Emily RobertsIt’s important to start early with retirement investments and be aware of your alternatives because it might be intimidating. You can use a variety of tax advantaged and taxable accounts, such as defined benefit plans, 401(k)s, IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs, to save for retirement.
There are also many different investment kinds to think about, including annuities, mutual funds, equities, bonds, and exchange traded funds. Here are six fundamental suggestions to remember to make retirement investments more approachable:
In a Nutshell
- Recognize your tax advantaged and taxable retirement account options.
- Differentiate between 401(k), IRA, and Roth IRA types of retirement plans.
- Understand the tax ramifications of each type of account as well as the contribution caps for each account.
- Pick assets based on your objectives and risk tolerance.
- To reduce risk, diversify your investing portfolio.
- To keep your portfolio’s asset allocation within your intended range, rebalance it frequently.
Six Rules for Successful Retirement Investments
1. Know your retirement investments account options
You can save for retirement in several tax advantaged or taxable accounts. Some are available through your company, while others can be bought from a brokerage firm or bank.
Someone’s sitting in the shade today because someone planted a tree a long time ago.
Warren Buffett
Keep in mind that accounts including 401(k) plans, individual retirement accounts (IRAs) and brokerage accounts are not investments in and of themselves. Once you open an account or accounts, you will purchase the investments each one holds on your behalf.
Tax Advantaged Accounts
Accounts can be tax advantaged in several ways. 401(k)s and IRAs are tax deferred accounts. That means you don’t have to pay taxes on your contributions or on the earnings that accrue each year on the investments you make in them. Income tax is only levied on the money you withdraw during retirement.
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In addition, traditional IRAs and traditional 401(k) plans are funded with pre tax dollars, which means you get a tax deduction for your contributions in the year you make them. In contrast, Roth 401(k)s and Roth IRAs are funded with after tax money. You cannot deduct the amount of your contributions. However, you will not pay taxes on withdrawals you make from these accounts during retirement.
Taxable Accounts
Taxable accounts do not offer any tax relief. They are funded with after tax money. Therefore, when you make a deposit, you get no deduction. In addition, you pay taxes on investment returns or capital gains (from selling an investment at a profit) the year you receive them.
Most bank and brokerage accounts are taxable. However, you can maintain a tax deferred account, such as an IRA, at a brokerage or bank.
Types of Retirement Accounts
Defined Benefit Plans
These retirement investment plans, also known as pensions, are funded by companies. They guarantee a specific retirement benefit based on salary history and length of employment. Today, they are increasingly rare outside the public sector.
401(k) and Company Plans
These are company sponsored, employee funded defined contribution plans. They provide automatic savings, tax incentives and, in some cases, matching contributions. For 2022, you can contribute up to $20,500, or $27,000 if you are age 50 or older (due to the $6,500 catch up contribution allowed). For 2023, you can contribute up to $22,500, or $30,000 if you are age 50 or older (due to the $7,500 catch up contribution allowed for that year).
Traditional Individual Accounts
An IRA is a retirement account that allows you to invest tax deferred for retirement. You can deduct your traditional IRA contributions if you meet certain requirements. Withdrawals in retirement are taxed at your individual income tax rate. For 2022, you can contribute up to $6,000, or $7,000 if you are age 50 or older (due to the $1,000 catch up contribution allowed). For 2023, you can contribute up to $6,500, or $7,500 if you are age 50 or older (due to the same $1,000 catch up contribution).
Roth IRA Accounts
Roth IRA contributions are not tax deductible, but qualified distributions are tax free. Unlike most retirement investment accounts, Roth IRAs have no required minimum distributions. By 2022, you can contribute up to $6,000 annually, or $7,000 if you are age 50 or older. These maximum amounts increase to $6,500 and $7,500 respectively by tax year 2023.
IRA SEP
These individual accounts are set up by employers and the self employed. Businesses make tax deductible contributions on behalf of eligible employees. A company’s annual contribution to an employee’s SEP IRA cannot exceed the lesser of 25% of the employee’s compensation or $61,000 by 2022 ($66,000 by 2023).
SIMPLE Individual Accounts
These retirement investment plans can be used by most small businesses with 100 or fewer employees. Employees can contribute up to $14,000 in 2022 and $15,500 in 2023. The additional catch up contribution (if age 50 or older) is $3,000 for 2022 and $3,500 for 2023. Employers can choose to make a 2% contribution to all employees or an optional matching contribution of up to 3%.
Types of Investments
Annuities
Annuities are insurance products that provide a source of monthly, quarterly, annual or lump sum income during retirement. Some annuities are themselves tax deferred investments, so investors may want to purchase them within taxable accounts.
Investment Funds
Mutual funds are professionally managed pools of stocks, bonds and other instruments that are divided into units and sold to investors.
Shares
Stocks, or equity securities, as they are also called, are securities that represent ownership of the company issuing the shares.
