It’s official: You’re one of the umpteen million Americans growing a nest egg for retirement. Now what?
How do you actually run this contraption? How much should you put in, and when? What kinds of investments should you consider — and in what proportions? When should you pull the cash out, and how fast?
Start Early, Take It to the Max
The most important piece of advice I can share with you about retirement accounts is to begin contributing as soon as possible. Time, not genius, is the great wealth-builder.
Here’s an illustration that bowled me over when I first saw it. Susie Sunrise, 22, tucks away $3,000 a year in her IRA for seven years, then never saves another dime. Marsha Midday doesn’t set up an IRA until age 35. But she faithfully deposits $3,000 a year for the next 30 years. Both ladies earn 8% on their investments.
At age 65, which contestant do you suppose has the bigger balance?
Roll the drums … it’s Susie! Her account is worth $461,637, versus only $367,038 for Marsha. Start early. I launched IRAs for all three of my daughters soon after they got their first summer jobs as teenagers.
If starting early isn’t an option for you anymore, the best way to make up for lost time is to contribute more. It just seems like common sense. Yet millions of Americans don’t take full advantage of the smartest retirement strategy (and most obvious tax dodge) out there.
Investing Your Retirement Money
People often ask me, “What kind of investments should I own inside my retirement accounts?” As we’ll see in a moment, the answer depends to a large extent on your stage in life. It’s worth bearing in mind, though, that retirement accounts are tax-sheltered. You want to take full advantage of that feature.
If you are in your 20s and 30s, I suggest using your retirement accounts to hold investments that tend to generate a lot of short-term capital gains (short-term gains, where you buy and then sell in 12 months or less, are taxed at the same high rates as wages and salaries). Mutual funds of the “aggressive growth” variety fit in this category.
In addition, if you plan to trade stocks or mutual funds frequently, a retirement account can save you a pretty penny in taxes. Most brokerage firms, including discounters like Charles Schwab (NYSE:SCHW) and TD Waterhouse, welcome self-directed retirement accounts.
As you move into your 40s and 50s, you’ll probably be ready to shift to a more conservative investment stance. It’s still OK to use your retirement accounts as a trading vehicle, but you can also benefit by accumulating bonds and dividend-paying stocks in a tax-protected format.
For people in this age bracket, I recommend storing up high-yield investments (like REITs and utilities) inside a retirement account. That way, your plump interest and dividends will escape Uncle Sam’s bite.
Five Years to Retirement: A Fork in the Road
Once you get within about five years of your projected retirement date, you’ll need to make a basic decision.
Do you have enough to live on in retirement without immediately tapping your tax-sheltered accounts? In other words, will your taxable investments, your pension (if any) and Social Security be enough, together, to pay your bills?
If you’re lucky enough to say yes to this question, I encourage you to allocate your retirement accounts along a growth-and-income track — about 70% stocks and 30% fixed income.
On the other hand, if you’re nearing retirement and you know you’ll need the money in your tax-sheltered accounts soon, the five-year mark is your signal to shift even more strongly toward an income posture. I find a 50-20-30 strategy optimal (50% in high-dividend banks and utilities, 20% in real estate and master limited partnerships and 30% in bonds or bond equivalents).
Fifty-twenty-thirty (or something close to it) is an allocation that should work well for most retirees in the decades ahead. It assumes the stock market will continue to grow, but it doesn’t count on the outsized — and unsustainable — returns we saw in the 1990s.
Cracking Open Your Piggy Bank
Finally, the day dawns when you’re ready to tap your retirement account. If you’re in a traditional IRA or 401(k), that date can come as early as age 59 1/2 (optional) or as late as April 15 of the year after you turn 70 1/2 (mandatory).
For Roth IRAs, there’s no required starting date or minimum distribution. If you wish, you can squirrel up the money for the rest of your life and pass the account to your heirs free of income tax (but not necessarily estate tax).
Regardless of the type of plan you’re in, I advise you to put off taking distributions as long as possible. Draw down your taxable resources before dipping into your tax-deferred accounts.
For now, though, all the wisdom in the world about managing your retirement account boils down to three simple principles: Save early. Invest wisely. Spend slowly!