Taxes and Mutual Funds

How taxes can affect your investmentspl

ain

talk

®

Why Plain Talk?

At The Vanguard Group—a leading proponent of investor education inthe mutual fund industry—we believe that knowledge is one of thekeys to investment success. To that end, we have developed our PlainTalk Library, a series of candid, concise, and easy-to-understandpublications 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 www.vanguard.com.

We hope you find the information in the Plain Talk Library helpful asyou chart your investment course with us.

■ Mutual Fund Basics■ The Vanguard Investment Planner■ Women and Investing■ Financing College■ Preparing to Retire■ Investing During Retirement■ Estate Planning Basics■ How to Select a Financial Adviser■ Measuring Mutual Fund Performance■ Bear Markets■ Bond Fund Investing■ Index Investing■ International Investing■ Taxes and Mutual Funds■ Dollar-Cost Averaging■ Why Vanguard?

T axes are an important consideration for investors. Unlessyou pay careful attention to the tax implications of yourmutual fund investments, taxes can sharply reduce the

earnings you are actually able to keep. Fortunately, you don’tneed an accounting or law degree to understand the basics oftaxes and mutual funds.

This Plain Talk brochure explains how mutual fund investmentsare taxed. The focus is on mutual funds in taxable accounts, butwe will also note how you can delay or even completely avoidtaxes by using tax-deferred or tax-exempt accounts.

Though this brochure is not meant to serve as a complete guidefor all tax questions, it can help you make sound investmentdecisions, choose funds that are appropriate for you, andminimize the impact of taxes on your investment returns.

Note that a glossary appears at the back of this brochure. Termsthat may be new to readers are printed in blue (for example, costbasis) the first time they occur.

Taxes and Mutual Funds

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

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HOW YO U R MU T UA L F U N D

IN V ES T M EN T S ARE TAX ED

Since your goal as an investor should be to keep as much aspossible of what you earn from mutual fund investments, youcan’t look past the inescapable reality that taxes take a big biteout of bottom-line returns.

As a mutual fund investor, you can incur income taxes in threeways: when the fund distributes income dividends, when thefund distributes capital gains from the sale of securities, andwhen you sell or exchange fund shares at a profit. First we’llexplain how a fund’s earnings are taxed—then we’ll show howyour sales or exchanges of shares can trigger taxes.

Owning shares and paying taxesA 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.

■ Income distributions represent all interest and dividend incomeearned by securities—whether cash investments, bonds, orstocks—after the fund’s operating expenses are subtracted.

■ Capital gains distributions represent the profit a fund makeswhen it sells securities. When a fund makes such a profit, acapital gain is realized. When a fund sells securities at a pricelower than it paid, it realizes a capital loss. If total capital gainsexceed total capital losses, the fund has net realized capital gains,which are distributed to fund shareholders. Net realized capitallosses are not passed through to shareholders but are retained by the fund and may be used to offset future capital gains.

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Occasionally distributions from mutual funds may include areturn of capital. Returns of capital are not taxed (unless theyexceed 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 aresubject to federal income taxes (and often state and local taxes aswell). You must pay taxes on distributions regardless of whetheryou receive them in cash or reinvest them in additional shares.The exceptions to the general rule are:■ U.S. Treasury securities, whose interest income is exempt from

state income taxes.

■ Municipal bond funds, whose interest income is exempt fromfederal income tax and may be exempt from state taxes as well.

However, any capital gains on U.S. Treasury securities ormunicipal bond funds are generally taxable.

While the amount of income and capital gains you receive from amutual fund affects the taxes you pay, another important factor isthe holding period—that is, how long the fund held the securitiesbefore they were sold. Securities held for one year or less beforebeing sold are categorized as short-term capital gains (or losses).Short-term capital gains are taxed at your ordinary income taxrate, as shown in Figure 1. But long-term capital gains—gains on

Figure 1

Federal Income Tax RatesRates 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 $297,351Filing Jointly $45,200 $109,250 $166,500 $297,350 and up

Married, Up to $ 22,601 to $ 54,626 to $ 83,251 to $148,676Filing Separately $22,600 $ 54,625 $ 83,250 $148,675 and up

Note: Income brackets are adjusted annually for inflation.

Source: Internal Revenue Service.

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New tax rates on certain capital gains

Federal income tax rates have been reduced on certain capital gains knownas “qualified five-year gains.”

■ For taxpayers in the 15% bracket, the tax rate on capital gains from thesale of assets that have been held longer than five years has droppedfrom 10% to 8%. Tax rates on capital gains from the sale of assets heldfive years or less are unchanged.

■ For taxpayers in the higher brackets (28%, 31%, 36%, and 39.6%), the taxrate 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 until2006 or later) has dropped from 20% to 18%. Tax rates on capital gainsfrom the sale of assets held five years or less are unchanged.

