Investing for Retirement
Investing can come in many different forms. The professionals on Wall Street use sophisticated analysis methods, and at times, take on significant risk to achieve their investment goals. For the average person, investing is a much different and much simpler process. The goal of retirement investing is to accumulate a large sum of money, over many decades, so that you can live comfortably for a long time after you leave the workforce.
A common and simple approach is to implement a buy and hold strategy. John C. Bogle, the founder of Vanguard Group, argues that the best way to retire comfortably is to invest in low cost, diversified mutual funds and simply leave them alone until you retire. A common mistake amateur investors make is to respond excessively to short-term market movements. When people see the market move significantly lower in a short amount of time, it’s natural to panic a little. Many people run for safety and sell at the lower market prices, thinking their investments are ‘trending’ downward and they need to stop the bleeding. The problem is, you don’t really know where the bottom is until it’s gone. Even Warren Buffett admits he can’t predict short term market fluctuations. What you can do though, is keep your costs low by investing in low cost funds, make consistent contributions to your retirement account, and only buy and sell to make strategic asset allocation changes (e.g. moving to lower risk assets as you get closer to retirement). Retirement investing is a long-term goal and you should treat it as such.
One of the most important concepts in retirement investing is diversification. This concept is important because it will protect you from major losses should one of your assets rapidly deteriorate in value. The idea is to allocate your money across many different assets and asset classes (e.g. stocks, bonds, commodities, cash, etc.) so that if one asset class performs poorly it will not drag your entire portfolio down. This is nothing more than the law of large numbers you probably learned about in school. You take many uncorrelated (or loosely correlated) random variables (asset price movements), add them together, and you end up with something that has significantly less variance (risk) than the components taken individually.
If all asset prices were completely independent, you could mitigate virtually all risk simply by diversifying your portfolio. Unfortunately, that’s not the world we live in. We have home prices in one state that affect home prices in another. We recently saw a drop in home prices across the country cause a huge drop in average American wealth, which caused a drop in consumer spending and deeply affected many businesses. The stock market as a whole has its good years and bad years. Same for the bond market and same for just about any other market you can think of. That’s why it’s important to also consider the risk of individual assets within your portfolio. Bonds are generally considered lower risk than stocks. Within the stock market, larger, so called ‘blue chip’ companies are generally considered safer than smaller, newer ones.
Both 401(k)s and IRAs are very similar. They’re both accounts that allow you to defer taxes on contributions until the money is withdrawn. Where they differ is mostly in income and contribution limits.
Let’s start with the 401(k). This has the higher annual contribution and income limits of $18,000 (2016) and $265,000. That means if you make between $18,000 and $265,000 within a year, you can put $18,000 into a 401(k), have a taxable income of $18,000 less. In addition to your $18,000 limit, some employers choose to make a matching contribution, usually on only part of the $18,000. You won’t pay any taxes on the money you put into a 401(k) until you withdraw from the account, usually in retirement, at which time your withdrawal will be taxed similar to income as if it were earned in retirement. Workers over 50 can add an additional $6,000/year ‘catch up’ contribution to their 401k, for a total of $24,000.
IRAs are taxed the same as 401(k)s. The biggest difference is that you can only contribute $5,500/year (plus an additional $1,000/year if you’re over 50). There’s also a much lower income limit. Contribution limits are phased out for single individuals with incomes between $116,000 - $131,000 and married couples filing jointly between $183,000 - $193,000. That means if you’re single and you want to contribute $5,500/year, you must make at most $116,000 in income. Otherwise, you won’t be allowed to deduct the contribution, which is the whole point of having an IRA. A single person making more than $131,000 won’t be able to deduct anything, and someone with an income between $116,000 and $131,000 will be able to deduct somewhere between $0 and $5,500.
Traditional retirement accounts work as I’ve just described above. Roth retirement accounts, on the other hand, are a little different. When you contribute to a Roth IRA or 401(k), you don’t deduct your contributions from your taxable income. Why would anyone choose to do that? The trade off is that you can withdraw from the accounts without paying any taxes. If you think you’ll be in a higher tax bracket when you retire (maybe you’re going through a rough time now and you have unusually low income, or many deductions that you won’t have later, etc.), a Roth account is a good way to go. You’ll pay taxes on all the money while you’re in a low bracket and be able to withdraw tax free when you’re in a higher bracket later in life. Of course, that’s not the case for most people, especially for those able to contribute to a retirement account. Usually you contribute to your retirement account during your peak earning years, which are usually your peak taxable income years as well. For those people, a traditional account usually makes the most sense.
Now that you have invested early and often, bought and held, diversified, and discovered which retirement accounts work best for you, it is time to enjoy the fruits of your labor. But what if you still have concerns about your money lasting as long as you do? This is where fixed income investments come into play. Fixed income investments are designed to provide you with a steady income with very little risk. If you are looking to boost your income well into retirement, these investments will work great for you. Bonds pay you a percentage of the total investment every year until maturity, when you are paid back the entire amount you invested. Annuities are another type of fixed income investment that are bought through insurance companies. These also pay out a fixed amount, and they usually pay out for the rest of your life but not a second longer. At the moment, bonds and annuities do not pay out large sums of money because interest rates are so low. A slightly riskier option that may offer a better return is to invest in low risk, high dividend stocks. Many retirees live off dividend streams and hold onto the underlying asset to leave to their heirs.
