Target Date Retirement Fund in Taxable Account - Bad Idea?

[AllTheStocks]

I retired 2 years ago at the age of 43.

When I was working my investment strategy was to first max out our 401ks buying index based target date funds and then invest any extra money in VTTHX in a taxable account.  I followed this simple strategy for 11 years and it has worked out well in terms of investment growth while being very simple to implement while I was working a super busy job.

But it looks like the capital gains that are generated within the fund and paid out at the end of December are unpredictable and can vary widely.  In prior years the capital gain plus dividend combined were around the 2 to 2.5% range.  This capital gain and dividend represents  the majority of my income.  This year the realized  capital gain is estimated to be 14.38%, many times higher than what it has been in recent years. 

The VTTHX holding is worth about $5,800,000, which means the expected capital gain of 14.38% will be $834,000 and with dividends added it will be more than $900,000, much more than the $140,000 or so of income that I was expecting!  The tax bill is going to be high this year.

I'm wondering what to do about this.  Selling all of my VTTHX now before the end of December payout  could allow me to switch to something different but it would be an expensive move because there are $1,800,000 in unrealized capital gains.  Or I could keep VTTHX but reduce my holdings in it over time by reinvesting the capital gains and dividends in VTSAX, then buy more bonds in a 401k account to get my total allocation to about 75/25.

Any advice on how to handle this situation would be much appreciated!  I may also do a consultation with Vanguards personal advisor service to get some advice from them on this.

[seattlecyclone]

That is a surprisingly high capital gains distribution for a Vanguard fund. They're usually pretty good at keeping those things under control. I'm reminded of a thread from a few years back about the risk of "embedded gains" in Vanguard funds potentially resulting in large capital gains distributions if there's ever a large net outflow of cash from the fund. They seem to have a process for minimizing this risk in many of their funds by moving older lower-basis shares into the ETF share class when those are created, but the target date funds don't have ETF equivalents to my knowledge.

I do see from the annual report that about $10 billion (net) exited the fund in the fiscal year from people selling their shares, leaving $37 billion still invested. Not too shocking that if they have to liquidate shares representing over a quarter of the current fund value that they might have to realize gains in the 14% range. I wonder why so many people sold out this year. I see similar outflows from the 2020, 2025, and 2030 funds in that report.

What do do about it now? If you'll be getting a $900k distributed from capital gains and dividends, that will cut your unrealized gain in half. Since you've been buying in for years, you surely have some older shares that have increased in value by quite a lot, and other newer shares that have not had time to go up that much. Cut the value down by 15% overnight and these newer shares might be underwater. Log in on New Year's Eve after the distributions are made and perhaps you'll be able to realize some capital losses to offset part of the gain distribution. You could then reinvest that cash in an ETF that won't pay capital gains distributions.

[AllTheStocks]

What do do about it now? If you'll be getting a $900k distributed from capital gains and dividends, that will cut your unrealized gain in half. Since you've been buying in for years, you surely have some older shares that have increased in value by quite a lot, and other newer shares that have not had time to go up that much. Cut the value down by 15% overnight and these newer shares might be underwater. Log in on New Year's Eve after the distributions are made and perhaps you'll be able to realize some capital losses to offset part of the gain distribution. You could then reinvest that cash in an ETF that won't pay capital gains distributions.

This is a good idea, thanks!  Based on current estimates and prices it looks like I will probably be able to sell some shares at a capital loss of about $8,000 to cancel out some of my capital gains.  It's not much savings percentage-wise but it will help and allow me to reduce the investment in VTTHX a bit more.  I've switched the cost basis method to SpecID  so that I can choose which shares to sell on New Years Eve.

Longer-term, I'll look for more ways to reduce my holdings in VTTHX in my taxable account.  Future dividends and capital gain payouts will be redirected to a more tax-efficient fund.  And if the market should drop sharply I'll look for opportunities to sell more of VTTHX.   

[SweatingInAR]

Congratulations on your massively successful savings and investments!

Future dividends and capital gain payouts will be redirected to a more tax-efficient fund. 

Definitely! Turning off reinvesting dividends and capital gains will keep this "problem" from getting bigger each year.

And if the market should drop sharply I'll look for opportunities to sell more of VTTHX.

Be careful with this one... If you sell VTTHX low and buy a similar fund that dropped the same or more, great! Selling low and buying some other asset class, or sitting on the money, is worse than just paying taxes on the gains now.


Consider charitable donations, or opening a Donor Advised Fund if you intend on donating your excess money in the end anyway.

[DaTrill]

ETFs in taxable accounts.