Frugal Fridays: Retirement Investing For Beginners
Fri Jun 01, 2007 at 01:04:40 PM PDT
Welcome to "Frugal Fridays" where we share money saving tips, discuss living frugally and generally talk about personal finance issues. I wanted to take today to talk about retirement investing, specifically addressed towards those who have no clue how and where to start. Originally I had planned on this diary being a basic primer on all types of investing, but as it grew, I realized that the topic of retirement savings was complex enough in and of itself for a single diary and it is a goal that everyone who hopes to stop working before they die should be working towards. Although this may seem like a diversion from the frugal theme, I think it is rather the most natural extension. It could be said that that living frugally is all about making every dollar you spend work harder for you, and there's no better way to put your money to work than to invest it wisely. I am not by any means an expert in this topic, so please join in the comments with your advice and questions. Most important: please correct me if I say something below you disagree with. I know I have a lot to learn about this stuff and I don't want to pass on any misinformation if I can avoid it.
In our house, it is mr. sarahnity who is a lot more interested and aware of this stuff than I am. I've stolen freely from his money blog to write this diary. If you are interested in more depth, check it out, there is some good stuff there. When I first started working on this diary, I found myself taking a fair bit of time to define different financial terms, since I didn't want to confuse any reader who is not that well versed in the terminology. Then I found Investopedia which is a good site for defining most terms you will encounter. I've removed most of my fundamental definitions and linked to theirs instead. They are also have some good articles there, so it would be another good spot to look for more information. Please add links to any other good education sites you know of in the comments. Note that I use the terms "saving" and "investing" interchangeably below. An important part of any savings plan is choosing the appropriate investment vehicle to help grow your savings. If you are saving your money in a box in your basement, the buying power of that money is decreasing every year and you are in essence losing money just as surely as if rats were nibbling on it.
The sooner you get started on your retirement savings, the sooner you will be to achieve the state where you are comfortable retiring. I cannot stress enough how important it is to start saving for your retirement the instant you get your first job. As a matter of fact, if you have teenagers who have started working, one of the best gifts you can give is to open a Roth IRA for them (more details here).
Social Security
If you are working, you and your employer are both contributing to your social security account. You should request a statement from the Social Security Administration that will summarize your contributions so far and let you know what your estimated benefit will be when you retire. Once you have made the request, they will send you a new statement every year. It's a really good idea to glance at these each year just to make sure that their records match yours. A discrepancy in this statement could be due to a paperwork error, employer fraud or even identity theft. All of these things are better caught and cleared up as soon as possible.
Accounts With Tax Advantages
There are two kinds of retirement accounts that have particular tax advantages: (1) employer established and contributed accounts such as 401k, 403b, SEP IRA, SIMPLE IRA or pension plans and (2) self-administered accounts such as traditional IRAs. The amount you can contribute and the rules for when you can and must withdraw from these accounts are fairly straightforward (well, as straightforward as anything you encounter from the IRS) but the tax consequences for breaking these rules can be dire. Educate yourself before you open any of these. Note that if you leave your job, you may be able to take your employer administered plan and roll it over into a self-directed IRA. This can be a very simple procedure, but there can be major tax consequences if done incorrectly. Here is an article explaining some of the potential pitfalls. Most of these accounts can come in one of three flavors, if you will:
- Standard Tax Deferred: Contributions to the account are tax deductible in the year they are made. All gains made are tax-free. Withdrawals are taxed at your ordinary income rate.
- Roth: Contributions are not tax deductible, but all gains are tax-free and all withdrawals are tax-free. This is by far the most attractive of these options. If your employer offers this option for your 401K plan, be sure to avail yourself of it. If you meet the income requirements for the IRA plan, use this type of account. If you have an existing standard IRA, and you meet the income requirements, you may be able to convert it to a Roth IRA. You may take a big income tax hit in the year you convert, but it will probably be well worth it in the long run.
- After-Tax: Contributions are not tax deductible and withdrawals are taxed at your ordinary income rate, but all gains are tax-free.
