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How to invest for retirement: What you should know

At a glance:

  • Know your time horizon

  • Volatility in retirement investing

  • Asset allocation in retirement investing

  • Tax considerations in retirement investing

  • Summary of retirement investing

  • Practical ideas you can start with today

The idea of saving money for retirement seems easy enough. The more money you save and the more wisely you invest it, the more financial freedom you will have when you retire. But the way to approach retirement funding depends on many factors.

Factors such as your present age, investment risk, and taxes will determine how you must plan for a successful retirement.

How you save for retirement is affected by your retirement time horizon. The longer you have to save and invest, the more appropriate investment options you will have available to use. Your retirement investment allocation is also affected by your risk tolerance.

Bruce and Esther Huffman sit a their computer in McMinnville, Ore. (Photo: AP Photo/Rick Bowmer)
Bruce and Esther Huffman sit a their computer in McMinnville, Ore. (Photo: AP Photo/Rick Bowmer)

If you are able to avoid taxes on your retirement savings, your savings should benefit. However, you also need to consider the tax effects on your retirement withdrawals.

The strategy you choose for funding your retirement depends upon many factors. You need to give them careful consideration before rushing into one investment or another.

Know your time horizon

You will not always want to use the same strategies for investing your retirement money wisely. You may want to change your investment strategy depending on whether you are still getting ready to retire or whether you are already retired.

The power of time

The longer your money grows, the more you will have for retirement. The money you have available for retirement will depend on how much you save, how long you let your savings grow, and at what rate your savings grow.

Deciding how much to save depends on the standard of living you'd like to obtain and how much you see yourself spending. Start with your monthly expenses now and ask yourself what would change in retirement. Plan for a few more years of retirement than you think you'll need.

What does time horizon mean?

Your time horizon is the amount of time you have available to save toward your goal. All other factors being equal, longer time horizons enable us to assume more risk. The younger you are, the more aggressive you might be willing to be with your long-term investments.

If you're close to retiring, you might choose to make safer investments with lower returns, because the risk of losing your money in the short term is higher. But remember, your retirement can span twenty or more years, so you may want to maintain a portion of your investments in higher-risk securities for the potential higher return.

Inflation can be significant over twenty years, and it will likely be necessary to keep a significant part of your investments in securities that can keep pace with or outpace inflation.

Your decision will ultimately depend on when you plan to retire and how long you expect your retirement to last. If you plan to go back to work after you retire, you might invest in safer, low-return investments after you retire but take more risks with your long-term investments in pre-retirement years.

Don't forget price increases

You should also consider inflation. Prices generally rise over time. A dollar today will buy fewer things tomorrow. It will take more money in retirement than now to enjoy the same standard of living. Your investments should increase at a higher rate than inflation to stay ahead of rising costs.

Be flexible

Your investment time horizon will change as you approach retirement, and will continue to change when you're in your retirement years. The longer your time horizon, the more you can take advantage of the high return potential of volatile investments.

As your horizon shortens, however, you'll need to pay more attention to protecting your capital and receiving income, while still defending yourself against inflation.

Volatility in retirement investing

If you are looking for large returns on your retirement investments, you'll need to accept more risk.

The greater the risk, the greater the potential rate of return. We often describe risk in terms of volatility, i.e., the amount your investment values fluctuate up and down over time.

Volatility potentially can work in your favor during the accumulation investment phase. It becomes more of a concern when you need to withdraw money, because it may be during a period when the markets and your account values are down.

Stocks: volatility and return

Historically, stocks tend to have the highest rate of return compared to bonds and cash. Of course, they also have the greatest risk due to their higher volatility. The longer the period of the investment, the lower the overall volatility, because the long-term growth trend of a stock tends to overcome short-term price drops. If you are close to retirement, you may want to stay away from investments that are more volatile.

However, if your retirement is still many years away, it may pay to invest in these volatile markets.

Let's say you invest a lump sum of $100,000 in a highly volatile asset returning an average annual rate of return of 10 percent over 25 years. The year you retire, it suddenly drops by 25 percent. The value of your investment after the drop is $813,000.

If you had invested that same $100,000 lump sum in a less volatile investment with a 6 percent return and experienced no 25 percent loss in the final year, you'd still have only $429,000 after 25 years. So even with a significant loss, it paid to invest in the more volatile investment.

While volatility increases the risks of an investment, its potential to increase returns may make it worth seeking if you have a long time to invest for retirement.

Learn more about the risks of investing. [Popup text: Investing involves risks, including fluctuation in value and possible loss of principal. Generally, greater volatility means greater risk. No investment provides guaranteed returns. You should consider your risk tolerance, investment horizon, liquidity, and other personal factors before purchasing any investment product.]

Asset allocation in retirement investing

What kinds of investments should you choose to build your retirement nest egg? The answer is likely to change with the passing of time.

What is asset allocation?

Putting your money into different investments in different amounts is called asset allocation. The amount you invest in any particular kind of asset depends on (among other things) your time horizon for retirement.

