Investing With a 401(k) vs. Index Funds (2024)

Investing With a 401(k) vs. Index Funds (1)

Index funds are low-cost mutual funds designed to track the performance of groups of stocks, while401(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. If you’re trying to decide between the two options to put your money in, here are the keys to understanding the pros and cons 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 account type. 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 withRoth 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 Roth 401(k)s have more flexibility than regular 401(k)s because contributions can be withdrawn at any time without penalty or additional taxes.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 However, both contributions and earnings can generally be withdrawn tax-free after age 59.5.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 fundwas 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 , 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 and Cons

Investing in a 401(k) is often deemed to be a no-brainer if your company offers you the option, especially if they offer any kind of company match. This is free money that you wouldn’t have access to otherwise and can speed up your ability to invest for retirement. Let’s take a closer look at the pros and cons of investing in a 401(k).

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 the 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

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 the 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 $22,500 in 2023 ($23,000 in 2024). 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 also have a good balance of pros and cons that make them a good fit for the right investor. From the returns being a major benefit to the biggest con of these investments not providing a tax advantage, let’s take a closer look at the pros and cons of an index fund.

Index Fund Pros

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.

Index Fund Cons

The primary con of index funds when in comparison 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, just like normal stock investments.

There is also a lack of flexibility in index funds. The fund managers must follow the rules set out to be in sync with the index so there is no room for creativity. This can also lead to a lack of returns in some situations that could have been prevented without those rules.

Bottom Line

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

  • Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Use SmartAsset’s free investment calculator to get a sense of how your investments could mature.

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Investing With a 401(k) vs. Index Funds (2024)


Investing With a 401(k) vs. Index Funds? ›

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.

Is it better to invest in 401k or index funds? ›

For most people, the 401(k) is the better choice, even if the available investment options are less than ideal. For best results, you might stick with index funds that have low management fees.

Is a 500 index fund good for a 401k? ›

As long as your time horizon is three to five years or longer, an S&P 500 index fund could be a good addition to your portfolio. However, any investment can produce poor returns if it's purchased at overvalued prices.

What are 2 cons to investing in index funds? ›

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

Is it better to contribute to 401k or invest in stocks? ›

401(k) plans are generally better for accumulating retirement funds, thanks to their tax advantages. Stock pickers, on the other hand, enjoy much greater access to their funds, so they are likely to be preferable for meeting interim financial goals including home-buying and paying for college.

Should I put my whole 401k into S&P 500? ›

Diversification is an important factor, and you'll want to balance having too much in one type of asset. For example, many experts recommend having an allocation to large stocks such as those in an S&P 500 index fund as well as an allocation to medium- and small-cap stocks.

What is a disadvantage to investing in index funds? ›

Lack of Downside Protection

Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.

What is the 4% rule for index funds? ›

The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after. The rule seeks to establish a steady and safe income stream that will meet a retiree's current and future financial needs.

Can you retire with just index funds? ›

Index fund investing might not seem as exciting as buying individual stocks, but that doesn't mean they can't build wealth effectively. It is possible (even likely) to build a million-dollar retirement nest egg using nothing but index funds.

Where should I put my 401k money right now? ›

10 of the Best-Performing 401(k) Funds
FundExpense Ratio10-year average annual return
Fidelity Nasdaq Composite Index Fund (FNCMX)0.29%15.7%
Fidelity Growth Discovery Fund (FDSVX)0.67%15.8%
Vanguard Growth Index Fund (VIGAX)0.05%14.7%
Fidelity 500 Index Fund (FXAIX)0.015%13%
6 more rows
Apr 1, 2024

Do billionaires invest in index funds? ›

There are many ways to start investing, but one that's worked for billionaires like Warren Buffett is investing in low-cost index funds.

Are index funds safe during a recession? ›

The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.

Why doesn't everyone just invest in the S&P 500? ›

That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.

Can you lose your 401(k) if the market crashes? ›

The worst thing you can do to your 401(k) is to cash out if the market crashes. Market downturns are generally short and minimal compared to the rebounds that follow. As long as you hold on to your investments during a bear market, you haven't lost anything.

Is a 401K worth it anymore? ›

The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory. Many 401(k) plans are expensive because of high administrative and record-keeping costs. Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.

Should a 401k be in index funds? ›

Minimize expense ratios

They're charged as a percentage of the amount invested. You might find your 401(k) offers only one choice in some of the above categories, but when you have a selection, you should generally pick the lowest-cost option — often an index fund.

Are index funds a good investment for retirement? ›

The best index funds for retirement offer growth potential and solid risk management that aligns with your time to retirement and risk tolerance. For long-term growth, consider broad-market equity index funds like the Vanguard Total Stock Market Index Fund (VTSAX) or the Fidelity 500 Index Fund (FXAIX).

Are index funds still the best way to invest? ›

The market tends to rise over time, but not without some downturns along the way, thanks to short-term volatility. For this reason, index funds make the most sense if you're looking for a long-term "set it and forget it" investment.

Is it better to just invest in index funds? ›

Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.


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