retirement on blackboard in chalk

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Okay, so I’ve listened to what you’ve had to say about cutting down my expenses and saving all this money – now what?!  For most people, retirement is the primary function for their investment accounts. This includes IRAs, 401(k)s and their Roth equivalents. It can get quite murky as one tries to sift through the technical jargon and I can honestly say it took me a while to fully understand the difference between all the options for saving for retirement.  Allow me to offer a breakdown of what you need to know.

Defined Benefit vs. Defined Contribution

Defined benefit is relatively straightforward: a company ensures a certain amount of money for each year of your retired life based on the years of service you provided to the company – for all intents and purposes – a standard pension plan. Defined contribution plans represent those in which employers contribute/match allocations or salary is deferred into certain retirement accounts including 401(k)s.

Retirement Investment Vehicles

The primary goal of retirement investing is to grow your money over a period of time via certain investment vehicles. These vehicles vary in risk and range from low-risk certificates of deposit to high-risk stocks. Let’s go through some of the more common types:

Bonds (Fixed-Income): more commonly referred to as debt – essentially a loan to a public or private entity that earns interest on the principal loan amount and ultimately the principal itself. Government bonds from a stable government are sometimes categorized as “risk-free.” Return (interest earned) is typically a positive function of risk – the riskier the product, the higher the expected return.

Stocks (Equities): shares of publicly traded (via an exchange) companies that are an ownership position in a corporation. Shareholder rights include the right to vote at shareholder meetings and to receive any profits distributed by the company (mainly dividends). Stocks are overall more risky than bonds, but also have the capability to provide higher returns. They contain a spectrum within themselves that range from highly risky younger companies to “lower” risk behemoths that have stood for decades. As we’ve seen in the past, though, even the longest tenured companies can go bankrupt– with their shareholders left empty-handed.Check out this Stock Wizard when doing research on stocksto invest in.

Mutual Funds: pool of stocks and bonds (usually) that many investors contribute money to in order to take advantage of the skills of a fund manager. There are different strategies ranging from large stocks to foreign securities to “junk bonds” (risky companies’ debt). A fee is charged to compensate the logistics of managing a large fund.

Exchange-Traded Fund (ETF): funds that incorporate features of mutual funds and stocks: they are baskets of securities (stocks, bonds, etc.) that also trade on an exchange like stocks. They are of lower cost relative to their mutual fund brethren and feature many different strategies (international companies, sectors/industries, foreign currencies, commodities, bonds, derivatives).

Alternative Investments: Derivatives (including options and futures), real estate, gold, even art and other collectibles make up this motley assortment. These types of investments are generally more advanced with more complex risk/reward characteristics. Derivatives “derive” their value from fluctuations of market value of other assets (stocks, bonds, etc.). For example: a stock option provides the holder the “option” to purchase a predetermined number of shares at a specified price. As the stock price goes up, so does the value of the option, and vice versa.

IRA vs. 401(k)

An Individual Retirement Account, or IRA for short, is a more personal form of retirement savings – as it is usually not tied to any employer and created independently. IRAs offer flexibility in a sense that you can invest in a broad spectrum of investment vehicles described in the previous section.

In contrast, a 401(k) only allows the plan holder to invest in certain mutual funds and the employers stock itself. I strongly feel 401(k)s are great for novice investors to focus their investing. The mutual funds offered are generally well-diversified in variety such as large cap, small cap, international, etc. for investors to take advantage of. Another popular option is a mutual fund tailored to an expected retirement date – more on this later.

A 401(k) is offered through your employer. The money contributed is from your pre-tax paycheck. When you withdraw the money from the account, taxes are subsequently paid. This can be a double-edged sword: if you expect to retire in a higher tax bracket (making more money as you reach retirement – applies more so to younger investors) you may be hit hard by Uncle Sam; alternatively, if you’re likely to remain in a similar tax bracket (investors closer to retirement), that impending tax bill doesn’t seem so bad.

The fact that most employers match a certain portion of the employee’s contribution to their 401(k) is another key characteristic to take advantage of. If you’re failing to contribute to your company’s 401(k), you are leaving money on the table by not utilizing your employer’s matching perk. For example, if you invest $100 a month for 30 years into an account that earns an annual interest rate of about 6%, you’d have $97,922.86 at the end of that period. If, instead, you contributed that $100 to a 401(K) in which the employee matched 100% of your contributions, under the same assumptions, you’d have $195,845.70. Make sure you capture this potential gain.

