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It’s important to actively choose investments for your 401(k). Read on to see why.
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There’s a key difference between IRAs and 401(k)s aside from the fact that 401(k)s come with much higher annual contribution limits. IRAs also allow you to invest your money in individual stocks.
But 401(k) plans generally do not allow you to invest in stocks individually. Instead, these employer-sponsored plans typically give you a choice of funds to invest in. And if you don’t actively choose your 401(k) investments, you might end up unhappy with the type of fund your money lands in.
When you’re left with the default option
When you don’t choose investments for your 401(k), in most cases, your money will end up in a target date fund. Target date funds are designed to adjust your asset allocation as different milestones near. What’ll typically happen in a 401(k) is that your target date fund will start you off with more aggressive investments, like stocks, when you’re younger, and then shift you over to more conservative investments, like bonds, as your target retirement date nears.
Target date funds are a good option for people who want to take a “set it and forget it” approach to 401(k) investing. And as of the end of 2022, a good 96% of 401(k)s offered target date funds, says Vanguard. So clearly, they’re quite popular. But just because they’re popular doesn’t mean they’re perfect.
One drawback of target date funds is that they tend to err on the side of investing conservatively. So you might lose out on higher returns in that regard.
Also, target date funds are known to charge fees that are on the high side, the same way mutual fund fees tend to be higher. Those fees could eat away at your returns in your 401(k), making it harder to meet your savings goal.
Take control of your money
If you’re going to work hard to fund a 401(k), then it really pays to take an active role in investing your money rather than just let it land in a target date fund. Of course, 401(k)s, by nature, limit the extent to which you can invest. But it’s a good idea to explore the different funds your plan offers and see what your choices entail.
One smart bet may be to invest your 401(k) in index funds. Index funds are passively managed — they simply aim to match the performance of the indexes they’re pegged to. So an S&P 500 index fund, for example, would invest in S&P 500 companies and aim to perform comparably to the S&P 500 itself.
The great thing about index funds is that their fees tend to be considerably lower than target date funds and mutual funds. That’s a good way to avoid losing money needlessly.
Of course, you may end up deciding that a target date fund is actually a good choice for your 401(k). And that’s totally fine. The key, however, is to do some research and make a decision — rather than let your money land in a fund you may not want to invest in.
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