Bonds
Bonds are securities that represent money lent to an issuer (such as a government or a company) in exchange for interest payments and future repayment of the bond’s face value.
Alex GoodmanExchange Traded Funds (ETFs)
ETFs are mutual funds that trade like stocks on regulated markets. They track broad or sector indexes, commodities and baskets of assets.
Cash Investments
You can place cash in short term, low risk obligations that provide you with returns in the form of interest payments. Examples include certificates of deposit (CDs) and money market deposit accounts.
Dividend Reinvestment Plans (DRIP)
DRIPs allow you to reinvest cash dividends by purchasing additional shares or fractional shares on the dividend payment date. DRIPs are an effective way to accumulate wealth with the help of compound interest.
IRAs
or Individual Retirement Arrangements, are more commonly known as individual retirement accounts. They were created by the Employee Retirement Income Security Act (ERISA) in 1974 to provide individuals who did not have a workplace retirement investment plan with a tax advantaged savings plan for retirement. A second objective was to provide an account into which an employee’s plan assets could be transferred when he or she changed jobs or retired.
2. Start Saving and Investing Early
Regardless of the type of accounts and retirement investments you choose, one piece of advice remains the same: start early. There are many reasons why it makes sense to start saving and investing early:
- You’ll have years to harness the power of compounding, that is, to continually reinvest your earnings and increase the value of your account.
- You’ll make saving and investing a lifelong habit, improving your chances of enjoying a comfortable retirement.
- You’ll have more time to recover from losses, so you can try higher risk, higher return investments.
- Unless you suffer a major loss, you’ll have more years to save, which means more money when you retire.
- You’ll gain more experience and develop expertise in a wider variety of investment options.
Compound
Remember that compounding is more successful over longer periods of time. Suppose you make a single investment of $10,000 when you are 20 years old, and it grows by 5% each year until you retire at age 65. Your investment would be worth nearly $90,000 if you reinvested, or compounded, your earnings.
Now imagine that you didn’t invest the $10,000 until you were 40 years old. With only 25 years of compounding, your investment would only be worth about $34,000. Wait until 50 to start, and your investment would grow to less than $21,000.
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This is, of course, an oversimplified example that assumes a constant rate of 5% without taking into account taxes and inflation. Still, it’s easy to see that the longer your money has to work for you, 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, that’s all that can be said about money. Instead of guessing how much money you have and where it 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, such as savings accounts, Treasury bills and certificates of deposit
- Securities, such as stocks, mutual funds and exchange traded funds
- Property, such as your home and any rental or second home property
- Boats, collectibles, jewelry, vehicles and furniture
Liabilities, on the other hand, include debts such as:
- Mortgages
- Car loans
- Outstanding credit card balances
- Medical bills
- Student loans
To calculate your net worth, subtract the value of your liabilities from the value of your assets. This figure can give 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, for example, once a year. That way, you’ll know if you’re headed in the right direction toward a well funded retirement, or if you need to make some changes.
Add Net Worth to your Retirement Investment Goals
It is said that you can’t reach a goal you never set, and this holds true for retirement investment planning. If you don’t set specific goals, it’s hard to find the incentive to save, invest and put in the time and effort to make sure you’re making the best decisions. Specific, written goals can provide the motivation you need. Here are some examples of written retirement goals.
- I want to retire at 65.
- I want to travel abroad 12 weeks a year.
- I want to have a nest egg of $1 million to fund the retirement I envision.
Periodic net worth reviews are an effective way to track your progress as you work toward achieving these goals.
4. Control your Emotions
Emotions can influence retirement investments much more easily than you think. This is the typical pattern of emotional behavior in investing.
When retirement investments work well:
- Overconfidence gets the better of you.
- You underestimate the risk.
- You make bad decisions and lose money.
When retirement investments perform poorly:
- Fear takes over.
- You sell investments at a loss and put all your money in cash and low risk bonds.
- You can’t benefit from a market recovery and you don’t make money.
Emotional investing hinders long term wealth creation. Potential gains are sabotaged by overconfidence, and fear causes investments that could turn around and continue to grow to be sold (or not bought). Therefore, it is important:
- Be realistic. Not every investment will be a winner and not every stock will grow like your grandparents’ blue chips did.
- Keep emotions in check. Be aware of your gains and losses, both realized and unrealized. Instead of reacting, take the time to evaluate your decisions and learn from your mistakes and successes. You will make better decisions in the future.
- Keep a balanced portfolio. Diversify it according to your age, risk tolerance and objectives. Rebalance your portfolio periodically as your risk tolerance and goals change. Most young investors have decades to recover from any market downturn. That means they can focus on higher risk, higher return investments, such as individual stocks.
However, those nearing retirement have less time to recover from losses. As a result, older adults tend to steer their portfolios toward a higher proportion of lower risk, lower return investments, such as bonds.
