You want to get from here to a comfortable retirement. Two suggestions: Start with a plan. And start right away. Read on and get ready to take a step in the right direction.
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RETIREMENT PLANNING SPOTLIGHT
A volatile market shouldn’t stop you from saving for retirement. But if you're concerned:
- Understand your risks
- Keep your portfolio diversified
- Match your investments to your goals
Are you worried about the market? Are you concerned that you may not meet your retirement goals? You are not alone. Many people share the same apprehension.
- Upside potential
Partial downside protection
What you'll learn
Discover simple steps for creating a savings plan that meets your retirement goals, and the benefits of starting early. You’ll also see how to make up for lost time—rebalancing your plan and reevaluating your goals as you near retirement.
Providing for income in retirement
How much will you need to save?
Since Social Security represents only a portion of your income in retirement, you’ll need to provide for the rest, somewhere between 60% and 100% of your final working year’s salary. Everyone’s situation is different, so it may be a wise move to work with a financial professional who can help you determine just how much you’ll need.
The power of compounding
To generate 60% or more of your salary 30 or 40 years from now, you don’t have to save 60% today. You can start small and benefit from the power of compounding.
The idea behind compounding is simple -- when your investment earns money, this amount is reinvested in your account and potentially generates more earnings. Over time, this process can increase the growth potential of your original investment. If your earnings are reinvested for a long enough period, compounding can reduce some of the pressure on you to invest greater amounts as you approach retirement.
The tax benefits of saving for retirement
By using investment vehicles such as workplace-sponsored plans or individual retirement accounts (IRAs), you can put off paying taxes on your earnings until you are retired and potentially in a lower tax bracket.
- If you made a $100 monthly contribution in a tax-deferred account over 30 years, you could grow your nest egg to $150,030.
- If you made the same contribution in a taxable account, it would amount to only $102,000.
That's a difference of almost $50,000 just because you didn't have to pay taxes up front.2 Of course, you'll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money, but you may be in a lower tax bracket when you retire.
Another key benefit of participating in a retirement account is that your contributions may be made pretax or may be tax deductible, helping reduce current tax bills. Let’s assume that you make $2,000 a month and contribute $200 to your employer-sponsored retirement plan. That would lower your income to $1,800, reducing your taxes from $500 to $450.
Types of retirement savings accounts
Employer-sponsored retirement savings plans
Your employer may offer a retirement plan, such as a 401(k), 403(b), or 457. These plans allow you to contribute up to $17,500 in 2014, plus an additional $5,500 if you’re aged 50 or older. There are two types of 401(k) plans: traditional and Roth plans.
- Traditional plans feature pre-tax contributions, which are taxed at ordinary rates when withdrawn in retirement. You may be in a lower tax bracket once you retire.
- Roth plans offer after-tax contributions, but qualified withdrawals are tax free.
With either plan type, employers may elect to match part or all of the contributions you make to your plan. Most of these plans typically provide you with several investment options in which to invest your contributions. Such options may include stocks, bonds, or money market investments. If you leave your company, you can roll over the accumulated balance into an IRA or other retirement plan in a tax-free transaction. However, if you choose to physically receive part or all of your retirement account balance, you will have to pay taxes and penalties.
There are two types of IRAs:
- Traditional IRA
- Roth IRA
The primary difference between them is the tax treatment of contributions and distributions (withdrawals).
- Traditional IRAs may allow a tax deduction based on the amount of a contribution, depending on your income level. Any account earnings compound on a tax-deferred basis, and distributions are taxable at the time of withdrawal at then-current income tax rates, which may be lower in retirement than they are now.
- Roth IRAs do not allow a deduction for contributions, but account earnings and qualified withdrawals are tax free.
Whichever one you pick, try to contribute the maximum amount allowed by the IRS: $5,500 per individual, plus an additional $1,000 annually for those aged 50 and older for 2014. Note: Those limits are per individual, not per IRA.
IRA tax benefits
If you fund a traditional IRA and don’t have access to an employer-sponsored retirement plan, you may be able to deduct all or part of your contribution on your taxes and also may be eligible for a tax credit. If you fund an IRA and do have access to an employer-sponsored retirement plan, you also may be able to deduct all or part of your contribution on your taxes, depending on how much you contributed to your employer plan.
In choosing between a traditional and a Roth IRA, weigh the immediate tax benefits of a tax deduction this year against the benefits of tax-deferred or tax-free distributions in retirement. If you need the immediate deduction this year -- and if you qualify for it -- then you may wish to opt for a traditional IRA. If you don't qualify for the deduction, then consider a Roth IRA.
Getting an early start
If you're in your 20s, you’re in luck. Starting early and contributing as much as possible to employer-sponsored retirement plans and IRAs may help you to potentially accumulate more money. Why? Because investing in these tax-advantaged accounts means your money will work harder for you.
