Taxes and Mutual Funds


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Taxes and Mutual Funds

  1. 1. Taxes and Mutual Funds How taxes can affect your investments ® plain talk
  2. 2. Why Plain Talk? At The Vanguard Group—a leading proponent of investor education in the mutual fund industry—we believe that knowledge is one of the keys to investment success. To that end, we have developed our Plain Talk Library, a series of candid, concise, and easy-to-understand publications on a wide variety of investment topics. To request a free copy of any of these brochures, call us at 1-800-662-7447 on business days from 8 a.m. to 10 p.m. and on Saturdays from 9 a.m. to 4 p.m., Eastern time. You can also read or order them online at We hope you find the information in the Plain Talk Library helpful as you chart your investment course with us. s Mutual Fund Basics s The Vanguard Investment Planner s Women and Investing s Financing College s Preparing to Retire s Investing During Retirement s Estate Planning Basics s How to Select a Financial Adviser s Measuring Mutual Fund Performance s Bear Markets s Bond Fund Investing s Index Investing s International Investing s Taxes and Mutual Funds s Dollar-Cost Averaging s Why Vanguard?
  3. 3. Taxes and Mutual Funds T axes are an important consideration for investors. Unless you pay careful attention to the tax implications of your mutual fund investments, taxes can sharply reduce the earnings you are actually able to keep. Fortunately, you don’t need an accounting or law degree to understand the basics of taxes and mutual funds. This Plain Talk brochure explains how mutual fund investments are taxed. The focus is on mutual funds in taxable accounts, but we will also note how you can delay or even completely avoid taxes by using tax-deferred or tax-exempt accounts. Though this brochure is not meant to serve as a complete guide for all tax questions, it can help you make sound investment decisions, choose funds that are appropriate for you, and minimize the impact of taxes on your investment returns. Note that a glossary appears at the back of this brochure. Terms that may be new to readers are printed in blue (for example, cost basis) the first time they occur.
  4. 4. Contents How Your Mutual Fund Investments Are Taxed ....................................... 1 How a Fund’s Investment Strategy Can Affect Taxes ............................... 8 Calculating and Reporting Your Taxes ...................................................... 12 The Impact of Taxes on Your Investment Returns .................................... 17 What to Do About Taxes ........................................................................... 19 Tax-Efficient Vanguard Funds ................................................................... 24 Vanguard’s Tax Information Services ........................................................ 26 A Vanguard Invitation ............................................................................... 28 Glossary .................................................................................................... 30
  5. 5. H OW Y O U R M U T UA L F U N D I N V ES T M EN T S A RE TAX ED Since your goal as an investor should be to keep as much as possible of what you earn from mutual fund investments, you can’t look past the inescapable reality that taxes take a big bite out of bottom-line returns. As a mutual fund investor, you can incur income taxes in three ways: when the fund distributes income dividends, when the fund distributes capital gains from the sale of securities, and when you sell or exchange fund shares at a profit. First we’ll explain how a fund’s earnings are taxed—then we’ll show how your sales or exchanges of shares can trigger taxes. Owning shares and paying taxes A mutual fund is not taxed on the income or profits it earns on its investments as long as it passes those earnings along to shareholders. The shareholders, in turn, pay any taxes due. Two common types of distributions that mutual funds make are income distributions and capital gains distributions. s Income distributions represent all interest and dividend income earned by securities—whether cash investments, bonds, or stocks—after the fund’s operating expenses are subtracted. s Capital gains distributions represent the profit a fund makes when it sells securities. When a fund makes such a profit, a capital gain is realized. When a fund sells securities at a price lower than it paid, it realizes a capital loss. If total capital gains exceed total capital losses, the fund has net realized capital gains, which are distributed to fund shareholders. Net realized capital losses are not passed through to shareholders but are retained by the fund and may be used to offset future capital gains. 1
  6. 6. Occasionally distributions from mutual funds may include a return of capital. Returns of capital are not taxed (unless they exceed your original cost basis) because they are considered a portion of your original investment being returned to you. Generally, income dividend and capital gains distributions are subject to federal income taxes (and often state and local taxes as well). You must pay taxes on distributions regardless of whether you receive them in cash or reinvest them in additional shares. The exceptions to the general rule are: s U.S. Treasury securities, whose interest income is exempt from state income taxes. s Municipal bond funds, whose interest income is exempt from federal income tax and may be exempt from state taxes as well. However, any capital gains on U.S. Treasury securities or municipal bond funds are generally taxable. While the amount of income and capital gains you receive from a mutual fund affects the taxes you pay, another important factor is the holding period—that is, how long the fund held the securities before they were sold. Securities held for one year or less before being sold are categorized as short-term capital gains (or losses). Short-term capital gains are taxed at your ordinary income tax rate, as shown in Figure 1. But long-term capital gains—gains on Figure 1 Federal Income Tax Rates Rates applied to taxable income in 2001 15% 28% 31% 36% 39.6% Single Up to $ 27,051 to $ 65,551 to $136,751 to $297,351 $27,050 $ 65,550 $136,750 $297,350 and up Married, Up to $ 45,201 to $109,251 to $166,501 to $297,351 Filing Jointly $45,200 $109,250 $166,500 $297,350 and up Married, Up to $ 22,601 to $ 54,626 to $ 83,251 to $148,676 Filing Separately $22,600 $ 54,625 $ 83,250 $148,675 and up Note: Income brackets are adjusted annually for inflation. Source: Internal Revenue Service. 2
