Your employer's 401(k) plan is likely the largest retirement account you will have. Understanding your investment options and making smart choices can mean the difference between a comfortable retirement and financial stress. This guide will help you navigate 401(k) investing with confidence.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement plan that allows you to save and invest money from your paycheck before taxes are taken out. Many employers also offer matching contributions, essentially giving you free money toward retirement.
The employer match advantage: If your employer matches 50% of contributions up to 6% of your salary, and you earn $70,000, contributing 6% ($4,200) means your employer adds $2,100. That is an immediate 50% return on your investment before any market gains.
401(k) Contribution Limits for 2025
- Employee contribution: $23,500 per year
- Age 50+ catch-up: Additional $7,500 ($31,000 total)
- Total limit (employee + employer): $70,000 ($77,500 if 50+)
These limits are higher than IRA limits, making 401(k)s essential for serious retirement savers.
Types of 401(k) Plans
Traditional 401(k)
Contributions are pre-tax, reducing your current taxable income. You pay taxes when you withdraw in retirement. Best if you expect to be in a lower tax bracket when you retire.
Roth 401(k)
Contributions are made with after-tax dollars (no immediate tax benefit), but withdrawals in retirement are completely tax-free. Best if you expect to be in a higher tax bracket later.
Traditional vs Roth 401(k) Example
You earn $80,000 and want to contribute $10,000 to your 401(k).
Traditional 401(k):
- Taxable income becomes $70,000
- Tax savings of approximately $2,200 (22% bracket)
- Full $10,000 invested grows tax-deferred
- Pay taxes on withdrawals in retirement
Roth 401(k):
- Taxable income stays $80,000
- No immediate tax savings
- Full $10,000 invested grows tax-free
- Withdrawals in retirement are tax-free
Common 401(k) Investment Options
Most 401(k) plans offer a limited menu of investment options. Understanding each type helps you build a balanced portfolio.
1. Target-Date Funds
These funds automatically adjust their allocation based on your expected retirement year. A "Target 2050" fund will be more aggressive now and become more conservative as 2050 approaches.
Pros: Simple, automatic rebalancing, diversified
Cons: Higher fees than index funds, one-size-fits-all approach
2. Index Funds
These funds track a market index like the S&P 500. They offer broad market exposure at very low costs.
Pros: Low fees, broad diversification, consistent with market returns
Cons: Cannot outperform the market
3. Actively Managed Funds
Professional managers try to beat the market by selecting specific investments.
Pros: Potential to outperform the market
Cons: Higher fees, most fail to beat indexes long-term
4. Bond Funds
These invest in government and corporate bonds, providing income and stability.
Pros: Lower volatility, regular income
Cons: Lower long-term returns than stocks
5. Company Stock
Some plans allow you to invest in your employer's stock, sometimes at a discount.
Pros: Potential for significant gains, discounted purchases
Cons: Concentrated risk (job and investments tied to same company)
6. Stable Value Funds
These aim to preserve capital while providing steady returns, typically 2-3%.
Pros: Very low risk, principal protection
Cons: Returns may not keep pace with inflation
How to Choose Your 401(k) Investments
Step 1: Determine Your Time Horizon
How many years until retirement? The longer your time horizon, the more risk you can afford to take.
Step 2: Assess Your Risk Tolerance
Can you handle watching your account drop 30% during a market crash without panic selling? Be honest with yourself.
Step 3: Review the Fund Options
Look at each fund's:
- Expense ratio: Lower is better (under 0.5% is good)
- Historical performance: Compare to benchmark index
- Investment style: Growth, value, blend
- Asset class: Large-cap, mid-cap, small-cap, international, bonds
Step 4: Build a Diversified Portfolio
A simple approach for a 35-year-old might be:
- 50% US stock index fund
- 20% international stock fund
- 15% small-cap stock fund
- 15% bond fund
The importance of low fees: A 1% difference in fees can cost you hundreds of thousands of dollars over a career. If you invest $500/month for 30 years at 7% returns, a 1% fee difference means $150,000 less in retirement.
401(k) Investment Strategies
1. Always Get the Full Match
At minimum, contribute enough to receive your full employer match. Not doing so is leaving free money on the table.
2. Prioritize Low-Cost Index Funds
If your plan offers S&P 500 or total market index funds, use them as your portfolio core.
3. Avoid Excessive Company Stock
Keep company stock to less than 10% of your portfolio. Enron employees learned this lesson the hard way.
4. Rebalance Annually
Review your allocation once a year and rebalance if any asset class has drifted more than 5% from your target.
5. Increase Contributions Over Time
Each time you get a raise, increase your 401(k) contribution. You will not miss money you never see in your paycheck.
6. Consider the Roth Option
If your employer offers a Roth 401(k), consider splitting contributions between Traditional and Roth for tax diversification.
What to Avoid in Your 401(k)
- High-fee funds: Avoid funds with expense ratios above 1%
- Too conservative too early: Young investors should not have 50% in bonds
- Too much company stock: Diversify beyond your employer
- 401(k) loans: You lose compounding and may owe taxes if you leave your job
- Cashing out when changing jobs: Roll over to an IRA or new employer plan instead
When You Change Jobs
You have several options for your old 401(k):
- Leave it: If the plan has good options and low fees
- Roll to new employer 401(k): Consolidates accounts
- Roll to a Traditional IRA: More investment options
- Cash out: Usually the worst option due to taxes and penalties
Track All Your Retirement Accounts
Pro Trader Dashboard helps you monitor your 401(k) and other investment accounts in one place, giving you a complete picture of your retirement progress.
Summary
Your 401(k) is a powerful tool for building retirement wealth, especially when you take advantage of employer matching. Focus on low-cost index funds, maintain proper diversification, and increase contributions over time. Understanding your investment options and avoiding common mistakes will put you on the path to a secure retirement.
Continue learning with our Solo 401(k) guide for self-employed individuals or explore retirement portfolio allocation strategies.