Why Are Funds-of-Funds Tax-Inefficient?

A reader writes in, asking:

“You’ve mentioned in several articles that target retirement funds are not tax efficient. I don’t fully understand why they would be any worse than just holding a few index funds, since they own the same stuff in the end. Could you elaborate on this idea in an article?”

There are a few reasons why funds of funds are less tax-efficient than a DIY allocation using individual index funds.

Firstly, they result in an impaired ability to tax-loss harvest. For example, with respect to any given share purchase of a fund of funds, there will likely come a time at which one of the underlying funds is worth less than it was worth when you bought into the all-in-one-fund, yet the overall portfolio has a gain. With a fund of funds, there would be no ability to tax-loss harvest. With the individual funds, there would be such an opportunity.

In addition, even when tax-loss harvesting opportunities do come around for an investor in an all-in-one fund, it can be difficult to find another all-in-one fund that makes a good tax-loss harvesting partner. Switching to a different target date fund from the same fund company would often mean an undesired change in your asset allocation, and switching to a target date fund with a different company would likely mean a dramatic increase in costs.

Second, depending on your federal income tax rate and your state income tax rate, you might find it advantageous to use municipal bonds (which are exempt from federal income tax) or Treasury bonds (which are exempt from state income taxes) instead of the “total bond” -type of fund that is included in many all-in-one funds (including Vanguard’s Target Retirement and LifeStrategy funds).

Third, if you have tax-sheltered retirement accounts in addition to taxable brokerage accounts, you might benefit from implementing an “asset location” plan — that is, placing your least tax-efficient assets in your tax-sheltered retirement accounts prior to placing your more tax-efficient assets in such accounts — rather than holding the same asset allocation in your taxable accounts and your retirement accounts.