Money expert Clark Howard is a huge proponent of target date funds as a way to invest for retirement. He also recommends index funds as a viable investment strategy for some people.
So which investment type wins in a target date fund vs. index fund battle royale? And more importantly, which fund type is better for you?
Table of Contents
- Target Date Funds vs. Index Funds
- Target Date Funds vs. Index Funds: Which Are Better for You?
- What Is a Target Date Fund?
- What Is an Index Fund?
- Where to Buy Target Date Funds & Index Funds
Target Date Funds vs. Index Funds
Ask Clark for his opinion on investing, and he’ll almost always mention target date funds before anything else. But Clark also thinks investing in low-cost index funds can be an appropriate choice.
So how do you know which option is right for you? Or should you consider investing in both?
The main thing you need to know is the major difference between the two, and it has to do with taxes. Target date funds are great investments inside of retirement accounts such as 401(k) plans and Individual Retirement Accounts (IRAs). Index funds, especially ETFs, are excellent choices if you’re investing in a taxable account (not a 401(k) or an IRA).
Target date funds are the “easy button” for investors. Index funds aren’t that complex but do require a little more attention on the part of the investor.
Target Date Funds vs. Index Funds: Which Are Better for You?
| Aspect | Target Date Funds | Index Funds |
|---|---|---|
| Account Type | Retirement | Retirement or taxable |
| Level of Involvement | Set and forget | Review at least yearly |
| Portfolio Holdings | Dynamic | Static |
| Annual Fees | Often higher | Often lower |
| Skill Level Needed | None | Semi-moderate |
If target date funds vs. index funds were a boxing match, each side would win a few rounds and the decision would be in the hands of the judges.
Target date funds are easier. Especially with a long time horizon, they’re just fine. They’ll ensure that you have a proper allocation within your portfolio no matter how far away or how close you are to retirement.
But in many cases, you’re leaving at least some small degree of return on the table. And you’re probably paying a bit more in fees than you would with an index fund.
However, index funds take a little more research and investing knowledge as well as a touch more hands-on involvement.
Traditionally, post-retirement investment portfolios are bond-heavy. Bonds tend to be more conservative and stable than stocks.
Target date funds help ensure that you’ll get a less risky portfolio as you reach and enter into retirement. So will a bond index fund. But, for example, a total stock market index fund won’t give you any exposure to bonds.
With index funds, you’ll have less of a safety net in terms of making sure you have an appropriate level of risk in your portfolio.
What Is a Target Date Fund?
A target date fund is an age-appropriate portfolio that moves into more conservative investments as you get closer to retirement.
Pick the funds with the year closest to when you think you’ll retire. They’re generally spaced out every five years (2045, 2050, 2055, etc.).
Clark says putting your money in a target date fund is the easiest investment you’ll ever make. In fact, once you’ve picked the right target date fund, you can simply put all your investment dollars into that fund for the rest of your working career and do nothing else.
“Most people either aren’t really interested in investing, are intimidated by it or don’t truly understand the long-term picture of how you build a portfolio,” Clark says.
“That’s why target date funds have become so immensely popular: Somebody for whom this isn’t their thing can let it be somebody else’s thing. What it does is build wealth for them methodically over time.”
Target date funds are mutual funds, which aren’t the most tax-efficient investments. Also, recall that target date funds change the assets within your portfolio over time. Target date fund managers buy and sell more often than index fund investments. Those additional trades create more taxable events.
The good news? Investing in target date funds within retirement accounts make those tax consequences obsolete.
“With target date funds you should be investing inside a traditional IRA, Roth IRA, 401(k),” Clark says. “That would also include Simplified Employee Pensions (SEPs) and any other account where there are no tax implications to the mix of investments being changed over time.”
What Is an Index Fund?
A financial index tracks the strength of a hypothetical portfolio for a particular segment of the market.
For instance, the S&P 500 is an index that measures the combined stock price of about 500 of the largest publicly-traded companies in the United States.
Index funds are designed to track the price action of a specific index. They can focus on international companies, bonds, commodities and more.
With an index fund, you hand your money to a fund manager. He or she pools your money with that of many other investors. If the index fund tracks the S&P 500, the portfolio manager will use the pool of money to buy the stock of every company in the index.
As an investor, you get instant diversification. You also don’t have to track, rebalance and figure out how to minimize your tax bill. The fund manager does that for you.
Index funds are passively managed. They tend to charge less expensive fees and generate lower tax bills than mutual funds.
“If somebody is investing in a standard brokerage account — not a tax-sheltered account — or if somebody really loves investing and managing their investments, then index funds are potentially a superior choice,” Clark says.
“Index funds are really only appropriate if you’re going to review what you’re doing every year. You’ve got to be one of those people who will stay on top of it.”
Where to Buy Target Date Funds & Index Funds
If you’re investing in a target date fund, you may not have to look further than your job to find one. Your 401(k) plan is an ideal place to invest in a target date fund.
If you don’t have access to a 401(k) plan, open an IRA at one of the Big Three (Fidelity, Schwab or Vanguard) — preferably a Roth IRA if you subscribe to Clark’s investing philosophy.
Just make sure that you’re careful with Fidelity and Schwab. They’re excellent options, but they offer inexpensive and expensive versions of each target date fund. Selecting the less expensive version matters.
Your 401(k) and IRA accounts should offer you index fund options as well. But index funds, especially the ETF versions (as opposed to mutual funds), are well suited for taxable investment accounts.
Final Thoughts
Target date fund vs. index fund doesn’t have to be a binary choice. There’s nothing wrong with investing in both simultaneously.
However, target date funds are best suited for retirement accounts and for hands-off investors. Index funds can work inside or outside of retirement accounts and are best for those who don’t mind being more involved in managing and monitoring their investments.
