In planning for retirement, you identify your goals and then figure out how to save and invest to get there. A lot of retirement investing advice revolves around very specific formulas and strategies. Still, sometimes it's helpful to take a step back and look at the big picture. Here are six basic tips to help make retirement investing a little easier.
- Understand your options when it comes to retirement savings accounts and investments.
- Start saving for retirement early, so your money has more time to grow.
- Calculate your net worth on a regular basis to see if you're on track for retirement.
- Pay attention to investment fees since they can significantly erode your retirement funds.
- Work with a financial professional if you need help or advice.
1. Understand Your Retirement Investment Options
You can save for retirement in various tax-advantaged and taxable accounts. Some are offered by your employer, while others are available through a brokerage firm or bank. Keep in mind that accounts—including 401(k)s, IRAs, and brokerage accounts—are not investments themselves. Instead, they are portfolios that hold the investments you choose.
Accounts can be tax-advantaged in different ways. 401(k)s and IRAs are tax-deferred accounts—meaning you don't have to pay taxes on the earnings that accrue from the investments within them each year. Income tax is due only on the money you withdraw during retirement.
In addition, traditional IRAs and traditional 401(k)s are funded with pre-tax dollars—meaning, you get a tax deduction for the deposits the year you make them. In contrast, Roth 401(k)s and Roth IRAs are funded with after-tax dollars; you can't deduct the amount you deposit at the time. However, you pay no taxes on any withdrawals you make in retirement from these accounts.
Taxable accounts don't incur any sort of tax break. They are funded with after-tax dollars—so, when you make a deposit, no deduction for you. And you pay taxes on any investment income or capital gains (from selling an investment at a profit) the year you receive it. Most "regular" brokerage or bank accounts are taxable accounts. However—at the risk of sowing confusion—you can maintain a tax-deferred account like an IRA at a brokerage.
These retirement plans, also known as pensions, are funded by employers. They guarantee a specific retirement benefit based on your salary history and duration of employment. They are increasingly uncommon today outside of the public sector.
401(k)s and Company Plans
These are employer-sponsored defined-contribution plans that are funded by employees. They provide automatic savings, tax incentives, and, in some cases, matching contributions. For 2020, you can contribute up to $19,500, or $26,000 if you're age 50 or older.
You can deduct your traditional IRA contributions if you meet certain requirements. Withdrawals in retirement are taxed at your individual income tax rate. For 2020, you can contribute up to $6,000, or $7,000 if you're age 50 or older.
Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. Unlike most retirement accounts, Roths have no required minimum distributions (RMDs). For 2020, you can contribute up to $6,000, or $7,000 if you're age 50 or older.
These IRAs are established by employers and the self-employed. Employers make tax-deductible contributions on behalf of eligible employees. For 2020, the annual contribution limit is $57,000.
These retirement plans can be used by most small businesses with 100 or fewer employees. Employees can contribute up to $13,500 for 2020. The catch-up limit (if you're age 50 or older) is $3,000. Employers can choose to make a 2% contribution to all employees or an optional matching contribution of up to 3%.
Types of Investments
Annuities are insurance products that provide a source of monthly, quarterly, annual, or lump-sum income during retirement.
Mutual funds are professionally managed pools of stocks, bonds, and other instruments that are divided into shares and sold to investors.
Stocks, or equities as they're also called, are securities that represent ownership in the corporation that issued the stock.
Bonds are securities in which you lend money to an issuer (such as a government or corporation) in exchange for interest payments and the future repayment of the bond’s face value.
ETFs are investment funds that trade like stocks on regulated exchanges. They track broad-based or sector indexes, commodities, and baskets of assets.
Dividend reinvestment plans (DRIPs)
DRIPs allow you to reinvest cash dividends by buying additional shares or fractional shares on the dividend payment date. DRIPs are an effective way to build wealth through compound interest.
Six Rules For Successful Retirement Investing
2. Start Saving and Investing Early
No matter which types of accounts and investments you choose, one piece of advice stays the same: start early. There are lots of reasons why it makes sense to start saving and investing early:
- You can take advantage of the power of compounding—reinvesting your earnings to create a snowball effect with your gains.
- You make saving and investing a lifelong habit, which improves your odds of a comfortable retirement.
- You have more time to recover from losses, so you can try higher-risk/higher-reward investments.
- Barring a major loss, you have more years to save, which means more money by the time you retire.
- You gain more experience and develop expertise in a wider variety of investment options.
Remember that compounding is most successful over longer periods of time. Assume you make a single $10,000 investment when you're 20 years old, and it grows at a conservative 5% each year until you retire at age 65. If you reinvest your gains (this is the compounding), your investment would be worth almost $90,000.
Now imagine you didn’t invest the $10,000 until you were 40. With only 25 years to compound, your investment would be worth only about $34,000. Wait until you’re 50 to start, and your investment would grow to less than $21,000.
This is, of course, an oversimplified example that assumes a constant 5% rate without taking taxes or inflation into consideration. Still, it's easy to see that the longer you can put your money to work, the better the outcome. Starting early is one of the easiest ways to ensure a comfortable retirement.
