Investing With a 401(k) vs. Index Funds

Index funds are low-cost mutual funds designed to track the performance of groups of stocks, while 401(k) accounts are tax-advantaged retirement accounts that many businesses offer to workers. These two investing vehicles provide different benefits that generally complement each other, and both play a role in many investors’ strategies. Here’s what you need to know about each, from where they fit in your financial plan to their pros and cons. You can also consider working with a financial advisor as you create or periodically modify your investment strategy.

401(k) and Index Fund – The Basics

While both 401(k) plans and index funds can play key roles in retirement planning and building long-term wealth, they serve very different functions within a financial plan.

What Is a 401(k)?

A 401(k) is a tax-advantaged retirement savings account offered by many employers. It was created as a result of a 1978 tax law and has since become the most widely used employer-sponsored retirement plan in the U.S. Employees contribute to their 401(k) through automatic payroll deductions, and in many cases, employers offer matching contributions, effectively adding free money to your retirement savings.

There are two primary types of 401(k) plans:

Traditional 401(k): Contributions are made with pre-tax dollars, reducing your taxable income today. However, you’ll pay taxes on withdrawals in retirement.
Roth 401(k): Contributions are made with after-tax dollars, but qualified withdrawals in retirement, including earnings, are tax-free, provided you’re age 59.5 or older and meet the five-year rule.

Both types of 401(k) plans are subject to contribution limits (up to $23,500 in 2025, or $31,000 if you’re over age 50) and early withdrawal penalties if funds are accessed before age 59.5, unless an exception applies.

What Is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to passively track the performance of a specific market index, such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite. Rather than actively choosing individual stocks in an attempt to beat the market, index fund managers build a portfolio that mirrors the components of a given index.

Because index funds follow a passive investment strategy, they typically:

Have low expense ratios, minimizing the fees you pay.
Offer broad diversification, spreading risk across many companies or sectors.
Deliver long-term performance that closely tracks overall market returns.

Since their introduction in 1975, index funds have grown in popularity. In fact, more investor capital is now held in passive funds than in actively managed ones, largely because index funds consistently outperform active managers over the long term after accounting for fees.

Key Differences Between 401(k)s and Index Funds

The following are some of the key differences between a 401(k) vs. index fund:

Investment Choice: 401(k) plans may offer access to index funds, but your selection is limited to the plan’s menu. In a brokerage account, you can invest in any index fund available on the market, offering greater flexibility.
Account vs. Investment Vehicle: A 401(k) is a retirement account with tax advantages and contribution limits. An index fund is an investment product that can be held inside or outside of a 401(k). For example, in a taxable brokerage account, IRA or even within your 401(k) plan itself.
Access and Penalties: With a 401(k), early withdrawals typically trigger a 10% penalty plus taxes. Index funds held in a taxable brokerage account have no age-based withdrawal restrictions, but gains may be taxed.
Tax Treatment: 401(k)s offer tax-deferred or tax-free growth depending on the type of plan (traditional or Roth). Index funds in a taxable account are subject to capital gains taxes when sold for a profit.
Employer Match: 401(k)s may include employer-matching contributions, adding extra value to your savings. Index funds purchased through a brokerage do not offer this benefit.

A financial advisor can help you create a retirement plan that works for you.

401(k) Pros and Cons

Investing in a 401(k) is almost always a sound decision for your financial future, especially if your company offers any kind of company match. This is free money that you wouldn’t have access to otherwise, and it can help you better prepare for retirement. Let’s take a closer look at the pros and cons of investing in a 401(k).

401(k) Pros

A 401(k) account’s major edge over an index fund is the tax advantage. Contributions to 401(k) accounts are pre-tax. This means owners don’t pay taxes on the money they contribute or the earnings from their investment portfolio until they start withdrawing funds.

Another advantage is that employers often offer a matching benefit. This means, for every dollar the employee puts in, the employer puts in another dollar. This effectively doubles the amount people can save. Not all employers match, and those that do generally limit matches to a percentage of the employee’s salary.

401(k) Cons

The major downside of a 401(k) is that the owner usually can’t take any money out of the account before age 59.5 without having to pay a 10% penalty, plus any income tax due on the withdrawals. This means 401(k)s are best suited to retirement savings and have limited use for other financial goals, such as emergency funds or saving for a down payment on a home.

Owners of 401(k)s also have to start making withdrawals, called required minimum distributions (RMDs), starting at age 73. Withdrawals from traditional 401(k)s, funded with pre-tax money, are subject to taxes, meaning retirees will have to plan for how to manage their tax liability.

A 401(k) plan typically also offers a limited selection of investments. Generally, the choices consist of a handful of the index and target-date funds. Most don’t let employees invest in individual stocks and bonds.

The IRS limits the annual contribution to a 401(k) to $23,500 in 2025, as we mentioned above. If employees want to save and invest more, they have to use another vehicle. High fees also diminish the 401(k) appeal. In addition to paying fees charged by mutual funds, 401(k) investors also must pay additional annual charges, often as high as 1.5% of the amount in the account, levied by the 401(k) plan.

Finally, not everyone has access to a 401(k) plan. Many employers, especially smaller businesses, don’t offer the plans.

Index Fund Pros and Cons

Index funds also have a good balance of pros and cons that make them a good fit for the right investor. From the returns being a major benefit to the biggest con of these investments not providing a tax advantage, let’s take a closer look at the pros and cons of an index fund.

Index Fund Pros

Index funds’ long track record of superior returns compared to actively managed funds is their primary appeal. They do this, in part, because of the low fees the passive management style enables.

Index funds are also generally well-diversified because they own large numbers of stocks. This can help limit the downside of fund performance during market lows.

Index funds are widely available for anyone to purchase at banks and traditional and online brokerages. There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.

Index Fund Cons

The primary con of index funds when in comparison to 401(k) plans is the lack of any tax advantage. Fund purchases are made with after-tax dollars and investors pay taxes on any gains in their holdings, just like normal stock investments.

There’s also a lack of flexibility in index funds. The fund managers must follow the rules set out to be in sync with the index so there is no room for creativity. This can also lead to a lack of returns in some situations that could have been prevented without those rules.

Bottom Line

Money manager checks an index fund's performance.

For many, if not most, retirement savers the tax advantages and opportunity to have contributions matched trump the low fees and expansive investment options offered by index funds. However, index funds have an important role to play by allowing investors to accumulate funds that can be used for purposes other than retirement. Generally speaking, both index funds and 401(k) plans are recommended as parts of an investor’s strategy.

Tips on Investing

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