While it’s very important to begin saving for retirement, you will never be able to save enough money to retire (and certainly not early) if you simply put it in a savings account. Instead, when we say “saving” for retirement, we mean “investing” for retirement. Investing is a tried-and-true method for ensuring that your money grows steadily over time in order to meet your long-term financial objectives.
In this article, we’ll go over the fundamentals of retirement investing and offer advice from Ted Snow, a certified financial planner with the Snow Financial Group and author of the Investing QuickStart Guide and Retirement Planning QuickStart Guide.
What Is the Definition of an Investment Portfolio?
If you’re new to investing, your portfolio is a collection of all the various types of investments you’ve made. Where you invest, your money is heavily influenced by your investment objectives. Some people are only interested in the short term and are willing to take risks in order to win (or lose) big. That is more speculative than investing. The goal of retirement investing is long-term growth. This is accomplished through a more conservative and consistent investment strategy.
Most retirement investors put most of their money in so-called “retirement accounts” to achieve long-term growth. The most popular choices are 401ks and IRAs (Individual Retirement Accounts). We’ll review each of these accounts in more detail later, but retirement accounts have a few big-picture advantages. Here’s a quick rundown:
They compound your money tax-free. That is, you will not be taxed on any earnings in a retirement account until you begin withdrawing the funds after you retire.
An investment portfolio uses the compound interest to double your money every ten years. They make it simple to diversify your investments and customize them to your personal risk tolerance.
Retirement accounts are unquestionably the safest bet for inexperienced investors. However, as you gain confidence in your investing abilities, you may want to diversify your retirement portfolio by including rental properties or annuities. For the time being, let’s take a closer look at 401ks and IRAs, the workhorses of most retirement portfolios.
In this article, we’ll go over the fundamentals of retirement investing and offer advice from Ted Snow, a certified financial planner with the Snow Financial Group and author of the Investing QuickStart Guide and Retirement Planning QuickStart Guide.
What Is an Investment Portfolio?
If you’re new to investing, your portfolio is a collection of all the various types of investments you’ve made. The decision about where to invest your money is heavily influenced by your investment objectives. Some people are only interested in the short term and are willing to take risks in order to win (or lose) big. That is more speculative than investing. The goal of retirement investing is long-term growth. This is accomplished through a more conservative and consistent investment strategy.
Most retirement investors put the majority of their money in so-called “retirement accounts” to achieve that kind of long-term growth. The most popular choices are 401ks and IRAs (Individual Retirement Accounts). We’ll go over each of these accounts in more detail later, but retirement accounts have a few big-picture advantages. Here’s a quick rundown:
They compound your money tax-free. That is, you will not be taxed on any earnings in a retirement account until you begin withdrawing the funds after you retire.
An investment portfolio uses the compound interest to double your money every ten years.
They make it simple to diversify your investments and customize them to your personal risk tolerance.
Retirement accounts are unquestionably the safest bet for inexperienced investors. However, as you gain confidence in your investing abilities, you may want to diversify your retirement portfolio by including rental properties or annuities. For the time being, let’s take a closer look at 401ks and IRAs, the workhorses of most retirement portfolios.
The Benefits of a 401k
A 401k is a type of employer-sponsored retirement investment account. If you work for a mid-sized or larger company, chances are the company has a 401k retirement plan. Many small businesses do as well. If you’re unsure, contact your human resources department. However, most companies that provide them will bring it up when you are hired for the first time.
Each 401k plan is a little different. They do, however, share the ability to set aside a portion of each paycheck. This money is put into stocks, bonds, and other types of investments. Beginning investors frequently choose mutual funds, which are professionally managed stock portfolios that provide consistent returns over time.
A 401k has two primary benefits:
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- Employee contributions that are tax-deductible.
- Employer-to-employee matching
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As an employee, you have two choices. You can have a set amount deducted from each paycheck (for example, $100) and invested in your 401k. This is “pre-tax” money, which means you do not pay income tax on it. It simply deposits itself into your retirement account without your intervention.
Even better, many employers will match a percentage of your savings. A common arrangement is to match 50% of employee contributions up to a certain amount. For example, if you earn $50,000 per year and save 5% of your earnings, you will save $2,500. Your employer may match your contributions dollar for dollar, up to a maximum of 4%. That adds another $2,000 per year to your retirement savings, for a total of $4,500 per year. That is free money.
Maxing Out Your 401K Contribution
It’s best to “max out” your 401K contributions to take full advantage of both tax-deferral and matching. This entails saving the maximum amount permitted by the IRS for each tax year. The 401k contribution limit for 2021 is $19,500 (with a $6,500 “catch-up” contribution for people 50 and older).
Keep in mind that any money you withdraw from a standard, tax-deferred 401k will eventually be subject to income tax. For most people, this means paying tax on it when they withdraw it after retirement, which means they will earn less money than they did during their working days.
