Retirement Planning

 

How to Save for Retirement


So by now you’ve probably noticed that personal savings are a big part of your retirement income. However, it’s not enough to just put money in the bank. As mentioned earlier, because of inflation, you need the money you save to grow at 4% or more per year to keep its purchasing power.

Based on this realization, you’ve decided not to just save, but invest your money so it earns interest. You have many different investment options available. So how should you save for retirement? If all other factors were the same and investment A would earn you 10% each year, but investment B would only earn you 6%, you would pick investment A every time. Of course, real life is never that simple. In general, the riskier an investment, the more money you could potentially make—or lose.

For example, let’s say you put $100 each into four different types of investments, each with a different average rate of return:

  1. Aggressive 401(k) plan (10%)
  2. Balanced Roth IRA (8%)
  3. Conservative Mutual Fund (6%)
  4. Certificates of Deposit (CDs) (5%)

Right off the top, items 2–4 lose $40 to taxes. So if we graph the return on investment for your money, it would look like this:

Retirement Planning Options


Chart created using the Money Chimp compound interest calculator.

As the chart demonstrates, the pre-tax 401(k) that is invested aggressively in stocks pays off over time. However, it’s also important to note that because you pay taxes upfront with the Roth IRA, you will not have to pay taxes when you take your money out. So even if it looks like the Roth IRA and mutual fund options are very similar, the Roth IRA will probably provide you with more spending money, as long as you wait past age 60 to start withdrawing.

Below are the definitions of the most common savings and investing options when planning for retirement. A table follows the definitions and gives a brief comparison of the pros and cons of each option.

Tax-Advantaged Investments

Suggestions on How to Save for Retirement

Having a hard time figuring out how to save 10% of your income for retirement? Here’s some suggestions!

  • Have a certain amount automatically deducted from your checking account every month to go straight to an IRA, mutual fund, or other form of savings.
  • Give yourself a personal spending allowance and get the cash out at the beginning of the week. Once the cash is gone, you’re done spending.
  • When you get a raise, automatically put that extra income toward your savings.
  • When balancing your checkbook, round up withdrawals to the nearest dollar. This should create some wiggle room in your checking. Every few months, transfer those extra savings to your retirement account.

To encourage people to save for retirement, the government has created several savings programs with tax benefits. A 401(k), 403(b), Keogh, SEP IRA, or SIMPLE IRA all offer pre-tax contributions. Traditional IRA contributions are tax deductible and Roth IRA withdrawals are not taxed. With all of these options, the principal and interest grow tax free while in the accounts.
Within these tax-advantaged accounts, investors can usually choose how their money is invested. If they want a more aggressive account, they can choose mostly stocks. For a balanced portfolio, they can choose a mix of stocks and bonds. If they are more conservative, they would put the majority of their investments in bonds.

If you have maxed out your contributions to tax-advantaged accounts, you may choose to invest directly in taxable stocks, bonds, and mutual funds. First we’ll discuss the merits of the tax-advantaged accounts and then how stocks, bonds, and mutual funds work. The important thing to remember is that, within your tax-advantaged account, you can control the mix of stocks, bonds, and other investments.

Defined Contribution Company Plan

This is an employer-sponsored plan where a certain amount or percentage of the employee’s salary is saved every year for the employee. These plans include 401(k)s, 403(b)s, 457s, profit sharing, employee stock options, and more. The popular 401(k) is considered a self-directed plan, where employees decide how much of their salary to set aside and how it is to be invested, choosing between employer-provided options. Contributions to the plans are tax-deferred, which means that the money is taken out of your paycheck before you pay taxes. The money will grow, tax-deferred, until you start making withdrawals, which will be taxed.

These plans usually have a maximum annual contribution amount and charge you a penalty tax if you take the money out before a certain age. One of the perks is that many companies will make matching contributions to your plan, so you will get even more money than you personally invest.

Keogh, SEP IRA, or SIMPLE IRA

These plans are the equivalent of a 401(k) for self-employed workers or small companies. Like a 401(k), these plans offer tax-deferred growth, limit annual contribution amounts, and penalize you for early withdrawals. SIMPLE IRAs are offered by small companies with 100 employees or less. With SEP IRAs, only the employer contributes, and contribution levels are tied to percentage of income. Individual 401(k)s are also available to the self-employed, with a cap of $12,000 per year. To learn more about the differences between these plans, read “Retirement for the Self-Employed” on The Motley Fool site.

Traditional IRA

Introduced in 1975, the traditional IRA (Individual Retirement Account) is set up by an individual (you) and can be invested in many different ways (stocks, bonds, CDs, etc.) and accepts annual contributions up to a limit that is currently determined by your age, but in 2008 will be indexed to inflation. Contributions are usually tax-deductible, unless you make a lot of money—deductability is phased out if your modified gross income as a single person falls between $50,000 and $60,000, or between $70,000 and $80,000 if you are married filing jointly. If you make withdrawals before age 59½ you will pay a 10% penalty; however, you are also required to start taking mandatory withdrawals at age 70½.

