Phosphoinositides direct membrane trafficking, facilitating the recruitment of effectors to specific membranes. In yeast phosphatidylinositol 4,5-bisphosphate (PtdIns(4,5)P2) isproposed to regulate vacuolar fusion; however, in intact cells this phosphoinositide can only be detected at the plasma membrane. In Saccharomyces cerevisiae the 5-phosphatase, Inp54p, dephosphorylates PtdIns(4,5)P2 forming PtdIns(4)P, a substrate for the phosphatase Sac1p, which hydrolyzes (PtdIns(4)P). We investigated the role these phosphatases in regulating PtdIns(4,5)P2 subcellular distribution. PtdIns(4,5)P2 bioprobes exhibited loss of plasma membrane localization and instead labeled a subset of fragmented vacuoles in Deltasac1 Deltainp54 and sac1ts Deltainp54 mutants. Furthermore, sac1ts Deltainp54 mutants exhibited vacuolar fusion defects, which were rescued by latrunculin A treatment, or by inactivation of Mss4p, a PtdIns(4)P 5-kinase that synthesizes plasma membrane PtdIns(4,5)P2. Under these conditions PtdIns(4,5)P2 was not detected on vacuole membranes, and vacuole morphology was normal, indicating vacuolar PtdIns(4,5)P2 derives from Mss4p-generated plasma membrane PtdIns(4,5)P2. Deltasac1 Deltainp54 mutants exhibited delayed carboxypeptidase Y sorting, cargo-selective secretion defects, and defects in vacuole function. These studies reveal PtdIns(4,5)P2 hydrolysis by lipid phosphatases governs its spatial distribution, and loss of phosphatase activity may result in PtdIns(4,5)P2 accumulation on vacuole membranes leading to vacuolar fragmentation/fusion defects.