Ten Rules for the Retirement Road
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Rule 1: Pay yourself first
Paying yourself first means prioritizing your financial well-being and saving for the future. This strategy can include setting aside money for short-term goals like an emergency fund and long-term goals like retirement. One way to pay yourself first is to contribute the maximum amount possible to your 401(k) plan, which many employers offer. These retirement plans often offer matching contributions from the employer, which can help you save more for the future.
In addition to your 401(k) plan, you can invest in Individual Retirement Accounts (IRAs). These types of investments can provide additional diversification and higher returns over the long term. Automatic investment plans, where a set amount is automatically deducted from your bank account or paychecks and invested, can make it easier to stick with a retirement investing program. This is because the money is invested before you can spend it on other things.
While automatic investing does not ensure a profit or protect against a loss in declining markets, it can help you prioritize saving for the future. Many financial advisors and investment professionals recommend paying yourself first as a critical strategy for achieving financial stability and security. By prioritizing saving for the future, you can work towards achieving your long-term financial goals and building a solid foundation for a secure retirement.
Rule 2: Do not let today's debt sink tomorrow's needs
It is important to remember that supporting yourself and your family today is not the only financial responsibility you have. You also need to plan and save for retirement. While reducing or stopping investments in your future to cover current expenses may be tempting, finding other ways to manage them is crucial. This strategy could involve reducing household expenses by cutting back on non-essential spending or negotiating lower rates for bills and services.
When you stop investing for the future, you risk missing out on the potential growth and compound interest your investments could provide over time. This can significantly impact your financial security and quality of life in retirement. It's important to keep contributing to your retirement, even during times of difficulty or when you have new expenses, to stay on track to meet your long-term financial goals.
While it is understandable to feel overwhelmed by financial pressures in the present, it is essential not to let them distract you from planning for the future. By finding ways to manage your current expenses and continuing to invest for your retirement, you can work towards a secure financial future for yourself and your family.
Rule 3: Put time on your side
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Giving your money more time to accumulate can significantly impact your investment return. This is because of the potential earnings on your investments and the annual compounding of those earnings.
When you invest your money, it has the potential to earn returns through dividends, interest, or capital gains. These earnings can then be reinvested, allowing them to make additional returns. This process, known as "compounding," can have a powerful impact on the growth of your investments over time.
For example, let's say you have two hypothetical investors who earn a 6% annual investment return. Investor A starts investing $2,000 per year for ten years, while Investor B waits ten years before investing $3,000 per year for the next ten years. Even though Investor B is investing more money in total ($30,000 versus Investor A's $20,000), Investor A ends up with a more significant nest egg due to the compounding of their earlier investments. Investor A's final account value is $50,042, while Investor B's is $41,915. This is because 60% of Investor A's account is earnings, while only 72% of Investor B's account is their principal investment.
Rule 4: Do not count on social security as your primary source of income
It is essential to rely on something other than Social Security as your primary source of income in retirement because, on average, it will only replace about 40% of your annual pre-retirement earnings. This means that you will need other sources of income to supplement your Social Security benefits to maintain your standard of living in retirement.
There are several reasons why having a variety of outside retirement assets is essential. First, you cannot predict your future Social Security benefits, as they are based on factors such as your earnings history and the age at which you retire. Additionally, the Social Security program is funded through payroll taxes, and there have been ongoing debates about the long-term sustainability of the program. While Social Security is a valuable source of income for many retirees, it is vital to have a backup plan in case your benefits are lower than you expect or the program experiences changes in the future.
Finally, by planning and diversifying your retirement income sources, you can better prepare for the financial challenges of retirement. By building a diverse portfolio of retirement assets, you can ensure that you have a reliable stream of income in retirement and can maintain your standard of living. This retirement strategy can involve saving and investing in 401(k) plans, IRAs, and other retirement accounts and considering other income sources such as rental properties or a part-time job.
Rule 5: Resist borrowing from your 401(k)
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There are several reasons why it's vital to resist borrowing funds from your 401(k) plan. First, borrowing from your 401(k) can result in fixed returns, as the interest rate you pay on the loan determines the amount you earn on that money. This may be a modest return compared to what your money could make if left invested in the financial markets.
