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Tax-Efficient Vanguard Readies Some Big Cap-Gains Distributions

Brace for some big capital-gains distributions this year, folks, because even one of the most tax-efficient shops around is raising a red flag.

Vanguard, best-known for index investing and tax efficiency, announced Thursday that it expects five of its 54 stock and balanced funds to make capital-gains distributions at or above 10% of their share price -- larger than usual.

In its announcement, the firm rightly warns investors that buying shares of a stock just prior to its fiscal year-end can stick them with a tax bill on other investors' gains. (Of course, these distributions don't affect investors who own one of the funds through a tax-deferred account.) The warning comes on the heels of steep gains last year and mammoth distributions from several other companies' stock funds.

The upshot: This year's distributions will probably be higher than usual, so start your tax planning now. Also, consider putting off buying a new fund until after it makes this year's taxable cap-gains payout.

Taxing Matters
Through Aug. 31, these funds had realized capital gains that equaled or topped 10% of their net asset value.
Fund Realized Cap Gain as a Percentage of NAV Realized Gain Per Share YTD Return
(VEXPX) Explorer 18% $14.63 16.8%
(VSEQX) Strategic Equity 16 3 6.3
(VWUSX) U.S. Growth 12 6 8.9
(NAESX) Small Cap Index 11 2.70 4.4
(VWNDX) Windsor 10 1.62 4.5
Source: Vanguard and Morningstar. Capital gains figures through Aug. 31. Performance figures through Sept. 20.

Last year, the average technology fund posted a 135% return, and the average small- and mid-cap growth funds rocketed up more than 60%, largely because nearly half their portfolios were sunk into the market-leading tech sector. Those returns were great, but as fund managers sell some of last year's winners, they're realizing sizable capital gains. When a fund's realized capital gains outweigh its losses, it is required to pay that profit to shareholders. Most investors reinvest those annual payouts in the fund, but they still pay taxes on them.

For most investors, the capital gains tax rate is 20%. So, for instance, if (VWUSX) Vanguard U.S. Growth's per-share capital gains distribution were $6, an investor who owns 500 shares of the fund would owe $600 to Uncle Sam.

Capital gains distributions that add up to more than 10% to 15% of a fund's net asset value (NAV) , or share price, are considered large. Vanguard is typically known for its tax-efficiency, and these impending distributions shouldn't diminish that reputation. Indeed, 27 of Vanguard's 54 stock and balanced funds had no realized capital gains at the end of August, according to the company.

Much of the firm's assets are invested in its index funds, which tend to be tax-efficient, because instead of actively buying and selling stocks, they merely replicate a broad index of stocks. The $110.5 billion (VFINX) Vanguard 500 Index fund, for example, had no realized cap gains at the end of August, according to the firm.

Only one of the funds set to make a sizable distribution -- the (NAESX) Vanguard Small Cap Index -- is an index fund. Small-cap stock funds that track the Russell 2000 Index, like this one, are often less tax-efficient because a significant percentage of stocks in the index change each year during the index's annual rebalancing. Index funds can lock in capital gains as they trade to reflect the benchmark's changes -- raised this issue in a June 9 article .

The other four Vanguard funds set to make sizable distributions are actively managed. All but (VWNDX) Vanguard Windsor have had solid tax-efficiency ratings relative to their peers before this, according to Morningstar.

Aside from these funds, four others were on target to make distributions equal to 9% of their NAV: (VMGRX) Vanguard Morgan Growth , (VHGEX) Vanguard Global Equity , (VEXMX) Vanguard Extended Market Index , and (VCVSX) Vanguard Convertible Securities .

Like the others, their distributions could rise above the magic 10% barrier or fall from these estimates by the end of the year. Market moves can give managers the opportunity to reduce gains by selling losing positions.

Got Gains?
The 10 biggest Vanguard funds and the potential gains distributions
Vanguard Fund Potential Capital-Gains Payout as a Percentage of NAV Realized Gain Per Share Fiscal Year-End
(VFINX) 500 Index 0 -$0.30 Dec. 31
(VPMCX) Primecap 4 2.73 Dec. 31
(VWNFX) Windsor II 4 1.07 Oct. 31
(VWELX) Wellington 4 1.28 Nov. 30
(VWUSX) U.S. Growth 12 6 Aug. 31
(VTSMX) Total Stock Market Index 0 0.13 Dec. 31
Growth Index 0 -0.59 Dec. 31
(VWNDX) Windsor 10 1.62 Oct. 31
(VGHCX) Health Care 7 8.29 Jan. 31
(VFIIX) GNMA 0 -0.04 Jan. 31
Source: Vanguard and Morningstar. Figures through Aug. 31.

Already this year, several funds have made big distributions. In June , high-profile fund manager Bill Miller's (LMVTX) Legg Mason Value Trust , the only fund to beat the S&P 500 in each of the last nine years, paid out a capital gain around 9% of the fund's NAV.

Last month, two of last year's highest fliers saddled investors with fat cap gains. (WPJPX) Warburg Pincus Japan Small Company and (WPJGX) Warburg Pincus Japan Growth paid gains equal to a whopping 55% and 22% of their NAVs.

And even the (SDCEX) Standish Small Capitalization Tax-Sensitive Equity fund, designed to minimize taxable distributions, paid out a gain equal to 14.3% of its NAV in August. The fund now holds the record for paying out the largest distribution for any "tax-managed" fund, according to Morningstar.

These gains were paid early due to their inordinate size, but along with Vanguard's warning, they point to higher gains than usual. To get an idea of where your funds stand, give your fund company a call and ask for estimates, or a date when estimates will be available. If you haven't made money on a fund, it might be cheaper to sell your shares before it makes a big cap-gains distribution.

Make the same call regarding funds you're thinking of buying now. As Vanguard warns, buying a fund just before it pays its cap-gains distribution can set you up to pay taxes on others' gains and put your investment firmly in the red. screened stock funds in May and August to highlight those with fat imbedded gains and a tendency to trade actively -- a recipe for a big distribution.

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