How to Invest for Retirement

One of my interests is personal finance. Here is a short guide to investing for retirement. Skip to the conclusion at the end for the recommended steps to follow if you are just getting started. I try to primarily stick with the facts, and any opinions expressed are my own. Before investing for retirement please consider all the risks, limitations on getting at money without penalty, and your personal situation. Please tell me in the comments if you see a mistake or if you would like to see more information on any of these topics!

Why Save for Retirement?

You may be asking, why should I save for retirement? At least in the USA, no one else is going to take care of you. If you do not save anything, you will be stuck with Social Security. The maximum Social Security benefit for 2018 is $3,698 per month, or $44,376, for those who wait until age 70 to claim benefits, only for those who were earning $128,400 or more. That is about 34% of the income earned previously. At lower incomes, the benefit is less, but the percentage is higher. I understand the benefit for an income around $50,000 is something like 58% ($29,000) at age 70 (less if you take benefits earlier). That definitely represents a reduction in spending money, so take that into account if you plan to spend everything and avoid saving for retirement.

Types of Retirement Accounts

Your strategy will probably depend upon whether you have a retirement account offered through work, especially if you are just starting out. The tax advantaged accounts mentioned below are defined contribution (you contribute money, invest it, and earn returns) - there are also defined benefit (pension) plans with some employers.

Tax Advantaged Accounts

These accounts offer tax advantages - either tax deferral for contributions (i.e. deposits) or tax free withdrawals. Below is the common list of tax advantaged accounts. Also included would be 403(b) and the federal government Thrift Savings Plan (TSP) but those are most similar to 401(k) for the majority of workers at a company.

Traditional versus Roth

A traditional account is tax deferred - contributions are tax free, but future distributions are taxed as income. A Roth account contribution is taxed up front (i.e. after-tax, like take home pay from a paycheck) but future distributions are not taxed. The decision of Traditional versus Roth is ever evolving, do not let this hold up your investing. If in doubt, choose pre-tax or traditional initially, and evaluate later.

Tax Advantaged Accounts Limitations

The primary limitations of tax advantaged accounts are contribution limits (you cannot simply add as much money as you want while avoiding taxes), investing options (employer sponsored plans may have a limited investment menu), and limits on distributions. In general, you must experience a hardship (hardship withdrawals) or reach retirement age (59.5) to take a distribution without additional penalties.

401(k) Accounts

401(k) accounts are employer sponsored retirement plans (unless you are an independent contractor and set up a solo version). These accounts allow tax deferred contributions (you avoid paying taxes on the money you set aside, but will pay tax in the future) and many now offer Roth contributions as well. After-tax contributions are also allowed for many plans, but fall into a category of more complicated rules. If you have additional funds to contribute, you might consider this option.

In general, a 401(k) account offers an employer approved list of investment options that will be much less choice than what can be found in other types of accounts. This is true for the federal government TSP and most 403(b) accounts as well. For 2018, the standard contribution limit for 401(k) accounts is $18,500, with a catch-up limit of $6,000 additional for those 55 and older. Contributions must be arranged through your plan provider and/or employer, as they come directly from your pay.

Many employers offer a company match of contributions. A typical match will be structured as 25-50% of the first 6% of employee contributions (50%*6%=3% total). This is the best deal in retirement accounts, as it represents free money! But there can be a catch with matching funds: vesting schedules indicate how long you have to have participated in the plan to get all of the employer match money (your contributions are always your money). A typical vesting schedule is 20% per year for 5 years - if you leave the company before 5 years, some of the company match money goes back to the company.

IRA Accounts

An Individual Retirement Account (IRA) is another type of tax-advantaged account. IRAs come in traditional (pre-tax) and Roth (after tax) varieties, as well as Non Deductible. In general your investment options will be similar to a brokerage account but some features such as margin are not allowed for an IRA. You can invest in options and other more complicated strategies with most providers. For 2018, IRA contribution limits are $5,500, with a catch-up limit of $1,000 additional for those 55 and older.

