Saving for retirement in a 401(k) is a great way to build wealth for the future. With a 401(k), you simply sign up with your employer to have funds deducted automatically from your paychecks.
Annual contribution limits for these plans are pretty generous — $19,500 if you’re under 50 and $26,000 if you’re 50 or older. Plus, many employers match employee contributions, so you may get some free money in your account, as well.
But the money in your 401(k) shouldn’t just sit there doing nothing. Rather, your goal should be to invest that money for maximum growth.
But what if you don’t know a thing about investing? If that’s the case, here’s a good solution for you.
The upside of index funds
In some ways, 401(k)s are great for people who don’t know a lot about investing or are new to the process because unlike IRAs, you can’t buy individual stocks in a 401(k). Rather, you’re limited to different funds.
Most 401(k)s offer a mix of actively managed mutual funds and index funds, which are passively managed. And if you have no idea what to do with your retirement savings, it pays to favor the latter.
The reason? Index funds charge much lower fees than actively managed funds since they don’t employ professional fund managers to hand-pick their contents. Rather, index funds are set up to track existing indexes, like the S&P 500, and that allows them to keep their expense ratios down. (An expense ratio is basically the fee you’re charged to invest in a given fund.)
One main difference between actively managed mutual funds and index funds, other than fees, is that active funds have the goal of beating the broad stock market’s performance. Index funds, on the other hand, seek to match it. But index funds frequently manage to outperform actively managed funds despite that difference in strategy, so if you load up on index funds in your 401(k), you won’t necessarily be losing out on performance.
What about target date funds?
Another option for your 401(k) is to put your money into a target date fund. As the name implies, these funds adjust your investments to meet certain milestones — in this case, retirement.
In some ways, target date funds are less risky than stock-based index funds because they’ll automatically shift you over to conservative investments as the end of your career nears. But the flip side of that is you may wind up with a 401(k) that’s invested too conservatively. And if you lose out on stronger returns, you could end up falling short once your time in the workforce comes to an end.
It’s for this reason that index funds may still be a better option. The downside of index funds is that you don’t get a say in how your money is invested — you can’t choose the stocks that comprise the funds you select. But the same holds true for actively managed mutual funds and target date funds, so it pays to consider index funds for your long-term savings.