Here's What Happens When You Only Invest in Mutual Funds in Your 401(k)

The money you're saving for retirement shouldn't just sit in cash. Rather, it should be invested in different assets so it grows into a larger sum over time.

Now, the nice thing about IRAs is that they allow you to invest your savings in different stocks. With a 401(k), that's generally not possible. Rather, 401(k)s typically limit account holders to a mix of funds to choose from. Those commonly include target date funds, mutual funds, and index funds.

Mutual funds are a popular choice for investing in a 401(k). But you may want to think twice before putting all of your money into mutual funds.

Be wary of high fees

Mutual funds are actively managed funds that contain different asset mixes, depending on the fund's strategy. Mutual funds have actual people behind the scenes picking investments for you to put your money into. And because of this, mutual funds charge pretty high fees to those who invest in them.

The problem, though, is that those higher fees can eat away at your 401(k)'s returns over time, leaving you with less money for retirement. So while it's certainly not a bad thing to own some mutual funds, you may not want to only invest your 401(k) in mutual funds. Instead, you may want to put some of your money into index funds, since those tend to come with substantially lower fees.

Index funds are funds that are passively managed. They simply aim to match the performance of the market benchmarks they're tied to.

An S&P 500 index fund, for example, will have the goal of performing comparably to the S&P 500 index itself. But because you don't have a fund manager actively picking assets, you're generally not going to be charged an expensive fee when you invest in an S&P 500 index fund.

In 2022, the Investment Company Institute found that the average fee, or expense ratio, for actively managed mutual funds was 0.68%, while the average expense ratio for index funds was just 0.06%. This means that for every $1,000 you put into mutual funds, you might lose $6.80 to fees, compared to just $0.60 with an index fund.

Ideally, your 401(k) balance will grow well beyond $1,000 since it's supposed to serve as your retirement nest egg. So imagine you have $100,000 invested in mutual funds. That means you may be losing $6,800 to fees, as opposed to $600 for index funds, which is a much bigger deal.

Aim for a mix of funds

There's definitely nothing wrong with buying mutual funds for your 401(k). But if you only stick to mutual funds, you might end up with a lower balance heading into retirement due to losing a lot of money to fees. Rather than resign yourself to that, consider a mix of mutual funds and index funds. 

And if you're worried that buying index funds will mean getting stuck with a lower return in your 401(k), you should know that for the five-year period ending Dec. 31, 2022, only 13.49% of actively managed mutual funds outperformed the S&P 500 index. So if you invest some of your retirement savings in an S&P 500 index fund, you might benefit from not just lower fees, but also, higher returns.