  7. 7. New tax rates on certain capital gains Federal income tax rates have been reduced on certain capital gains known as “qualified five-year gains.” s For taxpayers in the 15% bracket, the tax rate on capital gains from the sale of assets that have been held longer than five years has dropped from 10% to 8%. Tax rates on capital gains from the sale of assets held five years or less are unchanged. s For taxpayers in the higher brackets (28%, 31%, 36%, and 39.6%), the tax rate on capital gains from the sale of assets purchased after January 1, 2001, and held longer than five years (that is, the assets are not sold until 2006 or later) has dropped from 20% to 18%. Tax rates on capital gains from the sale of assets held five years or less are unchanged. Taxpayers in the higher brackets (28% or higher) can make assets they own eligible for the 18% rate (rather than the 20% rate) in 2006 or later by treating those assets as having been sold and reacquired at their closing prices on January 2, 2001. By “marking assets to market” in this way, a taxpayer can recognize capital gains (but not losses). The gains as of January 2 are taxed currently at the old rate of 20% (or a higher rate if it’s a short-term gain) and must be reported to the IRS in a letter filed with the investor’s tax return for the tax year that includes January 1, 2001. If the asset is then sold in 2006 or later, increases in the value of that asset are taxed at the 18% rate. Example: An investor bought 100 shares of a company for $1,000, or $10 a share, in 1996. On January 2, 2001, the shares closed at $20 each. The investor marks them to market and pays a 20% tax on her $1,000 profit—a total of $200 in tax. In 2006, she sells the shares for $3,000, or $30 a share, so she has a five-year gain of another $1,000 that is taxable at 18% ($180). Her total tax bill is $380—$200 paid in 2001 and $180 paid in 2006. If she had not marked the shares to market, her total tax bill would have been $400 in 2006—so she saved $20. However, the $200 paid in taxes in 2001 could have been invested from 2001 to 2006, possibly earning more than $20. We recommend that you consult a tax or financial adviser about whether marking to market would be beneficial in your individual situation. Be sure to consider state and local income taxes in making your decision. 3
  8. 8. securities the fund held for longer than one year before being sold— are taxed at a maximum rate of 20%. (The long-term capital gains rate is a maximum rate of 10% for taxpayers in the lowest income tax bracket.) Your mutual fund will tell you the category of any capital gains it distributes. This is determined by how long the fund held the securities it sold, not by how long you have owned your shares. For example, say you first bought shares in a fund last month and today the fund is making a capital gains distribution as a result of selling securities it owned for five years. That distribution is a long-term capital gain because the fund’s holding period was longer than one year. On the other hand, say you bought shares in a mutual fund ten years ago. The fund makes a capital gains distribution because it sold securities it had held for six months. That distribution is a short-term capital gain for you because the fund’s holding period was less than one year. These are key distinctions simply because not all investment income is treated equally. Income (such as interest and dividends) and short- term capital gains are taxed as ordinary income at your marginal tax rate (which can range from 15% to 39.6%, as shown in Figure 1 on page 2). Net capital gains on securities held longer than one year are taxed at a maximum rate of 20% (a maximum rate of 10% for taxpayers in the lowest tax bracket). Internal Revenue Service Form 1099-DIV, which your mutual fund usually sends in January for the previous tax year, details fund distributions you must report on your federal income tax return, including both income distributions and capital gains distributions from your funds. You won’t receive a Form 1099-DIV for mutual funds that distribute tax-exempt interest dividends (such as municipal bond funds) or for funds on which you earned less than $10 in dividends. (However, you still owe taxes on all taxable distributions, regardless of their size.) For more information, see Calculating and Reporting Your Taxes on page 12. 4
  9. 9. Taxes on sales or exchanges of shares You can trigger capital gains taxes on mutual fund investments by selling some or all of your shares at a profit, or by exchanging shares of one fund for shares of another. The length of time you hold shares and your tax bracket determine the tax rate on any gain. Three important notes: s All capital gains from your sale of mutual fund shares are taxable, even those from the sale of shares of a tax-exempt fund. s Exchanging shares between funds is considered a sale, which may lead to capital gains. (An exchange involves selling shares of one fund to buy shares in another.) s Writing a check against an investment in a mutual fund with a fluctuating share price (all funds except money market funds) also triggers a sale of shares and may expose you to tax on any resulting capital gains. Timing affects your taxes Here’s an example of how timing may affect taxes on the sale of mutual fund shares: If you buy 100 shares of mutual fund ABC for $20 a share and sell them six months later for $22 a share, you owe taxes on your $200 short- term capital gain. If you’re in the 31% marginal tax bracket, that’s $62. However, if you hold on to the shares for more than 12 months after the original purchase, your profit is considered a long-term gain. Therefore, it is taxed at a maximum capital gains rate of 20% (for a maximum total tax of $40 on the $200 capital gain). Real-life calculations often aren’t so tidy, especially for investors who buy mutual fund shares at different times and at different prices. In Calculating and Reporting Your Taxes (pages 12–16), we’ll explain how to figure gains or losses on sales of mutual fund shares. 5
  10. 10. Don’t buy a tax bill with your fund shares The tax owed on mutual fund investments may also depend in part on when you buy the shares. Mutual fund distributions, whether from income dividends or capital gains, are taxed in the year they are made. However, under certain circumstances, distributions declared during the last three months of a year and paid the following January are taxable in the year they were declared. If you hold shares in mutual funds that declare dividends daily —such as money market and bond funds—you are entitled to a dividend for each day you own shares in the fund. For other funds, such as stock and balanced funds, dividend and capital gains distributions are not declared daily but according to a regular schedule (monthly, quarterly, semiannually, or annually). When a mutual fund makes a distribution, its share price (or net asset value) falls by the amount of the distribution. For example, let’s say you own 1,000 shares of Fund X worth $10,000, or $10 a share. The fund distributes $1 a share in capital gains, so its share price drops to $9 a share on the fund’s reinvestment date (not counting market activity). You’ll still have $10,000 (1,000 x $9 = $9,000, plus the $1,000 distribution). But you’ll owe tax on the $1,000 distribution, even if you reinvest it to buy more shares. So when considering a purchase of fund shares, ask the fund company about the fund’s next distribution—when it will take place and how large it is expected to be. If you own shares on the fund’s record date, you will receive the distribution. That means if you purchase shares shortly before the record date, you are “buying the distribution”—you’ll owe taxes on the capital gains that were reflected in the share price when you bought shares. In effect, a portion of your investment is being “returned” to you as a taxable capital gain. 6
