How to Choose a Mutual Fund for Your 401k or IRA

If you are choosing a mutual fund for your 401k or IRA, you should generally have a long-term investment horizon, since both types of accounts are designed for retirement savings. If you have an IRA, you can choose almost any mutual fund to invest in, as IRAs have only a few types of investment restrictions. With a 401k, you usually only have a limited number of mutual funds from which to choose. In either case, apply the same diligence to choosing a mutual fund in your 401k or IRA as you would in any investment account.

Difficulty:

Moderate

Instructions

1. View your purchase in terms of your entire portfolio. If the fund will be the only investment in your IRA or 401k, your considerations are different than if it is one of several in your portfolio. Since the basis of investment theory is that you should diversify your investments, if you own only one mutual fund, consider a broad market fund that includes a wide variety of investments. If you already own 10 other funds that cover international stocks, large and small stocks, and bonds, you can afford to choose a more specialized fund for your 401k or IRA purchase.

2. Consider the tax characteristics of the fund and the account. One of the prime benefits of IRAs and 401k accounts is that you don't have to pay tax on the earnings of your mutual fund. While you will owe tax when you take money out of the account, you don't have to pay anything for the years that your fund remains in the account. As a result, consider funds that pay a high amount of taxable income for purchase within your 401k or IRA, since you can avoid the immediate taxation that you will face if you buy the same fund outside of your retirement account.

3. Take a realistic assessment of your risk tolerance. Most investors want the highest return possible from a fund, but typically risk and reward go hand in hand. If you don't think you have the stomach to own a fund with wild swings in value, consider funds with lower potential returns in exchange for less volatility.

4. Think long term. In most cases, you can't take money out of your 401k or IRA before 59 1/2 without paying a penalty tax. While you can certainly sell your mutual fund at any time, you can't take the money out of the account without incurring taxes and penalties. With this in mind, consider funds in your 401k or IRA that can best serve you as long-term investments. While stock funds are typically more volatile than other types of funds, they also generally have the best returns over long time periods, so consider adding at least some stock exposure in your long-term 401k or IRA.

5. Be mindful of fees. Mutual funds come in a myriad of pricing schemes. While you generally don't have to pay a commission to buy a fund in a 401k, you may have to in an IRA. All other things being equal, you should generally prefer funds with little or no commission over those with high sales charges. Another fee to be mindful of is the annual expense ratio, which is how much money the fund takes out every year for miscellaneous expenses. Over time, high annual expenses can dramatically eat into a fund's overall performance.

References

• The Motley Fool: How to Choose A Mutual Fund; Bill Barker
• FINRA: Mutual Funds -- Introduction
• Charles Schwab: The Portfolio Pyramid -- How to Diversify Your Investments; Bryan Olson; October 12, 2007
• Kiplinger: Funds Made For Your IRA; Russel Kinnel; March, 2007
• Prudential: General Investing -- Risk and Reward
• TaxationLawFirms.com: 401k and IRA Early Withdrawal