Exactly How to Pick Investments in Your 401(k)

If you have no idea what your 401(k) is invested in without looking at it, you’re not alone. According to a NerdWallet study, well over 50% of professionals don’t know what investments they hold in their retirement accounts and 401(k)’s. 

If you do take a look at your 401k and you still don’t know what your investments actually mean, you’re also not alone. 63% of Americans don’t understand how their 401(k)’s work from an investment or a tax perspective.

You can easily learn exactly how to pick investment in your 401(k) that can help you retire years earlier.

Why Is It So Important To Learn How To Pick Investments for your 401(k)?

Learning how to choose and change your 401(k) investments overtime can help you make and save thousands of dollars over your lifetime.

Make no mistake, if you have a 401(k) you are an investor. 

When I first learned how to properly pick investments for my 401k rather than just selecting a default target date fund, I was honestly a bit embarrassed and I felt ashamed that I had thousands of dollars in an account and really had no idea what investments I held in my 401(k).

I also was really unclear of which option would be best for me. 

Once I learned how to pick investments in my 401k, I increased my returns and now will be able to retire years earlier. You can learn how to do this too!

Here’s How Your 401(k) Actually Works

Before we dive into choosing investments, let’s get on the same page about how your 401(k) account actually works. Your 401(k) is an investment account that your employer provides for you. There are two types of 401(k)’s your employer can offer. Both of these types of 401k’s allow you to contribute money but impact your taxes differently. 

A traditional 401(k) will allow you to reduce your taxable income but whatever amount of contributions you make to your 401k.

A Roth 401(k) which some employers offer, allows you to contribute after-tax money. So while you don’t get a tax break right now, your investments will grow tax free and you get tax free withdrawals in retirement.

At the end of the day, your 401k is an investment account. You contribute money and then you invest it in stocks or bonds.

For 2023, the 401k contribution limits have increased! An individual can contribute up to $22,500 in a 401(k), 403(b), and most 457 plans, up from $20,500 in 2022.

Choosing Your investments for Your 401(k)

Learning the basics of exactly how to pick investments for your 401k is something that should be at the top of your list for two main reasons:

1. If you don’t learn how to choose your own investments you could be automatically invested in target date funds, which can carry very high fees. 
2. Target date funds can often be too conservatively invested for young people, significantly reducing their returns, meaning they will have less money in retirement.

There are two main routes you can take for your 401(k) investment strategy. The first one is target date funds and the second one is to select a few of your own investments. 
Most people end up choosing the 401k default investment, which most of the time is going to be a Target Date Fund.

What is a Target Date Fund?

A target date fund is a mutual fund made up of other mutual funds and holds a mix of stocks and bonds. This investment will automatically rebalance investments for you and reduce your risk over time as you near retirement. The benefit of this investment is it truly is a “set it and forget it” strategy.

Target date funds are meant to carry more stocks and therefore more risk when you are younger, and then as you age the amount of stocks will decrease and the amount of bonds in the fund will increase to reduce your overall risk as you near retirement.  

For example, if you are looking at Fidelity’s target date funds, they are labeled Fidelity Freedom Fund 2030 or 2050 and that number refers to the date in which you are looking to retire. 

If you are looking to retire in 2030, your target date fund will have less stocks and more bonds to make sure the risk is lower since you are retiring earlier.

In contrast, if you are looking to retire in 2050, your target date fund will have more stocks and less bonds, a mix that will produce higher returns but carries more risk.

While these funds are great in theory, they can be very expensive and will eat into your returns over time.

Why Target Date Fund Fees Matter in Your 401K

Let’s pretend two different people invest $500 a month for 30 years.

Nancy invests this $500 into a target date fund with a fee (expense ratio) of .75%. Over 30 years, assuming an 8 % annualized return, she will have ~$649,000. 

Lisa on the other hand invests in index funds that have low fees of .03%. Assuming an 8% annualized return, her balance after 30 years will be worth ~$755,000. 

Lisa will have $106,000 MORE than Nancy just by selecting funds with low fees!

Warning, you may not always have the option to choose index funds with low fees in your 401(k) but more and more 401k plans are offering better investment options so it’s important that you at least check!

What’s An Index Fund and Why Is It A Good Pick For My 401(k)?

An index fund is an investment that tries to mirror the performance of a particular index.

An example of an index is the S&P 500. This is just a group of the top 500 largest US stocks. So an S&P index fund would hold all 500 of the top US stocks. 

Since these funds are just tracking an index, they don’t require active management which means they are way cheaper to own than traditional mutual funds and target date funds. 

So instead of investing in a target date fund, you can select a couple index funds and create your own diversified portfolio.

What Type of Index Funds Can I Pick For My 401(k)?

One really easy way to create an index fund portfolio for your 401k is to use 3 types of index funds: 

1. A US or total market index fund
2. An international index fund
3. A bond fund

This portfolio will ensure you are invested in a diversified mix of US and international stocks and bonds. 

With this portfolio, you’ll have to make the choice of how much of your contribution should go to bonds versus stocks. Bonds typically have lower returns but help us reduce risk. Typically, you will want to invest heavier in stocks at a younger age and over time invest more in bonds.

A good rule of thumb to figure out how much you should invest in stocks is to subtract your age from 110. So if you are 30 years old, you could start by investing 80% of your contributions in stocks (in this example US and internationally) and 20% in bonds. 

This might seem complicated at first but it’s actually really easy to learn! If you want to learn more, check out my youtube video for more information on exactly how to pick investments in your 401(k). 

I am not a licensed financial advisor. Tessitory LLC, Wealth with Tess, and Tess Waresmith will never provide financial advice of any kind. This article and everything on the website is for educational purpose only. I offer education, not prescriptive advice. The information that is found here are my opinions and the opinions of other readers/contributors, and should be taken as such. Some content may contain affiliate links or sponsored content — I will never work with a brand or showcase a product that I don’t personally use or believe in.