  11. 11. Tax-deferred and tax-exempt accounts The rules explained in this brochure apply only to taxable investments, not to tax-deferred investments such as those in employer-sponsored retirement plans (401(k) and 403(b) plans), individual retirement accounts (traditional IRAs), or variable annuities. Nor do these rules apply to Roth IRAs, which can be tax-free at withdrawal. Usually people are not taxed on the earnings in tax-deferred accounts until they start withdrawing money from the accounts—typically during retirement. Whether the withdrawals take the form of a lump sum or an installment payment, the taxable portion is always considered ordinary income (as opposed to capital gains) and thus taxed at the taxpayer’s marginal rate for the years when the withdrawals occur. IRA withdrawals taken before age 59 1/2 are generally taxable and subject to an additional 10% penalty tax. (Note, however, that distributions from Roth IRAs after a taxpayer reaches age 591/2 will be tax-free if the Roth IRA has been held longer than five years.) Some tax-deferred investments offer added tax advantages. For example, you may be able to contribute wages or salary on a pre-tax basis. In a 401(k) plan, for example, money you contribute to the plan is deducted from your pay before it is taxed, which reduces your taxable wages. Similarly, many investors can deduct some or all of their contributions to traditional IRAs, which also reduces their taxable income. (Contributions to Roth IRAs are never deductible.) In retirement plans that allow pre-tax contributions (for example, 401(k) plans and traditional IRAs), withdrawals from the account are taxed as ordinary income. But for after-tax contributions to tax-deferred accounts (for example, if you invest $1,000 of take-home pay in a variable annuity or a nondeductible traditional IRA), you pay taxes only on earnings that accumulate in the account, because the contribution has already been taxed. 7
  12. 12. H OW A F U N D ’ S I N V ES T M EN T S T RAT E G Y C A N A F F E C T TAX ES The likelihood that a mutual fund will pass along taxable distributions is heavily influenced by two factors: the kinds of securities the fund invests in and the fund’s investment policies. Security holdings Money market funds Most money market funds pay dividends that are fully taxable. (Some funds—those that invest in municipal securities—earn interest that is generally not subject to federal income tax and that often is exempt from state and local taxes as well.*) However, because these funds are designed to maintain a constant value of $1 per share,** they do not ordinarily generate capital gains or losses, either within the fund or as the result of sales or exchanges you make. Bond funds Ordinarily, bond funds produce relatively high levels of taxable income. Over long periods, almost all the return from bond funds comes from dividend payments. However, because the prices of bonds and bond funds fluctuate in response to changing interest rates, it is possible to have taxable capital gains from investing in bond funds, even tax-exempt bond funds. Sometimes a fund will generate taxable capital gains distributions by selling bonds at a profit. Alternatively, a shareholder can trigger a capital gain by selling shares in a bond fund for a price higher than the original cost. *For some investors, however, a portion of the fund’s income may be subject to the alternative minimum tax. **An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. 8
  13. 13. Stock funds Stock funds may pass along income from dividends paid by stocks held in the fund as well as from capital gains from the sale of stocks. Over time, however, most of the return from stocks comes from appreciation in stock prices. Because stock prices fluctuate considerably, you are generally more likely to realize a capital gain or loss when selling shares of a stock mutual fund than when selling shares of bond funds or money market funds. If you sell shares that have fallen in value, you won’t owe taxes on the transaction; indeed, you may be able to take a deduction for a capital loss. But to gauge the tax impact, it’s not enough merely to know that a fund owns stocks. You must know what kind of stocks it owns. Carefully study a stock fund’s objective to learn whether it emphasizes income or capital appreciation. Also determine whether it concentrates on value stocks (which generally pay higher dividend yields) or growth stocks (which seek long-term capital growth rather than current income). The annualized rate at which a stock earns income (known as the dividend yield, which can be found in a fund’s annual report) serves as one indication of whether a fund takes a value or growth approach. Large, well-established companies are more likely to pay dividends than smaller companies, which generally reinvest any profits back into the company to pay for growth. Consequently, funds that emphasize large-company (“blue chip”) stocks tend to generate more taxable dividend income than funds that emphasize small- company stocks. Investment policies How a mutual fund’s adviser manages the fund’s securities can also affect the taxes of shareholders in the fund. Because capital gains distributions result from the profitable sale of securities in the fund, frequent selling within a fund makes the fund more likely to produce taxable distributions than a fund that follows a strategy of “buy and hold.” 9
  14. 14. A common measure of a mutual fund’s trading activity is its turnover rate, which is expressed as a percentage of the fund’s average net assets. For example, a fund with a 50% turnover rate has (over the course of a year) sold and replaced securities with a value equal to 50% of the fund’s average net assets. This means that, on average, the fund holds securities for two years. (The average turnover rate for U.S. stock mutual funds is about 113%.*) Turnover rates can’t be used to forecast a fund’s taxable distributions, but they can help you compare the trading policies among funds. Assuming that a fund’s holdings will increase in value over time, you need to consider how much of that increase in value will be passed along to you as a taxable capital gains distribution. The fund’s turnover rate bears directly on this point. A capital gain on the sale of securities is a realized gain. In contrast, an unrealized (“paper”) gain has not yet been locked in by the sale of securities. For example, a fund may have bought stock in XYZ Inc. for $5 per share three years ago. If the stock’s price rises to $15, the fund has an unrealized capital gain of $10 per share on XYZ’s stock. As long as the fund continues to hold the XYZ shares, there is no taxable gain. But if the fund actually sells the stock at $15 per share, shareholders will usually have to pay taxes on the $10 per share of realized capital gains, regardless of whether the shareholders owned their own shares in the mutual fund for a month or for a decade. Thus, all unrealized capital gains have the potential to be converted eventually into realized capital gains. This means that you should consider both a fund’s realized and unrealized gains (information that is available through your mutual fund company) and also its turnover rate to determine the potential tax implications of your investment. *Source: Lipper Inc. 10
