Understanding Common 401(k) Investment Options
A 401(k) retirement plan remains a popular investment choice for several reasons, including the potential for tax-deferred growth on contributions and earnings, and the reduced current taxable income through pre-tax contributions. While investment options within a 401(k) may be curated by the plan sponsor, understanding how each works is crucial. This knowledge empowers employees to make informed investment choices for their financial future.
This guide explores the different types of 401(k) plans, 401(k) investment options, and how to choose a plan.
401(k) Plan Options
Since the plan sponsor is typically in charge of choosing 401(k) investment options, it’s essential for the sponsor to consider which type of plan works best for its employees. Consider these four options:
- Traditional 401(k): The traditional 401(k) plan allows employees to make pre-tax contributions. This means they can avoid current taxable income through payroll deductions and then only pay tax on the funds when withdrawn from the account.
- Roth 401(k): This 401(k) plan is funded with after-tax contributions, meaning employees do not receive an immediate tax deduction. However, qualified withdrawals in retirement are entirely tax-free. Many employers offer Traditional and Roth 401(k) options, allowing employees to choose based on their tax situation while adhering to the annual employee contribution limit.
- Solo 401(k): A solo 401(k), also known as an individual or one-participant 401(k), can be ideal for self-employed individuals or small businesses consisting solely of the owner or the owner and their spouse. While the employee deferral limit is similar to traditional and Roth 401(k)s, these plans allow for employee and employer contributions, often resulting in a significantly higher overall annual contribution limit.
- Safe Harbor 401(k): Similar to a traditional 401(k), this plan requires employers to make mandatory, typically immediately vested, employee contributions. In return for these contributions and immediate vesting (with some exceptions like QACA plans, which allow a two-year cliff vesting), Safe Harbor plans generally exempt companies from certain annual nondiscrimination testing (like ADP/ACP and Top-Heavy tests), simplifying administration. This often makes them a popular option, especially for small businesses looking to maximize contributions for highly compensated employees.
Common 401(k) Investment Options
While employers offer 401(k) plans, it’s up to the employee to choose how to invest their savings. If you’re choosing 401(k) investments for your retirement, consider these options:
Index Funds
Index Funds: Index funds are designed to track the performance of a specific market index, such as the S&P 500. They aim to reflect the broader movements of the stock market or a particular segment. These funds are typically passively managed, which can often result in lower expense ratios compared to actively managed funds. They offer a way to gain diversified exposure across various asset classes, which can be a component of a strategy to manage risk within a broader portfolio.
Stock Funds
Stock funds, or equity funds, invest in the stocks of multiple companies. When you own shares in a stock fund, you own a portion of a diversified portfolio of company stocks. The value of these funds typically fluctuates with the performance of the underlying companies and broader market conditions. They offer growth potential, aligning with the profitability and expansion of the companies within the fund. Stock funds are often categorized in several ways:
- Market Capitalization: This method classifies stock funds by the size of the companies they invest in. For example, “large-cap” funds invest in large, established organizations, while “small-cap” funds focus on smaller businesses.
- By Industry/Sector: Funds can also be categorized by the specific industry or sector they focus on, such as technology or healthcare stocks.
- International/Global: These funds invest in the stocks of companies outside of the United States.
- Domestic: These funds invest solely in companies based within the United States.
Bond Funds
A bond is a fixed-income investment that represents a loan made by an investor to a borrower (typically a corporation or government entity). In return for the loan, the borrower promises to pay interest over a specified period and return the principal amount at maturity. Entities issue bonds to raise capital for various projects.
Bond funds (a common way to invest in bonds within a 401(k)) can be valuable for balancing your retirement portfolio. They are often chosen for their potential to provide more stability and income compared to stocks, making them a suitable option if you prioritize capital preservation and a more predictable income stream, especially as you approach retirement.
Target Date Funds
This investment option adjusts the investment strategy based on a pre-set date, such as your retirement date. These age-based funds allow employees to transition to different investments throughout their careers. As you approach retirement, you may switch to investments that are considered to be lower-risk to help preserve your wealth.
Cash as Another Top 401(k) Option
Cash Equivalents (e.g., Stable Value Funds, Money Market Funds): While not typically considered a growth-oriented investment, many 401(k) plans offer cash equivalent options such as stable value funds or money market funds. These options prioritize capital preservation and liquidity. While they generally offer lower returns compared to equity or bond investments, they can be a desirable option for employees seeking to minimize volatility, especially as they approach retirement.
How to Choose the Best 401(k) Plan Solution
Here are important considerations when choosing a 401(k) plan solution and provider:
- Custom solutions: A provider offering a 401(k) plan that can be altered to meet diverse employee needs can help ensure everyone is happy with their retirement plan. This may improve job satisfaction and employee retention, ensuring workers feel secure and valued.
- Transparency: Choose a provider that is transparent about the money management process and possible outcomes of investment strategies. This can help employees trust the 401(k) solution and its provider. Being well-informed can result in fewer issues in the long run.
- Reviews and Reputation: Conduct due diligence by exploring the provider’s reputation, client testimonials, and website. The provider’s website can provide insight into its expertise and service philosophy, while reviews may offer perspectives on its client service and overall client satisfaction.
- Investment Offerings & Philosophy: Inquire about the provider’s approach to curating and managing the investment lineup. Do they offer diverse options (e.g., various asset classes, active vs. passive funds, target-date funds) to accommodate different employee risk tolerances and financial objectives? Ask how they leverage analytics and market research to ensure the quality and suitability of the investment choices available within the plan.
- Fees: Compare the various fee structures of different plan solutions and providers. Choose one within your budget while still providing all the services and investment options you need.
Choose Custom 401(k) Plan Solutions With Fort Pitt Capital
Fort Pitt Capital serves retirement plan sponsors to help them develop a comprehensive retirement plan that’s designed to meet the needs of their business and their employees. We have financial advisors who specialize in 401(k) retirement plan services and we can create custom plans that support your employees’ preferences.
Fort Pitt Capital also offers individual wealth management services, including retirement income management and portfolio management services. Our advisors develop investment strategies informed by thorough market research and analytics. Through our comprehensive financial education resources, we can help you understand retirement planning and explore appropriate options for building your wealth.
To learn more about how we can serve you, contact our knowledgeable team for more information today.
