Maximize Your 401k: Why Savvy Investors Choose Low-Cost Index Funds Over Target Date Funds

Keywords: 401k investments, index funds, VTSAX, target date funds, low-cost investments, retirement savings, impact of fees

When it comes to maximizing your 401k investments, choosing the right funds can make a huge difference in how much you end up with by the time you retire. One of the most debated topics is whether to invest in index funds or target date funds. While target date funds offer convenience, low-cost index funds—like the popular Vanguard Total Stock Market Index Fund (VTSAX)—are often preferred by savvy investors who want to minimize fees and maximize returns over the long term.

In this post, we’ll break down the differences between these two options, explain why low-cost index funds are a smart choice for your 401k, and show how fees can significantly impact your retirement savings.

What Are Index Funds?

Index funds are mutual funds or exchange-traded funds (ETFs) designed to track a specific index, such as the S&P 500 or the total stock market. Instead of being actively managed by fund managers who pick individual stocks, index funds simply aim to mirror the performance of the broader market.

The main advantages of index funds include:

• Low fees: Because they are passively managed, index funds typically have much lower fees than actively managed funds.

• Diversification: By investing in an index fund, you’re essentially buying a small piece of every company within that index, giving you broad market exposure with a single investment.

• Consistent performance: Index funds tend to outperform actively managed funds over the long term due to their lower fees and diversified nature.

One of the most highly regarded index funds is VTSAX (Vanguard Total Stock Market Index Fund). VTSAX gives you exposure to the entire U.S. stock market, including small, medium, and large-cap companies, making it a favorite among retirement investors.

What Are Target Date Funds?

Target date funds are designed for investors who want a “set it and forget it” approach. These funds are automatically rebalanced over time based on a specific retirement date, becoming more conservative (with more bonds and fewer stocks) as you get closer to retirement. For example, a Target Retirement 2050 Fund would start off aggressive, investing heavily in stocks, but gradually shift to bonds as 2050 approaches.

While target date funds provide convenience, they often come with:

• Higher fees: The automatic rebalancing and management mean you’re paying for a more hands-on approach, which leads to higher expense ratios.

• Less control: You have no say in how the fund is managed, which might not align with your personal risk tolerance or goals.

• Lower long-term returns: Because target date funds shift more toward bonds as you near retirement, you may miss out on the growth potential of stocks over time.

Why Index Funds Like VTSAX Are Preferred

1. Low Fees

One of the biggest reasons investors prefer index funds over target date funds is the significantly lower fees. The average expense ratio of an index fund is often under 0.10%, compared to 0.50% or higher for a target date fund.

For example, VTSAX has an expense ratio of 0.04%, meaning for every $10,000 you have invested, you’ll pay just $4 in fees annually. In contrast, a typical target date fund might charge 0.50%, or $50 on the same $10,000.

While this might not seem like a big difference in the short term, the compounding effect of fees over decades can dramatically reduce your total savings. The lower your fees, the more of your investment dollars stay in your account, growing over time.

Impact of Fees on Your 401k

To highlight the impact of fees, let’s consider an example:

• Scenario 1: Investing in VTSAX

Let’s say you have $100,000 invested in VTSAX with an annual return of 7% and an expense ratio of 0.04%. Over 30 years, your investment could grow to approximately $761,225 after fees.

• Scenario 2: Investing in a Target Date Fund

Now, let’s say you invest the same $100,000 in a target date fund with a 0.50% expense ratio and the same 7% return. After 30 years, your investment would grow to approximately $660,561 after fees.

That’s a difference of $100,664—all due to higher fees!

Fees may seem small, but over time, they can erode your returns and take a significant bite out of your retirement savings. By opting for low-cost index funds like VTSAX, you keep more of your money working for you, rather than paying it to fund managers.

More Control Over Your Portfolio

Another advantage of index funds over target date funds is the control they offer. While target date funds are convenient, they don’t allow for customization. As you get closer to retirement, these funds automatically shift toward more conservative investments, like bonds. However, this strategy might not align with your personal goals or risk tolerance.

For example, some investors may want to stay more aggressive longer if they have other income streams in retirement, while others may prefer to shift to bonds earlier if they’re risk-averse. With index funds, you have the flexibility to make those adjustments yourself, tailoring your portfolio to your specific needs.

Better Long-Term Performance

While target date funds become more conservative over time, index funds continue to offer exposure to stocks, which historically outperform bonds over the long run. By sticking with an index fund like VTSAX, you’re more likely to see higher returns over time.

Real-life example:

Consider Peter, a 45-year-old investor who initially put his 401k in a target date fund set to retire in 2040. After learning about index funds, Peter switched to VTSAX. By avoiding the higher fees and staying invested in stocks, Peter projects his portfolio will grow by an additional $120,000 by the time he retires at 65—money he could have lost to fees and more conservative investments in the target date fund.

Actionable Steps for Your 401k

1. Review your 401k options: Log into your 401k account and see if low-cost index funds like VTSAX are available.

2. Compare fees: Look at the expense ratios of the funds in your plan. Prioritize index funds with low fees to keep more of your investment dollars.

3. Align your investments with your goals: Think about how much control you want over your investments. If you prefer a hands-off approach but don’t want to pay high fees, you can create your own diversified portfolio of index funds instead of relying on target date funds.

4. Adjust your strategy over time: As you approach retirement, gradually adjust your allocation to reduce risk, but keep in mind that staying too conservative too early can limit your growth.

Conclusion

When it comes to 401k investing, index funds like VTSAX offer a compelling combination of low fees, broad market exposure, and long-term growth potential. While target date funds may be convenient, their higher fees and automatic rebalancing can eat into your returns, especially as you approach retirement.

By choosing low-cost index funds and managing your own portfolio, you can save thousands of dollars in fees and potentially grow your retirement savings much faster. During open enrollment, take the time to review your 401k options and make a smart choice that aligns with your long-term financial goals.