  15. 15. When the markets move The financial markets also play a part in determining the taxable distributions a fund may pass along to you. Generally, rising markets lead to bigger gains and higher tax liabilities. (Rising markets are no cause for concern—after all, strong returns are undoubtedly the goal of every mutual fund investor.) All these factors—security holdings, investment policies, and market movements—cannot reliably predict your annual tax bill. Taken together, however, they should give you a sense of whether a fund may add to that bill. The information in Figure 2 may also help. Figure 2 Assessing Types of Mutual Funds for Tax Friendliness Potential for Potential for Type of Fund Taxable Income Capital Gains Taxable money market High None Tax-exempt money market Very Low None Taxable bond High Low Tax-exempt bond Very Low Low State tax-exempt bond Very Low Low Balanced (stocks and bonds) Medium to High Medium Growth and income stock Medium Medium to High Growth stock Low High International stock Low High Tax-managed Low Low 11
  16. 16. C A LC U LAT I N G AND R EP O RT I N G Y O U R TAX ES Your mutual fund company will provide a variety of forms to help you complete your tax returns accurately. This information is also provided to the IRS. Here is a list of the various forms and how they can be used. s IRS Form 1099-DIV, which is typically mailed by fund companies by late January of each year, lists the ordinary dividends and capital gains distributed by your funds. “Ordinary dividends” reported on Form 1099-DIV include both taxable dividends and any short-term capital gains. Form 1099-DIV may also include return-of-capital distributions and foreign taxes paid.* s IRS Form 1099-B serves as a record of all sales of shares. Mailed in January, this form lists all of your sales of shares, checkwriting activity, and exchanges between funds. It is essential to determining capital gains or losses. If you realize capital gains or losses from the sale or exchange of mutual fund shares (or other capital assets), you must report them on your tax return. s IRS Form 1099-R summarizes all distributions from retirement accounts such as IRAs, 401(k) plans, and annuities. Mailed in January, this form lists total distributions, the taxable amount, and any federal tax withheld. If you own shares of funds that hold U.S. Treasury securities, you may receive a United States Government Obligation listing with your Form 1099-DIV.** This provides the percentage of a fund’s income that came from U.S. government securities—and thus the percentage of income dividends that may be exempt from state income taxes. *Mutual funds that invest in foreign securities may elect to pass through foreign taxes paid by the fund to its shareholders. Shareholders may be able to claim a tax credit or deduction for their portion of foreign taxes paid. **Vanguard shareholders receive the United States Government Obligation listing. 12
  17. 17. If you own shares of a municipal bond fund, you may receive an Income by State listing* that tells you the percentage of the fund’s income that came from each state’s obligations. You can use this information to exclude income from municipal bonds issued in the state where you live. You may also receive other tax-related information, depending on the types of funds you own. For example, if you invest in an international mutual fund, you may receive information that you can use to take a credit for foreign taxes paid by the fund. Capital gain or loss? To determine the gain or loss when you sell (or exchange) mutual fund shares, you must know both the price at which you sold the shares and your cost basis (generally the original price you paid for the shares). The sale price is the easy part. Figuring your cost basis can be complicated, especially if you bought shares at different times and at different prices. An important note: Always count reinvested dividend and capital gains distributions as part of your cost basis. This will raise your cost basis and thus reduce the amount of your taxable gain when you sell or exchange your shares. Because the size of the taxable gain will be smaller, you will owe less in taxes. When figuring your cost basis, keep in mind that any sales charge or transaction fee you pay when you buy shares is part of your cost basis. Any fees or charges paid when you sell shares reduce the proceeds of the sale. In general, fees paid when you buy or redeem shares reduce your taxable gain or increase your capital loss. (Other fees charged by a mutual fund, such as account maintenance fees, do not affect your cost basis.) The IRS allows you to figure the gain or loss on sales or exchanges of mutual fund shares by using one of four methods, each of which has its own benefits and drawbacks. Once you begin using an *Vanguard shareholders receive the Income by State listing. 13
  18. 18. average cost method for the sale of shares of a particular fund, the IRS prohibits a switch to another method without prior approval. However, you may employ different methods for different funds. To determine which method is best for you, you may wish to consult a tax professional. First-in, first-out (FIFO) This method assumes that the shares sold were the first shares you purchased. While fairly easy to understand, this method often leads to the largest capital gains, because the longer you hold shares, the more time they have to rise in value. If you do not specify a method for calculating your cost basis, the IRS assumes that you use the FIFO approach. Average cost (single category) The simple approach to This method considers the your cost basis cost basis of your mutual Vanguard uses the average cost fund investment to be the single category method to average basis of all the shares calculate the tax basis of shares you own—a figure that redeemed from Vanguard fund changes as you continue accounts. We will send you the investing in a fund. Most cost basis for each eligible investment that you sell during the mutual fund companies year, updated on each statement (including Vanguard) use you receive. (This service is not this method to calculate available for all accounts, such as average cost. In determining those established before 1986 or whether a sale generated a some accounts acquired through a short-term gain or a long- transfer.) See page 26 for more term gain, the shares sold are information on Vanguard’s average considered to be the shares cost service. acquired first. Average cost (double category) This approach is similar to the single category method except that you must separate your shares into two categories—shares held for a year or less and shares held for longer than a year. 14
  19. 19. Selling short-term shares means basing the gain (which is taxed at ordinary income rates of up to 39.6%) on the difference between the average short-term basis and the sales price. By contrast, the gain on the sale of long-term shares (which is taxed at a maximum rate of 20%) is based on the difference between the average long-term basis and the sales price. If you choose this method, you must notify the fund company in advance of which category of shares to sell. Specific identification This method provides the most flexibility and therefore the best chance to minimize taxable gains. The first step is to identify the specific shares you want to sell—in most cases, these would be the shares bought at the highest price so that you can minimize your gain. However, this method is not necessarily the best choice because it can be complex and also imposes the heaviest recordkeeping burden on shareholders. In addition, the shares with the highest cost basis may be the ones you purchased most recently—which could mean your having to pay taxes at a higher rate if the gains that result are short-term. Help from the IRS More tax information is available from the Internal Revenue Service. Call the IRS at 1-800-TAX-1040 to ask questions about specific tax matters. You can order IRS forms and publications by calling 1-800-TAX-FORM. Among the publications you may find helpful in understanding and reporting mutual fund taxes are: s IRS Publication 17, Your Federal Income Tax s IRS Publication 564, Mutual Fund Distributions s IRS Publication 590, Individual Retirement Arrangements s IRS Publication 514, Foreign Tax Credit for Individuals IRS forms and brochures are also available on the IRS website at 15