Taxpayers in the higher brackets (28% or higher) can make assets they owneligible for the 18% rate (rather than the 20% rate) in 2006 or later by treatingthose assets as having been sold and reacquired at their closing prices onJanuary 2, 2001. By “marking assets to market” in this way, a taxpayer canrecognize capital gains (but not losses). The gains as of January 2 are taxedcurrently at the old rate of 20% (or a higher rate if it’s a short-term gain) andmust be reported to the IRS in a letter filed with the investor’s tax return for thetax 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. Theinvestor marks them to market and pays a 20% tax on her $1,000 profit—atotal 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 shehad not marked the shares to market, her total tax bill would have been $400in 2006—so she saved $20. However, the $200 paid in taxes in 2001 couldhave been invested from 2001 to 2006, possibly earning more than $20.

We recommend that you consult a tax or financial adviser about whethermarking to market would be beneficial in your individual situation. Be sure to consider state and local income taxes in making your decision.

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securities the fund held for longer than one year before being sold—are taxed at a maximum rate of 20%. (The long-term capital gainsrate is a maximum rate of 10% for taxpayers in the lowest incometax bracket.)

Your mutual fund will tell you the category of any capital gains it distributes. This is determined by how long the fund held thesecurities it sold, not by how long you have owned your shares.For example, say you first bought shares in a fund last month andtoday 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 waslonger than one year. On the other hand, say you bought shares in a mutual fund ten years ago. The fund makes a capital gainsdistribution 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 incomeis treated equally. Income (such as interest and dividends) and short-term capital gains are taxed as ordinary income at your marginal taxrate (which can range from 15% to 39.6%, as shown in Figure 1 onpage 2). Net capital gains on securities held longer than one year are taxed at a maximum rate of 20% (a maximum rate of 10% fortaxpayers 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 funddistributions you must report on your federal income tax return,including both income distributions and capital gains distributionsfrom your funds. You won’t receive a Form 1099-DIV for mutualfunds that distribute tax-exempt interest dividends (such asmunicipal bond funds) or for funds on which you earned less than $10 in dividends. (However, you still owe taxes on all taxabledistributions, regardless of their size.) For more information,see Calculating and Reporting Your Taxes on page 12.

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Taxes on sales or exchanges of sharesYou can trigger capital gains taxes on mutual fund investments byselling some or all of your shares at a profit, or by exchanging sharesof one fund for shares of another. The length of time you holdshares and your tax bracket determine the tax rate on any gain.

Three important notes:■ All capital gains from your sale of mutual fund shares are

taxable, even those from the sale of shares of a tax-exempt fund.

■ Exchanging shares between funds is considered a sale, whichmay lead to capital gains. (An exchange involves selling shares ofone fund to buy shares in another.)

■ Writing a check against an investment in a mutual fund with a fluctuating share price (all funds except money marketfunds) 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 fundshares: If you buy 100 shares of mutual fund ABC for $20 a share and sellthem 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 theoriginal purchase, your profit is considered a long-term gain. Therefore, it istaxed 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 buymutual fund shares at different times and at different prices. In Calculatingand Reporting Your Taxes (pages 12–16), we’ll explain how to figure gains orlosses on sales of mutual fund shares.

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Don’t buy a tax bill with your fund sharesThe tax owed on mutual fund investments may also depend in parton when you buy the shares. Mutual fund distributions, whetherfrom income dividends or capital gains, are taxed in the year theyare made. However, under certain circumstances, distributionsdeclared during the last three months of a year and paid thefollowing 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 otherfunds, such as stock and balanced funds, dividend and capitalgains distributions are not declared daily but according to aregular schedule (monthly, quarterly, semiannually, or annually).

When a mutual fund makes a distribution, its share price (or netasset 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, soits share price drops to $9 a share on the fund’s reinvestmentdate (not counting market activity). You’ll still have $10,000(1,000 x $9 = $9,000, plus the $1,000 distribution). But you’llowe tax on the $1,000 distribution, even if you reinvest it to buymore shares.

So when considering a purchase of fund shares, ask the fundcompany about the fund’s next distribution—when it will takeplace and how large it is expected to be. If you own shares onthe fund’s record date, you will receive the distribution. Thatmeans if you purchase shares shortly before the record date,you are “buying the distribution”—you’ll owe taxes on thecapital gains that were reflected in the share price when youbought shares. In effect, a portion of your investment is being“returned” to you as a taxable capital gain.

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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 retirementplans (401(k) and 403(b) plans), individual retirement accounts (traditionalIRAs), or variable annuities. Nor do these rules apply to Roth IRAs, whichcan 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 duringretirement. Whether the withdrawals take the form of a lump sum or aninstallment payment, the taxable portion is always considered ordinaryincome (as opposed to capital gains) and thus taxed at the taxpayer’smarginal rate for the years when the withdrawals occur. IRA withdrawalstaken before age 591/2 are generally taxable and subject to an additional10% penalty tax. (Note, however, that distributions from Roth IRAs after ataxpayer reaches age 591/2 will be tax-free if the Roth IRA has been heldlonger 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 yourpay before it is taxed, which reduces your taxable wages. Similarly, manyinvestors can deduct some or all of their contributions to traditional IRAs,which also reduces their taxable income. (Contributions to Roth IRAs arenever deductible.)

In retirement plans that allow pre-tax contributions (for example, 401(k)plans and traditional IRAs), withdrawals from the account are taxed asordinary 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 thataccumulate in the account, because the contribution has already been taxed.

