How to Choose the Best Funds for Your 401k Investing

Confused about how to choose the best funds for your 401k investments? You’re not alone!

There are a ton of good reasons why you should be contributing to your employer’s 401k plan, especially if you have a company match. Building your retirement nest egg, increasing your net worth, and taking advantage of employer matching contributions are just a few.

However, a 401k is just an investment account, it is not an investment in and of itself. You have to choose stocks, bonds, mutual funds, etc to invest in within the 401k account. You most likely have a few dozen funds to choose from within your 401k plan!

Choosing investments can be overwhelming at first, especially if you’re new to investing.

But don’t let that stop you from contributing to retirement accounts and educating yourself about investing!

If you’re young and still trying to figure out your 401k and how to choose investments, you’re lucky because you have time and the power of compound interest on your side.

I’ll explain everything you need to know about your 401k, what types of funds are available, and how to analyze different investment options. Ultimately, you’ll learn how to choose the best funds for your 401k that will produce the highest returns while minimizing risk at the same time.

How to Choose the Best Funds for Your 401k

Your 401k Plan: The Basics

A 401k is a retirement plan offered by employers that have significant tax advantages. You opt-in to the plan and contributions are deducted from your paycheck. Typically, you’ll elect to contribute a percentage of your yearly salary, and that percentage comes direcly out of your paycheck and goes into your 401k.

Typically, you won’t be able to access the money in your 401k until age 59 and a half.

The IRS imposes contribution limits for your 401k. In 2021, you can contribute up to $19,500 per year of tax-advantaged dollars to your 401k. Those over 50 are allowed an extra $6500 “catch-up” contribution. Your employer match does not count toward this limit.

401k Vesting Schedules

You’ll also want to become familiar with your employer’s 401k vesting schedule.

Being vested means that you get to keep your employer’s contributions to your 401k after you leave a job. It typically takes 1-5 years to be “fully vested,” meaning you forfeit the company’s contributions if you leave your job before the vesting period is up.

Your contributions will always be 100% vested immediately, however.

Check with your HR department for specific details on your 401k plan!

401k Tax Advantages: Roth vs. Traditional

A traditional 401k is funded with pre-tax dollars, meaning you get a tax break now, but will have to pay them upon withdrawal during retirement.

However, Roth 401k plans have become increasingly more popular in recent years. The word “Roth” means that you pay taxes when the money goes in your account, and it grows tax-free!

Your contributions will be Roth money, but your employer contributions will always be traditional (there isn’t an easy way to get around this, as your employer can’t pay taxes on your behalf when they contribute to your account). At retirement, your 401k will have a pile of Roth and traditional money.

For younger workers, the Roth option usually makes the most sense. You have a ton of time until retirement, so the majority of the money in your 401k at retirement age will be mostly investment gains! Having access to these gains tax-free will save you hundreds of thousands of dollars throughout your retirement.

If you’re young, you’re also probably in the lower tax bracket, so getting your taxes over with now also makes sense.

A traditional 401k might make sense for older, high-income earners who expect to be in a lower tax bracket at retirement.

It is up to you to determine if you’d rather pay taxes now, or in retirement.

If you’re young and trying to decide if you should save for retirement in a 401k, contributing just a small amount now will make a huge difference in the future!

Common Types of 401k Fund Choices

Do you know what funds your 401k is invested in? You could be losing out on hundreds of thousands of dollars at retirement if it is poorly invested!

When you sign up for your 401k plan, they’ll have a few different options that you can invest your money in. It’s important to remember that a 401k is not an investment itself, it is an account that holds investments. You get to choose what the money in the account is invested in.

Choosing investments can be overwhelming at first! There are thousands of different funds out there to choose from. But the good thing is, your company has already significantly narrowed the choices for you (or maybe that’s a bad thing).

Let’s talk about the most common types of funds, and how to choose the best ones from the options available to you.

