How a NYE Windfall Was Our Biggest Money Mistake of 2021

Many of us grew up picking up loose changes others dropped on the ground. We stuffed it in our piggybanks and saved up until we could get that cheap toy from the corner store.

Hardly a windfall, those pennies (and the occasional nickel, not to mention a quarter, which was like winning the lottery) were, but they also came with no downside.

Windfalls can be fun, unpredictable, and even life-changing. And typically their presence means you need to re-evaluate your financial plan to account for the new funds. What new goals can be achieved? Where should the funds live? Questions abound, and the circumstances for everyone are different.

As our guest poster discovered today, some windfalls aren’t always the most welcome thing, and sometimes they have far-reaching consequences.

 

 

As 2021 was drawing to a close, Jenni and I were celebrating the end of the year in our small ways. My parents met us in Colonial Williamsburg for an after-Christmas celebration. We fixed some tasty treats and admired the colonial history of Virginia. Little did we know that, at the same time, financial wheels were turning behind the scenes that’ll likely have cost us about $15,000 once the dust settles.

How? Well, that’s a story with quite a bit of bad luck, ignorance, and poor choices. Let’s see how our biggest financial mistake of the year came about!

 

An Investing Strategy for Enough

 

Years after I made my worst investing mistake fiddling with individual stocks, I finally had my investing goals settled in my head. And I didn’t need to do anything too complicated.

You see, at least in my view, once you have enough — there’s not much point in pursuing more. You wind up risking what you’ve earned and the financial security it provides to incrementally improve a life that you’re already quite happy with.

And if you’re thinking to yourself, no, no Chris! I could be much happier with a whole lot more! Well, then I’d argue you’re not at that point.

Keep grinding. Reach the level of FIRE you need to be satisfied in the long term.

Sewing crops that’ll yield just barely enough to keep you out of starvation and subsisting year after year is a recipe for a depressive and dissatisfied life, one where you’ll likely return to the rat race we all want to escape, but this time in even worse condition.

 

More than enough

 

Jenni and I have, arguably, overdone it. We’re sitting on $2M+ (at least, that might still be the case? — I don’t know, I hear murmurs of the stock market in turmoil — though that’s usually overblown!). And we live a pretty happy $40-50,000 per year lifestyle.

A little quick back of the napkin math suggests we’re at about half the typical 4% safe withdrawal rate. Readers have pointed it out before.

Why keep earning more?

Well, aside from Jenni’s responses in that comment thread, we’re not exactly financial geniuses! Getting to where we are is some combination of luck stumbling through life, a tiny bit of hard work, and sheer persistence.

My hope for this blog has always been to merely share with you our experiences, especially our foibles, in hopes that you might be able to avoid those very same expensive pitfalls.

 

Financial expertise

 

Reader Vincent recently sent along an email with some investing history and questions about their financial strategy.

His key final question:

Consequently, I want to ask, are you recommending people put their money in index funds as against individual stocks?

And while I’ll send along a more detailed response to Vincent, the simple answer is: no.

Neither Jenni nor I are investing wizards or financial experts. We make a lot of mistakesI don’t know if investing in individual stocks will be better for you or if index funds will win out. Bitcoin or NFTs could result in the highest return. Bonds might result in the lowest return. And these trends could cement themselves in the long term or just for next week!

I don’t know how you value your ability to sleep at night with a portion of your life savings invested into a bunch of ones and zeros flashing by on a computer screen. Your risk tolerance might be very different from mine, or, anyone else.

But I do hope we can continue to share our thought processes and financial decisions in a way that might leave you a little richer and a little more content at the end of the day.

This brings me back to our biggest money mistake of the year and that none-too-complicated investing strategy I developed.

 

Investing Allocations

 

Jenni and I each have our own 401(k)s, brokerage accounts, IRAs, HSAs, and the like. Over the years, we’ve developed similar investing strategies. Following typical FIRE investing principles, much of our net worth is invested in diversified index funds:

  • There are names you’re familiar with like VTSAX or VTI to own a stake in a wide range of US companies
  • Add some VXUS or VTIAX for international exposure
  • A dash of VBTLX for bonds

And of course, there are still a couple of legacy individual stocks from my younger years I’ve yet to get rid of.

But there are also quite a few dollars invested in funds that change over time. You might even call them actively managed (*gasp!*).

You see, actively managed mutual funds and their high load fees are very well known to rarely beat the average market return for the typical investor. That’s been true even over the market’s volatility and strong rise in recent years.

This is practically gospel in FIRE circles — thou shalt invest in passive index funds! Maybe even shoot for the classic Bogleheads’ three-fund portfolio!

So what in the world were we doing throwing hundreds of thousands of dollars at an actively managed fund?

 

Target Date Funds

 

If you’re not already familiar with target date funds, they often operate as a fund-of-funds that is adjusted over time to match, well, a target. In this case, as the fund’s date gets closer, they tend to adjust to more conservative portfolios.

For example, a 2050 target date fund might consist mostly of stock with just a little bonds. That’s because someone investing to retire in 2050 probably has many years to weather the volatility and risk of stock investments but would like to capture the higher average return over time.

