If you’d really like to get a jump on saving for retirement, then you’re in luck. Investing for retirement has never been more straightforward thanks to the success stories and tips of those who are living it.
Here are some fundamental questions you can ask yourself that will help determine exactly what investments you should make for a safe and secure retirement.
How Much Do You Need To Save For Retirement?
The first question anyone should ask themselves in retirement planning is: How much money will I need to save?
Your savings is called your “nest egg”, and a simple trick for figuring out how much this should be is to take the amount of money you think you’ll need every year in retirement and multiple it by 25. This comes from something called the 4 Percent Rule which says that statistically you should be able to safely withdraw up to 4 percent from your nest egg every year for at least the next 30 years (with adjustments for inflation).
Not sure how much money you’ll need every year once you’re retired? One simple estimation is to assume you’ll need at least 80 percent of your current income.
Putting this all together:
- Let’s say you earn $60,000 right now.
- You can assume you’ll need $60,000 x 0.8 = $48,000 per year in retirement
- Your nest egg target should be $48,000 x 25 = $1.2 million.
How Much Should I Save With Every Paycheck?
In order to figure out how much money you’ll need to be saving with every paycheck to hit your nest egg target (also called your contribution rate), you can go to any simple online calculator such as this one and play with the numbers.
Ultimately, your contribution rate will be highly dependent upon two main factors:
- How soon would you like to retire?
- What will you invest in?
The answer to “how soon would you like to retire” will be a personal one. If you’re relatively young and don’t mind working for 30 years, then you’ve got a lot of time on your hands to build up your nest egg. However, if you’re a little older and would like to retire in maybe 10 years, then you’re definitely going to need to bump up your contribution rate.
The other factor that will significantly impact your contribution rate will be what investments you choose for your nest egg. Here’s why …
What Should You Invest In For Retirement?
A good retirement investment portfolio is going to need to balance risk versus reward.
Risk is can be reduced by diversifying your contributions across a variety of different types of investments. This is something called “asset allocation” and there are many different opinions about the best ways to do this.
Reward is the rate of return that you will earn. A high return rate will help put the power of compound interest to work and grow your nest egg faster. However, don’t get too greedy. While higher is better, it shouldn’t come at the expense of taking on too much unnecessary risk.
Types Of Investments
Here are just a few of the most common types of investments found in most retirement plans:
- Large-cap stocks – Generally well-known U.S. companies that produce modest returns with a reasonable amount of risk.
- Mid-cap / Small-cap stocks – Smaller, lesser-known U.S. companies that are riskier but could produce higher returns.
- Foreign stocks – Companies from countries outside the U.S. (such as Europe or Asia). These are good for diversification since the U.S. is only a fraction of the world economy.
- Government bonds – Debt from the U.S. government. Considered one of the safest investments but also produces relatively lower returns.
- High-Yield bonds – Debt from companies (also called junk bonds). Risker by nature, but also produces higher rates of return.
- Commodities – Commonly used items such as gold and oil. Commodities can be a useful way to diversify beyond just stocks and bonds.
- REITs – Stands for “real estate investment trusts”. These funds allow you to own real estate alongside other investors without actually having to own any physical properties. They can also be good for diversification.
Keeping It Simple
When you start looking into investment options for any of the asset types mentioned above, you’ll immediately find out that there are thousands of different funds you can choose from.
If the idea of trying to “pick the right ones” seems overwhelming, then don’t fear. There’s a simple way to invest for retirement that takes out all the guesswork. It’s called investing in index funds.
An index fund is simply an investment that tracks a widely popular market benchmark such as the S&P 500 (for stocks). Besides simplicity, the advantage of investing in index funds is that you can earn the average rate of return of the market as well as be diversified.
In fact, this idea has become so popular that many financial gurus have come to endorse it. J.L. Collins, the blogger and author of “The Simple Path to Wealth”, recommends that most investors could greatly simplify how they invest for retirement by purchasing just two funds:
- Stocks – Vanguard Total Stock Market Index Fund (VTSAX)
- Bonds – Vanguard Total Bond Market Index Fund (VBTLX)
You can split the ratio between stocks and bonds according to your desired risk vs reward level: 80/20, 60/40, 50/50, etc.
Where To Build Your Retirement Savings
By far, the best place to build your nest egg is within your tax-advantaged retirement savings accounts. These are special plans approved by the I.R.S. that give you unique tax benefits.
Though that may not sound too exciting, trust me, it is. You could end up saving hundreds of thousands of dollars over time.
Here are the most commonly used retirement plans:
A 401(k) is an employer-sponsored retirement plan. The company you work for will offer to let you participate in this investment plan by regularly taking money out of your paycheck.
The advantage is that your contributions are made before taxes are taken out of your check, so you don’t pay any taxes on them up-front. They will then continue to grow tax-deferred until someday in the future when you withdraw them for retirement.
Another great thing about 401(k) plans is that, just for simply participating, your employer will often make matching contributions. That’s like literally receiving free money for doing nothing more than just saving your money.
The contribution limits for 401(k)s are $19,500. If you’re age 50 or older, then you can contribute up to $26,000. Employer matching contributions do not count towards these limits.
An IRA (individual retirement account) is a retirement plan that you set up yourself (outside of your employer). You can do this with any financial service provider or bank.
Also known as a “traditional” IRA, any contributions you make to this plan will be deducted from your taxable income at the end of the year. This means that similar to the 401(k), you effectively aren’t paying taxes on them. They will also then continue to grow tax-deferred until someday in the future when you withdraw them for retirement.
The contribution limits for an IRA are $6,000. If you’re age 50 or older, then you can contribute up to $7,000.
Roth IRA or 401(k)
A Roth IRA or 401(k) is similar to a traditional IRA or 401(k) except that the tax benefits are flipped. Instead of delaying your tax payments, you pay them now at the time your contribution and then enjoy tax-free income later on when you retire.
Someone who believes they will be in a higher tax bracket in the future than they are now may want to consider using a Roth style plan instead of a traditional one.
If you’re getting ready to retire, or just want to be prepared to do so, knowing how to invest and what to invest in is essential. If you’re examining your investment options for retirement, you may also enjoy our article on investing in mutual funds. Start investing now so you can have the retirement you want!