Investing With a 401(k) vs. Index Funds

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Couple checks their index funds

Index funds are low-cost mutual funds designed to track the performance of groups of stocks, and 401(k) accounts are tax-advantaged retirement accounts many businesses offer to workers. These two investing vehicles provide different benefits that generally complement each other, and both figure in many investors’ strategies. However, sometimes investors have to choose whether to put their money in index funds or 401(k) plans. Here are keys to understanding pluses and minuses of each. Consider working with a financial advisor as you create or periodically modify your investment strategy.

401(k) and Index Fund Basics

A 1978 tax law change led to the creation of 401(k)s, and today they are the most popular employer-sponsored retirement plan. Employees who opt to participate in 401(k)s can have contributions automatically deducted from their paychecks, and these plans offer important tax and other benefits for retirement planning.

Don’t confuse 401(k) plans with Roth 401(k) plans. Roth plans are funded with after-tax dollars. Roth 401(k)s have more flexibility than regular 401(k)s because contributions can be withdrawn any time without penalty or additional taxes. Early withdrawals of earnings may incur taxes and penalties. However, both contributions and earnings can generally be withdrawn tax-free after age 59.5.

The first publicly available index fund launched in 1975. Index fund managers seek to match the performance of the overall market, or a list of specific securities, such as an index like the S&P 500, rather than trying to pick stocks that will outperform the market. This passive management style leads to less trading and lower costs. Added to other strengths of the approach, this has helped index funds outperform most actively managed funds over the long haul. Today, more money is invested in passive funds, including index funds, than actively managed funds.

401(k) Pros

A 401(k) account’s major edge over an index fund is the tax advantage. Contributions to 401(k) accounts are pre-tax. Owners don’t pay taxes on dollars they put in or the earnings from their investment portfolio until they start withdrawing funds.

Another advantage of equal or greater importance for many 401(k) participants is that their employers match amounts they put into the funds. That is, for every dollar the employee puts in, the employer puts in another dollar. This effectively doubles the amount people can save. Not all employers match, and those that do generally limit matches to a percentage of the employee’s salary.

401(k) Cons

401(k) documents

The major downside of a 401(k) is that the owner usually can’t take any money out of the account before age 59.5 without having to pay a 10% penalty, plus any income tax due on the withdrawals. This means 401(k)s are best suited to retirement savings and have limited use for other financial goals, such as emergency funds and saving for a home.

Owners of 401(k)s also have to start making withdrawals called required minimum distributions (RMDs) starting at age 70 1/2. Making these withdrawals can cause tax problems for some retirees, but stiff penalties of 50% of the amount of any RMDs that are not withdrawn ensure compliance.

A 401(k) plan typically also offers a limited selection of investments. Generally, the choices consist of a handful of index and target-date funds. Most don’t let employees invest in individual stocks and bonds.

The IRS limits the annual contribution to a 401(k) to $19,500 in 2021. The cap goes up by about $500 every couple of years. If employees want to save and invest more, they have to use another vehicle.

High fees also diminish the 401(k) appeal. In addition to paying fees charged by mutual funds, 401(k) investors also must pay additional annual charges, often as high as 1.5% of the amount in the account, levied by the 401(k) plan.

Finally, not everyone has access to a 401(k) plan. Many employers, especially smaller businesses, don’t offer the plans.

Index Fund Pros and Cons

Index funds’ long track record of superior returns compared to actively managed funds is their primary appeal. They do this, in part, because of the low fees the passive management style enables.

Index funds are also generally well-diversified because they own large numbers of stocks. This can help limit the downside of fund performance during market lows.

Index funds are widely available for anyone to purchase at banks and traditional and online brokerages. There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.

The primary negative of index funds compared to 401(k) plans is the lack of any tax advantage. Fund purchases are made with after-tax dollars and investors pay taxes on any gains in their holdings.

Bottom Line

Money manager checks an index fund’s performance

For many, if not most, retirement savers the tax advantages and opportunity to have contributions matched trump the low fees and expansive investment options offered by index funds. However, index funds have an important role to play by allowing investors to accumulate funds that can be used for purposes other than retirement. Generally speaking, both index funds and 401(k) plans are recommended as parts of an investor’s strategy.

Tips on Investing

  • Deciding whether and how much to put into a 401(k) plan or index fund involves careful analysis of your individual tax and financial situation. Working with a financial advisor can improve your analysis of the options. SmartAsset’s free tool matches you in five minutes with financial advisors in your area who can help with these decisions. If you’re ready to be matched with local advisors, get started now.

  • If you’re going at estate and retirement planning by yourself, it’s a good idea to prepare fully. SmartAsset has you covered with lots of free online resources that can help you plan for the future. For example, check out our retirement calculator.

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