Saving for Retirement

The content contained on or made available through this website is not intended to and does not constitute as legal or investment advice. Please use and refer to the information at your own risk, and consult with a professional before making any finance-related decisions. Refer to the full Terms & Conditions here. Last updated January 1st, 2020.

Takeaways

  1. Start planning for retirement as soon as possible

  2. Enroll in your employer’s 401(k) or like-plan

  3. Take advantage of matching contributions

  4. Consider further investing in a Roth IRA and HSA

  5. Understand and optimize your Asset Allocations

 

The moment you enter the workforce is the best time to start planning for retirement. Cash put away in your early twenties can have 40+ years to accrue interest. For instance, $1,000 today at 6% interest - under the historical inflation-adjusted stock market return of 7% - will be worth over $10,000 in 40 years time. Compare that to the same $1,000 invested for only 20 years. With half the time to compound interest, you end up with just over $3,000 - a little over a quarter of 40-year value. The secret: invest early.

* This graph illustrates the above example and shows the benefit of investing early

Check out the Finance in a Flash Retirement Calculator!

The best place to start saving is in tax-advantaged accounts. Below is a list and description of the most popular retirement vehicles:

 

  • Traditional 401(k): There are multiple routes to successful investing. If offered, the easiest way to get started is your employer’s 401(k) or like-plan (e.g. 403(b)). These vehicles allow you to store away a percentage of your pre-tax income. Employers will often provide matching contributions up to a certain percentage of salary; for instance, 50% of your first 6% contributed. This means that, as long as you contribute at least 6% of your salary to the retirement plan, your employer will provide an additional 3% salary for free. Do not pass this up! All employee and employer contributions to a Traditional 401(k) grow tax-free until retirement, at which point they (alongside investment earnings) will be taxed as income.

    • Funds cannot be withdrawn before age 59.5, or else they will be subject to a 10% early withdrawal penalty. Exceptions to this rule include "qualified distributions," such as those resulting from total and permanent disability. Unless you are still working at age 70.5, you must begin to make annual withdrawals. These care called "Required Mandatory Distributions" (RMDs), the amounts of which are based on age and account balance.

 

  • Roth 401(k): The next option is the Roth counterpart to a Traditional 401(k) or like-plan. Roth options differ from other retirement accounts in that contributions are post-tax, while withdrawals (including investment returns) are tax-free. This may seem counterintuitive, as the main incentive of a Traditional 401(k) is its tax-deferred status. The key question here is: do you expect to be in a higher tax bracket now or in retirement? The reason being that Roth accounts tax you now, and Traditional accounts tax you later. 

    • Typically, people expect their expenses to drop once in retirement, and are therefore accepting of a lower gross income. If that is the case, a pre-tax 401(k) is preferable. However, if you are just starting your career and expect to have a higher income in retirement than you do currently, consider the Roth option. Lastly, no one can predict the future of U.S. taxes and tax brackets, so it is completely reasonable to split the difference and contribute some percentage of salary to each fund.

 

  • Traditional/Roth IRA: IRAs are similar to 401(k) plans in that they are great saving vehicles for retirement. Some differences include the following:

    • IRAs are individual accounts, meaning that you will likely create and manage them through a separate brokerage firm (e.g. Vanguard), and your employer will not make any contributions.

    • IRAs have much smaller contribution limits than 401(k)s ($6,000 IRA limit in 2019 for those below 50 years of age, compared to a pre-tax $19,000 401(k) limit).

    • Roth IRAs are restricted to those that have a Modified Adjusted Gross Income (MAGI) below the limit of $137,000 for singles and $203,000 for married couples (limits indexed annually). However, these limits may be sidestepped in certain cases through in service conversions of post-tax dollars (a.k.a. "Backdoor Roth").

    • IRAs typically have a much wider array of fund options compared to 401(k)s, which are ultimately determined by your employer. IRA funds may also have lower expense ratios, meaning that the facilitating company or broker charges a smaller fee to manage the account.

    • A Roth IRA must be open for 5 years before any penalty-free withdrawals may be made.

    • Contributions to a Roth IRA can be withdrawn at any time with no tax penalty (as long as the account is at least 5 years old). Withdrawals from a Roth 401(k) will be prorated between contributions and investment returns, causing an early withdrawal penalty on the earnings portion.

