I am admittedly a fan of target date funds. But for many investors, they feel almost too good to be true or like some danger must be lurking behind them. And, unfortunately, a tax fiasco involving target date funds with Vanguard seemed to confirm that bias for many investors.

My goal here is to provide an open and honest look at target date funds, their advantages and disadvantages, and whether or not this tax issue should change our perspective or how we use target date funds in our portfolio.

So saddle up!

What is a target date fund?

Let's start very basic. (And if you would like a refresher on the basics of mutual funds and index funds, you can find that here.)

Target date funds are like Cookie Monster.

They gobble up other mutual funds, including index funds. Because they are a fund of funds. How's that for meta. Put simply, if mutual funds are a big basket containing individual stocks, target date funds are a big basket containing other mutual funds, ideally broadly diversified, low cost index funds.

Some advantages of target date funds

Well, it turns out that a target date fund does some really cool things.

Let's take your average investor:

• Let's say they want to invest passively (smart!) using index funds
• And their desired asset allocation (more on that here, but basically how they split up their investments) is 80% stocks and 20% bonds because they are a young investor and can tolerate investment risk to achieve their desired growth
• But they want their asset allocation to become more conservative (lower stock percentage and higher bond percentage) as they get closer to retirement to favor capital preservation over growth (also smart!)

They have two ways to do this. They can:

1. Buy 2-4 index funds of stocks and bonds in a manner that 80% of their investments are in stocks and 20% in bonds. Then slowly adjust their investments to reach a goal asset allocation of, say, 20% stocks and 80% bonds by the time they retire at age 65

Or, they can:

2. Buy a target date fund (based on index funds) with a goal retirement year aligning with their goal retirement (for example, if she is 38 years old now and plans to retire at 65, a 2055 target date fund is perfect). This fund of funds will contain a mix of stock and bond funds that automatically becomes progressively more conservative as their target retirement date approaches. No work required. Pretty nice right!

Pretty nice, right?! That encapsulates the main differences between a mutual/index fund and its big brother, a target date fund.

But there are some downsides…

First, you have to check the target date funds and see what the asset allocation starts at and what it ends at to make sure it aligns with your desired risk. And you can always make an adjustment. For instance, if you want to be more aggressive, choose a target date fund with a later goal retirement date. Or choose a closer goal retirement target date fund if you want to be more conservative.

Second, not all target date funds contain index funds. There are target date funds full of actively managed mutual funds. You don't want these. Because active stock management just doesn't work…

Thirdly, there is a cost to target date funds. They require the fund manager to adjust the asset allocation over time. And that requires work (not much, but some). Therefore, the expense ratios of target date funds are a bit higher than the individual funds inside of them. So, if it is full of actively managed funds, these expense ratios can get quite high. Conversely, expense ratios for target date funds full of index funds are still very low. Vanguard target date funds have an expense ratio of 0.08 compared to 0.04 for a single index fund. Be careful that you are choosing a target date fund full of passively managed index funds with an overall low expense ratio.

Overall, target date funds look like a pretty nice and simplified way to invest passively, taking advantage of the overall upward long term trend of the stock market on your way to financial freedom as long as you pick one that aligns with your asset allocation/risk tolerance, make sure it contains index funds, and choose a low cost option.

But what about the whole tax issue with target date funds in 2020?

Let's set the scene.

In December 2020, Vanguard lowered the minimum investment threshold for its institutional share classes of one of their target date funds (Vanguard Target Retirement Funds) from $100 million to $5 million.

As a result, lower-cost institutional shares became accessible to many more retirement plans and investors. Naturally, many investors moved their assets out of the older share classes and into the new cheaper share class. However, because all of this money was moving out of the old share class, Vanguard had to cover those redemptions. And to do so, they had to sell underlying appreciated assets.

The end result: Massive capital gains tax realization for investors still holding investments in the old share class target date fund. Not such a big deal if you invested in a tax advantaged retirement account like a 401k or 403b. But a huge deal if you were invested in a taxable account.

The fallout

In short, the SEC said that the Vanguard's prospectus was misleading and did not fully explain these risks upon making the adjustments to the share class. And Vanguard, while not admitting fault, has paid over $100 million from federal and civil suits to restitute those impacted.

So what does this mean for us as individual investors when it comes to target date funds?

Let me start by sharing how I now use target date funds in my portfolio, which you can see detailed here.

Like I said, I'm a fan of target date funds. I think many investors look at them as cheating or cheap because they are even more “set it and forget it” than a self-managed index fund portfolio. But that doesn't make it bad. Remember, in personal finance, doing less – investing passively, avoiding fees and taxes – means you earn more. It seems unnatural to us as physicians that being less involved is actually good but that's the way it works in the financial freedom game. And target date funds are no exceptions.

Anyway, I primarily use a two funds for life investment strategy. About 90% of the portfolio in an appropriately allocated target date fund and 10% in a small value index fund.

And this allocation is present in my tax advantaged retirement accounts and in my taxable account…despite this previous Vanguard tax fiasco.

Why don't I worry about a repeat tax issue with my target date funds?

Mainly because the issue that happened wasn't necessarily an intrinsic issue with target date funds themselves. It was not some design flaw. They do a very good job at what they are supposed to do. And what they are supposed to do lines up very well with how I think is best to build wealth.

Instead, the issue was an organizational one on Vanguard's part. It certainly seems like they underestimated the shift in investors that would happen as a result of the new institutional class. And then they were forced to recover in a way that preserved as much capital for all investors but did result in a big, unfortunate tax hit for many.

And I believe they would have learned their lesson. That is why I still invest in target date funds in my taxable account. Is it foolproof? No. But nothing is and the benefits of the funds outweigh the risks for me.

But they may not outweigh the risks for you…

So, what can you do to minimize the tax risk of target date funds even more?

Here are 3 ways to mitigate this risk to different degrees:

• Do not invest in target date funds
• Do not invest in target date funds in your taxable brokerage account
• If you do invest in target date funds in your taxable brokerage account, invest in the share class with the lowest minimum available

Based on your risk tolerance, all 3 options are reasonable. So pick what fits you best. But I encourage you to weigh these risks and benefits of target date funds instead of outright rejecting them because someone mentions this (hopefully) one-off tax miscue!

What do you think? Do you invest in target date funds? If so, do you worry about the tax implications? Where do you hold them in your portfolio? Let me know in the comments below!