The Unseen Downsides of Not Investing in Your 401(k)

Workers are often encouraged to do their best to save for retirement so they're not forced to retire on Social Security alone. And to that end, you have choices.

You could save for retirement in an IRA that you manage yourself. Or, you could sign up to participate in your employer's 401(k) plan if that option is available at your place of work.

It can pay to contribute to a 401(k) because in the case of a traditional employer retirement plan (as opposed to a Roth), you can shield some income from taxes. You may also be privy to an employer match in a 401(k), which equates to free money for your retirement.

But if you don't actively invest your 401(k), you could end up losing out big time. Here's why.

You don't want to stunt your savings' growth

One of the biggest mistakes you can make in your 401(k) is to keep your money in cash. Imagine that doing so gives you an annual 2% return through the years, whereas loading up on different funds in your 401(k) results in an annual 10% return, which is in line with the stock market's average.

If you fund your 401(k) to the tune of $500 a month over 40 years, you're talking about an ending balance of about $362,000 for a cash portfolio versus $2.65 million for an invested portfolio. Clearly, that's a world of difference.

Actively choose your investments

Often, 401(k) savers who don't choose investments for their accounts have their money automatically put into a target date fund. These funds are designed to adjust your risk allocation based on how close or far away you are from retirement age.

Target date funds have the potential to generate much higher returns than simply keeping a 401(k) in cash. So of these two options, target date funds easily represent the lesser of two evils.

However, many people don't choose target date funds -- their money simply winds up there. As such, savers are often in the dark about the fees these funds impose. But those fees can be substantial enough to eat away at your returns significantly.

It often pays to actively choose investments for your 401(k). And one option it makes sense to consider is putting your money into index funds.

These funds largely aim to match the performance of the indices they're tied to. So if you invest in an S&P 500 index fund, that fund will follow the S&P 500 and aim for a comparable return. Because index funds are passively managed, their fees tend to be quite low, making them a far more cost-effective choice.

If you keep your 401(k) in cash, or if you don't choose investments and allow your money to land in a target date fund, you may wind up regretting it come retirement when you need that money to fund your golden years. Make sure to not only invest your 401(k) but play an active role in choosing the right funds for your savings.