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*For some investors, however, a portion of the fund’s income may be subject to thealternative 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.

HOW A F U N D’S IN V ES T M EN T ST RAT E G Y

CA N AF F E C T TAX ES

The likelihood that a mutual fund will pass along taxabledistributions is heavily influenced by two factors: the kinds ofsecurities 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—earninterest 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 orlosses, either within the fund or as the result of sales or exchangesyou make.

Bond fundsOrdinarily, bond funds produce relatively high levels of taxableincome. Over long periods, almost all the return from bond fundscomes from dividend payments. However, because the prices ofbonds and bond funds fluctuate in response to changing interestrates, it is possible to have taxable capital gains from investing inbond funds, even tax-exempt bond funds. Sometimes a fund willgenerate 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 theoriginal cost.

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Stock fundsStock 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 stockprices fluctuate considerably, you are generally more likely torealize a capital gain or loss when selling shares of a stock mutualfund than when selling shares of bond funds or money marketfunds. If you sell shares that have fallen in value, you won’t owetaxes on the transaction; indeed, you may be able to take adeduction 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 whetherit emphasizes income or capital appreciation. Also determinewhether it concentrates on value stocks (which generally payhigher dividend yields) or growth stocks (which seek long-termcapital growth rather than current income). The annualized rateat which a stock earns income (known as the dividend yield, whichcan 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 dividendsthan smaller companies, which generally reinvest any profits backinto the company to pay for growth. Consequently, funds thatemphasize large-company (“blue chip”) stocks tend to generatemore taxable dividend income than funds that emphasize small-company stocks.

Investment policiesHow a mutual fund’s adviser manages the fund’s securities can also affect the taxes of shareholders in the fund. Because capitalgains distributions result from the profitable sale of securities in the fund, frequent selling within a fund makes the fund more likelyto produce taxable distributions than a fund that follows a strategyof “buy and hold.”

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A common measure of a mutual fund’s trading activity is itsturnover rate, which is expressed as a percentage of the fund’saverage net assets. For example, a fund with a 50% turnover ratehas (over the course of a year) sold and replaced securities with avalue equal to 50% of the fund’s average net assets. This meansthat, on average, the fund holds securities for two years. (Theaverage turnover rate for U.S. stock mutual funds is about 113%.*) Turnover rates can’t be used to forecast a fund’s taxabledistributions, but they can help you compare the trading policiesamong funds. Assuming that a fund’s holdings will increase invalue over time, you need to consider how much of that increase in value will be passed along to you as a taxable capital gainsdistribution. The fund’s turnover rate bears directly on this point.

A capital gain on the sale of securities is a realized gain. Incontrast, an unrealized (“paper”) gain has not yet been locked inby the sale of securities. For example, a fund may have boughtstock in XYZ Inc. for $5 per share three years ago. If the stock’sprice rises to $15, the fund has an unrealized capital gain of $10per share on XYZ’s stock. As long as the fund continues to holdthe XYZ shares, there is no taxable gain. But if the fund actuallysells the stock at $15 per share, shareholders will usually have topay taxes on the $10 per share of realized capital gains,regardless of whether the shareholders owned their own sharesin the mutual fund for a month or for a decade. Thus, allunrealized capital gains have the potential to be convertedeventually into realized capital gains.

This means that you should consider both a fund’s realized andunrealized gains (information that is available through yourmutual fund company) and also its turnover rate to determinethe potential tax implications of your investment.

*Source: Lipper Inc.

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When the markets moveThe financial markets also play a part in determining the taxabledistributions a fund may pass along to you. Generally, risingmarkets lead to bigger gains and higher tax liabilities. (Risingmarkets are no cause for concern—after all, strong returns areundoubtedly the goal of every mutual fund investor.)

All these factors—security holdings, investment policies, andmarket movements—cannot reliably predict your annual tax bill. Taken together, however, they should give you a sense ofwhether a fund may add to that bill. The information in Figure 2may 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

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*Mutual funds that invest in foreign securities may elect to pass through foreigntaxes paid by the fund to its shareholders. Shareholders may be able to claim a taxcredit or deduction for their portion of foreign taxes paid.

**Vanguard shareholders receive the United States Government Obligation listing.

CA LC U LAT I N G A N D REP O RT I N G YO U R TAX ES

Your mutual fund company will provide a variety of forms to helpyou complete your tax returns accurately. This information is alsoprovided to the IRS. Here is a list of the various forms and how they can be used.■ IRS Form 1099-DIV, which is typically mailed by fund

companies by late January of each year, lists the ordinarydividends and capital gains distributed by your funds. “Ordinarydividends” reported on Form 1099-DIV include both taxabledividends and any short-term capital gains. Form 1099-DIVmay also include return-of-capital distributions and foreign taxes paid.*

■ IRS Form 1099-B serves as a record of all sales of shares. Mailedin January, this form lists all of your sales of shares, checkwritingactivity, and exchanges between funds. It is essential todetermining capital gains or losses. If you realize capital gains or losses from the sale or exchange of mutual fund shares (orother capital assets), you must report them on your tax return.