By 2050, as the investor should be retiring, they’ll need to protect their nest egg. Typically there’s a strong shift to bonds and other “safer” investments as the date closes in.

This is what makes target date funds actively managed even as they often consist of passive index funds. Fund managers transfer the fund’s assets around to match the glide path from high risk, high return to low risk, low return as the target date approaches.

That all sounds pretty great for folks like us who need to shift to more conservative portfolio allocations as we kick work to the curb and enter early retirement!

Why bother trying to do all that rebalancing yourself when the experts can handle it for you?

It sure seems like that’s worth the 0.13% fee that a fund like Vanguard’s 2020 target date fund offers (for comparison, VTSAX’s is 0.04%).

That’s a whopping $195 per year (vs. $60 with VTSAX) on $150,000 invested, and saves me hours of anguish, research, and work rebalancing.

And here’s where we get to our problem.

 

A Surprise Windfall

 

At the end of 2021, I received a surprise distribution in my Vanguard account that was way bigger than any recent year.

The distributions from $VTWNX on 12/29/2021 in my brokerage account totaled nearly $27,000!

And mind you, this is just one account. Between all of our accounts, we received a whopping $86,000 worth of distributions in December 2021.

Looking back at our December 2020 budget, that’s an increase of about $69,000!

The vast majority came from different Vanguard target date funds like VTWNX in the account above, and these distributions came from a mix of dividends and capital gains (both short and long term).

Now, of course, most people would be celebrating a surprise windfall of nearly seventy grand.

But realizing additional income you don’t intend to use is terribly inefficient when it comes to financial planning.

 

The tax implications of a windfall

 

The sudden influx of income will create some pretty severe tax implications for us.

In reality, here’s what the windfall means to us:

  • The large distribution from our investments (10-15% in several target date funds) is mirrored by decreased share prices, so our net worth is unaffected
  • We mostly hold these funds in taxable accounts, so those distributions equal taxable income
  • A big bump in taxable income means we won’t qualify for certain tax credit, like Jenni’s $2,400 in health insurance credits
  • This didn’t free up cash flow for us to use in other ways, as the funds were almost all reinvested immediately through our DRIPs
  • The automatic dividend reinvestment unfortunately compounds our problem in the future

Ultimately, all of this income should fall into the 15% capital gains tax bracket.

Our regular income will probably be just above the 0% cutoff of about $40,000 for each of us individually.

 

Tax-filing status Single Married, filing jointly Married, filing separately Head of household
0% $0 to $40,400 $0 to $80,800 $0 to $40,400 $0 to $54,100
15% $40,401 to $445,850 $80,801 to $501,600 $40,401 to $250,800 $54,101 to $473,750
20% $445,851 or more $501,601 or more $250,801 or more $473,751 or more

2021 Federal Capital Gains Tax Brackets, USA

 

So, that means we’re looking at a tax bill of nearly $13,000 just for December’s dividends!

Tack on the loss of certain credits and we’ll break $15,000 of unexpected taxes pretty quickly!

 

But a windfall can cover the taxes!

You may be thinking, “yeah, Chris, but a surprise $86,000 worth of income is a good problem to have — you can pay those taxes without issue from it!”

And, sure, you’re correct.

We can afford the taxes. We’re happy to pay what we owe.

But of course, we also don’t want to pay more than we need to pay, and tax planning is part of efficient financial planning.

Remember, this $86,000 is a distribution from the asset we own, primarily those target date funds. It’s effectively like if you transferred $86K out of your savings account to checking and were taxed upon $86K.

 

Remember, our net worth is unaffected.

We didn’t suddenly gain $86K overall, it was just distributed from the investment. It’s not a distribution of profits like a traditional dividend from individual companies tends to be.

This is because the root of this massive windfall appears to have come from the very rebalancing that I discussed as a benefit of target date funds above.

 

Why were distributions so high from target date funds?

 

Remember, target date funds need to maintain a certain ratio of different asset classes in the fund.

Let’s pretend it was a simple 50:50 stock:bond ratio. If stocks double over a period of time but bonds trade sideways, your ratio would reach 75:25 and you’d be very overweight stocks.

How do fund managers resolve this? They sell stocks and buy more bonds! And 2021 was certainly a year where stocks and bonds diverged pretty widely!

So, while no doubt fund managers have lots of tricky ways to try to avoid severe rebalancing — once things go too far, they’ve got to sell. Those transactions flow through the funds and back to the owners eventually.

That would seem to explain the big distribution, right? Rebalancing?

Well, probably not. 2020 had a similar disconnect between large stock price increases and bonds trading in a narrow range. Yet, we didn’t experience such a massive distribution. 2021’s was dozens of times larger!

There’s a lot of speculation around the web, including on Bogleheads, about how this happened. It seems to be that some internal changes within Vanguard (though this problem wasn’t limited to just Vanguard funds) triggered a flow of assets from one fund to another.

Ultimately, the reason doesn’t matter all that much. It’s the outcome that does.

