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Investing in your retirement
So you want to retire to the islands and live on a giant yacht? Or maybe you just want to know that you don’t have to work. Whatever your goal, getting there fastest is simply a matter of optimizing your financial situation and, perhaps, exercising a little restraint.
Step 1: Pay down debt
Chances are, there’s an MBA somewhere in the world (probably Delaware) coming up with clever ways to fuck you. His plan: extend easy credit when you need it most, and then jack up your interest rates when you can least afford it. Maybe he’ll offer you a credit card with no limit (but at a 24% interest rate), or maybe he thinks you’re a little more sophisticated and instead offers you a variable rate HELOC that allows you to borrow against your house at the low, low rate of 7% per year (for now, anyway).
You can steer your nest egg safely away from the vultures by refusing to incur any debt that isn’t good debt. Good debt is debt covered by interest that is fixed, tax advantaged, and guaranteed against legal loopholes by the federal government. If you’re like most people, a conventional 30 year mortgage and a school loan are the only good debt you’ll ever hold.
If you do have some bad debt (such as a credit card or a second mortgage), you should pay it off before investing too heavily in retirement. If you’re lucky, you might get your money to grow at 10% per year in the stock market, but that won’t be much good if you’re losing 12% a year on your debt.
Step 2: Get a tax shelter
Remember that MBA in Delaware? There’s someone in Washington who plans to take an even bigger bite out of your ass. If you do nothing, the federal government will take 25-40% of your earnings every year for the rest of your life. And if you still manage to invest a little after that, the government will take an additional 20% of any distributions from your investments. If debt is the quickest way to get poor in America, the quickest way to get rich is to pay the government as little as possible.
Luckily, there are a number of ways that you can delay some taxes and avoid paying others all together. Start with your employer. Most companies with more than 10 employees offer employer-sponsored retirement plans. Under such a plan, you should be able to put about $15,000 per year of your own money into the stock market (or bonds) without paying a penny in taxes. If you can afford to do so, you should make the full contribution. At the very least, you’ll be holding on to an extra $5,000 per year. If your employer matches your contributions, you’ll get even more out of the bargain. (If your employer doesn’t offer retirement benefits, ask a broker to set you up with a SEP plan).
You can also invest a smaller amount in an IRA. A traditional IRA works just like an employer-sponsored retirement plan: you save the most by not having to pay taxes on your earnings this year. A Roth IRA, by contrast, demands that you pay taxes on your earnings now, but then you never have to pay taxes on that money again. For most people, a Roth IRA is the better option because it forces you to save more (by paying the taxes now). If you’re making a lot of money now and plan to make a lot less when you retire, though, a traditional IRA may be the better solution.
Once you’ve picked your tax shelter, you’ll need to specify where the money goes. Few employer-sponsored plans allow you to invest directly in stocks, but you usually have a healthy choice of mutual funds. The smartest (and simplest) choice is usually to invest everything in a single index fund or exchange traded fund (ETF) that tracks the broadest section of the US stock market. If you don’t see a single fund for the whole stock market, you may need to cobble together a mix of two or three funds (for example, you might put 40% in a large cap fund or S&P 500 fund, 30% in mid-caps and 30% in small-caps). Avoid ‘life cycle’ funds and ‘growth’ funds. These funds generally have high management fees.
Step 3: Buy some stocks
If you’ve paid off your bad debt and are fully funding all tax-shelters at your disposal, you’re better off than most people. In both your IRA and in a separate brokerage account, you can now begin to invest directly in stocks. The benefit of stock investing is that you’re no longer paying any management fees, and you’re no longer tying your investments to a vehicle that buys stocks when others are buying them and sells them when others are selling them (which, in both cases, is the worst time to make a transaction).
This only works in your favor if you keep your trading to a minimum (that is, buy a stock and hold on to it forever) and diversify. If you need help picking stocks, see our piece on Investing in stocks.