■ IRS Form 1099-R summarizes all distributions from retirementaccounts such as IRAs, 401(k) plans, and annuities. Mailed inJanuary, 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, youmay receive a United States Government Obligation listing withyour Form 1099-DIV.** This provides the percentage of a fund’sincome that came from U.S. government securities—and thus the percentage of income dividends that may be exempt fromstate income taxes.

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If you own shares of a municipal bond fund, you may receive anIncome by State listing* that tells you the percentage of the fund’sincome that came from each state’s obligations. You can use thisinformation to exclude income from municipal bonds issued in the state where you live.

You may also receive other tax-related information, dependingon the types of funds you own. For example, if you invest in aninternational 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 yousold the shares and your cost basis (generally the original priceyou paid for the shares). The sale price is the easy part. Figuringyour cost basis can be complicated, especially if you boughtshares at different times and at different prices.

An important note: Always count reinvested dividend and capitalgains distributions as part of your cost basis. This will raise your costbasis and thus reduce the amount of your taxable gain when yousell or exchange your shares. Because the size of the taxable gainwill be smaller, you will owe less in taxes.

When figuring your cost basis, keep in mind that any salescharge or transaction fee you pay when you buy shares is part ofyour cost basis. Any fees or charges paid when you sell sharesreduce the proceeds of the sale. In general, fees paid when youbuy or redeem shares reduce your taxable gain or increase yourcapital loss. (Other fees charged by a mutual fund, such asaccount maintenance fees, do not affect your cost basis.)

The IRS allows you to figure the gain or loss on sales or exchangesof mutual fund shares by using one of four methods, each of whichhas its own benefits and drawbacks. Once you begin using an

*Vanguard shareholders receive the Income by State listing.

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average cost method for the sale of shares of a particular fund, theIRS 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 toconsult a tax professional.

First-in, first-out (FIFO) This method assumes that the shares sold were the first sharesyou purchased. While fairly easy to understand, this methodoften leads to the largest capital gains, because the longer youhold shares, the more time they have to rise in value. If you donot specify a method for calculating your cost basis, the IRSassumes that you use the FIFO approach.

Average cost (single category) This method considers thecost basis of your mutualfund investment to be theaverage basis of all the sharesyou own—a figure thatchanges as you continueinvesting in a fund. Mostmutual fund companies(including Vanguard) usethis method to calculateaverage cost. In determiningwhether a sale generated ashort-term gain or a long-term gain, the shares sold areconsidered to be the sharesacquired first.

Average cost (double category)This approach is similar to the single category method exceptthat you must separate your shares into two categories—sharesheld for a year or less and shares held for longer than a year.

The simple approach to your cost basis

Vanguard uses the average costsingle category method tocalculate the tax basis of sharesredeemed from Vanguard fundaccounts. We will send you thecost basis for each eligibleinvestment that you sell during theyear, updated on each statementyou receive. (This service is notavailable for all accounts, such asthose established before 1986 orsome accounts acquired through atransfer.) See page 26 for moreinformation on Vanguard’s averagecost service.

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Selling short-term shares means basing the gain (which is taxed at ordinary income rates of up to 39.6%) on the differencebetween the average short-term basis and the sales price. Bycontrast, the gain on the sale of long-term shares (which is taxedat a maximum rate of 20%) is based on the difference betweenthe average long-term basis and the sales price. If you choosethis method, you must notify the fund company in advance ofwhich category of shares to sell.

Specific identificationThis method provides the most flexibility and therefore the bestchance to minimize taxable gains. The first step is to identify thespecific shares you want to sell—in most cases, these would bethe shares bought at the highest price so that you can minimizeyour gain. However, this method is not necessarily the bestchoice because it can be complex and also imposes the heaviestrecordkeeping burden on shareholders. In addition, the shareswith the highest cost basis may be the ones you purchased mostrecently—which could mean your having to pay taxes at a higherrate if the gains that result are short-term.

Help from the IRS

More tax information is available from the Internal Revenue Service. Call theIRS at 1-800-TAX-1040 to ask questions about specific tax matters. You canorder IRS forms and publications by calling 1-800-TAX-FORM. Among thepublications you may find helpful in understanding and reporting mutual fundtaxes are:

■ IRS Publication 17, Your Federal Income Tax

■ IRS Publication 564, Mutual Fund Distributions

■ IRS Publication 590, Individual Retirement Arrangements

■ IRS Publication 514, Foreign Tax Credit for Individuals

IRS forms and brochures are also available on the IRS website atwww.irs.gov.

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To use the specific identification method, notify your mutual fundcompany in writing and provide detailed instructions about whichshares you are selling each time you sell or exchange shares.

Making losses work for youYou can use losses on the sale of shares to offset other capitalgains. You can also use up to $3,000 of net capital losses ($1,500 for people who are married and filing separately) tooffset ordinary income (such as salary, wages, or investmentincome) in any year.

For example, if you have a net capital loss of $2,000 (because ofunprofitable sales of mutual funds, for instance), that loss can beused to reduce your taxable income. Losses that exceed $3,000in one year can be carried forward for as long as you wish.

A few cautionary notes:■ If you redeem shares at a loss and purchase shares in the

same fund within 30 days before, after, or on the day of theredemption, the IRS considers the redemption a wash sale.This means that you may not be allowed to claim some or allof the loss on your tax return.

