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I read (mirror without paywall) that the fact that Vanguard converted many investor shares to institutional shares for their target date retirement funds in September 2021 created a huge capital gain distribution for investors owning investor shares (~15% of the asset value were capital gain distributions, which caused painful tax bills amongst individual investors). Why does such an event create a capital gain distribution?

2 Answers 2

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You need to quote from the document.

At the end of 2020, Vanguard reduced the minimum investment in its institutional Target Retirement funds to $5 million from $100 million. That set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the institutional equivalents. (Clients have to sell out of one format to buy the other.)

So investors in the 5 million to 100 million range switched from the regular version of the fund to the cheaper institutional version of the fund.

As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around. Some had made the mistake of owning these funds in taxable accounts.

When items inside a fund are sold there can be taxes involved.

Spokeswoman ...said that because the Target Retirement approach seeks to reduce risk over time by automatically trimming stock positions, “these funds are best served in a tax-deferred account.”

If the money was in a 401(k) or IRA or529 or HSA this would not even been noticed by most investors. But if the investor held the funds outside a tax deferred or tax free fund they will get hit with federal and state taxes.

If you had a ton of money in these funds you were caught off guard. You received notice when you saw the bug capital gains distribution in December. Now you have to pay the taxman by April.

Vanguard’s Target Retirement 2035 and Target Retirement 2040 funds, for example, distributed approximately 15% of their total assets as capital gains—which are taxable outside of retirement accounts.

Ouch.

said he received about $550,000 in distributions in Vanguard’s Target Retirement 2035 fund. So he owes 23.8% in federal tax and 4.95% in Illinois state tax—all told, more than $150,000. “HOW,” he asked in capital letters, “COULD VANGUARD LET THIS HAPPEN??”

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  • Thanks. "As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around" -> why do capital gains affect the remaining investors and not the investors who left to the other fund? Jan 22 at 17:44
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    @FranckDernoncourt the investors who left before the assets were sold didn't have a share of the realised gain.
    – Caleth
    Jan 22 at 21:25
  • @Caleth Thanks, I wrote an answer, is it correct? Also, do you confirm that both the corporations with a retirement plans between 5M USD and 100M USD and the small individuals pay cap gain taxes? If so, aren't those cap gain double taxed? Jan 23 at 0:50
  • @FranckDernoncourt corporations don't pay taxes. The cap gain distributions go to plan members (employees). But since they're qualified plans, they're tax-deferred, and are not affected.
    – littleadv
    Jan 23 at 1:01
  • @littleadv thanks, I see. Had those not being qualified plans, would there have been a double taxation? Jan 23 at 1:08
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Based on mhoran_psprep's answer and  Caleth's comment, here's a timelime of what happened, using fictitious dates:

Date Event
2021-11-01 As a result of a Vanguard policy change, corporate retirement plans between 5M USD and 100M USD got out of the standard target funds and into the institutional equivalents.
2021-11-10 Vanguard sell the underlying asset to account for it. This sale create capital gains.
2021-11-12 The capital gains are distributed to the "small investors" who still own shares of the standard target funds.
2022-04-17 Taxes must be paid by the "small investors" on these capital gain distributions

The blog post https://www.mymoneyblog.com/vanguard-target-retirement-funds-nav-drop-cap-gains-distribution.html contains more details on it and has a screenshot showing the capital gain distributions:

enter image description here

enter image description here

Other social network posts on it:

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  • This just doesn't really answer the question. @mhoran_psprep's answer explained what happened and why, and this really doesn't explain anything. The tables showing dividend amounts don't explain how it happened or why.
    – nobody
    Jan 25 at 2:01
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    @nobody this answer is mostly to show the timelime of what happened (see the first table)\. Jan 25 at 4:02

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