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What to Do With Your Target-Date Fund After Retirement

Wendy Connick, The Motley Fool

Target date funds are a popular option for retirement savers; these funds automatically rebalance stock and bond investments over time, taking care of asset allocation for their investors. But once you actually retire, such a fund may no longer be a good choice for you -- switching your retirement savings to a different set of stock and bond holdings can greatly increase your control over your investments.

What is a target-date fund?

A target date fund is a mutual fund designed for retirement savers. Each target date fund has a proposed retirement date associated with it; this date will typically show up in the name of the fund. For example "Target Date Fund 2060" is intended for savers who plan to retire in the year 2060.

A target date fund's managers will choose stocks and bonds for the fund, and will reallocate the fund's ownership of these two types of investments based on the fund's proposed retirement date. If the retirement date is far in the future, most of the target date fund's assets will be in stocks; as time passes, fund managers will shift money out of stocks and into bonds. The exact percentages of stocks versus bonds will vary from one fund to another based on the manager's decisions.

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"To" versus "through" target date funds

Target date funds fall into one of two categories: "to" funds and "through" funds. "To" funds are designed to take you up to the plan's retirement date, but no further; at that point, the fund manager stops rebalancing the fund's assets and its investments will basically just sit there. "Through" funds are designed to keep going after you retire; the fund manager will keep on rebalancing its assets and possibly choosing new investments. If you don't know which type of fund you have, check the prospectus or ask your broker. You can tell which type of fund you have by looking at its "glide path," meaning how it will change its balance of stocks and bonds in the future; "to" funds stop making changes at the fund's retirement date, while "through" funds continue to update their asset allocation.

If your target date fund is a "to" fund, you will definitely want to sell it and put the money into new investments once you retire. If you're holding a "through" fund, retirement is a good time to take a look at the fund's investment choices to confirm that they meet your own needs and preferences. For example, if you have a pretty high risk tolerance and think that strong returns are the best way to protect yourself in retirement, you definitely won't want to stay with a fund that's managed by a conservative advisor.

One way to measure your fund's asset allocation is to consider a common retirement formula for portfolio balancing: subtract your age from 110 and put that percentage of your money in stocks, with the remainder in bonds. If your target date fund has a greater emphasis on bonds than this formula recommends, it may be too conservative for your needs. On the other hand, if you are a more risk-averse investor, you may prefer a somewhat more conservative allocation than what the formula provides. However, going more than 10% higher in your bond holdings than the retirement formula suggests may not produce high enough returns to generate sufficient income.

Keep it or sell it?

If your target date fund is inside a tax-advantaged retirement savings account, such as a 401(k) or IRA, you can sell it with impunity and use the funds to purchase other investments. However, if you've kept your fund inside a standard brokerage account, selling out might expose you to heavy-duty capital gains taxes. In that case, you could be better off hanging onto the fund (at least for now) and adjusting the other assets in your portfolio to balance out any problems with the fund's asset allocation.

For example, let's say that you're 70 years old and your target date fund holds 30% of its assets in stocks and 70% in bonds. However, the formula from the previous section tells you that you should have 110 minus 70, or 40%, of your investments in stocks and 60% in bonds. In that case, you could either buy additional stocks or sell some bonds to bring your overall portfolio balance into a 40/60 split. Note that this is an aggressive asset allocation for a retiree; however, I think it's worth the risk of higher volatility to keep your expected average returns high as well, given how much longer many retirees can expect to live these days. The higher your returns are, the longer your savings will last and the less likely it is you'll run out of money late in retirement.

If you can afford to pay the capital gains tax you'd incur by selling part or all of a target date fund held in a standard brokerage account, then your best course of action would be to transfer the money into a Roth IRA rather than using it to purchase more investments in your current account (or at least, transfer as much as you can up to your current annual contribution limit). Note that you can only make such a contribution if you have a part-time job or other type of earned income, which makes a retirement side gig more than a mere source of income. Putting the money into a Roth account will protect you from future capital gains taxes, not to mention taxes on any dividends or interest you receive in the account. While it would be best to keep all retirement savings in a tax-advantaged account from the beginning, this is a situation where "better late than never" definitely applies.

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