■ If you redeem shares at a loss from a tax-exempt municipalbond fund by selling shares held for six months or less, aportion of the loss may not be allowed. In this case, therealized loss must be reduced by the tax-exempt income you received from these shares.

■ If you realize a short-term capital loss on shares held sixmonths or less in an account that received long-term capitalgains distributions on those shares, the short-term loss yourealize from a sale of shares (up to the amount of the capitalgains distributions they earned) must be reported as a long-term loss.

You may wish to consult with a tax adviser or tax preparer forguidance in dealing with these situations.

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TH E IM PAC T O F TAX ES O N

YO U R IN V ES T M EN T RE T U R N S

Understanding how mutual fund investments are taxed preparesyou for the critical next step, which is to understand the impactthat taxes can have on the overall performance of your investmentprogram. 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 substantiallyboost 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 payfederal income tax on dividend and capital gains distributions—especially for investors in high tax brackets. Specifically, for themutual funds included in the analysis, the average annual pre-taxreturn (for ten years ended December 31, 2000) was 16.1%, but the after-tax annual return was only 13.4%.* In other words, aboutone-sixth of the pre-tax returns was consumed by federal incometax. The amount lost to taxes for individual funds ranged from zero(the pre-tax and after-tax returns were equal) to 9.3 percentagepoints per year.

*Source: Vanguard analysis using data from Morningstar, Inc.

You can learn more about the after-tax returns on mostVanguard funds by using the After-Tax Returns Calculator on our website.

This interactive tool calculates the fund’s after-tax returns based on yourmarginal tax rate for any time period you choose. An advanced version of thecalculator can even factor in state and local income taxes.

To use the calculator, go to www.vanguard.com/?aftertax.

How Vanguard can help

Over the long haul, efforts to minimize taxes can provide ahandsome payoff. Figure 3 below demonstrates the growthof hypothetical taxable investments of $10,000 in two mutualfunds. Both funds have pre-tax total returns of 10% a year, buttheir after-tax returns are different. Investors in one fund paidtaxes equal to 10% of their earnings (for an after-tax return of9% a year), and investors in the other fund paid taxes equal to30% of their earnings (for an after-tax return of 7% a year).Though the advantage is not dramatic at first, it becomes hugeas earnings compound over time. After 30 years, the investmentwith the smaller tax bite grows to almost $133,000 after taxes—about 75% more than the $76,123 produced by the more heavilytaxed fund.

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5 10 15 20 25 300

20000

40000

60000

80000

100000

120000

$140000

$76,123

7% Annual Return

9% Annual Return $132,677

Years

Figure 3

The Effect of Taxes Over the Long Term

This example, which assumes original investments of $10,000 each, is for illustrativepurposes only and does not imply returns available on any particular investment.

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WH AT TO DO AB O U T TAX ES

Because most mutual fund managers focus on maximizing pre-tax returns (within a fund’s guidelines), the important task ofconsidering the tax effect of mutual fund investments is up to you.

Several approaches can help in crafting an investment programthat keeps taxes to a minimum:■ Deferring taxes on your investments for as long as possible.

■ Selecting mutual funds that feature low turnover rates.

■ Choosing tax-exempt investments such as municipal bondfunds (for people in high tax brackets).

Deferring taxesThe most efficient investment strategy is to avoid taxes entirely—at least for a while. For example, mutual funds held in tax-deferredaccounts (such as 401(k) and 403(b) plans, traditional IRAs, orvariable annuities) are exempt from current taxation. Generally,withdrawals (both contributions and earnings) from these accountsare taxable. However, non-deductible contributions to a traditionalIRA are usually not taxable when they are withdrawn.* The entireamount withdrawn from a Roth IRA is generally exempt fromincome taxes.

On the following page, Figure 4 demonstrates the long-termbenefit of delaying the payment of taxes. The “Taxable Account”column shows the value of annual $1,000 investments in a regularaccount on which taxes must be paid on the earnings every year.The “Tax-Deferred Account Before Taxes” column shows thevalue if the annual $1,000 investments are allowed to grow insidea tax-deferred account. The last column, “Tax-Deferred AccountAfter 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.

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that the account balance is withdrawn and taxes paid at the end ofeach period.

Though the advantage of tax deferral is evident early on, thedifference 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 taxableaccount over the same period. Even after taxes are paid at the end of the 30-year period, the tax-deferred account maintains anadvantage of more than $17,000 over the taxable account—morethan 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 taxableaccount, you would have to earn nearly $1,500 for every $1,000 oftake-home pay that you plan to invest (assuming a 33% combinedfederal and state tax bracket). Therefore, by participating in a planthat allows pre-tax contributions, you could invest $1,500 withoutdigging any deeper into your pocket than you would if you made a $1,000 investment after taxes.

Figure 4

The Power of Long-Term Tax Deferral Annual investments of $1,000

Year-End ValuesTax-Deferred Tax-Deferred

Number of Taxable Account AccountYears 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). Thischart should not be viewed as indicative of future investment performance. These datarepresent historical investment performance, which cannot be used to predict future returns.