  20. 20. To use the specific identification method, notify your mutual fund company in writing and provide detailed instructions about which shares you are selling each time you sell or exchange shares. Making losses work for you You can use losses on the sale of shares to offset other capital gains. You can also use up to $3,000 of net capital losses ($1,500 for people who are married and filing separately) to offset ordinary income (such as salary, wages, or investment income) in any year. For example, if you have a net capital loss of $2,000 (because of unprofitable sales of mutual funds, for instance), that loss can be used to reduce your taxable income. Losses that exceed $3,000 in one year can be carried forward for as long as you wish. A few cautionary notes: s If you redeem shares at a loss and purchase shares in the same fund within 30 days before, after, or on the day of the redemption, the IRS considers the redemption a wash sale. This means that you may not be allowed to claim some or all of the loss on your tax return. s If you redeem shares at a loss from a tax-exempt municipal bond fund by selling shares held for six months or less, a portion of the loss may not be allowed. In this case, the realized loss must be reduced by the tax-exempt income you received from these shares. s If you realize a short-term capital loss on shares held six months or less in an account that received long-term capital gains distributions on those shares, the short-term loss you realize from a sale of shares (up to the amount of the capital gains distributions they earned) must be reported as a long- term loss. You may wish to consult with a tax adviser or tax preparer for guidance in dealing with these situations. 16
  21. 21. T H E I M PAC T O F TAX ES O N Y O U R I N V ES T M EN T R E T U R N S Understanding how mutual fund investments are taxed prepares you for the critical next step, which is to understand the impact that taxes can have on the overall performance of your investment program. Ignoring their impact can be a serious error. Along with such fundamental factors as risk, return, and cost, taxes should be considered when deciding whether to invest in a mutual fund. Here’s why: Minimizing taxes can substantially boost the net returns you receive from mutual fund investments, particularly if you’re in a high tax bracket. According to one recent analysis, a significant portion of the pre- tax returns on domestic stock mutual funds ultimately goes to pay federal income tax on dividend and capital gains distributions— especially for investors in high tax brackets. Specifically, for the mutual funds included in the analysis, the average annual pre-tax return (for ten years ended December 31, 2000) was 16.1%, but the after-tax annual return was only 13.4%.* In other words, about one-sixth of the pre-tax returns was consumed by federal income tax. The amount lost to taxes for individual funds ranged from zero (the pre-tax and after-tax returns were equal) to 9.3 percentage points per year. *Source: Vanguard analysis using data from Morningstar, Inc. How Vanguard can help You can learn more about the after-tax returns on most Vanguard funds by using the After-Tax Returns Calculator on our website. This interactive tool calculates the fund’s after-tax returns based on your marginal tax rate for any time period you choose. An advanced version of the calculator can even factor in state and local income taxes. To use the calculator, go to 17
  22. 22. Over the long haul, efforts to minimize taxes can provide a handsome payoff. Figure 3 below demonstrates the growth of hypothetical taxable investments of $10,000 in two mutual funds. Both funds have pre-tax total returns of 10% a year, but their after-tax returns are different. Investors in one fund paid taxes equal to 10% of their earnings (for an after-tax return of 9% a year), and investors in the other fund paid taxes equal to 30% of their earnings (for an after-tax return of 7% a year). Though the advantage is not dramatic at first, it becomes huge as earnings compound over time. After 30 years, the investment with the smaller tax bite grows to almost $133,000 after taxes— about 75% more than the $76,123 produced by the more heavily taxed fund. Figure 3 The Effect of Taxes Over the Long Term $140000 $132,677 9% Annual Return 120000 100000 80000 $76,123 60000 40000 7% Annual Return 20000 0 5 10 15 20 25 30 Years This example, which assumes original investments of $10,000 each, is for illustrative purposes only and does not imply returns available on any particular investment. 18
  23. 23. W H AT TO D O A B O U T TAX ES Because most mutual fund managers focus on maximizing pre-tax returns (within a fund’s guidelines), the important task of considering the tax effect of mutual fund investments is up to you. Several approaches can help in crafting an investment program that keeps taxes to a minimum: s Deferring taxes on your investments for as long as possible. s Selecting mutual funds that feature low turnover rates. s Choosing tax-exempt investments such as municipal bond funds (for people in high tax brackets). Deferring taxes The most efficient investment strategy is to avoid taxes entirely— at least for a while. For example, mutual funds held in tax-deferred accounts (such as 401(k) and 403(b) plans, traditional IRAs, or variable annuities) are exempt from current taxation. Generally, withdrawals (both contributions and earnings) from these accounts are taxable. However, non-deductible contributions to a traditional IRA are usually not taxable when they are withdrawn.* The entire amount withdrawn from a Roth IRA is generally exempt from income taxes. On the following page, Figure 4 demonstrates the long-term benefit of delaying the payment of taxes. The “Taxable Account” column shows the value of annual $1,000 investments in a regular account on which taxes must be paid on the earnings every year. The “Tax-Deferred Account Before Taxes” column shows the value if the annual $1,000 investments are allowed to grow inside a tax-deferred account. The last column, “Tax-Deferred Account After Taxes,” shows the value of the tax-deferred account assuming *A 10% penalty tax may be levied on IRA withdrawals made before age 591⁄2. 19
