unwise to use a target-date fund outside of tax-favored accounts?

[pianoguy]

Hi friends,

I currently have a target-date fund in a taxable brokerage account. I have heard that this is unwise because target-date funds cause high tax bills unless they are in an IRA or 401k.  My questions are:

1.  Is this true?  Is it actually a bad idea to keep a target-date fund in a taxable account?
2.  Can you recommend something similar to a target-date fund that is good to keep in a taxable account?
3.  Now that I already have a target-date fund, should I sell what is already in there, or will that just generate lots of taxes?
4.  Can you please answer the above questions for both Vanguard (which I use) and Schwabb (which my wife uses)?

Thank you so much in advance; appreciate your help!

[Tasse]

Not an expert, but have made this mistake myself, so this is my experience.

• It's not ALWAYS bad, but it CAN be bad; it varies year to year. I have had a year of unusually high tax bill because of underlying buying and selling in my TDF.
• A mixture of a tax and bond index fund that you balance yourself. If you're not willing to do that, then it may be worth holding the TDF in taxable despite the higher taxes. Personally, I just decided to lean into 95%-100% stocks, so balancing isn't an issue for me.
• I chose not to sell my TDF in taxable, but it's <20% of our total taxable account and <6% of our total NW; you should probably calculate the taxes you'd pay on selling to decide whether it's worth it. I am a bit skeptical of paying a big tax bill to avoid paying small tax bills, but maybe it would be worth it over a long time. I did turn off dividend re-investment and redirected that money to an index fund. I'm also looking into donating the TDF to charity to offload it without paying tax on it.

I use Fidelity, so I can't say anything specifically about the providers you mentioned.

[ATtiny85]

Would need to know a lot more about your portfolio for a real good answer.

Maybe read this and then ask follow-ups

https://www.bogleheads.org/wiki/Tax-efficient_fund_placement

ETA: Check on your Target Date breakdown of the various holding types and keep that in mind when reading.

[Much Fishing to Do]

Yeah, I was nailed one year with a huge year end LTCG distribution from one in a taxable account. I'm guessing it is assumed these are almost always in a tax deferred account so not a concern when they did it.


The Vanguard LIfestrategy funds are basically set up the same way and where most of my taxable investments are and I havent seen that happen to them yet.  PLus I like that they just stay at a 80/20, or 60/40 etc.  Its driving me nuts for how long they continue to underperform the S&P  due to their large international component...but thats obviously a completely different issue/factor....

[RWD]

There's a lawsuit over the specific event that happen in the 2021 tax year. It doesn't happen every year, but it's good to be aware that it is a possibility.
https://www.cnbc.com/2022/03/15/vanguard-created-big-tax-bills-for-target-date-fund-investors-lawsuit-claims.html

[seattlecyclone]

My understanding is that Vanguard opened up a new institutional share class of their target date funds, a bunch of 401(k) money left the retail version for the institutional version, and the retail version had to sell a bunch of appreciated assets to facilitate that mass exodus. The remaining retail shareholders were then given a capital gains distribution, as required by tax law.

I don't think this is a risk unique to target date funds at all. If you're invested in any mutual fund that has a bunch of unrealized gains, and more people sell out of the fund than buy in during a given year, that fund is going to need to liquidate assets to pay out the people leaving, and that will lead to capital gains distributions paid to the remaining shareholders.

This can be a good reason to prefer ETFs over mutual funds for your taxable accounts, as ETF shares are created/redeemed in a different way that doesn't create a taxable event for the other shareholders.

[SeattleCPA]

I really like target retirement date funds. They weren't available when I was doing most of accumulating. But in my little free ebook, my idea is max your IRA and stick money into a cheap target retirement date fund. I'm saying all this so you know I'm a big fan...

All that said, for taxable accounts, I think you invest in a stock index fund. Probably if you're a US investor, something like VTSAX, and you let that ride. The tax burden on that will be really low...

And then if you wanted to use a target retirement date fund in your IRA or 401(k), you could use one with an earlier retirement date to effectively balance out your bond percentage to something that's appropriate given your taxable account allocation.

[Ron Scott]

I would not buy target date funds.

They are essentially expensive, overly-technical alternatives to the mainstream approach of asset allocation—asset location—rebalancing.

There is irony here too, in that the same institutions who offer those pseudo-psychological questionnaires to determine your risk tolerance and give advice on asset allocation/rebalancing also provide these TDFs, that automatically rebalance every year – – regardless of any change in your risk tolerance, or actual asset allocation.

[Tasse]

I would not buy target date funds.