Roth Variation

When “Roth” is placed before IRA or 401(k), numerous tax benefits arise that are not present in their non-Roth brethren.  I like to maximize the tax benefits of the Roth IRA as much as possible, since the account offers individual customization in addition to tax benefits. As opposed to enjoying a tax break for money contributed to the plan, the tax break is granted on withdrawals during retirement. The main restrictions are as follows: so long as you earn less than a modified adjusted gross income of $114,000 for individuals or $181,000 for joint filers the annual contribution limit is $5,500 (post-tax) ages 49 and below or $6,500 ages 50 and above, according to the IRS. There are conditions where you can make a reduced contribution over the limit, but once you earn over $129,000 or for joint filers $191,000, you can no longer contribute to your Roth IRA. This makes it crucial to make use of the Roth IRA while you are still within the income limits.

You’re allowed to withdraw your contributions at any time without penalty before 59 ½ but since the contribution criteria are so stringent, I’d avoid early withdrawal like the plague. The power of compounding as well as the fact that you pay nothing on your capital gains fuels this argument. You can also use up to $10,000 in earnings withdrawals if the money is put towards a principal residence.  Other benefits of a Roth: there are no required withdrawals upon retirement and Roth IRAs can be easily passed on to heirs. Earnings (gains) on the contributions can be withdrawn tax and penalty free after the following: (1) the seasoning period of five years must have elapsed and (2) retirement (reaching 59 ½ years of age) or disability used as justification.

The Roth 401(k) plan is a mixture of the two aforementioned plans: employees contribute funds post-tax and earnings are never taxable. It is not constrained to the same limitations as the Roth IRA (you can contribute up to $17,500 combined to Roth and non-Roth 401(k)s.

What Do I Invest In?

Alright, you’ve made it: your accounts are set-up and it’s time to deploy your capital. With an abundance of investment vehicles available, it can be overwhelming to simply pick stocks from all those available. Allow me to provide some suggestions to begin based on your investment experience level.

Investing Novice

You are aware of the stock market, but have never actively invested in anything. I recommend utilizing the 401(k) and selecting the expected retirement year mutual fund. For example: I will be 65 in 2055 and thus invest in the Fidelity Freedom Fund 2055. While I’m younger, the plan invests in risky assets and as 2055 approaches, reduces the holdings in those that are risky and increases the weight for those that are less risky. The 80/20 approach is a simplified version of this: If I’m 20 years old, I’d invest 80% of my investing assets in stocks and 20% in bonds (using the assumption stocks are quite risky and bonds are relatively and considerably less risky).

As you’re obviously already working for your employer, I’d steer away from investing in your employers stock via your 401(k) contributions – mainly for diversification purposes. As you grow more comfortable investing, you can proceed to invest in a Roth IRA or IRA.

Experienced Investor

Both a 401(k) and IRA are great ways to hedge your abilities as an investor: on one hand, you’re experience can be utilized in the customizable IRA whereas the 401(k ) provides a method of “letting the experts” manage your individual investments by selecting mutual funds managed by “experts.”

Advanced Investor

You’re a pro and already know everything I’ve discussed above. Why are you even reading this? Just kidding. 🙂 At this point, you probably have a pretty sizable sum saved for retirement that is nicely compounding every second of every single day. It’s a great feeling but I’m sure you wonder if you could be doing better. Take advantage of both your employer’s 401(k) and an IRA (ideally the Roth IRA) if they are available.

Though there are a bevy of options offered in most 401(k)s, I like the 80/20 rule (also known as the Pareto Priniciple) and invest mostly in stock funds (large cap, small cap, international). An international or emerging market fund offers another diversification avenue: depending on your opinion of the potential for a particular country or region. The remaining is invested in a “safe” US Government Bond fund. Accordingly, as your perception of the market changes, you can increase/decrease your allocations as you see fit.

For the Roth IRA component of your retirement portfolio, I love taking advantage of the tax benefits by investing in “dividend aristocrats” (S&P 500 constituents that have increased their dividend payouts for 25 consecutive years). In normal taxable accounts, dividends received are taxed at 15%. In your Roth IRA, they are never taxed. To take this benefit one step further, I like to reinvest dividends (receiving additional shares in lieu of a payout). Through the passage of time, this strategy has fared well. It is not for everyone, though, as there are advantages to both reinvesting dividends and collecting the cash.

I am neither a stock picker nor registered advisor, so I won’t solicit specific stocks to invest in, however, I believe these basic tenets of investing are a great foundation to build upon and use as a spring board for your own research as you build your golden nest egg to see you through your post-work life.


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