3. Calculate Your Net Worth
You make money, you spend money: For some people, that's about as deep as the money conversation gets. Instead of guessing where your money goes, you can calculate your net worth, which is the difference between what you own (your assets) and what you owe (your liabilities).
Assets typically include:
- Cash and cash equivalents—things like savings accounts, Treasury bills, and CDs
- Investments—for example, stocks, mutual funds, and ETFs
- Real property—your home and any rental properties or a second home
- Personal property—boats, collectibles, jewelry, vehicles, and household furnishings
Liabilities, on the other hand, include debts such as:
- Car loans
- Credit card outstanding balances
- Medical bills
- Student loans
To calculate your net worth, subtract your liabilities from your assets. This number gives you a good idea of where you stand (right now) for retirement. Of course, net worth is most useful when you track it over time—say, once a year. That way, you can see if you're heading in the right direction, or if you need to make some changes.
You should calculate your net worth at least once a year to ensure your retirement goals can stay on track.
Put Net Worth Into Your Retirement Goals
It’s been said that you can’t reach a goal you never set, and this holds true for retirement planning. If you don't establish specific goals, it’s hard to find the incentive to save, invest, and put in the time and effort to ensure you're making the best decisions. Specific and written goals can provide the motivation you need. Here are some examples of written retirement goals.
- I want to retire when I’m 65.
- I want to travel internationally for 12 weeks each year.
- I want a $1 million nest egg to fund the retirement I envision.
Regular net worth "check-ups" are an effective way to track your progress as you work toward these goals.
4. Keep Your Emotions in Check
Investments can be influenced by your emotions far more easily than you might realize. Here’s the typical pattern of emotional investment behavior when investments perform well:
- Overconfidence takes over
- You underestimate risk
- You make bad decisions and lose money
When investments perform badly:
- Fear takes over
- You put all your money into low-risk cash and bonds and can't benefit from a market recovery
- You don’t make any money
Emotional reactions make it difficult to build wealth over time. And potential gains are sabotaged by overconfidence, and fear makes you sell (or not buy) investments that could grow. As such, it is important to:
- Be realistic. Not every investment will be a winner and not every stock will grow as your grandparents’ blue-chip stocks did.
- Keep emotions in check. Be mindful of your wins and losses, both realized and unrealized. Rather than reacting, take the time to evaluate your choices and learn from your mistakes and successes. You’ll make better decisions in the future.
- Maintain a balanced portfolio. Diversify in a way that makes sense for your age, risk tolerance, and goals. Rebalance your portfolio periodically as your risk tolerance and goals change. Most younger investors have decades left to recover from any market declines—which means they can focus on higher-risk/higher-reward investments like individual stocks. Those at or near retirement, however, have less time to recover from any losses; as a result, older adults typically shift their portfolios toward a higher proportion of lower-risk/lower-reward investments, such as bonds.
5. Pay Attention to Investment Fees
While you're likely to focus on returns and taxes, your gains can be drastically eroded by fees. Investment fees include:
Depending on the types of accounts you have and the investments you select, these fees can really add up. The first step is to figure out what you’re spending on fees. Your brokerage statement should indicate how much you’re paying to execute a stock trade, for example, and your fund’s prospectus (or financial news websites) will show expense-ratio information.
If you're paying too much, you can shop for investments such as a comparable lower-fee mutual fund or switch to a broker that offers reduced transaction costs. Many brokers, for example, offer commission-free ETF and mutual fund trading on select groups of funds.
To illustrate the difference that a small change in expense ratio can make over the course of an investment, consider the following (hypothetical) table:
As the table shows, if you invest $10,000 in a fund with a 2.5% expense ratio, your investment would be worth $46,022 after 20 years, assuming a 10% annualized return. At the other end of the spectrum, your investment would be worth $61,159 if the fund had a lower, 0.5% expense ratio—an increase of more than $15,000 over the 2.5% fund’s return.
6. Get Help When You Need It
“I don't know anything about investing” is a common excuse for postponing retirement planning. Like ignorantia juris non excusat (loosely translated as “ignorance of the law is no excuse”), lack of investing prowess is not a convincing excuse for failing to save and invest for retirement.
There are plenty of ways to receive a basic, intermediate, or even advanced education in retirement planning to fit every budget. Even a little time spent goes a long way, whether through your own research or with the help of a qualified financial professional.
The Bottom Line
You can improve your chances of enjoying a comfortable future if you learn about your investment choices, start planning early, keep your emotions in check, and find help when you need it.
Of course, there are many issues to consider when you plan for retirement. How much you need to save depends on numerous factors, including:
- When you want to retire—the number of years you have to save, and the number of years you'll spend in retirement.
- Where you want to live—the cost of living varies greatly among cities, states, and countries.
- What you want to do in retirement—traveling is more expensive than, say, catching up on decades of reading.
- Your lifestyle now and the lifestyle you envision later.
- Your healthcare needs.
Specific investing “rule of thumb” guidelines—such as “You need 20 times your gross annual income to retire” or “Save and invest 10% of your pre-tax income”—can help you fine-tune your retirement strategy. Still, it’s helpful to remember the big picture, too.