  24. 24. Figure 4 The Power of Long-Term Tax Deferral Annual investments of $1,000 Year-End Values Tax-Deferred Tax-Deferred Number of Taxable Account Account Years Invested Account Before Taxes After Taxes 10 $13,477 $ 15,645 $13,782 15 23,361 29,324 24,597 20 36,194 49,423 39,713 25 52,854 78,954 61,149 30 74,485 122,346 91,872 Assumes an 8% annual rate of return and a 33% tax rate (federal and state combined). This chart should not be viewed as indicative of future investment performance. These data represent historical investment performance, which cannot be used to predict future returns. that the account balance is withdrawn and taxes paid at the end of each period. Though the advantage of tax deferral is evident early on, the difference becomes increasingly impressive over longer periods. The tax-deferred account grows to more than $122,000 after 30 years—nearly $48,000 more than the value of the taxable account over the same period. Even after taxes are paid at the end of the 30-year period, the tax-deferred account maintains an advantage of more than $17,000 over the taxable account—more than half the total investment of $30,000 over the 30-year period. The benefit of tax deferral is even greater on investments that offer additional tax advantages (such as 401(k) or 403(b) accounts, which permit pre-tax contributions). For example, in a taxable account, you would have to earn nearly $1,500 for every $1,000 of take-home pay that you plan to invest (assuming a 33% combined federal and state tax bracket). Therefore, by participating in a plan that allows pre-tax contributions, you could invest $1,500 without digging any deeper into your pocket than you would if you made a $1,000 investment after taxes. 20
  25. 25. The concept is similar for tax-deferred investments on which you may take a tax deduction, such as contributions to a traditional IRA (if you meet certain income limits). Receiving a tax deduction reduces the taxes that would otherwise be payable. Seeking low turnover Though most funds are not managed to keep taxes low, some types of mutual funds are tax-friendly by nature, especially those that keep turnover (the buying and selling of securities) low. As discussed earlier, a fund that buys and holds securities is likely to realize fewer gains than a fund that engages in active trading and is thus less likely to pass along taxable gains to investors. Such funds are sometimes called tax-efficient funds. Index funds The objective of an index fund is to track the performance and risk characteristics of a market benchmark, such as the Standard & Poor’s 500 Index. Stock index funds—but not bond index funds— can reduce an investor’s exposure to taxes. Index funds buy and hold the securities in a specific index (or a representative sample of the index). Because of this, the portfolio turnover of index funds is typically low. The chance that a security held in an index fund will be sold for a large gain (thus generating a large tax bill for shareholders) is much lower than a fund that employs an active management approach (buying and selling securities at the fund manager’s discretion). Nonetheless, index funds do sometimes realize gains—for example, when a stock is removed from a fund’s target index and thus must be sold by the fund. An index fund could also be forced to sell securities in its portfolio if many investors decide to sell their shares—say, during a downturn in the stock market. Bond index funds do not offer a tax-efficiency edge over actively managed bond funds because income—not capital gains— typically accounts for almost all of the long-term total return from bond funds. 21
  26. 26. Tax-managed funds Some funds are managed to keep taxable gains and income low. Among the strategies these funds employ are indexing (to hold down turnover), carefully selecting which shares to sell (so that capital losses offset most capital gains), and encouraging long-term investing (for example, by assessing fees on shareholders who redeem their shares soon after buying them). Investing for tax-exempt income Interest on most municipal bonds is exempt from federal income tax and, in some cases, from state and local income taxes as well. However, municipal bond funds (which pay lower yields than taxable bond funds as the trade-off for their tax advantage) are not for everyone. Generally, investors in lower tax brackets do not benefit from owning municipal bond funds. The box below explains how to compare yields on tax-exempt and taxable bond funds. Choose your bonds—taxable or tax-exempt? Deciding between taxable and tax-exempt bond funds for your portfolio takes some analysis. Municipal bonds offer the advantage of producing income that is exempt from taxes—but they also pay yields lower than those available on taxable bond funds of comparable quality and maturity. To decide whether to invest in a tax-exempt bond fund or a taxable one, you need to know which provides the best overall return. Here is how to compare the yield of a municipal bond fund with that of a taxable bond fund that holds bonds of similar credit quality and maturities. First subtract the percentage of your marginal tax bracket from 1, then divide the resulting number into the yield of the tax-exempt fund to find the equivalent taxable yield. For an investor in the 28% tax bracket considering a tax-exempt fund with a 6% yield, the calculation is as follows: Example: 1.0 – 0.28 = 0.72 6% ÷ 0.72 = 8.33% In this example, a taxable fund must provide a yield of more than 8.33% to top a yield of 6% from a tax-exempt fund. 22
  27. 27. Keep in mind that only a municipal bond’s income is exempt from taxes. Taxes are payable on any capital gains that a tax-exempt fund distributes. And for some investors, a portion of the fund’s income may be subject to the alternative minimum tax. State-specific municipal bond funds provide an additional tax advantage. Municipal bond income is generally exempt from both state and federal taxes for investors who live in the state where the bonds are issued. For example, New York State residents pay no state taxes on income from a municipal bond fund that holds only securities of New York State issuers. 23
  28. 28. TAX -E F F I C I EN T VA N G UA RD F U N D S Vanguard understands that taxes are an important consideration for all investors. To address that concern, we offer a wide variety of funds that may be suitable for tax-conscious investors. Vanguard® Municipal Bond Funds High-Yield Tax-Exempt Fund Insured Long-Term Tax-Exempt Fund Intermediate-Term Tax-Exempt Fund Limited-Term Tax-Exempt Fund Long-Term Tax-Exempt Fund Short-Term Tax-Exempt Fund Tax-Exempt Money Market Fund Vanguard® State Tax-Exempt Income Funds California Insured Intermediate-Term Tax-Exempt Fund California Insured Long-Term Tax-Exempt Fund California Tax-Exempt Money Market Fund Florida Insured Long-Term Tax-Exempt Fund Massachusetts Tax-Exempt Fund New Jersey Insured Long-Term Tax-Exempt Fund New Jersey Tax-Exempt Money Market Fund New York Insured Long-Term Tax-Exempt Fund New York Tax-Exempt Money Market Fund Ohio Long-Term Tax-Exempt Fund Ohio Tax-Exempt Money Market Fund Pennsylvania Insured Long-Term Tax-Exempt Fund Pennsylvania Tax-Exempt Money Market Fund 24
  29. 29. Vanguard® Index Funds Vanguard ® Domestic Stock Index Funds 500 Index Fund Balanced Index Fund Calvert Social Index™ Fund Extended Market Index Fund Growth Index Fund Mid-Cap Index Fund Small-Cap Growth Fund Small-Cap Index Fund Small-Cap Value Index Fund Total Stock Market Index Fund Value Index Fund Vanguard ® International Stock Index Funds Developed Markets Index Fund Emerging Markets Stock Index Fund European Stock Index Fund Pacific Stock Index Fund Total International Stock Index Fund Vanguard ® Tax-Managed Funds Tax-Managed Balanced Fund Tax-Managed Capital Appreciation Fund Tax-Managed Growth and Income Fund Tax-Managed International Fund Tax-Managed Small-Cap Fund 25