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The concept is similar for tax-deferred investments on which youmay take a tax deduction, such as contributions to a traditional IRA(if you meet certain income limits). Receiving a tax deductionreduces the taxes that would otherwise be payable.

Seeking low turnoverThough most funds are not managed to keep taxes low, sometypes of mutual funds are tax-friendly by nature, especially thosethat keep turnover (the buying and selling of securities) low. Asdiscussed earlier, a fund that buys and holds securities is likely torealize fewer gains than a fund that engages in active trading andis thus less likely to pass along taxable gains to investors. Suchfunds are sometimes called tax-efficient funds.

Index fundsThe objective of an index fund is to track the performance and riskcharacteristics 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 arepresentative sample of the index). Because of this, the portfolioturnover of index funds is typically low. The chance that a securityheld 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 thatemploys an active management approach (buying and sellingsecurities 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 mustbe sold by the fund. An index fund could also be forced to sellsecurities in its portfolio if many investors decide to sell theirshares—say, during a downturn in the stock market.

Bond index funds do not offer a tax-efficiency edge over activelymanaged bond funds because income—not capital gains—typically accounts for almost all of the long-term total returnfrom bond funds.

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Tax-managed funds Some funds are managed to keep taxable gains and income low.Among the strategies these funds employ are indexing (to hold downturnover), carefully selecting which shares to sell (so that capitallosses offset most capital gains), and encouraging long-terminvesting (for example, by assessing fees on shareholders whoredeem their shares soon after buying them).

Investing for tax-exempt incomeInterest 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 thantaxable bond funds as the trade-off for their tax advantage) are notfor everyone. Generally, investors in lower tax brackets do notbenefit from owning municipal bond funds. The box below explainshow 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 takessome analysis. Municipal bonds offer the advantage of producing incomethat is exempt from taxes—but they also pay yields lower than thoseavailable on taxable bond funds of comparable quality and maturity. Todecide whether to invest in a tax-exempt bond fund or a taxable one, youneed to know which provides the best overall return.

Here is how to compare the yield of a municipal bond fund with that of ataxable 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 theequivalent taxable yield. For an investor in the 28% tax bracket considering atax-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% totop a yield of 6% from a tax-exempt fund.

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Keep in mind that only a municipal bond’s income is exempt fromtaxes. Taxes are payable on any capital gains that a tax-exemptfund distributes. And for some investors, a portion of the fund’sincome may be subject to the alternative minimum tax.

State-specific municipal bond funds provide an additional taxadvantage. Municipal bond income is generally exempt fromboth state and federal taxes for investors who live in the statewhere the bonds are issued. For example, New York Stateresidents pay no state taxes on income from a municipal bondfund that holds only securities of New York State issuers.

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TAX-EF F I C I EN T VA N G UA RD F U N D S

Vanguard understands that taxes are an important considerationfor all investors. To address that concern, we offer a wide varietyof funds that may be suitable for tax-conscious investors.

Vanguard® Municipal Bond FundsHigh-Yield Tax-Exempt FundInsured Long-Term Tax-Exempt FundIntermediate-Term Tax-Exempt FundLimited-Term Tax-Exempt FundLong-Term Tax-Exempt FundShort-Term Tax-Exempt FundTax-Exempt Money Market Fund

Vanguard® State Tax-Exempt Income FundsCalifornia Insured Intermediate-Term Tax-Exempt FundCalifornia Insured Long-Term Tax-Exempt FundCalifornia Tax-Exempt Money Market FundFlorida Insured Long-Term Tax-Exempt FundMassachusetts Tax-Exempt FundNew Jersey Insured Long-Term Tax-Exempt FundNew Jersey Tax-Exempt Money Market FundNew York Insured Long-Term Tax-Exempt FundNew York Tax-Exempt Money Market FundOhio Long-Term Tax-Exempt FundOhio Tax-Exempt Money Market FundPennsylvania Insured Long-Term Tax-Exempt FundPennsylvania Tax-Exempt Money Market Fund

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Vanguard® Index Funds

Vanguard® Domestic Stock Index Funds

500 Index FundBalanced Index FundCalvert Social Index™ FundExtended Market Index FundGrowth Index FundMid-Cap Index FundSmall-Cap Growth FundSmall-Cap Index FundSmall-Cap Value Index FundTotal Stock Market Index FundValue Index Fund

Vanguard® International Stock Index Funds

Developed Markets Index FundEmerging Markets Stock Index FundEuropean Stock Index FundPacific Stock Index FundTotal International Stock Index Fund

Vanguard® Tax-Managed Funds

Tax-Managed Balanced FundTax-Managed Capital Appreciation FundTax-Managed Growth and Income FundTax-Managed International FundTax-Managed Small-Cap Fund

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VA N G UA RD’S TAX IN F O R M AT I O N SERV I C ES

If figuring your taxes already includes more calculations thanyou’d like, several Vanguard services can make tracking andreporting taxes easier.

Average Cost ServiceIf you sell or exchange shares of any Vanguard fund that has afluctuating share value, you will receive an Average Cost Statementthat lists the average cost basis (using the single category method)of the shares you sold or exchanged. In addition, the statement liststhe 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 orloss. This service simplifies tax reporting and recordkeeping. Notethat using a different method of calculating your cost basis couldchange the amount of taxes that you owe. Consult your tax adviserfor further information.

