Is This Popular 401(k) Investment Right for You?

Key Points

• The money in your 401(k) plan should be invested.

• An easy way to do so is to put your money into a target date fund.

• There are pitfalls to using a target date fund you should know about before making your choice.

• The $23,760 Social Security bonus most retirees completely overlook ›

When you save for retirement, whether in an IRA, 401(k), or another account, the money you contribute shouldn't just sit in cash. You need your money to grow over time, and to outpace inflation. And investing is the best way to make that happen.

When it comes to investing your 401(k) plan, you have choices. Granted, you may not have as many choices as an IRA, which allow you to invest in individual stocks. But it's common for 401(k)s to offer a variety of funds you can put your money into.

Where to invest $1,000 right now? Our analyst team just revealed what they believe are the 10 best stocks to buy right now. Continue »

Image source: Getty Images.

One option you'll generally see in a 401(k) is a target date fund. And these funds have their benefits. But it's important to be aware of the drawbacks, too.

What's a target date fund?

A target date fund is a fund that adjusts your risk profile based on how far or close you are to a given milestone. In the context of a 401(k), a target date fund will typically invest your money more aggressively when retirement is far off, but then shift you into safer assets as retirement nears.

The primary benefit of a target date fund is that it takes the brainwork out of investing. All you need to do is set a target retirement date, and your fund will take care of the rest. It's a great option if you consider yourself a hands-off investor and don't want to stress about how your portfolio is doing.

Pitfalls of target date funds you should know about

A target date fund might seem like the simplest way to invest your 401(k). But one issue is that you don't get to personalize your investments to match your risk tolerance or goals.

Furthermore, target date funds tend to err on the side of investing conservatively. That could leave you with a serious income shortfall down the line.

Also, while a target date fund may be a simple way to invest, figuring out how yours is actually invested is a different story. It can be tricky to determine exactly what assets your money is being put in when you opt for a target date fund.

Also, target date funds are notorious for charging higher fees, known as expense ratios, that can eat into your returns over time. Those fees, combined with a more conservative strategy, could make it so you don't reach your savings goal by the time your career comes to an end.

Should you put your 401(k) into a target date fund?

You may like the idea of putting your money into an investment fund you don't have to think about. But even if you consider yourself a hands-off investor, before opting for a target date fund, there's another option you may want to look at in your 401(k) -- index funds.

Index funds are passively managed, and they're meant to match the performance of different market benchmarks. If your 401(k) offers an S&P 500 index fund, that could be a good alternative to a target date fund.

Granted, an index fund like that won't shift your risk profile as retirement nears. That's something you'll have to remember to do yourself.

But an S&P 500 index fund gives you access to a wide range of stocks (the roughly 500 largest by market capitalization). It's a great way to diversify, especially if you're many years away from retirement and don't have to worry about dialing back risk just yet.

Plus, because index funds are passively managed, they tend to charge low expense ratios. And the less you pay, the more money you get to keep for your retirement.

This isn't to say that a target date fund is a bad choice for your 401(k). But before you go all in on one, explore other options and make sure you understand the drawbacks involved.

The $23,760 Social Security bonus most retirees completely overlook

If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income.

One easy trick could pay you as much as $23,760 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Join Stock Advisor to learn more about these strategies.

View the "Social Security secrets" »

The Motley Fool has a disclosure policy.