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Maximize Your 401(k) With These Mutual Funds - Here are my four favorite types of mutual funds to own in a 401(k). Thumbnail

Maximize Your 401(k) With These Mutual Funds - Here are my four favorite types of mutual funds to own in a 401(k).

The 401(k) is one of the best and most popular places to save for retirement. However, in my experience with advising executives and retirees on their retirement plans, I've noticed how little attention investors pay to the mutual funds they select inside their 401(k). Some don't have the time and simply pick a target date fund or let a computer algorithm pick the funds for them. I've never been a fan of those approaches because I find it is too "cookie-cutter" and may not fully take into consideration the client's overall asset allocation, such as coordinating with money outside of the 401(k). 

Instead, I prefer to comb through the choices of funds and cherry pick the best for each client's situation. After all, most 401(k)s have a long list of funds to choose from, and there may be some very good choices but there are also usually a few duds to avoid. There are also some types of mutual funds that make more sense to own in the retirement plan rather than outside the plan, like REITs or active managers which I discuss below. But before you make any change, remember there are several considerations to take into account when selecting the right mutual funds inside a 401(k). This includes your risk tolerance, time horizon for needing the money, and your goals and objectives, so the four examples below may not be appropriate for all audiences. With that in mind, here are my four tips on the types of mutual funds to consider in a 401(k): 

1. Consider Active Management in the 401(k)

There are two types of investment management - active and passive. Passive usually means owning an index fund, a static basket of securities tied to a specific benchmark, such as tracking the S&P 500 Index. Whereas active management relies on a manager to actively buy and sell securities on your behalf. There are pros and cons to both approaches.

However, all else being equal, I can make the case that a low-cost active manager is a better fit inside a 401(k). The reason has to do with taxes. Active management is notoriously tax-inefficient. Normally the buying and selling of stocks within an active mutual fund triggers a capital gain or income tax if held in a regular brokerage or investment account. That is not the case within a 401(k). The manager can trade as much as he or she wants in the mutual fund and you the investor will pay no tax so long as the money is kept inside the 401(k). For this reason, I usually recommend my clients to own their active managers inside qualified accounts like IRAs and 401(k)s and own tax-efficient funds like passive index mutual funds which do very little trading in their taxable accounts. Bottom line, if you are going to own active managers, look to your 401(k) first. 

2. Go for Yield in the 401(k)

If you like dividends and income, a great place to look is  in a 401(k). The reason again is for the tax-deferral. Income producing investments like Real Estate Investment Trusts (REITs) can help diversify a portfolio, but if the REIT is held in a taxable account then the income or yield is getting eaten up by taxes which is a problem.  Most investors overlook this, but it is important. A typical REIT can pay a 5% dividend, but that is all ordinary income taxable unless it is held in an IRA or 401(k) then the tax is deferred. For this reason, if you want to own income producing investments, first look to retirement accounts like a 401(k) - it's not what you make, it's what you keep.

Certain funds may make more sense to own in a 401(k). 

3. What is unique in the 401(k)? 

Sometimes mutual fund companies have interesting and unique fund choices in their 401(k)s. Whenever I review a client's retirement account at work, I always look for what is different or what can I buy in this 401(k) I can't buy elsewhere? The usual suspect is a quasi-fixed income fund called "stable-value." A stable-value fund is a conservative fund focused on preserving capital. Because it is so conservative, it usually will pay less interest than other bond funds. However, there may be times to consider a stable-value fund. For instance, if you expect interest rates to rise, bond funds may lose value, but a stable-value fund may not. A stable-value fund can also help round out a fixed income allocation. For instance, in a 401(k), if an investor wants or needs bonds, we may pick an active fixed income manager for yield and a stable-value fund for consistent income and preservation of capital to create a diversified fixed income allocation. 

The SECURE ACT has also opened the possibility for annuities in 401(k)s. These annuities may be unique to the 401(k) - meaning not offered outside the retirement account somewhere else - it may be worth exploring as well. 

4. For Clients Only or email me for tip #4. 

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Read More: 9 Ways to Get the Most Out of Your 401(k)

Michael Aloi

Sophisticated and customized advice for today's busy professional.