Information on your Average Cost Statement is not reported to the IRS, and you are not required to use it to calculate yourcapital gains or losses. However, if you use one of the three othermethods (as described on pages 14 and 15), you must keepcareful records for purchases and sales. Remember that whileForm 1099-B provides information about sales, it does not showthe cost basis for the shares.

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 youraverage cost basis as of the previous day’s market closing price. Comparethat 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.

How Vanguard can help

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Information for state tax returnsIn 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, orbonds). This information allows you to exclude that percentageof the income you earned from the income subject to state tax.

Also in January, Vanguard furnishes shareholders of municipalbond funds a list of the percentage of the fund’s income derivedfrom each state. Use this information to exclude from your taxreturn any income attributable to municipal bonds issued in thestate where you live.

Foreign Tax Credit ServiceVanguard’s Foreign Tax Credit Service provides detailed taxinformation in January for all shareholders of Vanguard mutualfunds that hold primarily international investments. A mutualfund that invests in stocks of overseas companies may have topay 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 onlyreduces your taxable income, while a credit reduces the tax youowe 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 Form1040 without completing Form 1116; check with your tax adviser.)

You may receive a credit or deduction for foreign taxes only onfunds you hold in taxable accounts. International investmentsheld in a tax-deferred account such as an IRA are not eligiblefor a tax credit or deduction. If you are eligible to receive a creditor deduction for any of your fund investments, Vanguard willsend you the appropriate information.

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A VA N G UA RD IN 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 www.vanguard.com. There you’ll find thecomplete Plain Talk® Library, Retirement Center, and ourpopular Education Center. Register for immediate secure access to our online investment-management center, and you can monitor your accounts, conduct transactions, tradesecurities, and invest in both Vanguard and non-Vanguardfunds—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 associatesare always pleased to answer your questions or provideinformation about our funds and services.

Vanguard also invites you to take advantage of the broadselection of programs and services that we offer that can teachyou more about investing and help you stay on track towardreaching your financial goals.

Vanguard® Personal Financial Planning Service 1-800-567-5162At an affordable fee, this service offers customized one-timeanalysis and advice on investment, retirement, and estate planning.

Vanguard® Asset Management and Trust Services 1-800-567-5163Individuals who have a minimum of $500,000 in investable assetscan receive comprehensive, ongoing wealth management servicesat a very reasonable fee.

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Vanguard Brokerage Services® 1-800-992-8327Through 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 1-800-205-6189Our experienced retirement specialists can provide a wealth of information to help you plan or manage your retirementinvestments.

Individual Retirement Plans 1-800-823-7412Self-employed individuals and small-business owners can find outhow to establish and administer retirement plans for themselvesand/or their employees.

Voyager and Flagship Services 1-800-337-8476

Vanguard offers special services for clients with substantial assets.

■ Voyager Service®, for clients investing more than $250,000 in Vanguardmutual funds, offers the expert assistance of a special service team.

■ Flagship Service, for clients whose Vanguard mutual fund investmentsexceed $1 million, offers personal service from a dedicated representative.

Eligible clients are invited to call Vanguard for more information.

GLO S S A RY

Active managementPortfolio management that seeks to exceed the returns of thefinancial markets. Active fund managers rely on research,market forecasts, and their own judgment and experience inmaking 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 fromprivate activity bonds, accelerated depreciation deductions, andincentive stock options) pay their fair share of income taxesdespite tax benefits. Taxpayers must first calculate regulartaxable income, then add back tax adjustments and preferencesto determine the AMT. If the AMT is higher than the regulartax liability, the taxpayer must pay the AMT.

Capital gains distributionPayment to mutual fund shareholders of net gains realizedduring the year on securities that have been sold at a profit.Capital gains are distributed on a “net” basis—that is, aftersubtracting any capital losses for the year. If losses exceed gains for the year, the difference may be carried forward andsubtracted from the fund’s future gains.

Cost basisFor tax purposes, the original cost of an investment, including anyreinvested dividend or capital gains distributions. Cost basis mayinclude adjustments such as increases for transaction fees paid atpurchase or decreases for return-of-capital distributions. It issubtracted from the sales price to determine any capital gain or loss from the sale of mutual fund shares or other securities.

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DeclaredWhen the Board of Directors of a mutual fund announces theamount and date of a dividend or capital gains distribution, thedistribution is said to have been declared. A declared distributionis payable to the shareholders of record as of the record date.

Dividend yieldThe annualized rate at which an investment pays dividends,expressed as a percentage of the investment’s current price.

Growth stocksStocks of companies with a strong potential for earningsgrowth. They are likely to generate much of their total return in the form of capital gains rather than dividend income.

Income distributionInterest and dividends earned on securities held by a mutualfund and paid out to shareholders (after reduction for fundexpenses) in the form of dividends.

IndexStatistical benchmarks designed to reflect changes in segmentsof the financial markets or the economy. In investing, indexesare used to measure changes in segments of the stock and bondmarkets and as standards against which fund managers andinvestors can measure the performance of their investmentportfolios. You cannot invest in an index.