  30. 30. VA N G UA RD ’ S TAX I N F O R M AT I O N S ERV I C ES If figuring your taxes already includes more calculations than you’d like, several Vanguard services can make tracking and reporting taxes easier. Average Cost Service If you sell or exchange shares of any Vanguard fund that has a fluctuating share value, you will receive an Average Cost Statement that lists the average cost basis (using the single category method) of the shares you sold or exchanged. In addition, the statement lists the proceeds from each sale and the amount of any gain or loss. Each sale is classified as either a short-term or a long-term gain or loss. This service simplifies tax reporting and recordkeeping. Note that using a different method of calculating your cost basis could change the amount of taxes that you owe. Consult your tax adviser for further information. Information on your Average Cost Statement is not reported to the IRS, and you are not required to use it to calculate your capital gains or losses. However, if you use one of the three other methods (as described on pages 14 and 15), you must keep careful records for purchases and sales. Remember that while Form 1099-B provides information about sales, it does not show the cost basis for the shares. How Vanguard can help Vanguard can give you daily updates on the cost basis of your shares. For example, if you’re considering a sale, you may want to check your average cost basis as of the previous day’s market closing price. Compare that figure with the current market value of your shares to estimate the tax implications of a sale. For assistance, call Vanguard® Client Services at 1-800-662-2739. 26
  31. 31. Information for state tax returns In January, Vanguard provides a breakdown of the percentage of income that each Vanguard fund derives from direct U.S. Treasury obligations (such as U.S. Treasury bills, notes, or bonds). This information allows you to exclude that percentage of the income you earned from the income subject to state tax. Also in January, Vanguard furnishes shareholders of municipal bond funds a list of the percentage of the fund’s income derived from each state. Use this information to exclude from your tax return any income attributable to municipal bonds issued in the state where you live. Foreign Tax Credit Service Vanguard’s Foreign Tax Credit Service provides detailed tax information in January for all shareholders of Vanguard mutual funds that hold primarily international investments. A mutual fund that invests in stocks of overseas companies may have to pay foreign taxes on the dividends it receives. If this happens, you may either deduct your share of the foreign tax on your U.S. income tax return or claim a credit for it. (Claiming a credit is usually more advantageous, because a deduction only reduces your taxable income, while a credit reduces the tax you owe dollar-for-dollar.) This information specifies the foreign income you earned as well as the foreign taxes you paid. If you claim a credit, you can use this information to complete IRS Form 1116, Foreign Tax Credit. (Some shareholders may be able to claim a credit directly on Form 1040 without completing Form 1116; check with your tax adviser.) You may receive a credit or deduction for foreign taxes only on funds you hold in taxable accounts. International investments held in a tax-deferred account such as an IRA are not eligible for a tax credit or deduction. If you are eligible to receive a credit or deduction for any of your fund investments, Vanguard will send you the appropriate information. 27
  32. 32. A VA N G UA RD I N V I TAT I O N For more information about Vanguard® funds and services, to learn more about investing, or to open an account online, visit our website at There you’ll find the complete Plain Talk® Library, Retirement Center, and our popular Education Center. Register for immediate secure access to our online investment-management center, and you can monitor your accounts, conduct transactions, trade securities, and invest in both Vanguard and non-Vanguard funds—24 hours a day. Or you can speak with a Vanguard associate by calling us at 1-800-662-7447 on business days from 8 a.m. to 10 p.m. and on Saturdays from 9 a.m. to 4 p.m., Eastern time. Our associates are always pleased to answer your questions or provide information about our funds and services. Vanguard also invites you to take advantage of the broad selection of programs and services that we offer that can teach you more about investing and help you stay on track toward reaching your financial goals. Vanguard® Personal Financial Planning Service 1-800-567-5162 At an affordable fee, this service offers customized one-time analysis and advice on investment, retirement, and estate planning. Vanguard® Asset Management and Trust Services 1-800-567-5163 Individuals who have a minimum of $500,000 in investable assets can receive comprehensive, ongoing wealth management services at a very reasonable fee. 28
  33. 33. Vanguard Brokerage Services® 1-800-992-8327 Through Vanguard Brokerage, you can invest in individual stocks, bonds, options, and more than 2,600 non-Vanguard mutual funds. You can open an account and trade on our website as well. Retirement Resource Center 1-800-205-6189 Our experienced retirement specialists can provide a wealth of information to help you plan or manage your retirement investments. Individual Retirement Plans 1-800-823-7412 Self-employed individuals and small-business owners can find out how to establish and administer retirement plans for themselves and/or their employees. Voyager and Flagship Services 1-800-337-8476 Vanguard offers special services for clients with substantial assets. s Voyager Service ®, for clients investing more than $250,000 in Vanguard mutual funds, offers the expert assistance of a special service team. s Flagship Service, for clients whose Vanguard mutual fund investments exceed $1 million, offers personal service from a dedicated representative. Eligible clients are invited to call Vanguard for more information. 29
  34. 34. G LO S S A RY Active management Portfolio management that seeks to exceed the returns of the financial markets. Active fund managers rely on research, market forecasts, and their own judgment and experience in making investment decisions. Alternative minimum tax (AMT) The AMT is a tax intended to ensure that taxpayers who receive certain tax benefits (such as tax-exempt interest from private activity bonds, accelerated depreciation deductions, and incentive stock options) pay their fair share of income taxes despite tax benefits. Taxpayers must first calculate regular taxable income, then add back tax adjustments and preferences to determine the AMT. If the AMT is higher than the regular tax liability, the taxpayer must pay the AMT. Capital gains distribution Payment to mutual fund shareholders of net gains realized during the year on securities that have been sold at a profit. Capital gains are distributed on a “net” basis—that is, after subtracting any capital losses for the year. If losses exceed gains for the year, the difference may be carried forward and subtracted from the fund’s future gains. Cost basis For tax purposes, the original cost of an investment, including any reinvested dividend or capital gains distributions. Cost basis may include adjustments such as increases for transaction fees paid at purchase or decreases for return-of-capital distributions. It is subtracted from the sales price to determine any capital gain or loss from the sale of mutual fund shares or other securities. 30