5. Pay Attention to Investment Fees
While you are likely to focus on returns and taxes, your earnings can be drastically dented by fees. Investment fees include:
- Transaction fees
- Expense statement
- Administrative fees
- Charges
Depending on the types of accounts you have and the investments you select, these fees can be really high. The first step is to find out how much you spend in commissions. Your brokerage account statement should tell you how much you pay to execute a stock trade, for example, and your fund’s prospectus or website (or research sites such as Morningstar) will show you expense ratio information.
If you are paying too much, you can look for retirement investments such as a comparable mutual fund with lower fees or switch to a broker that offers reduced transaction costs. Many brokers, for example, offer commission free ETFs and mutual funds for certain fund groups.
6. Ask for Help When you Need It
“I don’t know anything about investing” is a common excuse for postponing retirement investment planning. Just as ignorance of the law is no excuse, lack of investment skills is not a compelling excuse for not saving and investing for retirement.
There are many ways to get basic, intermediate or even advanced training in investing and retirement investment planning to fit every budget. Even spending a little time learning goes a long way, either through your own research or with the help of a qualified financial professional.
Wrap Up
You can improve your chances of enjoying a comfortable future by educating yourself about your retirement investment options, starting to plan ahead, managing your emotions and seeking help when you need it.
Of course, there are many things to consider when planning 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 will spend in retirement
- Where you want to live: the cost of living varies greatly between cities, states and countries
- What you want to do in retirement: travel is more expensive than, say, catching up on decades of reading
- Your current lifestyle and what you envision for later
- Your healthcare needs
Investment rules of thumb 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 investment strategy. Still, if you know the big picture of retirement investing, you can move more confidently toward a more secure financial future.
FAQs about Retirement Investments
A tax advantaged retirement investment account is one that provides tax advantages to promote retirement savings. 401(k)s, regular IRAs, and Roth IRAs are a few examples. The key benefit of using pre tax funds to fund these accounts is that you won’t have to pay taxes on the money until you remove it in retirement. In the short term, this can lower your taxable income and save you money on taxes. Furthermore, contribution limitations for tax advantaged accounts are frequently larger than those for taxable accounts.
Because pre tax funds are used to finance traditional retirement investment plans, you can deduct your contributions from your taxes in the year you make them. Taxes will be levied on the money you withdraw during retirement, though. Because Roth accounts are funded with after tax funds, your contributions are not tax deductible. However, tax free withdrawals are permitted during retirement. In general, traditional accounts are preferable if you anticipate paying less tax in retirement than you do now, while Roth accounts are preferable if you anticipate paying more tax in retirement than you do now.
A 401(k) is a company sponsored retirement investment plan that enables you to make pre tax salary contributions up to a certain annual cap. Companies might also match employee savings with their own to encourage staff to save. Individual retirement accounts, or IRAs, are accounts that you can open on your own to save for retirement. Depending on your income level, you are permitted to make contributions up to a particular yearly pre tax maximum. Both types of accounts have tax benefits and can be useful tools for retirement savings.
A variety of products, including equities, bonds, mutual funds, annuities, and exchange traded funds, are available for retirement investment accounts. (ETFs). Your unique retirement investment goals, level of risk tolerance, and investment horizon will determine the ideal combination of investments for you. To reduce risk, it is generally advisable to diversify your portfolio among different asset classes.
A number of variables, such as your present income, planned retirement lifestyle, anticipated expenses, and investment returns, will affect how much money you should set aside for retirement. Financial gurus generally advise saving at least 10% to 15% of your annual income for retirement. However, your chances of achieving your retirement investment goals increase with the earlier you begin investing and saving.
There are several options. You can open an IRA with a bank, a brokerage firm, a mutual fund company, or even a life insurance company.
You’ve taken a great first step by simply asking. That shows that you are aware of the importance of getting moving, regardless of what stage of your working life you are in. In general, you should immediately participate in a retirement investment plan at work, if one is available. If not, consider opening an IRA at a local bank or brokerage firm. Set aside a portion of each paycheck to save and invest. If you need specific help, check with the financial institution where you open your IRA about what help they can offer.
Yes, you can. The tax deduction you can take for contributions to your IRA may be limited (or even eliminated) due to certain factors, such as the amount of your income. Most importantly, however, you can contribute the maximum amounts allowed by the IRS to both accounts. In turn, all that money can grow tax deferred for, potentially, many years. That can help you grow your retirement savings, so go for it.
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- Internal Revenue Service | Retirement Investments – Traditional IRAs
- Internal Revenue Service – Roth Comparison Chart
- U.S. Department of Labor | Retirement Investments – Types of Retirement Plans
- Internal Revenue Service – 401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500
- Internal Revenue Service | Retirement Investments – Roth IRAs
- Internal Revenue Service | Retirement Investments – Retirement Topics – IRA Contribution Limits
- Internal Revenue Service | Retirement Investments – SEP Contribution Limits (Including Grandfathered SARSEPs)
- Internal Revenue Service – SIMPLE IRA Plan
- Investment Company Institute | Retirement Investments – Individual Retirement Account Resource Center
