Smart 401(k) Investing

I'd like to put some money into my 401(k). How do I determine which of my plan's fund choices are best for me?

QUESTION: I'd like to invest a substantial amount of money in my 401(k). I have a list of 12 no-load funds to pick from. How do I research these funds?

ANSWER: The good news is that investing inside a 401(k) is in some ways simpler than investing outside of it, because the investment options are typically quite limited. This doesn't mean, however, that employees are off the hook when it comes to carefully researching the funds in their plan. On the contrary, picking the best 401(k) investments is crucial, since poor choices compounded over the long haul could lead to a significantly smaller nest egg.

The first step in the fund-selection process has nothing to do with the funds themselves. The key is to start off with a strategy, says Russ Kinnel, director of fund analysis at investment-research firm Morningstar. In other words, employees should have a sense of their ideal asset allocation before they start delving into performance history, manager philosophy and the like. Keep in mind, the goal for employees shouldn't be to come up with a strategy to beat the broader market over the short term, but rather to make sure that they have the proper exposure to equities and bonds -- and for those nearing retirement, cash -- based on their risk tolerance and investment horizon. "You're trying to get the long-term returns that the market provides," says David Wray, president of the Profit Sharing/401(k) Council of America (PSCA), and author of the new book, "Take Control With Your 401(k)."

Once an employee has a sense of what types of funds he or she is looking for, it's time to start reviewing investment options. Be prepared: This could lead to crushing disappointment. While the average 401(k) offers 12 options to employees, according to the PSCA, some plans offer significantly fewer, and the funds available may seem woefully inadequate. Even so, 401(k) investing is usually a great deal -- particularly for plans that include a company match in cash. That's because the tax break on contributions, combined with the returns offered by the match, more than make up for mediocre choices in most cases, says Wray. (To see just how good your 401(k) plan is, check out our Grade Your 401(k) analyzer.)

What differentiates a good fund from a bad one? Among other things, a solid fund will have superior long-term performance, reliable management, low fees and a volatility level that won't have you slugging back the Pepto-Bismol. For a review of how to evaluate each of these factors, see our story Seven Steps to Picking a Good Fund. You can also use our Rank Your 401(k) Funds analyzer to see how the funds offered in your plan stack up against their peers.

Of course, if a plan offers only, say, one large-cap fund -- and the employee knows that should make up the core of his or her portfolio -- then the fund-selection process may be fairly straightforward. But if the only fund offered for a particular asset class is truly awful, it may be worth avoiding. Married people whose spouses also have a 401(k) could review the investment choices in the spouse's plan to see if there's a better alternative, says certified financial planner Dee Lee of Harvard, Mass. If that's not an option, we'd recommend that employees still contribute enough to their 401(k)s to ensure that they get the company match, and then consider investing in an IRA, since that won't restrict investment choices.

For sophisticated investors who have substantial holdings outside of their retirement accounts, 401(k) investing can also be done with an eye toward tax liability, says Wray. Since 401(k) accounts grow tax-deferred, holding 401(k) funds that have a history of significant capital-gains distributions or dividend or interest payments can be a smart strategy, since none of those monies are taxable until the employee begins taking withdrawals. In this case, the investor might want to hold more tax-efficient funds in taxable accounts. But novices or people who do all their investing inside their 401(k) need not worry about such matters.

Of course, the work doesn't end with fund selection. At least once a year, investors should review their holdings and rebalance their portfolios as necessary. Yes, that means opening 401(k) statements -- something that's not easy to do during bear markets. But trust us, keeping a cool head and a watchful eye on your retirement stash will pay off handsomely during your golden years.