Special Case: Roth IRA as Emergency Fund

One option if you are just starting out, is to use a Roth IRA as an emergency fund. You can find a lot of guidance on this so I will keep this brief. Do your research. From what I understand you can withdraw Roth IRA contributions from an account open at least 5 years. If you take this approach, make sure to invest the emergency fund part of your IRA accordingly - cash or somewhat stable investments.

Rollovers

Transfers from one type of tax-advantaged account to another is called a rollover. You can rollover funds from a past company 401(k) to a new 401(k), or to an IRA under your name. Or from one IRA custodian to another. Generally look to perform a direct rollover and let your current provider send the funds directly to the new account. Otherwise you will get a check in the mail (sometimes quite large!) and need to sign it over to the new account. Work with your new provider first to sign up for the rollover and gather all forms, then check with your existing plan to initiate the transfer. I did this with an account where they sent me a check, I endorsed it to the new account (as instructed by that company)and then put it in the mail. The whole process took about two weeks.

Health Savings Accounts

When used for investing purposes, Health Savings Accounts (HSAs) offer tax advantages as well. If you have the funds, you can set aside money tax deferred, and actually withdrawal money tax and penalty free for health care expenses. When you reach age 65, you can take distributions taxed as income with no penalty (like a traditional IRA) or keep the money in the account to pay medical expenses tax free. Many plans offer investing options in mutual funds, but fees are generally higher than a 401(k) or IRA. Companies sometimes offer a match, on the level of $500-$1,000. These accounts span healthcare and retirement and are worthy of a standalone post.

Investing Retirement Funds

If you are not familiar with asset allocation for retirement funds and you have many years of employment ahead you will want to be mostly invested in equities. Some balance of bonds and international equities may also be a good idea. This is worth another post, but for simple approaches check out the three fund Bogleheads portfolio (do an internet search on that) or target date funds (based on your target retirement year). Just make sure to take a look at fees: target date funds have their own fee, but invest in other funds that also are charging fees. You can mimic the investment pretty easily, as fund information documents will tell you what the underlying investments are. Worth more discussion in the future.

Non-Tax Advantaged Accounts: Brokerage Account

Some prefer to invest in a brokerage account. While you generally have to pay tax on dividends and capital gains, there are benefits such as no early withdrawal penalties, and potentially a wider variety of investing options (with margin and day trading) that can be done with a brokerage account.

Other Types of Investing for the Future

Others prefer to invest in alternatives. Real Estate, Commodities (Gold, Silver, or other precious metals), Cryptocurrencies, and collectibles are all examples of this. In general, using one of these alternatives as the primary method of retirement investing could be more risky and require more personal expertise. But it is still a much better approach than saving nothing!

Conclusion - What to do?

The below is my recommended approach for those just getting started, you will find similar lists elsewhere. My best advice however is to save something! Saving nothing is not an option long term. Your future self will thank you. Start with steps 1-4:

Contribute enough to get the company match in your 401(k) if offered. This is generally 6% of income to get a match from 1.5-3% or more, depending on the company.
Contribute enough to an HSA to get the company match, if offered.
Open a Roth IRA and contribute enough to keep it open, usually $1,000. This establishes the account as early as possible to use it for a future Emergency Fund if needed.
Establish and contribute to an Emergency Fund, using either your standard checking account or savings account. Even if you have to start small ($1 a day). In the future, grow this fund to 3-6 months of expenses if you can.
Establish "short-term" savings goals - new car, house down payment, etc.
Save up to the maximum in an IRA, if eligible.
Save up to the maximum in a 401(k), if available.
Set up transfers to a brokerage account and begin investing in ETFs.

I would try to do steps 1-4 no matter what. Even if you have to move in with your parents, get roommates, or drive a beater for 5 more years. Again, your future self will thank you many times over!

Future Topics (Please Add Suggestions in the Comments!)

How much should you save for retirement?
How to allocate retirement investments
Health Savings Accounts in Depth
401(k) Accounts in Depth
IRAs in Depth
Tips for Increasing Retirement Savings