Retirement Investing
Investing can be incredibly simple, or incredibly complex – we’re going to make it simple for you here, and provide access to additional resources for you to make it as complex as you would like! So let’s dive into retirement investing 101! But before we do…
The Basics
There are two buckets of Investing that we are concerned with:
- Retirement investing
- Shorter-term investing
The strategies for these two buckets should be different, especially when you are further from retirement. When we talk about strategies, we are really thinking about the risk you take on with the investments you select for your money (your “portfolio”). Equity stocks (pieces of companies) are widely considered to be riskier than bonds (money borrowed by companies), particularly government bonds (money borrowed by the government), which are essentially loans that you receive interest on for the life of the bond. The sooner you need the money, the less risky your portfolio should be, i.e. you should have more bonds and fewer equity stocks.
“Smart Investing”
Over the long term, the stock market has averaged annual growth in the high single digits or low double digits, depending on what indicator you use to measure market growth. So for money that you don’t need in the near future, such as retirement accounts when you’re in your twenties, it makes sense to take on more risk. You can afford to take a hit if the market has a year or two in decline, and you will most likely recoup your losses and still end up with strong returns over a long period of time.
A famous trope associated with the stock market is that “time in the market, not timing the market” is how to grow your investments. The truth is that smart investing is pretty boring, particularly when it comes to your retirement accounts, and that the best approach is often to “set it and forget it”, revisiting periodically to adjust the amount of risk as time passes.
Retirement Investing (Long-Term)
What Sort of Account Should I Have?
There are multiple types of retirement accounts, with the two most common being 401(k), offered through your employer, and Individual Retirement Arrangement (“IRA”), which is set up by you, the individual. There are two types of each account with the same name, Traditional and Roth. Once you contribute money to these accounts, you are then able to invest that money in stocks, bonds and other types of assets that you can watch grow as you make your way towards retirement.
For those that have less common retirement accounts through a non-profit or government agency you may have a 403(b) or 457(b). They operate very similarly to an employer 401(k). For simplicity purposes follow along with 401(k) though do note the 403(b) and 457(b) include some beneficial features that are superior to a 401(k). For more information check the IRS webpages for 403(b)& 457(b).
Traditional Accounts vs. Roth Accounts
Traditional accounts are funded with pre-tax dollars, i.e. you won’t be taxed on contributions you make to those accounts. With a traditional account, you will ultimately pay ordinary income tax on withdrawals you make in retirement.
Roth accounts are the opposite, whereby you make contributions using post-tax dollars, i.e. money you’ve earned and paid tax on. In this case, you won’t be taxed on withdrawals you then make during your retirement.
Employer Sponsored 401(k)
Traditional 401(k) accounts are the most common retirement accounts, and the easiest to contribute to. Many employers have a 401(k) program that you can sign up for, and have contributions taken directly out of your paycheque. Most of those employers will also offer what’s called a “401(k) match”, whereby they will contribute the same amount as you to your account up to a certain percentage of your salary, essentially giving you free money towards your retirement. There are limits on how much income you can contribute to these accounts each year, which we will get further into in the next section.
Roth 401(k) accounts function in exactly the same way as Traditional accounts, except that the money contributed to the account has already been taxed. More and more employers are starting to offer a Roth style 401(k) in addition to a Traditional one, and you can in fact have both if you want. Indeed, any employer match has to be contributed pre-tax, so that amount at least will have to be contributed to a Traditional 401(k).
Retirement Accounts You Can Open
A Traditional IRA account is similar to a Traditional 401(k), but instead of being set up through your employer, it is set up by you. Check out our Marketplace to see our recommended Investment account providers, through whom you can set up an IRA. The contribution limits are different for these accounts, and there are limits on who can contribute to an IRA based on how much money you make each year. Again, as with the 401(k) accounts, the main difference between the Traditional and Roth IRAs is that you contribute money you’ve already paid tax on to a Roth IRA.
Note: if your employer offers a 401(k) retirement plan or similar, you will not qualify for pre-tax contributions to an IRA.
