Just how tax-inefficient are TDIFs?

Firstly, hi everyone. Huge fan of PFC — you guys introduced me to Target Date Index Funds, and I love how simple they make investing. I use them in all my tax-deferred accounts, and now that I’m planning to start investing in taxable, I was wondering if I should default to the same.

I keep reading about how TDIFs are supposedly “tax-inefficient” because their bond portion throws off dividends that are taxed at ordinary income tax rates, and how this can be a problem, especially when approaching the target date. To solve for this, I’ve been looking at robo-advisors like Betterment or Vanguard Digital Advisor because they utilise tax-exempt municipal bonds instead (plus I see how tax-loss harvesting could be a minor bonus).

I wanted to ask: Is this concern regarding TDIFs in taxable warranted? I’m in a high-tax industry/state (between 24-34%), so how bad could the costs of this “inefficiency” be over a lifetime? It’d be helpful if someone could put numbers to this. The robos all cost ~0.25%/yr — so if the cost of TDIFs’ tax inefficiency is lesser than that over a lifetime, it would be helpful to know.

The TLH and flexibility still has me leaning towards robos for now (mostly Betterment because I appreciate its UI and flexibility despite the slightly higher cost). But it’d be illuminating to actually know what I’m choosing, and what you guys think of my current plan. Thank you!

Hi @Carefully_Careless

Thank you for the kind words! You ask a great question! I would encourage you to ask it in the PFC Facebook group since I know this exact topic has come up in the past and a lot of people will share their opinions with you. Here is the link!

I have never done the calculation before that you described. I think both Betterment and a TDIF in a brokerage account are great options. I would not hesitate with doing either. Using muni bonds instead of treasuries/corporates/agencies is not as helpful as it may appear (or as the marketing language tells you!). Yes, muni’s offer federal tax advantages, but they tend to have higher credit risk AND their tax-adjusted yields tend to be comparable to similar non-muni bonds.

You will see a lot of people mention the tax inefficiency of TDIF not for the reason you said, but because of the Vanguard problem at the end of 2020 when one of their TDIF’s had a large distribution due to changes they made to their minimum investment. However, it’s important to note that this is a one off event and should not be the deciding factor whether holding TDIFs in a brokerage account makes sense.