Retirement Plans - How to Invest in a 401(k) or Other Retirement Plan

by Staff - Original publish date: January 18, 2012

Not sure how much to contribute to your retirement plan every month? That's easy: Put in as much as you possibly can without leaving yourself stuck.

Investment limits
Every year the IRS puts a limit on how much pretax income you can contribute to your retirement plan. For the year 2005 the maximum is $14,000. This is quite a nice equalizer that prevents bigwig executives from feathering their nests much more than the mail clerk. If you want to contribute more, you can, but it'll have to come from income you've already paid tax on. Though once in there, the extra money can earn tax deferred until retirement.

How to invest
Now you're a fully-fledged retirement plan partner, how do you make the money work best for you? The good news is, if the company is matching your contribution, you're already seeing an instant return.

But what to buy with the money? Your benefits department won't be able to advise you here, because it would be legally and ethically problematic. Ask your personal financial adviser, if you have one, or do your best to allocate your contributions in a way that fits your risk profile.

Each plan is different, but they're all regulated to offer variety. Typically you have a choice of stock, bond, or money market mutual funds. Choose a little from each or a few categories, as long as you don't put all your eggs in one basket. Nothing is set in stone, so you can easily move things around as your situation changes.

Since this is all about securing money for retirement, the degree of risk you take should depend on how old you are and how much money's at stake. If you're young, retirement is further off so you can take more risks knowing you will have time to play it safe later.

Stocks are riskiest in the short run, but historically they actually yield the best long-term rewards. There is a nice advantage built into this plan. Since you're investing more or less the same amount every month, you're following a popular strategy for successful investing called dollar-cost averaging. Because the stock market has risen consistently over time, investing this way means you're buying more shares when prices are low.

If you work for a publicly traded corporation, you might be able to buy company shares in your plan, which is how Microsoft secretaries got to be millionaires. But often the stocks offered in a retirement plan are packaged in mutual funds.

Which fund is which?
There are several kinds of mutual funds, and it pays to understand the differences. Growth funds invest primarily in the stocks of young, fast-growing companies and can be a risky, aggressive way to go. Income funds invest primarily in corporate and government bonds. Putting money in investment-grade bonds is not high risk, but some of these income funds chase big returns by investing in lower-grade corporate bonds, so be sure to study the prospectus. Growth and income funds mix stocks with bonds to offset some of the risk. International/global funds deal with overseas securities, which carry unique risks because of currency fluctuation and global political and economic change.

Money market funds invest in short-term debt securities and are all about playing it safe. Often you'll find some of the securities are insured or guaranteed by the U.S. government. Consequently they're not the biggest earners. If you prefer to take an ultra-cautious approach (which most investors do), or you're approaching retirement and want to at least maintain, then stick with investment-grade bond or money market funds. But over the long haul the gains from these plans are paltry compared to earnings from stock funds.