Target Date Funds

A target date fund is often the default option when you start contributing to your 401k. This a fund that sets a “target date” retirement year (such as 2055 or 2060), and will auto-balance the asset allocation for you as you age.

They’re named something like “Blackrock LifePath 2055 Fund” or something with a future year in it. It’s a set-it-and-forget-it type of investment.

In theory, this sounds like a great idea! The fund will start off agressive, then re-balance to a more conservative asset allocation as you get older.

But what happens when you’re 65 and 80% of your nest egg is invested in bonds earning only 3% and you still have 20-30 years to live? Target date funds can often be a bit too conservative as you get closer to retirement age.

If you make it to age 65, you’re much more likely to make it to 95. Which means that you’ll need your nest egg to last you 30+ more years once you retire!

30 years is huge amount of time for compounding to do it’s thang, and make you more money. I’m not a huge fan of target date funds because your portfolio will often be too conservative, even at age 65. This can leave tens or hundreds of thousands of dollars on the table!

Target date funds often have high management fees as well. Since someone behind the scenes has to manage the fund and rebalance it, that level of management will require a higher expense ratio.

Target date funds aren’t the worst option, but I believe that you can do better with a bit of self-education.

Bond Funds

A bond represents a loan that an investor (you) issues to a borrower (typically the government or a central bank). They pay you back a low interest rate, but are a “safe” investment, since it is a guaranteed rate of return.

Typically, bonds only earn 1-3%.

I’m not a fan of bonds used for retirement accounts, especially when you’re young. It takes a lot longer for compound interest to really start working at 1-3% compared to the 7-12% you could earn in the stock market.

Yes, the stock market is riskier, but the returns are much higher and it always goes up over time.

Also remember that inflation averages about 2-3% each year, which essentially makes your bond investment net zero (the loss in purchasing power erases the small earnings that your bonds would return).

Additionally, you can open a high-yield savings account (I use this one) with a 1-2% interest rate and have the money completely liquid to you. Bonds are a pretty sucky investment in today’s world!

Remember that time is on your side when investing for retirement, so be aggressive! There are so many low-to-medium risk index and mutual funds to choose from that will make you a lot more money than government bonds. Bonds suck.

Company Stock

Some companies will offer company stock as an option for your 401k. This is generally a bad idea, as it is a single stock. Single stocks are super risky, and are more on par with gambling than saving for a secure retirement.

Even if your company lets you purchase stock at a discount for your 401k, I’d steer away from doing so unless you really know what you’re doing.

Having the majority of your wealth tied up into one company isn’t a great idea. If you have some extra money on the side and want to play around with some single stocks, great! Just don’t put your entire retirement nest egg at risk while doing so.

Active and Passive Stock Funds

When you think of stocks, you probably think of individual stocks, such as Apple or Tesla. Individual stocks are considered “risky” investments, but have potential for higher returns. Individual stocks put all your eggs in one basket (company), so I wouldn’t recommend building a portfolio of all individual stocks.

Stock funds allow you to take on less risk since you’re spreading your investment over multiple companies. It’s a win-win because you get the benefit of high returns from individual stocks with less risk since you’re diversifying over a bunch of companies.

Stock funds are where you want the meat and potatoes of your retirement nest egg. More often called mutual funds (actively managed) or index funds (passively managed), these funds represent hundreds or thousands of different companies in one single fund!

Actively-managed stock funds will generally have higher fees than their passively-managed counterparts. The active funds are supposed to “beat” the market index, but studies show that over 90% of actively managed investment funds failed to outperform the market.

Passively-managed (more often referred to as index funds) aim to track a benchmark index and have ultra-low management fees. If the investment professionals can’t even beat the market index, why would you pay a higher expense ratio for a worse-performing fund?

An S&P 500 index with low fees is a great fund to invest most of your 401k money in!

If you’re young, 100% of your retirement portfolio should be in passively managed stock funds.