 

  • The variations between a Traditional and Roth IRAs mirror those of 401(k) plans. The main reasons for contributing to an IRA over a 401(k) are the following:

    • Your employer does not offer a 401(k)/like-plan or Roth option

    • You prefer the investment options provided by the IRA account

    • You have maxed out your 401(k) option and would like to further invest

Sound like too many options? The good news is: you do not need to choose! If offered, you may contribute to any combination of Traditional/Roth 401(k) and IRA accounts in the same year

*The chart above shows an example retirement account for an individual with a starting

salary of $60K (with 3% annual raises) contributing 15% a year to a 401(k)

 

If you are self-employed, there are other tax-advantaged retirement vehicle options. These include (but are not limited to):

 

  • Simplified Employee Pension (SEP) IRA: A SEP IRA is typically created by self-employed individuals and small business owners. As the employer, you can contribute up to the lesser of 25% income and an annually indexed dollar value (in the $50,000 - $60,000 range). These accounts are easier to set up and administer than 401(k) plans, and offer self-employed individuals a high level of retirement savings flexibility.

 

  • Simple IRA: This plan allows small employers (with fewer than 100 employees) to set up an IRA that is easy to administer. Simple IRAs require employer contributions and impose percentage of income limits that are lower than those of 401(k)s.

 

Lastly, an option that many tend to overlook:

 

  • Health Savings Account (HSA): An HSA, typically tied to an employer’s High Deductible Health Plan (HDHP), offers another avenue for tax-advantaged savings. Both the employee and the employer may contribute pre-tax dollars to an HSA, and funds can only be withdrawn (tax-free) for qualified medical expenses. Contributions are often invested and accrue interest over time. The key feature: upon reaching age 65, funds can be withdrawn from an HSA for any reason (and taxed only as income, while health-related expenses will remain tax-free). As a result, an HSA can double as a retirement savings vehicle.

 

In terms of a simple hierarchy of investment vehicles, consider the following prioritization:

  1. 401(k) Matching: Start by contributing up to your employer's matching percentage (e.g. 6% if your employer matches 50% of your first 6% contributions).

  2. HSA: If you have a High Deductible Health Plan (HDHP), contribution to a Health Savings Account (maximum of $3,500 for an individual and $7,000 for a family in 2019).

  3. Roth IRA: Next, contribute to a Roth IRA ($6,000 maximum in 2019) if you are able to and if your income qualifies.

  4. 401(k) Non-Matching: Then, increase contributions to your 401(k) or like-plan as much as your budget allows or up to the maximum of $19,000 for 2019.

  5. Taxable Brokerage Accounts: Lastly, once all tax-advantaged options are exhausted, consider contributing to a taxable brokerage account (offered by Vanguard, Fidelity, Schwab, etc.). These accounts are taxed on both contributions and investment earnings, but they are otherwise more liquid than the aforementioned vehicles (i.e. they can be withdrawn penalty-free at any time).

​Once you have decided upon investment vehicles, the next question becomes: “what assets do I invest in?” Depending on your employer’s 401(k) offering, your options may be limited. If possible, you should look to invest in the following three asset classes:

 

  • Investment Grade Bond Index Funds: Purchasing a bond is essentially making a loan to an entity (traditionally a corporation or the Government). In return for your money, the borrowing entity will compensate you with interest. This interest comes in the form of either “coupon payments” or a higher bond price (called "Face Value") over time. “Investment Grade” bonds are those that are widely agreed upon to not have a significant risk for default (meaning the borrowing entity will be able to fulfill its promise to pay you back). Finally, an “Investment Grade Bond Index Fund” is a mix of assets that represent a wide variety of high quality bonds across the U.S. and/or internationally.  When searching, look for funds with very low expense ratios and steady historical returns.

 

  • U.S. Stock Index Funds: A stock represents a slice of ownership in a corporation. In return for your buy-in, a corporation rewards stockholders with dividends and/or an intended increase in stock value over time. Similar to bonds, a stock-based index fund should represent a collection of stocks at varying levels of risk. “Small Cap” stock index funds are higher risk and include smaller companies and start-ups. “Large Cap” funds include large and less risky companies. Other options, like an S&P 500 index fund, attempt to mimic the actual composition of the S&P 500. Your retirement portfolio’s level of risk is up to you and your time horizon (i.e. years to retirement). Again, index funds are easily identifiable by their very low expense ratios (often less than 1/10 of a percent).

