The Best Funds for Your 401(k)

By Dan Caplinger Markets Fool.com

401(k) plans have become increasingly popular over the years as many employers have moved away from traditional defined benefit plans. Most 401(k) plans offer a limited selection of investment options, which are most often mutual funds. Although some 401(k) plans offer only unattractive funds with high fees and poor investment performance, you'll more commonly find at least some fund options that will help you get to your financial goals in retirement. Below, we'll look at how you can determine that best funds that your 401(k) offers and concentrate on them in accumulating a nest egg for retirement.

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Best-case scenario: Flexible investment options

Those who are extremely fortunate will discover when they look at their investment options in their 401(k) that their plan offers a flexible investment options. Sometimes referred to as a brokerage option or directed investment, a few employers offer their workers the opportunity to invest using what amounts to a brokerage account. This opens up the full universe of investing options, including individual stocks, exchange-traded funds, and mutual funds.

For those who are comfortable picking individual stocks, this best-case scenario is ideal. Even those who want to stick with diversified investments will find that being able to choose from the thousands of exchange-traded funds and mutual funds will let them pick the ideal investment for them. For instance, basic stock investors could go with an all-purpose index investment like SPDR S&P 500 ETF (NYSEMKT: SPY), while those who prefer dividend stocks could choose a dividend ETF like Vanguard Dividend Appreciation (NYSEMKT: VIG). Not being restricted to a particular financial institution's offerings is rare, and it makes sense to take full advantage of the situation if you find yourself in it.

The typical 401(k): Low-cost index funds

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Unfortunately, most 401(k)s don't offer a flexible brokerage option. However, you'll typically find among your menu of set mutual funds at least some index funds. Good index funds are valuable for retirement savers for two main reasons: they have low expenses, and they are designed to track the target market closely. Both of those features keep index funds roughly in line with overall market performance, avoiding surprises and keeping you on track to reach your long-term goals.

One thing to double-check, however, is that any index fund in your retirement plan actually has low costs. Although they're rare, there are some funds out there that track indexes but nevertheless have extremely high expense ratios. If you have such an option in your 401(k) plan, be wary and do some outside research to find out why that particular index fund has such high expenses. If the answer doesn't make sense to you, you'll want to steer clear.

When you don't find what you want in your 401(k)

Some 401(k)s don't have index funds among their offerings. In that case, you're often faced with finding the best fund in a bad lot. Occasionally, you'll find some actively managed funds that have a solid track record of performance and below-average fees. Unfortunately, the employers that don't include index funds among their options often also don't pay much attention to choosing good investment options overall, taking the advice of the financial institution with which they're working even if it isn't necessarily in their workers' best interest.

If there's absolutely no fund worth buying in your 401(k), then your best alternative is to fund outside IRAs to the maximum extent possible. This is far from ideal, because contribution limits on IRAs are less than a third of what you can contribute to a 401(k). Nevertheless, if the financial institutions that run the high-cost funds in your 401(k) plan take too big a cut for themselves, you won't be able to perform well enough to overcome the negative impact of their costs.

The best funds for your 401(k) are investments that you can pick yourself. Absent that right, choosing from low-cost index funds will be the best way for you to reach your financial goals.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.