Vanguard settles lawsuit over TDF capital gains tax mess

Vanguard is settling a two-year-old lawsuit over a massive capital gains tax fiasco that followed the company’s decision to lower the investment minimums for institutional shares of its target-date funds.

In court records filed Monday, the firm indicated it had reached an agreement in principle with a group of retail investors who sued it in 2022, alleging hundreds of thousands in capital gains taxes they faced as a result of the investment minimum change in 2020. No details about the agreement were published, as those will be filed with the court when the final settlement is inked.

The settlement follows a $6.25 million settlement Vanguard reached with Massachusetts regulators in 2022 over the same tax issue that more than 5,500 of the state’s residents faced.

The issue occurred starting in December 2020, when Vanguard reduced the plan asset minimum to $5 million, from $100 million, to qualify for the low-cost institutional shares of its target date funds. There was an “elephant stampede” from retail share classes to the institutional ones, with many 401(k) plans making the switch. That didn’t trigger tax issues for 401(k) participants, but investors in taxable accounts were hit hard – they faced capital gains distributions that were at least 40 times higher than they had ever seen in those funds, according to the lawsuit.

The company had an option to avoid that issue – merging the retail and institutional share classes, the plaintiffs noted. Vanguard actually did that in 2021.

“At this point, however, the harm was done,” the plaintiffs stated. “Taxable investors had already incurred unnecessary capital gains distributions – and corresponding taxes – that could not be erased.”

Although the company’s decision to lower the investment minimums benefited 401(k) participants, the implementation was clumsy, said Jeff DeMaso, editor and founder of The Independent Vanguard Adviser.

“Vanguard’s motives here were ‘good,’ providing more investors access to lower-cost funds,” DeMaso said in an email. “However, its approach was ham-handed and needlessly stuck investors with a large tax bill. And [it was] not Vanguard paying a price for that.”

Vanguard did not respond to a request for comment about the settlement.