In the short term, cash, certificates of deposit (CDs), and bonds have returns that are the most dependable and the least volatile. But generally, along with lower risk comes lower returns. In the long term, equities such as stocks may have higher returns than other investments.

So if you are 30 and have a long time until retirement, you might want to consider placing a larger percentage of your investments in stocks than in fixed-income investments. If you are about to retire, you might want to start investing more in bonds and CDs than in stocks.

The importance of knowing your risk tolerance

The way you allocate your investments also depends on your risk tolerance — in other words, how much of your investment you can afford to lose and are comfortable with losing. If you have a high tolerance for risk, you may be more comfortable in more volatile investments such as stocks, regardless of your age. On the other hand, if you have a low risk tolerance, you may want to seek out more conservative investments.

You might also want to reallocate some of your investments upon reaching retirement. For example, even if you decide to keep the majority of your investments in long-term, higher-risk assets, you may want to move some of your money into short-term, low-risk assets that are designed to generate monthly income and decrease volatility.

What the research says

Research has shown that the asset allocation of your investments has a greater impact on your returns than the particular investments you choose, so it is important to consider carefully how to allocate your capital among investment classes as you plan for retirement. Asset allocation is no "magic bullet," however. It does not assure a profit or protect against loss.

Tax considerations in retirement investing

The taxes you'll owe on your retirement money depend on the decisions you make before and after you retire.

The value of postponing taxes

The longer you can postpone paying your taxes, the more likely it is that you can make your money work for you. Paying taxes later instead of today is known as tax deferral. By investing in tax-deferred investments, money normally used to pay taxes stays in your account, potentially building your investments faster.

Even after paying taxes in retirement, you'll generally have greater income and account values than by investing in regular taxable accounts along the way. Individual retirement accounts (IRAs), 401(k)s, and annuities are examples of tax-deferred savings plans.

Plan your withdrawals carefully

The amount of tax you owe at retirement depends not only on your income, but also on the timing of your withdrawals. Distributions from retirement plans and annuities are taxed at regular income tax rates. You must begin receiving minimum distributions from most retirement plans at age 70½ or there will be a considerable tax penalty.

The exceptions to this rule are Roth IRAs and non-qualified annuities (annuities outside of retirement plans). In most cases, you will also be penalized for withdrawing retirement income before age 59½. This applies to retirement plans and non-qualified annuities.

What is tax efficiency?

A mutual fund is an investment company that raises money from investors to invest in stocks, bonds, and other securities. It is a portfolio made up of several individual investments. When those investments gain or lose value, you gain or lose as well. When they pay dividends, you get a share of them.

Mutual funds also offer professional management and diversification. Mutual funds have fees and expenses, and investing in them also involves risks including but not limited to the possible loss of principal, all of which are all outlined in the prospectus.

You also have the choice of putting your money into tax-efficient or tax-managed mutual funds. Tax efficiency refers to the after-tax return of an investment in comparison to its pre-tax return — in other words, how much of your investment return is lost annually to taxes.

A fund with low turnover rates and smaller dividends is probably tax-efficient. By investing in a tax-efficient fund, you defer paying most of your taxes until you sell your shares.

A Schwab Institutional brokerage account application form from the Enrichment Group is shown in Miami. (Photo: Joe Raedle/Getty Images)
A Schwab Institutional brokerage account application form from the Enrichment Group is shown in Miami. (Photo: Joe Raedle/Getty Images)

A tax-managed fund invests with tax-efficiency as a goal. Tax-managed funds use trading strategies to reduce taxes. Stocks and stock-based funds often pay capital gain dividends that are subject to long-term capital gains taxes. Tax rates on any long-term capital gains are lower than on regular income for most individuals.

These rates are also lower than the rate at which other kinds of investment returns are taxed, such as most bond interest, and even income from retirement plans such as IRAs and 401(k)s. Other tax-efficient investments include municipal bonds, which generate tax-exempt income, and US savings bonds, which allow you to defer your taxes until your bonds are redeemed.

Being aware of the tax implications of your retirement investing decisions can mean thousands more dollars in your pocket when you retire.

Summary of retirement investing

Saving for retirement isn't simply a matter of stashing your money away for later. It is an involved process with many factors to consider. Ask yourself questions like the following:

  • How many years do I have before I need to draw on my retirement investments?

  • What is my tolerance for risk — how much can I afford to lose on a poor investment choice?

  • Will I benefit from current income tax savings — will I likely be in a higher or lower income tax bracket when I retire?

Using your answers to questions like these will help you design a retirement plan asset allocation model that will work for you. Here are some additional ideas to try:

Practical ideas you can start with today

  • Add up your monthly expenses to get a sense of how much you need to live on. Ask yourself what would change in retirement.

  • Determine your risk tolerance.

  • Create a diversified portfolio of investments that is likely to provide the greatest return in keeping with your risk tolerance.

  • Meet with a financial planner or investment advisor to craft an investment plan that can fund your retirement.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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