target date funds: three strikes

By: Mike Tuohey

Strike One:

Target Date funds, like all mutual funds,  are tax inefficient and may not be the most appropriate investment for non-qualified accounts. Let’s assume your portfolio is made up of qualified (IRA’s, 401k’s, etc) and non-qualified accounts (Individual, Joint, etc). A basic, but not always ironclad rule, is that tax-efficient investments (equities) should be placed in non-qualified accounts and the tax inefficient investments (i.e. Bonds and REITs) should remain in qualified accounts. Implementing a traditional asset  allocation method, one can better position investments in accounts to take advantage of their unique tax features.

Strike Two:

Tax Harvesting is a useful tax planning tool investors use to take advantage of capital losses by offsetting capital gains in order to reduce capital gains taxes. Traditional asset allocation methods using various indexes or equities or mutual funds allow for such tax strategies. Unfortunately, using a Target Date fund, though providing allocation, eliminates the ability to tax harvest.

Strike Three: 

Fixed Income planning within the framework of your overall portfolio can be tax advantageous using either Treasury bonds and/or municipal bonds for high income earners and non-qualified accounts. The coupon payments received may be exempt from federal and/or state income tax and provide a greater net return on your investment. Target Date funds, currently, do not provide the opportunity to utilize this type of tax planning in your investment strategy. 

This article is not intended as a comprehensive guide to the state or federal tax treatment of tax-exempt bonds or the treatment of capital gains. However, in general, most states do not tax individuals on the interest income arising from tax-exempt bonds issued by that state, its agencies, or its political subdivisions. Also, an investor who recognizes a capital gain may be required to pay state tax on such capital gain and should consult a tax advisor with respect to the state tax consequences of such a sale.