I like them because they were what gave me the confidence to start investing when I was brand new. I didn't really understand rebalancing and I didn't want to screw something up, and TDFs were a good-enough option I could trust while I learned instead of nervously sitting on cash until I felt comfortable.

8 years later, I understand what I'm doing better and I've moved everything in tax-favored accounts out of TDFs and into zero-fee index funds. But I don't regret the $40k of TDFs in taxable that let me get started sooner. TDFs offer a service: it's not worth the price to me anymore, but it was at one time. They offer a nice safety net for newbies.

[AllTheStocks]

1.  It is a bad idea to keep a target date fund in a taxable account because the interest they pay is taxed as ordinary income, there is a risk of high capital gains payouts (like what happened with Vanguard in 2021), and if you don't like the asset allocation of the target date fund many years from now it can be hard to sell it without paying a high tax bill. 
2.  I have a 3-fund portfolio as documented on Bogleheads, with the bond portion of the portfolio in IRAs and stock in the taxable account.   This is almost as easy to manage as having a single target fund but allows for more tax efficiency and flexibility.
3.  If your existing target date fund has a large unrealized capital gain, personally I wouldn't sell it, just invest in the more tax efficient funds going forward.  Keep an eye on things and if the market drops substantially you might be able to sell the target date fund and buy the other funds.  If you've invested in the target date fund over many years you might be able to sell specific shares that are at a loss using Vanguard's SpecID feature or a similar feature that Schwab has. 
4.  Bogleheads has published suggested 3-fund portfolios for both Vanguard and Schwab. 

[NotJen]

I would not buy target date funds.

I like them because they were what gave me the confidence to start investing when I was brand new. I didn't really understand rebalancing and I didn't want to screw something up, and TDFs were a good-enough option I could trust while I learned instead of nervously sitting on cash until I felt comfortable.

Agree.  If target dates had been mainstream when I first started investing, I probably would not have ended up with an Edward Jones account for the first few years of my working life (I needed a placeholder for investments before I had time to learn more).  Which would have saved me money.

I also found them useful once my company established a 401k - they did not select index funds that could make the 3-fund portfolio, but they did have the target dates.

When I quit and rolled everything over to Vanguard, I just did the simple 3-fund portfolio across all my accounts, following the Bogleheads tax efficient fund placement guide.

[dandarc]

Target Date funds are not that expensive - yeah you can do it cheaper, but 0.15% vs. 0.05% (rough estimate of the two options at Vanguard) is probably worth it if you value the convenience vs. manual approach (which is admittedly not that much work, but still more work than some want to do). I'd have done a lot better if I'd had the wisdom to choose a Target Date fund from a place like Vanguard vs. what I did when I opened my first Roth about 16 years ago.

Something that gets lost in "investing costs matter!" discussions pretty often is that the impact of 10 basis points is a lot less than 100 or 200 basis points. When you're looking at sub 0.2% ER vs. 1-2%, then yeah - you almost certainly should pick the lower cost. Perfect in the way of good can lead many people to not invest at all or delay investing and is that delay worth it for 0.2% vs. 0.06%? Usually not.

ETA: oh - and on the original question. There was an event a few years back at Vanguard that really screwed over anyone holding a Target Date Fund in a taxable account. What they did within the fund is not common, but there is a risk there. I'm not convinced it is necessarily a larger risk than with other funds - fund managers screw stuff up sometimes, although I would say that the usual index funds at Vanguard are generally VERY tax efficient due to their design of their ETFs (is this still proprietary? patent may have run out?).

[seattlecyclone]

Also I think the 0.15% expense ratios for Vanguard target date funds may be a thing of the past. This target 2050 fund has a 0.08% expense ratio and a minimum investment of $1,000. I would have no qualms whatsoever about recommending that fund as a "set it and forget it" option for anyone who wants to retire in about 25 years and has no particular interest in spending time thinking about their investments.

[Ron Scott]

Regardless of the cost of target date funds (which is higher for sure) the constant rejiggering of asset allocations and buying-selling when a person’s risk tolerance is just fine—is unnecessary and gimmicky. It’s a way for firms like Vanguard, which no longer want you to set-and-forget a 2 or 3 fund portfolio like Jack advised when he was running the place, to shift you into more active stuff.

No thanks.

[dandarc]

Regardless of the cost of target date funds (which is higher for sure) the constant rejiggering of asset allocations and buying-selling when a person’s risk tolerance is just fine—is unnecessary and gimmicky. It’s a way for firms like Vanguard, which no longer want you to set-and-forget a 2 or 3 fund portfolio like Jack advised when he was running the place, to shift you into more active stuff.

No thanks.