Additionally, repaying a 401(k) loan can be challenging, especially if you are trying to maintain contributions to your plan simultaneously. This can make meeting your retirement savings goals challenging, as you may have to redirect some of your savings toward paying off the loan.
Furthermore, switching jobs before repaying a 401(k) loan can have unwanted tax consequences. If you cannot pay off or transfer your loan to your new employer's plan, your loan balance will be considered a distribution from your plan. This distribution is taxable as ordinary income and may be subject to a premature distribution penalty tax of 10% unless you meet the age exemption provided for in the Internal Revenue Code.
Given these considerations, many financial advisors or investment professionals recommend that clients consider borrowing from other sources, such as home equity, before taking 401(k) loans. You should carefully weigh the potential benefits and drawbacks of borrowing from your 401(k) plan and seek a financial professional's advice if you consider this option.
Rule 6: Do not "cash out" retirement plans when switching jobs
Cashing out your retirement account assets when changing jobs may seem like an easy way to access your money. Still, it can have significant negative consequences for your long-term financial security. Here are five reasons why you should consider avoiding cashing out your retirement account assets when switching jobs:
• Tax implications: If you are under 55 and cash out your retirement account assets when switching jobs, you may be subject to income tax and a 10% early withdrawal penalty on the amount you withdraw. An early withdrawal can significantly reduce the value of your retirement savings and make it more challenging to achieve your financial goals in the future.
• Loss of compound interest: When you cash out your retirement account assets, you lose the opportunity for your money to grow through compound interest. This means that the value of your retirement savings will not increase as much over time, which can significantly impact your financial security in retirement.
• Limited options: When you cash out your retirement account assets, you are limited to the options available to you at that time. Suppose you leave your money invested in a tax-deferred vehicle, such as a 401(k) plan or an Individual Retirement Account (IRA). In that case, you can choose investments that align with your financial goals and risk tolerance.
• Loss of employer matching contributions: If your employer offers matching contributions to your retirement account, cashing out your assets when switching jobs means you will lose out on those contributions. This can significantly reduce the value of your retirement savings over time.
• Risk of spending money: When you cash out your retirement account assets, you may be tempted to spend the money on non-essential items rather than saving it for the future. This can make it more challenging to achieve your financial goals and may leave you without sufficient funds for retirement.
Instead of cashing out your retirement account assets when switching jobs, you generally have three options for keeping your money invested in a tax-deferred vehicle:
• Keep it in your old employer's plan
• Roll it into an IRA
• Roll it into a new employer's plan
Each option has advantages and disadvantages, and it is essential to consider your unique financial needs and goals when deciding. A financial advisor or investment professional can help determine your best option.
Rule 7: Take advantage of your IRA options
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Investing in an Individual Retirement Account (IRA) can be a valuable way to save for the future and achieve your financial goals. There are two main types of IRAs: traditional IRAs and Roth IRAs. Both types of IRAs have different eligibility requirements and features, and you should consider the differences between them to determine which option is best for your situation.
Traditional IRAs offer tax-deductible contributions, which can reduce your current tax bill. This can benefit investors in a high tax bracket looking to lower their tax burden. Additionally, traditional IRAs offer a range of investment options, including stocks, bonds, and mutual funds, which can provide the potential for long-term growth.
On the other hand, Roth IRAs offer tax-free distributions if certain conditions are met. Contributions to a Roth IRA are not tax deductible, but the money you withdraw from a Roth IRA in retirement is generally tax-free. This can be a valuable source of tax-free income in retirement, especially for those who expect to be in a higher tax bracket. Roth IRAs also offer flexibility, as owners are not required to take any distributions during their lifetime.
When deciding between a traditional IRA and a Roth IRA, it's essential to consider your financial goals and circumstances. It's also important to consider your age and how long you have until retirement, as this can impact the potential tax benefits of each type of IRA. A traditional IRA may be a good option if you primarily want to reduce your current tax bill. A Roth IRA may be a better choice if you are more interested in tax-free income in retirement.
Investors should also consider making annual IRA contributions to maximize their potential benefits. Annual contribution limits have increased over the years, making IRAs a more valuable way to invest for retirement. Individuals over age 50 can make additional "catch-up" contributions each year, which can help them catch up on their retirement savings if they have fallen behind.
