If you want to save for retirement successfully, your 401(k) plan at work is one of the most valuable tools that you have at your disposal. By contributing to your 401(k), you can often cash in on employer matching contributions that can boost your eventual nest egg by tens of thousands of dollars by the time you retire. You'll also avoid the tax burden that savers face when they use regular brokerage accounts to invest for retirement.
There's been a lot said about the impact of which 401(k) investments you choose. The key downside of 401(k) plans is that they typically come with fixed investment menus, and some of the choices you have will probably be lousy. Yet if there's one single mistake that people make in their 401(k)s time and time again, it's that they overuse what are really the worst funds they could choose for their retirement investing: money market funds.
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The appeal of cash
At first glance, it might seem counterintuitive to think of a money market fund as the worst fund on your 401(k) menu. During tough periods for the stock market, as we've seen to begin 2018, you'll often find that your money market fund is among the best performers, typically producing at least small positive returns even when stocks fall double-digit percentages.
That's one reason why until recently, most 401(k) providers set up their plans to a money market fund the default investment option for those who made contributions without specifically directing how they wanted those contributions to get invested. Employers believed that by putting their employees' money in an option that was almost guaranteed never to lose money, they were serving their fiduciary duty until participants made their own investment decisions.
The downside of money market funds
But for those who've invested in money market funds in recent years, there's a big price to pay for the safety and stability that these investment vehicles provide. Ever since the financial crisis, the Federal Reserve's decisions to keep short-term interest rates as low as possible have put downward pressure on the income that money market funds generate. For many years, money market funds paid next to nothing, and some funds stopped operating because the income that they generated was insufficient to cover their own expenses, let alone pay anything to their shareholders.
More importantly, having a large cash position in your retirement account runs counter to the entire objective of saving for retirement in the first place. It's important for savers to choose investment options that will let their investment grow to the maximum extent possible that's consistent with your tolerance for risk. When you're young, that typically means keeping all or nearly all of your money invested in stocks, because you're in a better position to weather short-term fluctuations in order to capture the greater long-term returns that stocks have delivered in the past.
Even as you grow older and get closer to retirement, diversifying part of your money beyond the stock market ideally involves choosing lower-risk alternatives that still offer either healthier income or some modest growth prospects. Funds that focus on real estate investment trusts, bonds, and specialty areas like master limited partnerships can offer better total returns, and although they carry more risk of loss of principal than a money market fund, the higher income and gain potential is enough to make them more attractive even for conservative investors.
Lastly, even if you want to have cash available, having it in your 401(k) is just about the worst place for it. Unlike an emergency fund in a regular bank account, you can't simply go to your employer and ask for the cash without serious negative consequences, including taxes and penalties. Liquidity in your 401(k) doesn't give you the same flexibility as liquidity in your finances more generally, and it's generally smarter to keep your cash outside your retirement account while staying fully invested in your 401(k).
Don't waste your retirement savings
To take maximum advantage of the tax benefits of 401(k) funds, you need to invest at least somewhat aggressively. That makes using money market funds a mistake for most 401(k) investors, and if you need cash, you'll typically want to have it where you can get to it more easily than inside your retirement plan account.
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