If you’ve been saving for retirement, you’re likely familiar with target date retirement funds.
These funds allow you to choose your expected retirement year (e.g., 2025) and they automatically rebalance your holdings toward a more conservative asset allocation as you approach your retirement. Typically, they reduce your allocation to stocks and increase your exposure to bonds. As summarized by Investopedia, “Theappeal of target-date funds is that they offer investors the convenience of putting their investing activities on autopilot in one vehicle.”
The following graph from Vanguard’s Target Retirement Fund page illustrates the concept:
I’m a big fan of target date retirement funds and have had them in my 401(k) for years. During my working years, while I was still accumulating for retirement, they made a lot of sense. They automatically rebalance, they offer instant diversification, and they become more conservative as retirement approaches.
All good.
But now that I’m retired, they have some flaws.
Serious enough, in my opinion, that I decided to sell them all. *
Today, I’ll tell you why. I’ll also tell you how I executed the trade.
If you’re blindly carrying your target date retirement funds after you’ve retired, this article is for you.
I'm a fan of target date retirement funds, but I just sold all of mine. Why? Now that I'm retired, they aren't as well suited for my needs. Click To Tweet
* Disclaimer: I am not a financial professional and the decision I made for our retirement funds may not be appropriate for you. If you don’t regularly rebalance or own your target date retirement funds in a taxable account, this strategy most likely isn’t best for you. This strategy is best for more advanced DIY investors who own their target date retirement funds in a 401(k), pre-tax IRA or Roth accounts.
Target date retirement funds work great when you’re in your working years. You automatically invest the money (e.g., through your 401(k)), and let the fund do all of the work. “Set it and forget it” is a perfect mantra for these funds. The simplicity is attractive, and they do their job well.
For 90% of investors, they’re an excellent choice during your working years and I highly recommend them.
That all changes with retirement, though.
Since retirement, I’ve been looking at my target date funds every year during my Annual Financial Review. I’ve come to realize they have some serious flaws in retirement and finally decided to “fix” the problem.
Last week, I sold all of my target date retirement funds and reallocated the money into specific stock and bond funds that matched the % allocation previously held in the target date funds. I maintained the same asset allocation I had prior to the sale, but I’m in a much better position to more effectively manage our portfolio in retirement.
Why?
Read on…
4 Problems With Target Date Funds in Retirement
The following problems developed when we moved from the Accumulation Phase of our working years to the Withdrawal Phase in retirement:
1) How Do I Sell Only Stocks (or only Bonds)?
In the withdrawal phase, you must strategically refill your spending bucket. In The Bucket Strategy that we’re using, I look at our asset allocation and sell whatever asset class is overweight. If stocks have outperformed, I’ll sell stocks in the amount required to refill Bucket 1. But how do you do that when both stocks and bonds form a blended portfolio inside a target date fund?
By definition, you MUST sell both stocks and bonds whenever you sell a portion of your target date fund. If the target date fund owns 55% stocks / 45% bonds and you sell $10,000, you’ll sell $5,500 of stocks and $4,500 of bonds. It is unavoidable, and to me, it’s the most serious flaw of using a target date fund in retirement.
By selling all of our target date retirement funds and reallocating the money into the individual fund holdings, it’s now easy to select $10,000 to sell from whichever asset class has outperformed.
2) Tax Location is Sub-Optimized
This is more nuanced, but there is a longer-term tax cost impact of where you hold your assets. If you’d like to read the details on the strategy, I’d recommend Vanguard’s Asset Location Can Lead To Lower Taxesand Morningstar’s Uncover Long-Term Tax Savings With Location Optimization.
In the Morningstar report, you’ll see the following quote:
“Simply put, location optimization is the act of locating specific types of investments in specific types of accounts to minimize taxes.”
I’ll summarize the key themes of the strategy below.
In general, you want your assets with the highest growth potential (Stocks) to be in your Roth, where the higher growth will be 100% tax-free. Lower growth and income-producing assets (Bonds) are prioritized in your pre-tax IRA, where any growth and dividends are taxed as income when you withdraw the funds.
I discussed this strategy in some detail in Our Retirement Drawdown Strategy, where I included the following matrix as a summary:
Two additional quotes from the Morningstar report are appropriate to explain why stocks are best located in the Roth and bonds make the most sense in the before-tax IRA account:
Stocks in Roth: “Holding the highest return investments in a Roth IRA ensures the greatest tax efficiency from an account that will never be subject to tax. Because this account will likely be the last account tapped for cash flow needs, it can handle volatile investments that will produce higher returns in the long run.”