Indexing An investment management approach in which a mutual fundseeks to track the performance of a specific financial marketbenchmark, or index, by holding all the securities that compose the market segment (or a statistically representative sample of theindex).

Marginal tax rateThe income tax rate at which the last dollar of your income istaxed. Under federal law, you often pay a lower tax rate on your

first dollar of taxable income than you do on your last dollar.The marginal rate—the highest rate at which your income istaxed—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 isexpressed as the value of a single share in the fund and is reporteddaily in many newspapers.

Ordinary incomeOrdinary income includes earned income (such as wages, salaries,and self-employment income), unearned income (such as taxableinterest and dividends), and other income (such as taxable refundsof state income taxes). Ordinary income is taxed at higher ratesthan long-term capital gains.

Record dateThe deadline for owning shares of a fund for the purpose ofreceiving the next distribution of dividends or capital gains. Allinvestors who own shares on the record date receive a distributionand owe taxes on it, regardless of how long they have owned theshares. By buying shares after the record date, investors can avoidthe distribution and resulting taxes.

Return of capitalWhen a mutual fund’s distributions exceed its earnings andprofits, the excess is considered a return of capital (or return ofbasis). That part of the distribution is generally not taxablebecause it represents a portion of the original investment beingreturned. The effect of a return of capital is to reduce basis inthe investment, which may cause future capital gains to behigher. If a shareholder’s basis is eliminated by return-of-capitaldistributions, any excess is treated as a capital gain.

Tax-deferred accountAn investment vehicle that shields earnings from taxes. Thesetypes of accounts include 401(k) plans, 403(b) plans, IRAs, and

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variable annuities. Although mutual funds held in these accountsare not taxed currently, they are subject to federal and state taxesupon withdrawal (except for qualified distributions from RothIRAs and Education IRAs and withdrawals of non-deductiblecontributions to traditional IRAs).

Tax-efficient fundA fund that generates low taxable income for its shareholders is said to be tax-efficient.

Tax-exempt bondA bond whose interest payments are not subject to income tax.The interest on bonds issued by municipal, county, and stategovernments and agencies is typically exempt from federalincome tax and may also be exempt from state or local incometaxes. Tax-exempt bonds are also called municipal bonds or tax-free bonds.

Turnover rateA measure of a mutual fund’s trading activity. Turnover iscalculated by taking the lesser of the fund’s total purchases or salesof securities (not counting securities with maturities under oneyear) and dividing by the average monthly assets. A turnover rateof 50% means that, during the year, a fund has sold and replacedsecurities with a value equal to 50% of the fund’s average net assets.

Value stocksStocks of companies with good long-term prospects but whosecurrent prices are considered low given the companies’ assets orprofit potential. These stocks tend to pay above-average dividends,so much of the total return from value funds comes in the form ofordinary income rather than capital gains.

Wash sale ruleIRS regulation that prohibits a taxpayer from claiming a loss on the sale of a security (such as stock, bond, or mutual fundshares) if that same security is purchased within 30 days beforeor after—or on the same day of—the sale.

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Invest with a leader

The Vanguard Group traces its roots to the opening of its first mutualfund, 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 theworst years in U.S. financial history, Wellington Fund prospered andwithin a generation was one of the largest mutual funds in the nation.

The Vanguard Group was launched in 1975 solely to serve theVanguard mutual funds and their shareholders. From its start as asingle fund in an infant industry, Vanguard has become one of thelargest 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 shareholderswho have entrusted their investment assets—indeed, their financialfuture—to a company that they believe offers the best combination ofinvestment performance, service, and value in the industry.

Post Office Box 2600Valley Forge, PA 19482-2600

© 2001 The Vanguard Group, Inc.All rights reserved.Vanguard MarketingCorporation, Distributor.

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Calvert Group ® and Calvert Social Index are trademarks ofCalvert Group, Ltd., and havebeen licensed for use by TheVanguard Group, Inc. Vanguard®

Calvert Social Index™ Fund is notsponsored, endorsed, sold, orpromoted by Calvert Group, Ltd.,and Calvert Group, Ltd., makes norepresentation regarding theadvisability of investing in the fund.

Standard & Poor’s ®, S&P ®, S&P 500 ®, Standard & Poor’s500, and 500 are trademarks of The McGraw-Hill Companies,Inc., and have been licensed foruse by The Vanguard Group, Inc.Vanguard mutual funds are notsponsored, endorsed, sold, orpromoted by Standard & Poor’s,and Standard & Poor’s makes no representation regarding the advisability of investing in the funds.

Vanguard funds and non-Vanguard funds offered throughour FundAccess® program are offered by prospectus only.Prospectuses contain morecomplete information on risks,advisory fees, distributioncharges, and other expenses and should be read carefullybefore you invest or send money.Prospectuses for Vanguard fundscan be obtained directly from TheVanguard Group; prospectusesfor non-Vanguard funds offeredthrough FundAccess can beobtained from VanguardBrokerage Services, 1-800-992-8327.

Vanguard Brokerage Servicesis a division of VanguardMarketing Corporation.

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