Achieving the goals you have in retirement largely depends on the choices you make while in your working years. The three most important areas to focus on during those years are: the amount you save, the account you use to save in, and your asset mix.
Today we are all responsible for generating our own income in retirement. We can no longer depend on working for a company that will provide a pension in our retirement. Therefore, it becomes imperative that we sock away enough savings while we are working to generate the income we will require for what could be a 35 to 40 year retirement. That’s why its important to follow these three principles of saving:
It’s how much and for how long that make the difference. The earlier you start saving the longer the money can benefit from the incredible power of compounding. Starting as soon as you begin getting a paycheck through your employer’s retirement plan offers the most painless way to begin. Your contribution to your employer’s retirement plan is automatically deducted from your paycheck before you receive it. It’s simple and there’s no chance that you’ll spend the money instead of saving and investing it for your retirement.
Which type of account you save in matters. Favor saving in tax advantaged accounts that allow your savings and earnings to grow tax deferred or tax free. Corporate retirement accounts like 401(k)s and 403(b)s allow you to make pretax contributions that will reduce your current taxable income and only be taxed when you withdraw the money in retirement.
Traditional IRAs may allow you to deduct your contributions during your working years and grow tax deferred until those funds are withdrawn in retirement.
With a Roth IRA, you are contributing after-tax dollars, and you get no tax deduction for your contribution. The money you earn grows tax-free, and you pay no tax on withdrawals after you reach age 59 1/2. Plus, unlike with regular IRAs, there are no required minimum distributions (RMDs) at age 70 1/2, which can also make a ROTH IRA a powerful estate planning tool.
If you’re self‐employed or a small‐business owners, small business retirement plans like a self‐employed 401(k) or SIMPLE or SEP IRA allow you to set aside a certain percentage of your income and have it grow tax deferred.
Stocks have historically outperformed bonds and cash over the long term. So if you are investing for a goal like retirement that is years away, it’s necessary to have more of your savings invested in stocks and stock mutual funds. But higher volatility comes with investing in stocks, so you need to be comfortable with the risks.
We believe that an appropriate mix of investments should be based on your time horizon, financial situation, and risk tolerance. As a general rule, investors with a longer investment horizon should have a significant, broadly diversified exposure to stocks. As you approach retirement the amount of stocks or stock mutual funds held in your portfolio should be reduced and the amount of bonds or bond mutual funds should be increased.
When retirement is years away it’s easy to put off savings and investing, but starting early and investing in tax advantaged accounts will make the most of the powerful effects of compounding, making your retirement years more enjoyable. As Taylor Larimore points out in “The Bogleheads’ Guide to Retirement Planning,” start early and reap the rewards!