Target-date funds have become popular options in many company-sponsored retirement plans because of their perceived simplicity and convenience. Instead of having to spend hours poring over reams of information about a long list of investment choices, plan participants can just put their retirement savings plans on auto pilot using these funds, which promise to periodically reallocate the money in them toward appropriate investments as they approach their target date.

But while these funds may be a good choice inside a tax-deferred plan or account, it's important for investors who purchase these funds in retail accounts to understand how they will be taxed on their earnings. (For more, see: The Pros and Cons of Target-Date Funds.)

Target-Date Fund Tax Consequences

Target-date funds are mutual funds that are made up of a collection of other mutual funds, such as growth and income funds or sector funds. They are designed to invest aggressively when they are a long way from their target dates and then move their money into progressively more conservative holdings over time as the target date approaches.

This strategy requires target-date funds to periodically sell a portion of their current holdings and purchase new ones that are less aggressive in nature. This means that investors who own these funds in taxable retail accounts will periodically be hit with capital gains (or losses) when the fund undertakes its reallocation procedure. Many of these gains and losses will be long term, but some may be short term, which means that those gains (or losses) will be counted as ordinary income for tax purposes.

Investors will also have to pay taxes on the gains and losses that are generated in the underlying funds at the end of each year. For example, a target-date fund that has a growth fund as one of its holdings will have to pass through the capital gains and losses that are generated by that growth fund to the fund's investors. And it will have to do this with every fund that it owns. These gains and losses come on top of any gains and losses that are realized when the fund sells shares of these funds and moves into something else. (For more, see: Why You Should Be Wary of Target-Date Funds.)

The same holds true for dividends and interest income. All dividends and interest that are generated by the underlying funds are passed through the target date fund to its investors. This income is considered ordinary income by the IRS, which means investors will be taxed on this income at their top marginal tax bracket.

Owning a target-date fund in a taxable account can be an expensive proposition in many cases, because target-date funds cannot perform actions to reduce the taxable income that they generate such as tax-loss harvesting. Their returns are generated entirely from the underlying funds that they hold, so they have no real control over the tax consequences that come with them.

For these reasons, many financial advisors recommend to their clients that they hold any target-date funds they wish to own inside an IRA or their employer-sponsored retirement plan. The only disadvantage this could pose is that all gains generated by the fund will be taxed as ordinary income in traditional IRAs and employer-sponsored retirement accounts, and investors will not be able to receive any capital gains treatment for long-term gains that are generated. Of course, those who hold these funds in Roth IRA accounts will pay no tax at all on any of the income generated by the fund in any capacity.

The Bottom Line

Target-date funds can provide automated investment management for investors who do not wish to actively manage their own portfolios. However, their tax inefficiency may make them a bad choice to hold outside of a retirement plan or IRA. (For more, see: When to Use Target-Date Funds.)