Where should I save my retirement money?
Tax-favored retirement accounts such as individual retirement accounts (IRAs) and 401(k)s are the best places to save for your retirement. The different types of plans have different features, but most of them allow you to defer taxes on the money you save and the returns you earn within the account.
“Tax deferral” means that the amount you contribute escapes the usual income taxes until you start withdrawing the money years later. As a result, more of your money can earn investment returns over time – an enormous advantage over ordinary taxable accounts.
The plans have other advantages as well. For example, many employers will match part of their workers’ contributions to employer-sponsored retirement plans such as 401(k)s.
How should I invest the money?
To build a nest egg large enough to see you through retirement, which may last 30 years or more, you’ll need the growth that stocks provide.
The stock market returned 9.8% a year on average between 1926 and 2009, versus just 5.4% for bonds, according to research firm Ibbotson Associates. Given stocks’ superior returns over the long haul, most financial advisers recommend that investors whose retirement is more than 20 years away hold at least 3/4 of their portfolios in stocks and stock funds.
Of course, a stock-heavy portfolio can give you some hair-raising moments (or years). For example, during the 1973-74 bear market, U.S. stocks lost 43% of their value – and it took the market three-and-a-half years to recoup those losses. The stock market also suffered a 47.6% decline during the bear market at the start of this decade.
If you don’t have the stomach for steep downturns, you might increase your allocation to include more bonds or bond funds. Holding, say, 70% of your portfolio in stocks and 30% in bonds will let you capture most of the long-term growth of stocks while sheltering your investments to a certain extent during market downturns.
How should my strategy change as I get older?
As you approach retirement age, most experts agree you should gradually shift more into bonds to protect the money you’ve accumulated. But retirement can last a few decades, so it generally pays to maintain a healthy dose of stocks well into retirement: possibly between 40% and 50% while you’re in your 70s, and up to 30% when you’re in your 80s.
If you want to put your asset allocation on autopilot, consider “target-date retirement funds,” which are available in many retirement plans. You simply choose a fund that’s labeled with the year you intend to retire, and it will automatically adjust what it invests in (usually a mix of stocks, bonds and cash) to maximize your return and minimize your risk as you get older.
For an idea of what the right mix of stocks and bonds is for you, go to our asset allocation calculator.
How much money will I need in retirement?
Ah, the key question. One rule of thumb is that you’ll need 70% of your pre-retirement yearly salary to live comfortably. That might be enough if you’ve paid off your mortgage and are in excellent health when you kiss the office good-bye. But if you plan to build your dream house, trot around the globe, or get that Ph.D. in philosophy you’ve always wanted, you may need 100% of your annual income – or more.
It’s important to make realistic estimates about what kind of expenses you will have in retirement. Be honest about how you want to live in retirement and how much it will cost. These estimates are important when it comes time to figure out how much you need to save in order to comfortably afford your retirement.
One way to begin estimating your retirement costs is to take a close look at your current expenses in various categories, and then estimate how they will change. For example, your mortgage might be paid off by then – and you won’t have commuting costs. Then again, your health care costs are likely to rise. For more help making a precise estimate, use this calculator.
Will pensions and Social Security be enough?
Unfortunately, probably not. When you run the numbers, you should definitely factor in other sources of income in retirement, including Social Security and a traditional pension, if you’re lucky enough to have one. But your personal savings will have to generate enough income to cover the shortfall.
You can check your estimated Social Security benefits by using the government’s Social Security Online calculators. Current or former employers can provide estimates of any pension benefits you might receive when you retire.
H/T Source: CNN Money