A 401(k) is a retirement plan that lets an employee invest in a tax-advantaged, long-term manner, often with periodic matching contributions. An index fund is an investment fund constructed to track a specific financial index, such as the S&P 500. So, which is better—index funds or 401(k) plans?
Index funds are not “better” than a 401(k). If your choice is between contributing to a company’s 401(k) plan or investing in an index fund on your own, consider choosing both. In fact, many 401(k) plans today use index funds as their primary underlying investment asset.
If you have the choice of how your 401(k) plan invests, then an index fund could be a good bet for a tax-advantaged, low fee, diversified investment portfolio. Read on to learn more about the nature of 401(k)’s, their advantages and disadvantages, and how index funds could be well-fitted to their long-term investment goals.
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401(k) Plans and How They Work
“401(k)” retirement plans are named after the IRS code, which allows for their existence as a form of employee benefit plan.
The 401(k) is a newer kind of employee benefit plan, known as a “defined contribution plan” as opposed to a “defined benefit plan,” such as a pension. A simple google search will highlight plenty of aspects in which the two plans differ.
However, the primary distinction is that the defined contribution plan is tied more closely to employee contributions and stock market performance, whereas the defined benefit plan is tied more to employer contributions and time spent working with the company.
In short, a pension provides more of a guaranteed endgame of payouts than a 401(k). This is because a pension’s benefits are defined in advance, whereas the 401(k)’s benefits are tied directly to the stock market investment vehicle that they are invested with.
Defined benefit plans typically require participants to meet eligibility requirements, including working a set amount of time.
The U.S. Social Security system is perhaps the best example of a defined benefit plan, along with a teacher or police pensions, for example. The 401(k) is the best example of a defined contribution plan. The former is much rarer now, mostly reserved for traditional, more union-based jobs, and the latter has become the new norm for the American workforce.
The 401(k)’s purpose is to encourage employees to invest in the stock market – via mutual funds or ETFs – through their employer-sponsored plan, on a periodic basis, and for the long-term.
There are two primary functions in the tax code around 401(k) retirement plans that accomplish this:
- A % employer matches to your periodic contributions.
- 10% tax penalty for early withdrawals.
Thousands of employers use 401(k) retirement plans and will match their periodic (typically monthly) employee contributions from their paycheck. The employee chooses how much, if any, they want to contribute to their 401(k) plan, and depending on the employer match scheme, there’s always a maximum amount that they’ll match.
Most investment advisors recommend employees contribute at least up to the maximum employer match, if not more.
To encourage a long-term outlook on the employee’s 401(k) plan, all the way to retirement age (60+), there’s a tax penalty to the individual for any early withdrawals they make from the account. Specifically, the IRS will tax early withdrawals from a 401(k) plan, before age 59.5 or without special circumstances, at a 10% penalty.
Additionally, there are two general styles of 401(k) just like the IRA (individual retirement account) — the Traditional versus Roth. A traditional 401(k)’s contributions are considered pre-tax and are deducted from the employee’s gross income with no taxes due until the money is later withdrawn. A Roth 401(k) is reversed, with contributions coming after-tax but future withdrawals, at retirement age, coming tax-free.
Another potential choice (depending on your 401(k) service provider and/or company) is what kind of investment fund(s) you want within your 401(k) portfolio. This is where the question of index funds comes into play.
Index Funds Provide a Long-Term Investment Outlook
Index funds are pre-diversified investment funds that collect a basket of securities meant to mirror a particular index, such as the S&P 500 or Russell 2000, among many others.
Most 401(k)s let the individual choose the underlying fund associated with their portfolio. That means that you can theoretically choose an index fund. CNBC, Investopedia, and Nerd Wallet all feature guides on how exactly to strategize your 401(k) investments. These are all good beginner reads and will help you determine your choice among the many mutual funds and ETFs out there from providers such as Fidelity or Vanguard.
As previously discussed, given that 401(k) retirement plans are meant to be invested via dollar-cost averaged contributions deducted from your regular paycheck – matched up to a % limit by your employer – and done so for the long-term through your career, index funds fit their overarching purpose well.
Therefore, I strongly believe, and as many online investing guides attest, using index funds within your 401(k) retirement plan is a great choice.
To succinctly explain why index funds form a great choice for your retirement portfolio, here are my top three reasons for you:
- Lower research time.
- Immediately diversify your portfolio.
- Keep fees to a minimum.
TIME featured a recent piece on a millionaire investor doing a retrospective on his career with a simple sentiment: “If He Could Start Over, He’d Put Everything Into a Target Date Index Fund.” (link in article sources down below)
Warren Buffett himself – the American investing icon – says that index funds make the absolute best choices for your retirement accounts, such as your 401(k).
Do You Invest in an Index Fund on Your Own or in Your 401(k)?
It’s clear that index funds make for a solid choice for your 401(k) investment account.
However, if you’re trying to decide whether to invest in an index fund on your own, with an individual brokerage account or robo-advisor, etc., versus investing in an index fund through your employer’s 401(k), then you should understand the trade-offs.
Either way, an index fund investment will net you a low-cost, long-term-oriented, and risk-managed investment asset.
A 401(k) plan, either traditional or Roth, will net you tax advantages as you contribute or withdraw. Given your employer’s individual matching scheme, you’ll get additional funds invested from your employer for free.
On the other hand, with index fund investments through an individual, non-retirement account, you’ll be able to withdraw from your investment freely without a tax penalty before you are at retirement age.
The choice between an individual index fund investment versus a 401(k) index fund investment comes as a choice between:
- Availability (do you have an employer with a defined contribution plan?)
- Are you willing to wait until retirement age to withdraw from your investment without a tax penalty?
It’s difficult to choose just one—but if it’s possible and acceptable for your own individual financial circumstances, the best course of action is to use both a 401(k) and index funds together.
By investing your 401(k) retirement fund into an index mutual fund or exchange-traded fund, you could truly get the best of both worlds — a tax-advantaged, low fee and highly diversified long-term investment portfolio.
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Conclusion
On the matter of how to invest your 401(k), index funds make for a good investment choice. They provide the same main attribute that the 401(k) defined contribution plan is meant to favor – a long-term outlook. A retirement account allows for an index fund to grow, with a tax-advantaged status and from contributions from both employee and employer.
The question is less “are index funds better than 401(k)?” and more “how can I use index funds in my 401(k)?”
I hope this article has helped clarify definitions and strategies for your financial situation’s array of choices.
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