Your financial advisor or investment professional can help you determine which IRA could work best for your situation based on your financial goals and circumstances. They can also help you decide on an investment strategy and choose suitable investments for your IRA. Taking advantage of your IRA options and investing consistently over time can build a strong foundation for your financial future.
Rule 8: Compare the merits of Roth contributions and pretax contributions
Roth IRA contributions and traditional IRA pretax contributions are two options for saving for retirement, each with unique benefits and drawbacks. Investors should consider their financial goals and circumstances when deciding which option is best.
One key difference between Roth IRA contributions and traditional IRA pretax contributions is how they are taxed. Contributions to a traditional IRA are made with pretax dollars, which means you can deduct your contributions from your taxable income in the same year. On the other hand, contributions to a Roth IRA are made with after-tax dollars, which means you cannot claim a tax deduction in the current year. However, qualified Roth IRA distributions in retirement are generally tax-free, while traditional IRA distributions are taxable as ordinary income.
Both Roth IRAs and traditional IRAs have eligibility requirements that you must meet to contribute. For example, you must have earned income to contribute to either type of IRA. There are income limits that apply to Roth IRAs. In addition, Roth IRAs and traditional IRAs offer a range of investment options, including stocks, bonds, and mutual funds. Your investment strategy should align with your financial goals and risk tolerance.
Traditional IRA owners must begin taking required minimum distributions (RMDs) at age 72, while Roth IRA owners are not required to take any distributions during their lifetime. Roth IRA owners have more flexibility and the potential for long-term growth, as they can leave their money invested for as long as they like.
Rule 9: Do not try to time the stock market
Trying to time the stock market can be risky and potentially costly for investors. While it may seem like a smart strategy to try to get out of the market when you fear a crash and get back in when you expect a boom, the reality is that no one can consistently predict the short-term events that push the market up or down.
One of the main risks of trying to time the stock market is the potential loss of returns. If you get out of the market when you think it will experience a significant correction, you may miss out on potential gains if the market does not decline and instead continues to rise. Similarly, if you try to get back into the market after a correction, you may miss out on potential gains if the market continues to decline.
Another risk for investors trying to time the market is the potential for increased volatility. When you frequently shift your money in and out of the stock market, you expose yourself to the risk of wild price swings. This strategy can be risky if you try to time the market based on your predictions rather than relying on a well-diversified investment strategy.
Finally, investors who try to time the stock market may incur increased trading costs. Every time you buy or sell a stock, you incur trading costs in the form of brokerage fees, which can eat into your potential returns. These costs can increase quickly if you frequently buy and sell stocks to time the market.
Overall, investors should consider an investment plan customized to their goals, time frame, and risk tolerance. Your strategy should include diversifying your investments, allocating them among different asset classes and sectors, and rebalancing on a periodic schedule.
Rule 10: Use the Allocate, Diversify, and Rebalance (ADR) Strategy
When you have specific long-term financial goals, you must also account for risk when investing your money. As part of a disciplined diversification investment strategy, the Allocate-Diversify-Rebalance (ADR) approach can help you find and maintain your balancing point so you can pursue your goals at a level of risk you find comfortable.
The first step is to allocate your assets across the major asset classes – stocks, bonds, and cash - to pursue the optimal returns for the level of risk you are willing to undertake. An investor with a 10-year or longer time horizon could consider a portfolio of 60% equity and 40% fixed income.
Secondly, investors should diversify within each asset class to take advantage of different investment styles and sectors. Investment styles can include growth and value, or size – small, mid, and large stocks. Investment sectors can include fixed-income sectors such as government and corporate bonds.
Finally, investors should consider rebalancing their portfolios semi-annually or annually. Rebalancing will help you maintain your desired allocation. Market activity can shift the percentage of your portfolio dedicated to each asset class.
Please remember that no investment strategy, including diversification or ADR, can ensure a profit or protect against a loss. In addition, all investments, including exchange-traded funds (ETFs) and mutual funds, carry a certain amount of risk, including the possible loss of the principal amount invested.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
Portions of this article were sourced from the work of MFS Heritage Planning. Neither MFS nor any of its subsidiaries are affiliated with Optima Capital Management.
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