Bonds in IRA: “Holding tax-inefficient investments, like U.S. bonds, in a retirement account effectively defers tax until drawdown. Although this will eventually incur ordinary tax when earnings are realized, the income would have been subject to ordinary tax anyway.”
With target date funds you lose the opportunity to gain this tax location efficiency since you’re forced to hold both stocks and bonds in whatever location you hold your target date fund. If you hold the target fund in your Roth, you’ve got your bonds in the “wrong” place. If you hold the target fund in your Before-Tax IRA or 401(k), you’ve got your stocks in the “wrong” place.
3) Roth Conversions – Inability to target conversions
When I do our annual Roth conversion, I prefer to move stocks from the pre-tax IRA to the Roth. As mentioned above, stocks are best suited for the Roth, whereas bonds are best suited for the IRA. Since I still have stock holdings in my IRA, I target these as my primary funds for the annual conversion from the IRA into the Roth.
With target-dated funds, however, I don’t have the luxury of moving “only” the stock funds into the Roth. Vanguard automatically “buys” the same asset class in your Roth as you “sell” from the IRA. So, if I choose to exchange the target-dated fund, I end up buying the same target-dated fund in my Roth, which means I’ve moved some bonds as well as stocks into the Roth.
4) Asset Allocation calculation is manual
While Personal Capital(affiliate link) will automatically calculate your bond and stock %’s in your target date funds, I also do the calculation manually during my Annual Financial Review to double-check the numbers. Every January I have to look up the current allocation of my target date funds and manually extract the stock and bond figures in my Asset Allocation spreadsheet. Minor issue, but it’s still painful.
Bottom Line: For me, it’s a matter of simplification. By knowing what I own and having the ability to target what I’m choosing to sell, it simplifies my life. My focus in retirement is on refilling our cash bucket for spending and executing annual Roth conversions, and I find it much easier to do both without the target-dated funds in our portfolio. Since I already do regular rebalancing, I’m not worried about the automated rebalancing feature that makes target date funds attractive to investors who don’t rebalance. If you decide to sell your target date funds, it’s critical that you rebalance your portfolio on a regular basis.
How I Sold My Target Date Retirement Funds
This section will explain how I sold my target date retirement funds and replaced them with their underlying holdings. As we work through this process, you’ll notice the asset allocation remains at 60/40 (stocks/bonds) in both the “pre-sale” and “post-sale” scenarios.
For the sake of this explanation, we’ll assume the following model scenario:
- A $1 Million retirement portfolio, with $500k in a pre-tax IRA and $500k in a Roth
- A 60% / 40% allocation between Stocks / Bonds.
- $200,000 of the IRA is held in Vanguard’s 2025 Target Retirement Fund (VTTVX)(*)
- Since holdings are in retirement accounts, there are no tax implications of the sale (*)
* There are tax implications when doing Roth conversions, but those are not a required element of selling your target date retirement funds. Also, I’m using VG mutual funds throughout this explanation. If you’d prefer to trade in ETF’s the same logic would apply, but the ticker symbols would change to reflect the appropriate ETF.
IMPORTANT: If you hold your target date funds in a taxable account, you should review potential capital gain implications with your accountant. If you’ll incur significant taxes as a result of the transaction, it’s most likely not worth taking these steps and you should consider continuing to hold your target date funds to avoid the taxes associated with the reallocations.
Step 1: Determine Target Date Fund Holdings
As a first step, let’s take a look at what holdings are currently in our 2025 target fund VTTVX. By scrolling through the fund overview link, you’ll see that the 2025 fund currently holds the following assets:
To determine how our current $200,000 in VTTVX is allocated, we simply do the math, using the % allocation from the fund profile chart shown above:
For simplicity, we’ll combine the international and domestic allocations to summarize bonds/stocks as follows:
- Bonds: 45.4% (28.3% Total Bond + 12.4% Total Int’l Bond + 4.7% TIPS)
- Stocks 54.6% (32.6% Total Stock + 22.0% Total Int’l Stock)
Step 2: The Easy Method – Sell VTTVX, Buy 5 Funds:
If you’re making no other changes beyond eliminating the target date retirement funds in your account (and keeping the funds in the same account), you simply click on your VTTVX holding on the Vanguard page and do an exchange into the funds summarized in the table above.
