A Plain English Guide to Retirement with an Introduction to Investing & Investing Principals.
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Retirement is the main goal of personal finance. We've covered the foundational steps, so how do we reach retirement? By harnessing the power of compound interest. Most people do not invest outside of their retirement account, so we'll cover a lot of investment basics as we look at retirement.
First, lets address a common question: chronologically, my kid's college comes before I reach retirement shouldn't we save for college before retirement?
NO! Sorry kids, but if push comes to shove, you can finance college through scholarships, grants, and loans. If you kid doesn't want to go into debt for his or her education and you haven't set up a college fund, he or she can always work & save or attend a more affordable school. Regardless, ways can be found to fund college, but you cannot finance your retirement. Retirement must come first!
Okay, now back to compound interest. A simple way to see the power of compound interest is from the Rule of 72. The Rule of 72 is a method of estimating compound interest. It's rather accurate with lower interest rates, but doesn't do so well with high interest rates, e.g. 75%. What you do is take the number 72 and divide it by your rate of return on your investment. The answer tells you the number of years an initial investment takes to double with that interest rate. Let's look at three examples: 3%, 6% and 12%. Let's assume for the sake of illustration, you received $2000 when you graduated high school at the age of 18. Now let's look at how the three rates of return work for your investment.
1. 72 divided by 3 equals 24. So at 3%, in 24 years, by age 42, your money has doubled to $4000, and in another 24 years at the age of 66 has doubled again to $8000.
2. 72 divided by 6 equals 12. At 6% in 12 years at 30 your money has doubled to $4000, 12 more years at the age of 42, it has doubled again to $8000, age 54 = $16,000, and by the same age of 66 you now have $32,000. A bit better than $8000 from the 3% return.
3. 72 divided by 12 equals 6. At 12% in 6 years, at the of 24, your money has already doubled to $4000, by age 30 to $8000, 36 to $16,000, 42 to $32,000, 48 to $64,000, 54 to $128,000, 60 to $256,000 and by the same age of 66, you now end up with $512,000 from the exact same initial investment of $2000 when you were 18.
The following table further demonstrates this hypothetical example:
Ready to begin investing? All three cases begin with the exact same amount, but there's just a slight difference between the outcome (rather subtle difference as the table above demonstrates).
You must, at all times, keep inflation in mind. U.S. inflation has tended to average between 3 − 4%, so if you're not getting a 4% return on your money, e.g. in the 3% example above, your money is losing value over time, i.e. you're losing money if you're rate of return doesn't match the rate of inflation.
Many employers offer a retirement plan like a 401(k), 403(b), etc. There are also small business plans like a SEP or SIMPLE and traditional and Roth IRAs. These retirement plans are not an investment. They should be thought of as an umbrella, giving your actual investment tax and other protections from the IRS and sometimes protection in other areas like bankruptcy court.
Your actual investment will, for most people, be a mutual fund or a portfolio of mutual funds. Unless you're annual income is $250k or higher, you're probably going to want a mutual fund (open ended) because you generally won't have the available money to adequately diversify in individual stocks & bonds. Mutual funds also offer the benefits of daily liquidity, professional money management, the ability to purchase partial shares, and the ability to earn money in three ways:
Stocks, bonds, and mutual funds are the most frequent options to fund your retirement account. Sometimes an annuity is used in a retirement account, but this usually doesn't make sense - it's unnecessarily complicated and usually comes with a lot of fees. Annuities have their own place and are usually already tax advantaged.
Do you want a 100% return on your investment? If your employer offers 100% matching funds, take it! That's an immediate 100% return on your investment. If your employer offers matching funds, whatever the amount may be, take it!
The rate of return on your investments is generally going to vary with the amount of risk you're willing to take. You can expect lower rates for lower risk and the potential for higher rates for higher risk. If you're in the position where your retirement goals are further behind than you'd like, and you're only a few years away from retirement, it's generally not a good idea to take on a riskier profile to try and make up the difference.
IRA or an Individual Retirement Account, can also play an important role in your retirement plans. You first want to be sure you're maxing out your 401(k) or other employer sponsored plan before you look at an IRA or Roth IRA. An IRA is very similar to other retirement accounts, but it usually has lower contribution limits. You get penalized by the IRS if you withdraw from your IRA before the age of 59 & 1/2 except in specific instances, e.g. The purchase of a new home.
In an employer sponsored retirement plan, e.g. A 401(k), you want to see a diversity of mutual fund companies - most major companies have a particular area where they tend to outshine other companies, and you want the best funds possible.
You can fund an IRA with a bank CD, a savings account, stocks and bonds (often even an annuity - but that's usually does not make sense), but for most people mutual funds are going to still be your best option. In an IRA, you're generally going to want to stick with one, well established mutual fund company because most companies offer breakpoints.
Breakpoints are certain dollar amounts where the cost of investing in sales fees get smaller and smaller and the total sum of a household usually counts. So, e.g. say you and your spouse each have an IRA investing with company X and company X offers a breakpoint at $25,000 where the sales fee goes from 5.75% to 5.5%. You have $15,000 in your account and your spouse has $10,000 in their account. Since your household has more than $25,000 invested with the same company, or Fund Family, most of the time you both get the advantage of the $25,000 breakpoint. Do your kids have a Coverdell Education Savings Account? If the funds are also invested with the same Fund Family, this also works towards hitting breakpoints.
Another major advantage of staying with the same Fund Family, is that most don't charge you if you want to move from one fund to another. Say you've been investing in one aggressive fund between the age of 18 - 60, but you want to retire in 5 years and thus move your money into a less aggressive fund. If you move the money to another company, you pay a new round of sales fees, but most companies will let you seamlessly move from one mutual fund to another of their mutual funds (or divided amongst a portfolio of their funds).
The only real difference is the contributions to a Traditional IRA is tax deductible and the contributions to a Roth IRA are not. This can have some serious long term implications, so, before you pick one over the other, you should think through the results.
Most people are at their highest tax bracket right before they retire. This means, when you go to retire and withdraw from your Traditional IRA, you're going to be taxed at your highest level, so the value of your IRA funds won't be as high as you think they are. You also don't know what future tax rates will be. Taxes may be lower when you hit retirement, but do you want to bet on that? Also, do you really want to worry about taxes when you're in retirement?
A Roth IRA is the answer for most US families. A Roth doesn't allow you to have tax deductions for your contributions now, but because of this, you don't pay taxes when you withdraw - either on the principal you contributed, or on the growth. The government allows this because the money you contribute to a Roth is the same post-tax money you use to go shopping or pay your bills with, so it would be double taxation if they taxed you on your Roth funds. The tax deduction you receive on a Traditional IRA returns the money to a pre-tax status, so you get taxed when you withdraw the funds.
Be sure to consult a certified professionals to find out what retirement plans, options, and tax advantages are available and best for you.
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