Tax bills are bad enough when you know they are coming. When they are unexpected and large, and come from what seemed like a safe and reliable place, they are infuriating.

That’s a rough summary of the effect of the big bills that some investors face because they hold retirement funds run by Vanguard and a handful of other fund companies in taxable accounts.

This tax problem hasn’t arisen for people who hold these so-called target date funds in tax-sheltered accounts — workplace retirement accounts like 401(k)s, or I.R.A.s. But for investors holding target date funds in ordinary, taxable accounts, it’s a different story.

One man in California who sent me copies of his Vanguard account data on the condition that he not be identified has an unexpected tax bill of more than $70,000 this tax season.

“Sure, I’m angry,” he said. “That tax bill could pay a lot of college tuition bills for my kids. I’m happy to pay my taxes but why is this even happening? Why do I have such a big tax bill?”

The simple answer is that a series of seemingly routine actions taken by Vanguard that lowered costs for the majority of shareholders who own these funds in retirement accounts resulted in unexpected bills for everyone else.

Vanguard, which has in the past been happy to discuss the merits of its target date funds, declined to comment about them for this column.

Why target date funds have become so popular

I own Vanguard target date funds in my New York Times 401(k) accounts and they have been working as intended, as “set-it-and-forget it” portfolios of stock and bond funds. They also have low fees, which Vanguard has been reducing over the last decade.

Target date funds received government approval to be the default offering in corporate retirement plans back in 2007 and, since then, have quietly become central all-in-one pillars of diversified investment for many Americans. The funds shift gradually toward bonds from stocks as a worker approaches a chosen target date: 2025 or 2030 or 2065.

Morningstar, the investment research company, estimates that more than 99 percent of people who own target date retirement funds do so in tax-sheltered accounts, where the funds can compound without taxes for decades.

With this approach, people tend to avoid behavioral missteps like panicking when the market falls and investing after stocks have already risen. One study concluded that the “adoption of low-cost target date funds may enhance retirement wealth by as much as 50 percent over a 30-year horizon.”

Where you keep them is critical

But to borrow a line from real estate, three things really matter for target date funds, as well as many other investments: location, location, location.

Where you hold your stocks and bonds — in a tax-sheltered or taxable account — can make all the difference in the world.

This is a broad issue that goes far beyond the current difficulties faced by target date fund investors.

“Generally speaking, once you have money for emergencies set aside in accounts you can easily access without penalties, then putting the most tax-inefficient assets in retirement accounts is the general rule of thumb,” said Sharon Carson, a retirement strategist at J.P. Morgan Asset Management.

For example, if you are going to invest in a taxable bond mutual fund, it may be wise to hold it in a tax-sheltered account because bonds tend to produce a lot of income. Similarly, actively managed stock mutual funds that trade frequently may produce sizable capital gains when they sell shares.

On the other hand, municipal bonds are generally well-suited for taxable accounts because at least some of the income they generate typically isn’t taxed. Holding stocks directly can be tax efficient, too, because unless you sell the shares, you don’t owe capital gains taxes on them, though the dividend income is taxable. Low turnover stock index funds or exchange traded funds are often appropriate for taxable accounts, too.

But target date funds are different.

They produce taxable income from several sources: interest income from bond holdings; dividends from stock; and, crucially, taxable capital gains distributions, especially when large numbers of investors sell the funds. When that happens, fund managers may be forced to sell underlying shares of appreciated securities and the capital gains are passed on to investors.

Large capital gains distributions last year set off big tax liabilities for investors at Vanguard and, to a lesser extent, at some other fund companies, said Megan Pacholok, a Morningstar analyst.

Tax problems caused by fund sales

“What’s unusual in the Vanguard case is that it took some actions that ended up helping the majority of investors in retirement accounts by cutting their costs — but that had the unfortunate result of much larger tax bills for people who held them in regular accounts,” Ms. Pacholok said.

What Vanguard did seemed innocuous at first.

In December 2020, it reduced the minimum needed to invest in the “institutional” target date funds used by many companies for employee retirement accounts. The threshold dropped to $5 million from $100 million. For people using the institutional funds through their workplaces, the fees were only 0.09 percent. For individuals using the retail funds, the fees were 0.14 percent.

Cheaper is better for investors, so that announcement set off a flood of sales of the retail funds, effectively requiring the fund managers to liquidate underlying investments. That, in turn, set off capital gains distributions for the diminished pool of retail investors who remained at the end of the year, Morningstar has found. Vanguard’s long-term capital gain distributions in 2021 averaged 12.1 percent, compared with less than 1 percent in recent years.

How Vanguard handled its target date funds is the subject of a class-action lawsuit filed this month in Pennsylvania by three plaintiffs. “These massive distributions resulted from Vanguard’s own decision to favor its larger retirement plans over its smaller, taxable investors,” said Jonas Jacobson, one of the lawyers who filed the suit.

The suit says the sequence of Vanguard’s actions is important.

A year after Vanguard set off the mass sales of its retail funds by lowering the institutional threshold, it merged the institutional and retail versions of the funds and lowered fees for all investors to 0.8 percent. (They are cheaper for corporate plans that hold the funds as trusts; at The Times, the fee is 0.65 percent.) But Vanguard could have first merged the funds, then lowered the fees, the suit says. If the process had proceeded in that order, the lawyers argued, there would have been no flood of fund sales and no tax shock for retail investors.

Morningstar has found that other companies’ target date funds also produced hefty capital gains distributions for investors who held them in taxable accounts, though none as large as Vanguard’s. They included:

• JPMorgan SmartRetirement funds, with an average long-term taxable gain of 10.2 percent.

• Fidelity Freedom funds, with an average long-term gain of 6.7 percent.

• T. Rowe Price Retirement investor funds, with an average long-term gain of 6.2 percent.

Kristen Chambers, a spokeswoman for JP Morgan Asset Management, said, “For our target date funds, capital gains are a function of portfolio flows, as well as portfolio turnover at both the target date fund level and the underlying funds held within the target date fund strategies.” Less than 10 percent of JPMorgan’s “investor base holds these funds in taxable accounts,” she said.

Fidelity and T. Rowe Price declined to comment.

In response to these tax surprises, the secretary of the commonwealth of Massachusetts is reviewing target date fund disclosures and interviewing the customers of several fund companies, including those of Vanguard, Fidelity and T. Rowe Price, Debra O’Malley, a spokeswoman, said.

Try to prepare yourself

So what should an investor do?

Until recently, target date retirement funds, especially those constructed from low-cost index funds like Vanguard’s, weren’t on my radar as being tax inefficient. Now, they are.

I think there’s enough evidence for new investors to stay away from them in taxable accounts.

If you already hold them, Ms. Pacholok said, “be aware that you could face further capital gains in the future.” She added that the size of the potential tax liability for Vanguard shareholders this year appeared to be an outlier caused by the reduction in the investment minimum for the institutional funds.

The California investor who contacted me about his Vanguard target date funds said he intended to hold onto them. “Taxes aside, and while I’m angry at Vanguard, I still think these are good funds,” he said. Their automatic rebalancing as he ages “makes them an efficient way to reduce equities as I get older.”

Target date funds continue to be a worthwhile option in workplace retirement accounts. I plan to stick with mine — but to monitor them and Vanguard’s pronouncements much more regularly. All shareholders deserve careful treatment, not just those investing under the shelter of corporate retirement plans.

Fancy tax loopholes are always available for those with access to the best advisers and lawyers. For everyone else, this episode is a reminder that even if you watch your own money closely, you may not be protected from an unwelcome surprise.