 

  • International Stock Index Funds: Similar to its U.S. counterpart, international index funds include a collection of overseas companies. You will further diversify your risk by splitting your stock investments between U.S. and International-based companies. Like all index funds, keep an eye out for low expense ratios.

 

Why index funds? Simple. Index funds are passively managed - hence their low expense ratios. They have been found to historically outperform their actively managed counterparts when factoring in the large spread between fees and expenses.

 

Next, deciding what percentage of your retirement savings you want in each of these buckets is called “Asset Allocation.” The most common way to determine your asset allocation is called a “Glide Path.” This strategy uses your age (and implied number of years until retirement), and allocates funds accordingly. One potential configuration is as follows:

Sample Glide Path Asset Allocation Strategy

  • Your age as a percentage in bonds, and the remainder in equity

    • E.g. if you are 22, then you will have 22% in bonds and 78% in equity

  • Two thirds of your equity in U.S. stocks

  • One third of your equity in International stocks

*The above graph illustrates an example asset allocation by age

The goal is to have a high percentage of equity holdings when you are young and able to outlast a bear market. Then as you approach retirement, your bond allocation grows, creating a more stable (albeit lower) return on investment. Most employer-sponsored plans and brokerage firms offer "Target Date Fund" options, which use the Glide Path strategy. You can also create your own by manually creating an asset allocation similar to the one outlined above.

If you are young, consider trying something a little riskier. Allocate 100% into stock index funds; for example 2/3 in the Vanguard Total Stock Market Index Fund (VTSAX) and 1/3 in the Vanguard Developed Markets Index Fund (VTMGX) for domestic and International exposure respectively. If you are a little older, shift towards to the glide path above with some bond exposure mixed in as well.

Lastly, some miscellaneous topics:

  • Vesting: Employers contributing to your 401(k) is essentially free money. Frequently, however, you do not technically own that money as soon as it is deposited into the account. A “Vesting Period” refers to the amount of time you must work at a company before you fully own your employer’s matching contributions. Vesting periods can be scaled (e.g. you own 25% of contributions after one year, 50% after the next, etc.) or fixed (e.g. you own 100% of the contributions after exactly two years of work). So, if you are unhappy at your current job, consider sticking it out until you are fully vested!

 

  • Rebalancing your Portfolio: If you have decided to manually invest capital (ideally in a split of bond, U.S. stock, and international stock index funds), then you will soon notice that your percentage allocations change over time. Sometimes, U.S. stocks will outperform International stocks - and vise versa. The goal of rebalancing is to (at least annually) make sure that your asset allocations are where you want them to be. This can mean moving money from the over-performers to the under-performs in order to capitalize on the “buy low, sell high” philosophy of investing.

  • Defined Benefit Plans: Up until this point, the focus has been on what are called “Defined Contribution Plans” (DCPs). These include 401(k), 403(b), and the other “like-plans” discussed above. In today’s world, DCPs are the most common form of retirement benefits. In the past, however, “Defined Benefit Plans” (DBPs) were the norm. DBPs typically function on a formula of salary and years of service. For instance, A DBP would promise to pay retirees the following on an annual basis: 0.5% - 2.5% multiplier * years of service * final year’s salary. DBPs have largely fallen out of favor due to the high financial burden it places on employers. Some retirement plans, however, have combined aspects of DCPs and DBPs in order to best meet their employees’ needs.

  • Social Security: The impact Social Security (SS) may have on your retirement has been purposefully left out of this article due to its future uncertainty. While SS will likely exist in some form or another in the coming decades, it will likely undergo dramatic changes in order to maintain solvency, thus making it difficult to plan around in the present moment.

 

Conclusion

 

The U.S. Government has an interest in enabling you to fund your own retirement; otherwise, they may be on the hook through Medicaid and other publicly funded programs. As a result, they offer a wide variety of tax-friendly solutions to help you save for the future. Take advantage of these whenever possible.

The content contained on or made available through this website is not intended to and does not constitute as legal or investment advice. Please use and refer to the information at your own risk, and consult with a professional before making any finance-related decisions.

© 2020 London Levinson LLC