So the answer to the question of what account you should have is really “all of them”. If you aren’t sure whether you’ll be able to afford to put into these accounts, we have put together a hierarchy of contributions below for what to target first. As you think about what accounts you need though, you should automatically be enrolled in any employer 401(k) when you join a company, and it will likely be a Traditional account that you have to actively choose to add a Roth 401(k) option to.
Alongside these accounts, you should have both a Traditional and a Roth IRA. To the extent that you need/are able to, this will offer you the chance to get a tax refund on contributions to your Traditional IRA, and as your income rises and eventually becomes too high to contribute to a Roth IRA, it will enable you to do what is known as a “Back-door Roth Contribution”. This is easiest if the IRA accounts are held with the same financial institution.
How Much Money Should I Put Into My Retirement Accounts?
As discussed above, there are limits on how much money you can contribute to a retirement account. Generally, if you are able to afford it, you should maximize the contributions you can make up to the limits set by the government. The IRS has handy webpages where you can find the current contribution limits for 401(k) and IRA accounts. If you can’t afford to maximize those contributions, or you’re not sure, we’ve put together a hierarchy of what contributions to focus on first, and then where to go next as your income rises.
Retirement Account Contribution Hierarchy
- Traditional 401(k) up to your employer match OR Traditional IRA up to the contribution limit if your employer doesn’t offer a 401(k) or similar retirement account
- Roth 401(k) if available, up to your employer match
- Traditional 401(k) up to the contribution limit
- Roth 401(k) up to the contribution limit
- Roth IRA as long as you remain under the income limit
- Backdoor Roth IRA contribution (no income limit applies here)
But…
There is an important caveat here, demonstrated in the example below, that this hierarchy is targeted towards younger people. As you get older and your income probably rises, you will be in a higher tax bracket, and have less time to make the gains on retirement investments that make a Roth account so appealing. At this point, likely some time in your mid to late 40s (assuming you start taking distributions at 60), you will probably want to go back to making Traditional 401(k) contributions. If you are covered by a 401(k), you won’t be able to make tax deductible Traditional IRA contributions in any case, so you would continue with Roth IRA or Backdoor Roth IRA contributions at that point.
The good news for folks older than 50 is that the IRS allows catch up contributions over and above the maximum contribution limits for that age group. You can find the current retirement investing catch up maximums here.
A demonstration of the tax situation
Maritza the Ostrich is back, and she’s trying to decide how much money to put into her retirement account, and what sort of account to use. Maritza is 32, single and making $100,000 annually, but her employer only offers a Traditional 401(k), not a Roth. That being said, they will match 100% of her contributions up to 3% of her salary. Maritza also has Traditional and Roth IRA accounts, but because she is able to contribute to an employer sponsored 401(k), she does not qualify for pre-tax Traditional IRA contributions. Her effective tax rate (including state and local taxes) is 25%.
Gross Annual Income: $100,000
401(k) Contributions: $19,500 (limit for 2020)
401(k) Employer Match: $3,000 (3% of $100,000)
Taxable Income: $100,000 – $19,500 = $80,500
Net Income After Tax: $80,500 x 0.75 = $60,375
Roth IRA Contributions: $6,000 (limit for 2020)
Income After Tax and Roth IRA: $54,375
So Maritza contributed a total of $25,500 to her retirement accounts, and thanks to her employer match, got an additional $3,000 for free on top of that. Now let’s assume that she retires at 60, in 35 years, and that in the meantime, the money she has put in her retirement accounts earns a 6% return each year from investments.