Even if you invest a relatively small amount on a regular basis, you may still be able to pursue large goals over time thanks to the power of compounding. Assume that your investments earn 8% annually. If you invest $2,000 a year from age 25 to 35 ($20,000 in all) and then stop completely, you could accumulate $315,000 by age 65. But if you wait until age 35 and invest $2,000 a year for 30 years ($60,000), you'd accumulate just $245,000 by age 65.2
Procrastination has been called the thief of time. Don't let it rob you of a more secure financial future -- start investing as early and often as you can.
Catch-up solutions for those who got a late start
Entering your 40s or 50s and behind in your retirement planning goals? Don't fret. You've still got time to get your financial plan back on track. There are many steps that older investors can take to better prepare themselves financially for retirement.
If you have access to a 401(k) or other workplace-sponsored plan, make the $5,500 catch-up contribution that is available to participants aged 50 and older. Also note that investors aged 50 and older can contribute $6,500 annually (the $5,500 annual contribution plus an additional catch-up contribution of $1,000) to an IRA.
Consider how you can trim expenses while continuing to enjoy life. Some suggestions for quick savings: Eliminate or reduce premium cable channels that you do not watch, memberships that you do not use regularly, and frequent splurges on dining out or coffee runs. An extra $100 a month saved today could make a big difference 10 or 20 years from now.
Most importantly, don't give up. Many pre-retirees falsely believe that there is nothing they can do to build retirement assets, and as a result, do nothing. Remember that you control how much you invest, and in many areas, how much you spend. Make a plan -- and stick with it.
Balancing risk and reward
All investments have risks. In order to figure out how to manage risk, you must first understand it. Investment risk -- or the risk of losing investment value -- comes in many forms, including:
Market risk, or the likelihood that a security’s value will move in tandem with its overall market.
- Interest-rate risk, or the risk that the price of a bond will fall with rising interest rates.
- Inflation risk, or the chance that the purchasing power of an investment will be eroded by inflation.
- Credit risk, which refers to the risk that a bond issuer will not be able to repay its debt when the bond matures.
There is also the risk of investing too conservatively -- not getting a high enough return to provide for your financial future. To effectively manage these elements of portfolio risk, you need to evaluate your personal investment goals and match these goals to your portfolio risks. Factors such as your investment time horizon and risk comfort level also must be considered. These will determine what kinds of and how much risk you are willing to take.
Strategies for investment success
You can potentially reduce your investment risk and increase your chances of meeting your investment goals by practicing strategically dividing your money among each of the major asset classes based on your financial goals, risk tolerance, and time horizon. This is called “asset allocation.”3
Here’s a quick look at the three asset classes:
- Stocks have historically earned higher returns than other asset classes, but they carry higher levels of risk. Stocks are generally most suitable for long-term financial goals. There are different asset classes within stocks, including foreign stocks, small-cap stocks, and large-cap stocks.
- Bonds typically offer less return potential than stocks, but they may be less risky. Bonds may potentially offset some stock volatility in a long-term portfolio and also provide income for shorter-term needs. Types of bonds include Treasuries, corporates, and municipals.
- Money market instruments usually offer the lowest return and are the least risky of the asset classes. They may be appropriate for short-term financial goals or emergency savings.
Your plan or IRA should give you access to a variety of mutual funds or exchange-traded funds (ETFs) that comprise the above asset classes. You also may be able to invest in each type of the asset classes directly.
Rebalancing and reevaluating your goals
Conducting an annual review of your retirement goals and strategy is a great way to help ensure that your plans for your financial future remain realistic and on track.
Your first step should be to review your retirement savings goals and assess whether anything significant has occurred during the past year that might affect either your outlook for retirement or your current strategies to prepare for it. A financial professional can help you find a strategy that is suitable for you.
Secondly, review your asset allocation to ensure that it is still appropriate for your current needs. Even if your personal outlook hasn’t changed, keep in mind that uneven returns provided by different investments may have caused your portfolio to shift from your intended asset allocation.
Finally, understand that a good way to improve the odds that you have saved enough for retirement is to save more, no matter how prepared you may already be. Can you contribute an extra 1% or 2% of your salary?
Getting close to retiring?
After years of saving and investing, you are finally getting ready to enjoy the benefit of your planning and hard work. But there are still decisions that need to be made, including the following:
- Update the retirement income needs estimate you may have projected long ago. Is it still accurate?
- Identify all of your potential income sources, including Social Security, pensions, and personal investments. How many do you have?
- Review your asset allocation -- how you divide your portfolio among stocks, bonds, and cash. Is it still suitable?
Once you've assessed your needs and income sources, it's time to make a plan to withdraw the assets you’ve built up.
- First, determine a prudent withdrawal rate. A common approach is to liquidate 5% of your principal each year of retirement; however, your income needs may differ.
- Next, you'll need to decide when to tap into tax-deferred and taxable investments. The advantage of holding on to tax-deferred investments (employer-sponsored retirement plan assets, IRAs, and annuities) is that they compound on a before-tax basis and therefore have greater earning potential than their taxable counterparts.
Be sure to consult a qualified financial professional, a tax advisor, and an estate-planning attorney to make sure that you're prepared for this new -- and exciting -- stage of your life.