Understanding financial investment options can be tricky. Many types of financial accounts and even more kinds of investment products have emerged over the years. Some investment options offer tax advantages, but these advantages come at the expense of additional regulations. With some background knowledge, you'll find that understanding the basic workings of 401(k) accounts and mutual funds is relatively easy.
401(k) Basics
A 401(k) plan is a type of retirement savings plan offered by businesses for their employees. As an employee, you can contribute to a 401(k) by deferring part of your salary into the 401(k). These contributions are made with pretax dollars, which both reduces your income taxes and lowers your gross income for the purposes of calculating eligibility for other tax deductions and credits. Money inside a 401(k) grows tax-deferred, which means you don't have to pay taxes each year on interest earned or on any investment gains.
Mutual Fund Basics
A mutual fund is a type of investment product. The investors in a mutual fund pool their money. These funds are then used to invest in individual securities such as stocks and bonds. An actively managed mutual fund invests as directed by a professional money manager. A passively managed mutual fund invests in a way that attempts to replicate the performance of an index or other benchmark. The mutual fund's profits and losses are passed on to individual investors in the fund.
401(k) Investment Options
Many types of investments are allowed inside a 401k plan. Self-directed 401k plans allow you to choose your own investments. Traditional 401k plans offer a menu of investment options selected by the company as it administers the plan. Most 401k plans offer a selection of mutual fund investments. As an employee, you can choose how your contributions are allocated among the various mutual funds that are offered.
Mutual Funds Inside 401k Plans
Most mutual funds offer different versions. These different versions are known as share classes and are often represented by a letter. For example, a mutual fund may be offered as A shares, B shares and C shares. In addition, many mutual funds have special share classes for use within 401k plans. These share classes may have higher or lower overall expenses than the more common retail share classes. As a result, the performance of a mutual fund inside a 401k plan may not match the performance of the same mutual fund's non-401k shares.