Example Retirement Investing Withdrawls
This example is simplified by necessity, but will also demonstrate the power of compounding, and investing in your retirement as early as possible:
401(k) Balance in 2020: $22,500
401(k) Balance in 2055: $22,500 x 1.06^35 = $172,937
Roth IRA Balance in 2020: $6,000
Roth IRA Balance in 2055: $6,000 x 1.06^35 = $46,117
As you can see, putting money away early is incredibly valuable! Now Maritza finds herself with a total retirement balance of $219,054 just from her savings of $25,500 that she made in 2020. In this simplified example, let’s assume that Maritza needs to withdraw all of that money in 2055 (she’s living a LAVISH lifestyle at that point), and assume that her effective tax rate is still 25%. Now we start to see the difference between a Traditional account and a Roth account:
Traditional 401(k) Withdrawal: $172,937
Tax Owed on 401(k) Withdrawal: $172,937 x 0.25 = $43,234
Traditional 401(k) Withdrawal, Net of Tax: $129,703
Roth IRA Withdrawal: $46,117
Tax Owed on Roth IRA Withdrawal: $0
So in this example, we see that Maritza has to pay over $43k in taxes on the Traditional 401(k) withdrawal – that’s more than double her original contribution, and almost as much as she withdrew from the Roth IRA account!
So what’s the upshot?
Although it’s always wise to put money into a retirement account whether it’s Traditional or Roth, if you’re young and can reasonably expect that the gains on your investments will be greater than the original contributions, it is better to contribute to a Roth account if you’re able to. As you get older and your income likely increases (alongside which, so will your tax bill), there will come a point where it will probably make sense to switch back to making Traditional contributions, and taking the tax deduction up front.
What should my portfolio look like?
Finally, we get to the really difficult bit… the reason this is such a tough question is because the answer is different for almost everyone! The reason for this is that the pieces making up the pie that is your portfolio should be different based on your appetite for risk. Risk is a difficult thing to effectively measure and quantify. But at least from an investment standpoint, we have a pretty good idea of what constitutes a less risky vs. more risky investment. The following list is simplified and excludes many of the more esoteric types of assets, but can be thought of as a general rule of thumb:
Least Risky
- Cash
- Government Bonds (money borrowed by the government)
- High Quality Corporate Bonds (money borrowed by companies)
- Lower Quality Corporate Bonds
- Publicly Traded Company Equity Shares (portions of companies available for anyone to buy on the stock market)
- Private Company Equity Shares (portions of companies only available to Accredited Investors)
Most Risky
When you’re young, it is generally advised that you hold high growth investments (often considered more risky), as you have the time to recover from blips in the market (such as the one experienced in February/March 2020 due to COVID-19) before you need to withdraw money from your investments. As such, your portfolio would skew towards equity shares to begin with, holding a little cash and bonds as protection in the event of a downturn. As you get older though, it makes sense to rebalance your portfolio, and start to reduce the risk you have by selling some equity shares and buying more bonds with the money that you have available from those sales. This helps protect your retirement investing and your nest egg.
Build Your Retirement Investment Portfolio
Building a portfolio that incorporates all of these types of assets (and potentially more) across different sectors and countries can feel incredibly overwhelming. Fortunately, there is a much easier way to achieve the right mixture of assets to ensure that you have the opportunity to achieve strong returns (increases in value) whilst protecting yourself from downturns. Mutual Funds and Exchange-Traded Funds (ETFs) operate like a basket of of stocks and bonds, taking the decision on what individual investments to make out of your hands, and picking them for you based on thousands of hours of research and experience, or zillions of bytes of data in the case of “robofunds”.
You can do your own research into each of these funds, pick sectors of the market or countries that you think will do well and invest in funds that specifically focus on those areas. Or… you can choose a selection of the broader funds that cover large parts of the market in one go, and just invest in those. This can be the easiest way to put your money to work, especially in the long run when you want to be able to revisit your portfolio only periodically to make adjustments.
This Money Under 30 Article conveniently summarizes three fund portfolios that you could use to gain exposure to the market, as well as showing how you would adjust the balance of that portfolio as you get older.
That’s it for Ostrich’s retirement investing guide!
Now check out Investing 101 Part 2: Short-Term Investing for more info on achieving your short-term investment goals. You can also take a look at our other 101 guides such as Debt 101, Saving & Budgeting 101 and Giving 101.