Employer Plans
Few employers these days offer traditional pension plans. If yours is one who does, look into the details of the plan carefully. Often they are designed so that unless you stay with your employer for many years (decades) you are not fully vested in the plan. In today's job market that may be an unreasonable expectation, and you may want to opt out of such a plan (if that is possible). Far more common these days is an employer will offer a 401k plan. Ask if your employer offers a Roth version of this plan and enroll in that plan if they do. Your employer will match your contribution up to some level. At the very least you want to contribute enough to take advantage of the full matching. That is just free money there for your taking. I strongly urge you to contribute to the maximum level allowed by the IRS. For 2007, that is $15,500 for both tax deferred and Roth accounts. In addition, there may be an after-tax contribution allowed that some employers may offer and some employees may qualify for. Ask your employer.
Setting Up An IRA
Before you open your account, you need to choose the financial institution that will hold it. While it is true that you can always move your accounts to another institution if you grow unhappy with your current broker, that move can be costly in both money and effort, so it's best to put a bit of thought into this decision early on. As your investment portfolio grows, you will probably want to keep all your accounts under one roof so it is most important to choose wisely. Here's mr. sarahnity's blog entry on how to choose a broker, but the gist of his advice is to stay away from high fee old style houses and pick either a discount full-service house (like Schwab or Vanguard) or an ultra-low cost house if you only need a limited set of services (like E-Trade or Ameritrade).
Building a Balanced Portfolio
How your IRA is invested is completely your decision, limited only by the types of funds that are offered by your financial institution. For your 401k, your employer will probably offer a variety of funds and you will have to decide which you want to invest in. The first thing every financial advisor ever says is that you must maintain a balanced portfolio. When you ask what this balance should be, they start talking about how it depends on your desired rate of return, what your time frame is and how much risk you can afford and soon I feel like I'm in a Peanuts cartoon because all I hear is the "whaa-whaa-whaa" sound that adults make when they are talking (except in this case it sounds more like "smallcapslargecapsbondsTbillsemergingmarketsindexfunds"). All I wanted was a simple set of instructions to follow without having to do much research. Financial institutions have finally figured there are a lot of people like me and many now offer just the instrument for those of us whose investing motto is "don't ask, don't tell": target lifecycle/retirement mutual funds. You buy into a fund that is designed for people who want to retire in a given year (e.g., 2020, 2025, 2030, etc). This fund balance is maintained by the managers and over time it is weighted to be more conservative as you approach retirement age. Kossack sipples (who also does a diary series on personal finance) wrote an entire diary discussing these funds a few weeks ago.
If you want to have a bit more control over your portfolio, mr. sarahnity wrote a blog with some more detailed advice for the starting investor. Here are his recommendations in brief:
If you have less than $6K to invest, use a complete US and a complete foreign fund:
* 60% Total US index (VTI)
* 40% Foreign including some emerging markets (VGTSX or FSIIX, but if you don't have enough money, buy EFA)
If you have less than $20K to invest, put the money in the following categories:
* 55% US stocks (say VTI or VFINX)
* 35% International developed countries (say EFA, DODFX)
* 10% Emerging markets (EEM or VWO)
If you have more than $20K you can also add some real estate or US bonds/Treasury bills:
* 40% US stocks (say VTI or VFINX)
* 25% International developed countries (say EFA, DODFX)
* 5% Emerging markets (EEM or VWO)
* 15% REIT index (VNQ or VGSIX)
Keep in mind that if you are maintaining your own portfolio, one of the most important steps you can take is to make sure that you rebalance once or twice a year. If one sector has had a lot of growth, you should sell some of your gains and buy some more of the underperforming sectors. Over the long haul this will significantly increase your return.
Other Retirement Investment Vehicles
Chances are, you will probably need more than just Social Security and your IRAs to live off of by the time you retire. There are lots of other ways to save for retirement as well. If you own your own home, it may turn out that the equity you have in the house is your most valuable asset by the time you retire. However, you may have to sell your home to access this equity in the most efficient manner. As your assets grow and once you are comfortable investing using tax-deferred or tax-free brokerage accounts, you may want to set up a taxed account as well and invest in that too. You may have a different investment strategy for these other accounts, in order to minimize tax losses, but you will need to keep in mind the big picture of your entire portfolio (including any real estate you may own) when you come up with your balancing scheme.
I know that I have just scraped the surface of this topic. Please use the comments to flesh out my discussion. This week I'm using the poll to answer the demographic question meerkoet asked a few weeks ago. For comparison, of the 7000+ who responded to DrSteveB's poll last year, 32% of the folks on this site self-identified as female.
Update [2007-6-1 16:35:10 by sarahnity]: Disclaimer: I am not any kind of financial professional. Take any of this advice at your own risk.
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