And, how we can avoid it in the future.

 

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Don’t Put That in Taxable Accounts!

 

The too long; didn’t read version of this article is this:

Don’t put investments that are likely to generate large dividend distributions into taxable accounts.

Now, I knew that before this problem arose. I didn’t think of the target date funds as distribution-heavy. The key here is the rebalancing needed to maintain this fund of funds.

It’s that “active management” part of target date funds.

If we kept these funds in our 401(k)s, IRAs, or HSAs, which are tax-deferred, the distributions would NOT be immediately taxable. We’d maintain our tax credits and not blowup our income for the year!

It’ll be difficult for us to unwind this problem since selling the funds as they exist now, even if we just watched to switch to something simple like VTSAX, would be a taxable event itself.

What we’ll probably do to try to ameliorate this issue is prioritize selling our target date funds as our income continues to drop in early retirement.

We’ll suffer the consequences of this mistake, now, through some higher taxes today than what we’d likely pay in the future. It’s unfortunate, but we’ve planned for an early retirement that has room for plenty of mistakes.

It’s my hope that sharing mistakes like this can help you better avoid such failures in your own financial planning. Don’t repeat our mistakes!

Now, if only we can internalize the point that our readers were making earlier, we’ll avoid another mistake: waiting too long to really bring to fruition the life we want as time passes by!

If you enjoyed this post, read TicTocLife for more on how your financial life crosses with money psychology and day-to-day FIRE strategy!

 

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9 thoughts on “How a NYE Windfall Was Our Biggest Money Mistake of 2021”

  1. I’m curious to see if I understand this post correctly — it sounds like within your target fund, the stocks outperformed the bonds, leading to a large “distribution” of $86,000 of stocks that were sold to buy bonds to balance the fund. The “mistake” was that this happened within a taxed account, leading to a large tax bill. Could this have been avoided if the fund wasn’t actively managed, but instead you managed your own glide path? Also, is it possible to put target funds in non-taxable accounts? (the author notes that if this was in a 401K or other account, then this mistake could have been avoided).

    I’m new to finance so would appreciate any clarity that people can offer. Thanks.
    -Adrian

    Reply
    • Hey Adrian! Chris here (the author), you’ve got it—the primary issue is that another entity is managing our assets. Even with index funds (or target date funds in this case), that can have unexpected consequences we don’t have control over.

      It’s the trade off we make in letting the reigns go in some of our financial management. Indeed, simply having our own glide path setup with a mix of VTSAX and a bond fund, for example, could have avoided this. Similarly, having the target date funds in a tax advantaged account like a 401k would have avoided the tax/income issue (even though the distribution would have stilled occurred).

      It sounds like you’re doing a great job of learning about your money path ahead!

      Cheers from Portugal,
      Chris

      Reply
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  3. Thank you for sharing your story. I guess the lesson learned here is don’t have actively managed mutual funds in your Taxable accounts?
    Stick with passive index ETF’s and mutual funds in your Taxable account?
    With the recent crash, I’ve been going through some Tax Loss Harvesting and putting that money into passive index ETF’s, like VTI and MGK.

    Reply
    • Hey, thanks! Chris here (the author), you’ve got it—the primary issue is that the taxable accounts held these fund of funds (which are in a way, actively managed).

      Cheers from Portugal,
      Chris

      Reply
  4. That’s not really a windfall– it was just a conversion of equity into dividends.

    I didn’t know about the Vanguard Target-date rebalancing problem. I guess that means ours must all be in retirement accounts. I have had similar problems with an old American Century Trust fund occasionally resetting itself (like never for a decade and then several times in the next few years) . I’d very much like to sell it except by now the tax situation is so complicated it’s probably best to wait until I die and my heirs get step-up basis.

    Reply
    • Hi Nicole and Maggie!

      Chris here (the author), indeed certainly not a traditional “windfall”! 🙂

      Yep, it was apparently more than just Vanguard that had this issue. But, it was mostly with target date funds.

      Sounds like you’ll be able to leave an educational financial problem to your heirs, ha! 😉

      Cheers from Portugal,
      Chris

      Reply
  5. Hey dude great post. Sorry that happened to you. On the White Coat Investor forum there’s been a lot of discussion about this and unfortunately it seems that that because vanguard lowered the initial investment to get into the share class target date fund with lower expense ratios, institutions sold their existing target date funds and bought the the target date funds with the lower expense ratio. Very unfortunate for many people that this happened, and Vanguard should have given forewarning to its investors like you who in the end are Vangaurd owners.

    Reply
    • Hey Rikki, thanks for the kind words!

      Yep, it seems like this issue occurred in varying severity to more than just Vanguard. I recall reading the problem you mentioned, too, that shift between fund prices occurred which triggered a big sell/buy in Vanguard even though money was just moving around within Vanguard itself. Confusing stuff! Indeed, it’d be nice if Vanguard was a little more clear about it. Apparently there was some early warning but it was quite late in the year.

      Cheers from Portugal,
      Chris

      Reply

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