gains distributions.  Why is that? Well, apparently Vanguard has a patent to avoid these yearly taxable annoyances.  As if you needed another reason to invest in index funds or Vanguard…

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