How to invest in index funds to build long-term wealth

You can invest in an index fund through your 401(k), IRA, or a brokerage account. Dean Drobot/Shutterstock

Financial planners – and legendary investor Warren Buffet – agree: Index funds are one of the best investments for building long-term wealth.

“I always am going to side with a portfolio of low-cost index funds, whether you’re investing your first dollar or you have 40 years of investment management experience,” said Andrew Westlin, a certified financial planner at Betterment.

Buffett has sung its praises on multiple occasions, once calling the index fund “the most sensible equity investment.”

Index funds may sound intimidating, but they’re really just a type of mutual fund, an all-in-one investment that diversifies your money across a broad selection of stocks or bonds. Rather than choosing and buying individual stocks, an investor owns a small piece of every company or asset in the index fund, which minimizes overall risk. Best of all, index funds are low-cost and regularly outperform actively managed funds.

Here’s how to get started:

How to invest in index funds

1. Check your 401(k)

Your office retirement plan is often the best place to start investing. Though many people regard their 401(k) as a savings vehicle, it’s really a pretax investment account. Funelling part of your salary into the account is just as important as choosing where to invest the money.

When you set up your 401(k) at work, you’ll decide on a contribution, or deferral, rate, which is the percentage of money taken out of each paycheck before income taxes and dropped into an investment account at a brokerage firm like Vanguard, Fidelity, or Charles Schwab. Your company will likely offer a limited selection of safe-bet mutual funds to choose from.

2. If you don’t have a 401(k), open an IRA

If you don’t have access to a 401(k) through your company, open a traditional or Roth IRA through a brokerage firm, bank, or other financial institution. The only difference between the two IRAs is tax treatment, but both will give you access to index funds.

You may also choose to open an IRA even if you have a 401(k) – most people benefit from having both.

3. Consider a brokerage account

You can also invest in index funds through non-retirement accounts, otherwise known as taxable investment accounts or brokerage accounts.

Some of the most popular low-cost brokerage firms include Charles Schwab, Fidelity, E*Trade, and Vanguard. You may also consider opening a brokerage account through a robo-advisor like Wealthfront,Betterment, or Ellevest. Robo-advisors let you get started investing within minutes and rely on computer algorithms to rebalance your portfolio and save money on taxes.

You may want to shop around and see what index funds are available through each brokerage before opening an account. Most firms will make it easy to compare index funds side by side.

4. Decide what market(s) you want to invest in

Index funds can track a particular asset (ex. foreign bonds), industry (ex. tech), or type of company (ex. large or mid-sized).

There are S&P 500 index funds, which track the 500 largest companies that make up the US stock market; total stock market index funds, which track a much larger selection of stocks from large, mid-sized, and small companies; international index funds, which expose investors to companies abroad; bond index funds, which track the performance of a basket of US bonds; and many more.

Which funds you choose should depend on your overall risk level and what other (if any) investments you have. Generally, stocks are seen as riskier than bonds because they fluctuate more often – but with higher risk comes the potential for a greater returns.

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5. Check the minimum investment amount

Most index funds require a minimum investment to buy into, typically anywhere from $US1 to $US3,000. If you have less cash on hand to invest than is required for a particular index fund, you can eliminate it from your list of options for now.

6. Look for index funds with expense ratios around 0.5%

Whether you’re investing through a 401(k), IRA, or taxable investment account, you’ll want to opt for index funds with an expense ratio below 1% – ideally around 0.5% or lower.

The expense ratio is the fee you pay the brokerage to manage your investments, expressed as a percentage of your total account balance. It’s taken out automatically, so it can be easy to miss. For example, if you invest in an index fund with a 0.5% expense ratio, the brokerage will take $US5 for every $US1,000 of your total account balance annually.

Index funds keep costs low because they’re designed to be passive, so they don’t require much attention from fund managers (and even less if you’re using a robo-advisor).

6. Fund your account

If you’re investing in index funds through your 401(k), you’ll make your investment selections directly through the 401(k) provider, whether it be Vanguard, Fidelity, or another brokerage. You don’t have to invest your entire balance and future contributions in the same place – you’ll have the ability to choose how you want to allocate it.

If you’re investing through an IRA or brokerage account, you can fund the account by connecting a checking or savings account and making a transfer. Once the money is transferred, it will remain in a holding account of sorts until you buy into the index fund.

Investing in the index fund is a lot like online shopping. You choose the fund, enter the amount of money you would like to invest, and click “buy.”

7. Set up automatic contributions

You’ll already have an automatic contribution set up if you’re investing through a 401(k), since it’s a salary deferral, but you’ll have to set it up yourself in an IRA or brokerage account. You can decide how frequently the transfers will happen, how much, and where you want to direct them (either into your holding account or directly into the index fund). You can do this online, through your brokerage’s website, or by phone.

Need help with your investment strategy? SmartAsset’s free tool can help you find a licensed professional near you »

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