Choosing the Best Funds for Your 401k Investing

Here’s the exact process for how to choose the best funds for your 401k investments:

1. Narrow it down to the passive stock funds

First things first, you need to figure out what your investment options are! This might warrant a call to HR or asking for help navigating your company’s benefits site.

Once you’ve found your options, immediately mark off the bond funds, target date funds, and your company stock. Hopefully, they have each investment type categorized for you.

You want to find all of the stock funds available to you (they might be called index funds, mutual funds, etc). It is unlikely that they’ll have the stock funds divided into active and passive categories. If yours does, mark off the actively managed options as well.

This step should narrow down your choices pretty quickly!

2. Make sure the fund has been around for at least 10 years

Now that you’ve got your list of all the stock funds that are available to you, it’s time to vet that list for the top ones.

First, you want to find funds that have been around for awhile, usually for at least 10 years. This ensures that you have enough data to look at in order to make sure the fund has a good track record. You might find a fund with a super-high return, but it’s only been around for 1-2 years! Stay away from those.

The goal of a 401k is to maximize your returns while minimizing risk. Finding funds that have been around for at least 10 years is a key component of “minimizing risk.”

3. Look at average 5, 10, and 15-year returns

Hopefully you’ve got a pretty short list of potential funds to invest your 401k in. Now, we want to fine-tune the list to find the best 2-3 funds we can.

Your company website should have the average 5, 10, and 15-year returns listed (you can google them if needed). Pick the top 3-4 funds with the highest return, prioritizing the highest returns for the longer periods. We’re saving for retirement here, which means you’re in it for the long haul.

One fund might have an amazing 1-year return, but then it drops significantly over the next 10 years.

You should have a pretty short list at this point.

4. Check the management fees

Cross off all the funds that have an expense ratio higher than .2%. Hopefully you have a few of these low-cost index options.

If all of your options have fees higher than this, just narrow down the top 3 lowest fee funds available to you. I would get my company match in the 401k, and then invest in a Roth IRA instead since you don’t have great investment options in your 401k.

You’ll have a lot more in a separate Roth IRA.

Related: 5 Key Reasons a Roth IRA is Better Than a 401k After Getting Your Company Match

5. Diversify

Now that you know which funds are the best for your 401k, it’s time to choose the top 1-3 and allocate them!

If you’re offered an S&P 500 index, I would make that the “anchor” of my portfolio. These funds include the largest 500 US based companies, which is a pretty solid foundation for your 401k investments.

The S&P 500 historical average annualized return is about 10%, which is really hard to beat.

You’ll likely want some smaller US companies and international exposure as well. Allocate a small amount (20% or less) to international and small/mid cap US funds.

An example of a 401k portfolio could look like 70% S&P 500 index, 20% small/mid cap US, 10% international. Something along those lines will minimize your risk and ensure diversification over a wide range of stocks.

More 401k Tips

Once you’ve got your 401k set up and you’ve picked the best funds available to you to invest in, here are a few more tips on saving for retirement with a 401k!

• If your company has a match, contribute at least the minimum amount to get the full match.

• Whenever you get a raise, up your contribution by the amount of the raise.

• See if your plan allows you to slowly increase your 401k contribution over time. My 401k has an option to increase my contribution by 1% each year! This can be a great set-it-and-forget-it option if you’re a more hands-off investor.

• Make a plan to eventually save 15-20% of your income for retirement. It’s okay if you can’t do this now, but as your income grows, so can your 401k balance! This can be in combination with your 401k, Roth IRA, or any other retirement account.

• Check your account balances at least once a quarter. It’s always a good idea to stay in-tune with your account and make adjustments if needed.

• Ignore the “investment advice” you see when you log into your 401k account. Mine tells me that I’m “too aggressive” even though I’m only 26 years old!

• Remember that you can fine-tune and make changes at any time. Don’t let analysis paralysis keep you from starting!

Now you’ve learned how to pick the best funds for your 401k. Let me know if this helped you narrow down your investment choices!

What funds are you invested in?

-Megan

This post was all about choosing the best funds for your 401k investments.