Vanguard allows you to direct an exchange into multiple funds within the same account, so it’s as simple as choosing “Exchange All” on the “sell” side, then entering the %’s from the table above into each fund that you’d like to move the money into. For example:
- 22.0% into VTIAX (Total Int’l Stock Fund)
- 32.6% into VTSAX (Total Stock mutual fund)
- 28.3% into VBTLX (Total Bond Fund)
- 12.4% into VTABX (Total Int’l Bond Fund)
- 4.7% into VTIP (Inflation-Protected Bond Fund)
If you’d prefer to simplify, you could simply exchange into two funds, 54.6% into VTSAX (Total Stock Fund) and 45.4% into VBTLX (Total Bond Fund). While you’d lose a bit of the diversification, it’s a viable option if you prefer the simplicity of fewer holdings (Bogleheads, rejoice).
If the funds are held in a retirement account (Roth, IRA or 401(k)), the transaction is non-taxable. (If you’re holding the target date fund in a taxable account, see the “Important” disclaimer above).
Once you’ve concluded that trade, you’ve successfully sold your target date retirement funds and have replaced them with their underlying holdings. If you stop at this point, don’t forget the need to rebalance your portfolio on a regular basis.
While you could stop at this step, I’d encourage you to take things a step further and improve your tax location…
The Harder Method (Roth Conversion & Tax Location)
I did NOT choose the Easy Method.
Since I had decided to sell my target date retirement funds, I also decided to implement the tax location optimization strategy as part of the process. Since I would be allocating our target date funds to their respective stock and bond holdings, it would be possible to “relocate” those holdings to their optimal place during the process (stocks in Roth, bonds in IRA). Also complicating matters, I sold my target date retirement funds during my Annual Roth Conversion. I’ll go through each of the steps below.
While the process had more steps, the logic is the same as the easy method presented above, with the major addition of addressing the tax location of the stocks and bonds after executing my Roth conversion.
Using the assumptions outlined above, below is the model portfolio prior to making any changes ($1M total, $200k of Target date funds in IRA, 60/40 allocation).
Original Portfolio With Target Date Funds:
For those who prefer charts, here’s the same data presented graphically (I won’t present charts at every stage, but I will present a comparable chart showing the final portfolio after all changes were made, highlighting how the changes improved the portfolio):
Key Points – Opening Position:
- Both pre-tax IRA (chart of left) and Roth (middle chart) hold 60/40 stocks bonds.
- Target Date funds are held in pre-tax IRA (dark blue and orange slices in chart on left)
- Total portfolio (chart on right) holds 60% stocks (light & dark blue) / 40% bonds (red & orange)
- Portfolio is sub-optimized from a tax location standpoint (IRA has stocks, Roth has bonds)
Step 1: Roth Conversion
In step 1, we’ll assume a Roth conversion of $100,000 (taxes on the Roth conversion were paid from separate funds kept in our after-tax “Bucket 1 cash” account). We chose the Target Date Fund as the holding we transferred from the pre-tax IRA to the Roth. The resulting portfolio is as follows:
Summary of Roth Conversion
- Pre-Tax balance declines to $400k while the Roth increases to $600k (green highlight)
- Total Asset Allocation remains 60/40, but now varies between IRA (61%/39%) and Roth (59%/41%)
- Both the IRA and Roth now hold $100,000 in Target Date funds.
Step 2: Sell The Target Date Funds AND Improve Tax Location
In the “Easy Method”, we simply exchanged the target date funds with their underlying holdings. Since the “Harder Method” is also improving asset location, we’ll do the same exchange, but with a twist.
- In the IRA, we’ll exchange the target date fund into bond funds.
- In the Roth, we’ll exchange the target date fund into stock funds.
- The overall balance of the portfolio will be maintained at 60/40.
Let’s look at the Roth first, where we’re currently holding $100,000 of target date funds after completing the Roth conversion in Step 1. If we simply exchanged the $100,000 target fund into stocks, we’d end up exceeding our overall 60% stock target for the portfolio (remember, the target fund held 45.4%, or $45,400 in bonds). To solve this problem, on the same day I exchanged the target fund into stocks within the Roth account, I also exchanged $45,400 of stocks into bonds in the IRA account. This resulted in the overall portfolio remaining at 60/40, but moved a higher % of the bonds into the IRA, while also increasing the stock % in the Roth.