  35. 35. Declared When the Board of Directors of a mutual fund announces the amount and date of a dividend or capital gains distribution, the distribution is said to have been declared. A declared distribution is payable to the shareholders of record as of the record date. Dividend yield The annualized rate at which an investment pays dividends, expressed as a percentage of the investment’s current price. Growth stocks Stocks of companies with a strong potential for earnings growth. They are likely to generate much of their total return in the form of capital gains rather than dividend income. Income distribution Interest and dividends earned on securities held by a mutual fund and paid out to shareholders (after reduction for fund expenses) in the form of dividends. Index Statistical benchmarks designed to reflect changes in segments of the financial markets or the economy. In investing, indexes are used to measure changes in segments of the stock and bond markets and as standards against which fund managers and investors can measure the performance of their investment portfolios. You cannot invest in an index. Indexing An investment management approach in which a mutual fund seeks to track the performance of a specific financial market benchmark, or index, by holding all the securities that compose the market segment (or a statistically representative sample of the index). Marginal tax rate The income tax rate at which the last dollar of your income is taxed. Under federal law, you often pay a lower tax rate on your 31
  36. 36. first dollar of taxable income than you do on your last dollar. The marginal rate—the highest rate at which your income is taxed—is used to calculate taxes due on investment income. Net asset value (NAV) The value of a mutual fund’s assets, after deducting liabilities, divided by the number of shares currently outstanding. NAV is expressed as the value of a single share in the fund and is reported daily in many newspapers. Ordinary income Ordinary income includes earned income (such as wages, salaries, and self-employment income), unearned income (such as taxable interest and dividends), and other income (such as taxable refunds of state income taxes). Ordinary income is taxed at higher rates than long-term capital gains. Record date The deadline for owning shares of a fund for the purpose of receiving the next distribution of dividends or capital gains. All investors who own shares on the record date receive a distribution and owe taxes on it, regardless of how long they have owned the shares. By buying shares after the record date, investors can avoid the distribution and resulting taxes. Return of capital When a mutual fund’s distributions exceed its earnings and profits, the excess is considered a return of capital (or return of basis). That part of the distribution is generally not taxable because it represents a portion of the original investment being returned. The effect of a return of capital is to reduce basis in the investment, which may cause future capital gains to be higher. If a shareholder’s basis is eliminated by return-of-capital distributions, any excess is treated as a capital gain. Tax-deferred account An investment vehicle that shields earnings from taxes. These types of accounts include 401(k) plans, 403(b) plans, IRAs, and 32
  37. 37. variable annuities. Although mutual funds held in these accounts are not taxed currently, they are subject to federal and state taxes upon withdrawal (except for qualified distributions from Roth IRAs and Education IRAs and withdrawals of non-deductible contributions to traditional IRAs). Tax-efficient fund A fund that generates low taxable income for its shareholders is said to be tax-efficient. Tax-exempt bond A bond whose interest payments are not subject to income tax. The interest on bonds issued by municipal, county, and state governments and agencies is typically exempt from federal income tax and may also be exempt from state or local income taxes. Tax-exempt bonds are also called municipal bonds or tax-free bonds. Turnover rate A measure of a mutual fund’s trading activity. Turnover is calculated by taking the lesser of the fund’s total purchases or sales of securities (not counting securities with maturities under one year) and dividing by the average monthly assets. A turnover rate of 50% means that, during the year, a fund has sold and replaced securities with a value equal to 50% of the fund’s average net assets. Value stocks Stocks of companies with good long-term prospects but whose current prices are considered low given the companies’ assets or profit potential. These stocks tend to pay above-average dividends, so much of the total return from value funds comes in the form of ordinary income rather than capital gains. Wash sale rule IRS regulation that prohibits a taxpayer from claiming a loss on the sale of a security (such as stock, bond, or mutual fund shares) if that same security is purchased within 30 days before or after—or on the same day of—the sale. 33
  38. 38. Invest with a leader The Vanguard Group traces its roots to the opening of its first mutual fund, Wellington™ Fund, in 1929. The nation’s oldest balanced fund, Wellington Fund emphasized conservatism and diversification in an era of rampant market speculation. Despite its creation just before the worst years in U.S. financial history, Wellington Fund prospered and within a generation was one of the largest mutual funds in the nation. The Vanguard Group was launched in 1975 solely to serve the Vanguard mutual funds and their shareholders. From its start as a single fund in an infant industry, Vanguard has become one of the largest investment management firms in the world. Today, some $550 billion is invested with us in more than 100 investment portfolios. And some 11,000 crew members now serve millions of shareholders who have entrusted their investment assets—indeed, their financial future—to a company that they believe offers the best combination of investment performance, service, and value in the industry. 35
  39. 39. Post Office Box 2600 Valley Forge, PA 19482-2600 Calvert Group ® and Calvert Vanguard funds and non- World Wide Web Social Index are trademarks of Vanguard funds offered through Calvert Group, Ltd., and have our FundAccess® program been licensed for use by The are offered by prospectus only. Toll-Free Vanguard Group, Inc. Vanguard® Prospectuses contain more Investor Information Calvert Social Index ™ Fund is not complete information on risks, 1-800-662-7447 sponsored, endorsed, sold, or advisory fees, distribution promoted by Calvert Group, Ltd., charges, and other expenses and Calvert Group, Ltd., makes no and should be read carefully representation regarding the before you invest or send money. advisability Prospectuses for Vanguard funds of investing in the fund. can be obtained directly from The Vanguard Group; prospectuses Standard & Poor’s ®, S&P ®, for non-Vanguard funds offered S&P 500 ®, Standard & Poor’s through FundAccess can be 500, and 500 are trademarks obtained from Vanguard of The McGraw-Hill Companies, Brokerage Services, 1-800-992- Inc., and have been licensed for 8327. use by The Vanguard Group, Inc. Vanguard mutual funds are not Vanguard Brokerage Services sponsored, endorsed, sold, or is a division of Vanguard promoted by Standard & Poor’s, Marketing Corporation. and Standard & Poor’s makes no representation regarding the advisability of investing in the funds. Printed on recycled paper. © 2001 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. BTAX 032001