Money expert Clark Howard loves target date retirement funds.
Inside of a retirement account, they offer portfolio diversity, risk management and age-appropriate allocations. In short, they’re a simple, stress-free solution that, combined with good savings habits, will go a long way toward setting up your retirement.
When it comes to investing advice, Clark often focuses on helping the most people possible. And he also thinks that saving for retirement is your No. 1 long-term financial responsibility.
However, there are limitations to target date funds. And it’s important to understand the context in which Clark recommends them.
Can I use a target date fund for intermediate-term savings?
That’s what a listener recently asked Clark.
Asked Jared in Tennessee: “My wife and I currently max our Roth IRAs. I contribute up to the match with my company’s Roth 401(k). We have an emergency fund of six-plus months.
“I am curious [to hear] your thoughts about using a target date retirement income fund for a part of the emergency fund for additional intermediate-term savings. I think it would be a clever way to store intermediate savings that [we] might access in three to five years for trips.”
Keep in mind that with a 401(k) account, the most typical place for a target date retirement fund, your investments grow tax-free. In a Roth, you’ve already paid taxes, and any gains you make are yours, as long as you follow withdrawal rules.
In a traditional account, even if you sell for a profit, you won’t pay any taxes on your earnings until you withdraw in retirement.
However, taxes are a major consideration if you’re investing in any type of fund outside of a tax-advantaged account. And target date funds shift from more aggressive (equities) to less aggressive (bonds) over time, necessitating plenty of selling (and realizing gains).
“I love the way you think. [But] don’t use a target retirement fund [for savings],” Clark says.
“They’re typically in a tax-sheltered account. An IRA, 401(k), that kind of thing. So the tax problems could be huge inside a targeted retirement fund.”
Right now, some of the best high-yield savings accounts are paying 5% APY or more.
You’ll owe taxes on the interest you earn. But your money is FDIC insured up to $250,000. And until the Fed starts cutting rates — the market is predicting that it may happen sometime next summer — that’s a great place for savings.
At the same time, if you have six-plus months of expenses in a high-yield savings account, you have a mature emergency fund according to Clark. Especially for someone like Jared, who is doing an excellent job of saving for retirement, it’s OK to invest some additional savings to hopefully get a little extra return.
The key is to avoid getting hammered by the IRS on your profits.
“If you were looking to do something that would have lower risk that would be for more intermediate-term savings, look at a balanced index fund that has minimal trade activity,” Clark says.
“You’d be subject typically only to overwhelmingly long-term capital gains, which is an extremely low tax rate.
“And all my three favorite children [Fidelity, Schwab, and Vanguard] sell balanced index funds or balanced index ETFs, exchange-traded funds. And that would be a viable alternative. But no target retirement funds ever outside of a retirement account.”
Target date retirement funds are great for, you guessed it, investing inside of a tax-advantaged retirement account.
However, you shouldn’t invest in them in a standard taxable brokerage account. You’ll face a heavy tax burden. You’d do better to invest in a total stock market ETF or an equivalent.