For the IRA, we did the opposite. Since there was still $100,000 of the target date fund remaining in the IRA after the Roth conversion, we exchanged those funds into bonds. If we simply exchanged the $100,000 target fund into bonds, we’d end up exceeding our overall 40% bond target for the portfolio (remember, the target fund held 54.6%, or $54,600 in stocks).To solve this problem, on the same day I exchanged the target fund into bonds stocks within the IRA account, I also exchanged $54,600 of bonds into stocks in the IRA account.
After doing those transactions, the model portfolio is as follows:
Summary of Post-Sale Portfolio
- Pre-Tax IRA and Roth balances remain as prior at $400k and 600k, respectively.
- Overall portfolio remains at 60/40, but significant allocation shifts in IRA/Roth to optimize tax location.
- Sale of target date funds used to increase bonds in IRA, bonds are now 64% of IRA allocation.
- Sale of target date funds used to increase stocks in Roth, stocks now 76% of Roth allocation.
The tax location has been significantly improved, with the IRA holding a higher % of bonds and the Roth holding more stocks. However, if you have a discerning eye, you’d notice we’re still “sub-optimal” after making the changes, with $144,600 of stocks remaining in the IRA and $145,400 of bonds in the Roth.
In full transparency, this is the stage I’m at with our portfolio. I’ve sold all of the target date retirement funds and reallocated the funds as described in this section. As illustrated in the model portfolio, I still have some work to do to move the remaining balances around, and plan on doing that in the coming months.
For the sake of today’s article, let’s clean up that last detail in the final step.
Step 3: Final Adjustment To Achieve The Best Tax Location
Since our tax location is not yet optimized (note $144,600 of stocks in the IRA and $145,400 of bonds in the Roth, both of which are sub-optimized), we’ll make our final adjustments.
We’ll enter a trade to exchange the remaining $144,600 of stocks into bonds in our IRA, while doing the opposite trade in our Roth ($144,600 of bonds into stocks). This ensures our total portfolio remains at the 60/40 target, while also placing the assets in their “best” tax location.
The final “optimized” portfolio is as follows:
Before & After – A Comparison of Charts
As promised, below is a comparison of the “Before” and “After” charts showing the impact of the changes outlined above:
Summary of Optimized Portfolio
- By exchanging our target date retirement funds into their underlying holdings, we’ve optimized tax location.
- Overall portfolio remains at 60 / 40 (stocks / bonds), but the assets are now in their optimized location.
- The pre-tax IRA holds all of the bonds and the Roth holds the stocks.
Conclusion
I was a long-time fan of target date retirement funds during my accumulation years. However, once I retired my priorities changed, and now focus on:
- Annual Roth conversions (targeting stocks to move from pre-tax IRA to Roth)
- Refilling cash in Bucket One (selling either stocks or bonds, depending on overall asset allocation)
- Optimizing tax location of the assets held (stocks in Roth, bonds in pre-tax IRA)
With the new priorities in retirement, target date funds made my life more difficult.
- They inhibited my ability to only sell stocks, or only sell bonds.
- Whenever I sold target date funds I was forced to sell both stocks and bonds.
- If I included target date funds in my Roth conversion, I was forced to move both stocks and bonds.
- I was unable to improve tax location while holding target date funds.
By selling our target date retirement funds and reallocating the money into the underlying holdings, I’ve been able to overcome these obstacles. During my annual Roth conversion, I was able to improve my tax location by increasing the stock allocation in our Roth account and the bond allocation in our pre-tax IRA. In addition, I will be able to easily target stocks for my future Roth conversions. Finally, I’ll be able to sell either stocks or bonds as part of my Bucket Strategy refill process, based on their relative performance as measured by changes in our asset allocation.
In reality, we’ll never achieve the perfect portfolio (reality is always messier than the model portfolio used to explain the concept), but selling our target date retirement funds has allowed us to improve our tax location and simplified the ongoing management of our retirement portfolio. It’s important to note that I have always, and will continue to, rebalance on a regular basis (typically as part of my Annual Portfolio Review every January).
What About You? Do you hold target date funds in your retirement accounts? If so, have you noticed the same shortcomings? Are they serious enough to consider reallocating your target date funds, or is something keeping you from making that change? Let’s chat in the comments…