Roth IRA

Roth IRA 401(K)

In 2006, a new option became available for retirement investments. The Roth IRA 401(k) is a great option for people who make too much to invest in a Roth IRA (income is capped at $95,000 for an individual or $150,000 for a married couple). “A tax-free retirement just got closer” on MSN Money further explains the benefits of this new plan.

The main difference between a traditional IRA and a Roth IRA is that the Roth IRA contributions are taxed—not the withdrawals. The money in the account, however, grows tax-free. You do not face mandatory withdrawals. You can withdraw your principal at any time, but must wait until 59½ to start withdrawing earnings unless you have a “qualifying distribution” situation, including: disability, you are deceased and your beneficiary takes the distribution, or you qualify as a first-time homebuyer. There is an income limit on who can contribute to Roth IRAs ($95,000 for single filers and $150,000 for married couples).

Annuities

Annuities offer retirees fixed payments over a specific time (usually your lifetime). Annuities offer tax-deferred compounding, but annuitants pay additional fees and costs over the life of the annuity for the security of fixed payments.

Taxable Investments

Stocks

When you buy stocks, you own a share of a company and become entitled to part of the company’s assets and earnings. Historically, the stock market has outperformed nearly all other investments over time.

Bonds

Similar to stocks, bonds are a financial transaction between an investor and a company. A bond, however, is a debt rather than a piece of ownership. With a bond, the investor loans money to a company for a specified period at a specific interest rate. Because they are not tied to a company’s performance, bonds are both lower risk and typically lower reward than stocks. However, it is possible for a company to default on a bond, so they are not completely risk-free.

Mutual Funds

A mutual fund is a way for a smaller investor to have a well-balanced portfolio. Mutual funds combine the contributions of many investors to buy a diversity of stocks and bonds. They are typically managed by professionals, although some, like index funds, are not actively managed. Index funds such as the S&P 500 work to diversify assets and mirror the performance of the stock market as a whole, ensuring that you never do worse than the general market.

Summary Chart

The following table helps condense the pros and cons of each type of savings/investment for easier comparison.

Tax-Advantaged Investments

 
Name Pros Cons Notes
Pre-tax savings, including 401(k), 403(b), Keogh, SEP IRA, or SIMPLE IRA
  • pre-tax contributions
  • often has a company match
  • numerous investment options
tax-deferred growth
  • usually a limit on annual contributions
  • limited to investment options offered by company
10% early withdrawal penalty
Often the #1 choice for retirement investing.
Traditional IRA
  • tax-deductible contributions
  • tax-deferred growth
  • no income restrictions
many investment options
  • Contribution limits (in 2006: $4,000 for those 49 and below, $5,000 for 50 and up)
  • 10% early withdrawal penalty
  • Mandatory withdrawals after age 70½
Limits are lower than 401(k)s
If you think that you are currently in a higher tax bracket than you will be when you retire, a traditional IRA might be the right choice to supplement your 401(k).
Roth IRA
  • tax-deferred growth
  • many investment options
  • no mandatory withdrawals
  • can make early withdrawals under qualifying circumstances
earnings are 100% tax free
  • not tax deductible
  • income restrictions ($95,000 for singles, $150,000 for married couples)
can withdraw contributions at any time (earnings withdrawals are restricted)
To decide between a Roth and Traditional IRA, look at your income level, tax bracket, and try the MSN Roth calculator. For many—but certainly not all—the Roth IRA will be a better choice.
Annuities
  • guaranteed payments, usually for the rest of your lifetime
  • helps with budgeting and planning
tax-deferred growth
  • fees and expenses can reduce your nest egg
  • investment choices often restricted
The additional fees associated with annuities often cancel out any benefit of fixed payments. This option may appeal more to an older person who starts investing later in his career.

Fully Taxed Investments

 
Name Pros Cons Notes
Stocks
  • best rate of return of most investments
  • can be very individualized according to your knowledge and preferences
  • taxable income
  • highest risk of nearly all investments
  • can be confusing to a beginner
For retirement planning, it is usually best to invest in stocks through a program like a 401(k) or IRA so the earnings aren’t taxed.
Bonds
  • relatively high rate of return without the risk of stocks
  • can be very individualized according to your knowledge and preferences
  • taxable income
  • can be confusing to a beginner
lower return rate than stocks
For retirement planning, it is usually best to invest in bonds through a program like a 401(k) or IRA so the earnings aren’t taxed.
Mutual Funds
  • Minimizes the risks of playing the stock market
  • Better diversified portfolio
  • Either actively managed by a professional or indexed to match market’s performance
  • taxable income
  • fees and expenses associated with managed funds
  • hard to predict from past performance which mutual funds will do well in the future
For retirement planning, it is usually best to invest in mutual funds through a program like a 401(k) or IRA so the earnings aren’t taxed.

So, now that you understand the option you have on how to save for retirement, let's turn to some specific retirement planning strategies.

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