You're skipping over the rebalancing part of the approach to a 2 or 3 fund portfolio intentionally.

[Ron Scott]

Regardless of the cost of target date funds (which is higher for sure) the constant rejiggering of asset allocations and buying-selling when a person’s risk tolerance is just fine—is unnecessary and gimmicky. It’s a way for firms like Vanguard, which no longer want you to set-and-forget a 2 or 3 fund portfolio like Jack advised when he was running the place, to shift you into more active stuff.

No thanks.

You're skipping over the rebalancing part of the approach to a 2 or 3 fund portfolio intentionally.

I must have missed the part where target date funds sold high and bought low. Please educate me.

[dandarc]

Regardless of the cost of target date funds (which is higher for sure) the constant rejiggering of asset allocations and buying-selling when a person’s risk tolerance is just fine—is unnecessary and gimmicky. It’s a way for firms like Vanguard, which no longer want you to set-and-forget a 2 or 3 fund portfolio like Jack advised when he was running the place, to shift you into more active stuff.

No thanks.

You're skipping over the rebalancing part of the approach to a 2 or 3 fund portfolio intentionally.

I must have missed the part where target date funds sold high and bought low. Please educate me.

So you don't understand the Bogle approach to investing at all. It is 2-3 funds that matches your allocation + periodic rebalancing. Not "buy and hold forever" that winds up approaching 100% stocks over time regardless of your intended allocation. A couple of basis points is worth it for some (many perhaps?) to handle the rebalancing part.

Plus a lot of people really do want a less aggressive portfolio as they age (and will extend this to big ass fights at managing non-profit endowments that isn't even their own money). So target-date funds really do hit the mark for a lot of people.

ETA yet more - Target Date Funds actually do solve a real problem in that 401K/403B offerings have historically sucked ass and been almost completely inappropriate for majority of investors. And the default option for those who cannot be bothered to choose their own investments historically was some flavor of guaranteed return option - which was very harmful to plan participants because guarantees are EXTREMELY expensive in the investment space on all but the shortest of time-frames. I'm not 100% sure if this is law or just quickly becoming an industry standard, but now the default option is going to be a target-date fund at most places. And a Vanguard target date fund is pretty much best-in-class.

[dandarc]

Also I think the 0.15% expense ratios for Vanguard target date funds may be a thing of the past. This target 2050 fund has a 0.08% expense ratio and a minimum investment of $1,000. I would have no qualms whatsoever about recommending that fund as a "set it and forget it" option for anyone who wants to retire in about 25 years and has no particular interest in spending time thinking about their investments.

Wonder if they'll extend this to the LifeStrategy funds as well, which to me are pretty much the same idea without the glide-slope part. Life Strategy still in that "investor share" cost range at Vanguard.

[Ron Scott]

Regardless of the cost of target date funds (which is higher for sure) the constant rejiggering of asset allocations and buying-selling when a person’s risk tolerance is just fine—is unnecessary and gimmicky. It’s a way for firms like Vanguard, which no longer want you to set-and-forget a 2 or 3 fund portfolio like Jack advised when he was running the place, to shift you into more active stuff.

No thanks.

You're skipping over the rebalancing part of the approach to a 2 or 3 fund portfolio intentionally.

I must have missed the part where target date funds sold high and bought low. Please educate me.

So you don't understand the Bogle approach to investing at all. It is 2-3 funds that matches your allocation + periodic rebalancing. Not "buy and hold forever" that winds up approaching 100% stocks over time regardless of your intended allocation. A couple of basis points is worth it for some (many perhaps?) to handle the rebalancing part.

Plus a lot of people really do want a less aggressive portfolio as they age (and will extend this to big ass fights at managing non-profit endowments that isn't even their own money). So target-date funds really do hit the mark for a lot of people.

ETA yet more - Target Date Funds actually do solve a real problem in that 401K/403B offerings have historically sucked ass and been almost completely inappropriate for majority of investors. And the default option for those who cannot be bothered to choose their own investments historically was some flavor of guaranteed return option - which was very harmful to plan participants because guarantees are EXTREMELY expensive in the investment space on all but the shortest of time-frames. I'm not 100% sure if this is law or just quickly becoming an industry standard, but now the default option is going to be a target-date fund at most places. And a Vanguard target date fund is pretty much best-in-class.

I do not rebalance as a personal strategy, but you don’t understand the concept: Typically, people rebalance when their stocks grow above their AA, they sell some (at a relative high) and reinvest into their safer tier, like a bond fund. I never said let stocks to go 100% LOL

If you're a target date fund fan, enjoy. It’s a bit wack for my taste.