If you’re still young and expect to be in a higher tax bracket when you retire, it may be better to pay income tax on the money now and withdraw it tax-free later. A Roth 401k is a type of arrangement like this. If you’re under 50, the maximum amount you can invest in a Roth 401k for 2021 is $19,500, just like the regular 401k. You can add $6,500 if you’re over the age of 50.
“We’re probably at the lowest tax level we’ll see for the rest of our lives right now,” Snow says. “Why not pay the taxes now and let it grow tax-free forever?”
Self-employed business owners (those who do not employ others) can also invest in a Solo 401k. It functions similarly to a traditional 401k but without the employer match. To compensate, the IRS allows Solo 401k investors to contribute up to $58,000 per year in 2021.
IRAs Explained
An IRA works similarly to a 401k. You, as the investor, contribute to your IRA on a regular basis. You also have some control over where your money is invested. Again, investing in one (or more) mutual funds that invest in a diverse range of stocks is the safest bet.
An IRA, unlike a 401k, does not have employer matching. The contributions are not deducted from your paycheck. Instead, it is your responsibility to make regular contributions with your after-tax earnings. Set up a monthly automatic withdrawal from your checking account.
Contribution limits in IRAs are also lower. The IRS only allows you to invest $6,000 in an IRA each year. (Or $7,000 if you’re over 50.) If you do not have a 401k (or another type of employer-sponsored retirement account), you can deduct your IRA contributions from your taxable income in April.
Again, if you believe you will earn more in your 60s than you do now, you should consider a Roth IRA. A Roth IRA, like a Roth 401k, allows you to withdraw money from the account tax-free in retirement. The disadvantage is that you can no longer deduct Roth IRA contributions from your taxes. However, with proper planning, it will pay off in the long run. Contribution limits for Roth IRAs are the same as for regular IRAs.
Why not have both?
One popular investment strategy is to invest in both types of retirement accounts, one taxed now and one taxed later. If you have a regular 401k at work that is currently tax-free, it makes sense to supplement it with a Roth IRA that will be tax-free in the future. Consider it “tax diversification.”
A SEP IRA is a type of IRA that is available to self-employed business owners (Simplified Employee Pension). It, like the Solo 401k, raises the annual contribution limit to $58,000.
How to Avoid Penalties for Early Withdrawal
Because this series is about retiring early, it’s important to note that both 401ks and IRAs impose a 10% penalty if you withdraw any money from the retirement account before reaching the age of 59.5. (with some exceptions).
To avoid this type of penalty, Snow suggests opening a brokerage account, which is a non-retirement investment account. You can buy mutual funds or other stocks and hold them in a brokerage account with a large firm like Vanguard or Fidelity, just like you would in a 401k or an IRA.
Brokerage accounts do not provide the tax benefits of a 401k or an IRA. They do not, however, have contribution limits, and you can withdraw the funds whenever you want. So, if you plan to retire at 55 and can save a portion of your savings in a brokerage fund, it could cover the 4.5 years during which you won’t be able to withdraw without penalty from your other retirement accounts.
Maintain a Plan (and Let Compound Interest Work It’s Magic)
Snow believes that the keys to successful retirement investing are to 1) start early and 2) stick with it.
The earlier you begin investing for retirement, the more you will benefit from compound interest, which Albert Einstein (allegedly) referred to as the “eighth wonder of the world.” Because compound interest reinvests all of your investment earnings continuously, your money grows exponentially faster than it would in an interest-bearing savings account.
According to Snow, if you can earn a 7% return on your investments (the stock market averaged a 10.1 percent annual return from 1926 to 2018), your retirement funds should double every ten years. If you begin investing when you are 20, your money will have doubled by the time you are 30, and it will have doubled again by the time you are 40. It could double again before you retire. Compound interest has that kind of power!
Maintain Your Position
Compound interest works only when you play the long game. Don’t be alarmed if the market falls and your investments lose value. That’s precisely what happened during the Great Recession when many investors saw their retirement savings halved. The temptation is to withdraw all of your money and deposit it somewhere secure, such as in a bank (or under the mattress).
Snow believes that withdrawing money when prices are low is a terrible mistake. He compares it to a roller coaster ride when you reach the top of the big hill and begin tumbling down the track.
“You can’t help but scream and yell when it’s falling, but you won’t get hurt if you don’t jump off,” Snow says. “Investing is the same way. Maintain your presence in the market and allow yourself to emerge on the other side.”
If you decide to start investing in a 401k or IRA, continue to make regular contributions. When possible, raise the value of those contributions whenever possible. The more stocks you purchase during your working years, the more income you will have in retirement.
What Comes Next?
Now that you’re ready to begin investing read up on our other tips to get you up to speed on common investing terms and common mistakes to avoid when investing. The stock market can be a strange and perplexing place, especially if you seek advice in odd (but popular) corners of the internet like Reddit’s WallStreetBets. Before you dive in head first (and wallet second), read Early Retirement’s Unexpected (and Unwelcome) Surprises.
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