Retirement Savings 101 - Educate Yourself Early for Financial Freedom in Retirement - Smart Money Seed


Retirement Savings 101 - Educate Yourself Early for Financial Freedom in Retirement

You see, young stud, if you follow the information in this
article, you'll never have to worry about your financial future!

Okay maybe you don't need this information quite that early. And maybe that was just a dumb excuse for me to show off how cool my earruffs... err... earmuffs were. But the point is, if you follow this advice early and stick with it, you'll be sitting pretty when retirement comes around!

We've taken the first half step towards helping you plant your retirement seeds with a high level investing discussion. Your retirement savings are a long-term investment that should be overwhelmingly comprised of mutual funds and ETFs especially for younger investors. If you're new to the investing game, give yourself a refresher with that post and come back to us.

Our generation has been bombarded since well before our working lives that saving for retirement early and often is probably the most important tool available to us in our financial lives. Market returns can contribute substantially to our wealth building process over our 40 year working lives.

But generally speaking, that's where the advice stops. Nobody cares to take the time to explain what or how to invest for retirement which leaves hungry young professionals with good intentions but poor knowledge and preparation.

The Skinny

The true power of retirement investing is a magical phenomenon called compound returns. When you invest money, the money you take out of your pocket is called your principal. Your principal makes a return on the market and then the returns start making their own returns. 

The easiest way to illustrate this is with graphs. I found a great tool that simplistically lays this out for us which I used back in our first post. This graph is showing the compound returns over 20 years from an initial investment of $1,000 assuming a 10% annual return. The interest from your principal will be $100 per year which means you'll have $3,000 over the 20 years, right? 

Not quite, Dwight. Because of the power of compound returns, you will end up with nearly $7,000 after 20 years! The amount of return you make off your returns actually exceeds the amount of return you make off your initial investment. 

Graph and calculation courtesy of MSN Money.

And it doesn't have to stop there. Compound returns cause your money to grow exponentially. For example, if you invested in that same scenario over 40 years, you would end up with over $45,000!

That's great, but what does this have to do with saving for retirement?

Great question, Alex! You're so smart, awesome, funny, and handsome.

 Retirement savings are a long-term investment. If you're in the workforce, you need to have a retirement account. If you don't already have an account, go establish one right now. We'll wait for you.

Types of Retirement Accounts

Private sector workers have two main options for retirement accounts: 401(k) and IRA. A 401(k) is a company sponsored plan where you can invest pre-tax dollars in a traditional 401(k) or post-tax dollars in a roth 401(k). Roth 401(k)s are not quite as popular but are starting to be offered by more and more employers. 

Often times employers receive discounts on fee structures and may offer a company match on some level of investment you make yourself. For example, Marathon matches the first 7% I invest in my 401(k). Both 401(k) options are easy set it and forget it options since the money can come straight out of your paycheck before it hits your bank account.

IRAs, or Individual Retirement Accounts, are accounts you directly setup with a financial institution. Similar to the 401(k), you have an option of a traditional IRA or a Roth IRA. Often times you can setup an IRA through the same institution and platform you use for your company's 401(k) plan. If not, just Google how to setup an IRA. That type of advice is why we get paid the big bucks, folks.

Generally speaking, you should utilize traditional accounts if you think you're in a higher tax bracket now than you will be in retirement, and you should utilize roth accounts if you think you'll be in a higher tax bracket in retirement than you're in now. Many people utilize some mix of both to diversify their risk. The important thing to remember is that traditional dollars are taxed when you withdraw the money and roth dollars are taxed now.

Investment Options

Within a 401(k) or IRA, you will face multiple investment options which can be somewhat overwhelming if you don't know what to look for. My recommendation if you're new to the investing game is to keep it simple. Invest in a target date or lifecycle fund which will start out risky and gradually lower risk as you get closer to retirement or index funds which will generally follow the overall stock market.

The important attributes of any fund you need to be cognizant of are the age of the fund and the expense ratio. Generally speaking, I would not recommend any fund with an age less than 5 years or an expense ratio greater than 1%.

My Retirement Investments

I invest 10% of my income into a traditional 401(k) account. 10% is a good number to shoot for with 15% being what is widely considered the ideal threshold to all but ensure a financially prosperous retirement. Because of my company match, 17% of my income is being invested for retirement, so I'm on a pretty good path.

70% of my money is invested in an index fund which follows the S&P 500 (0.01% expense ratio) and 30% is in a mutual fund focused on growth stocks (0.4% expense ratio). Growth stocks are generally newer companies that have some probability to grow and produce high returns.

They are also more risky than a company in the S&P 500 since they have a shorter track record, so the growth stock funds tend to be more volatile. My year to date rate of return is about 16% which is slightly better than the return of the S&P 500 around 14%. I expect those numbers to be very similar over the life of my retirement accounts.

Experts suggest that you save 10-15% of your income for retirement. If that's a stretch for you, start with 5 and increase your savings rate by 1% each year. Another strategy my dad learned early in his career and has used is to put half your raise towards savings (retirement or otherwise) each time you get a raise.

Fortify Your Financial Future

Investing is a powerful tool over the long haul- especially when we're talking about investing for retirement. It's important to setup your investments as almost a set it and forget it with regular monthly or quarterly check-ins.

DO NOT ACTIVELY INVEST ON A PASSIVE BASIS. Don't trade individual stocks or constantly switch your retirement accounts. If you're in a vastly under-performing account, switch to something with a longer, solid track record. If you see an individual stock kicking the crap out of the market, let it go. You don't want to introduce the risk associated with actively trading into the determination of your future financial well-being. Unless you're essentially dedicating your life to learning the trade, you will not beat the market.

Don't freak out when the market dips. It will happen, but the market will come back. It always does. The market has produced an average return of 10% over the past 90 years which we have every reason to continue to expect over a long period of time. Start investing now and stay investing throughout your working life.

When you're sitting on a beach at 65 sipping an ice cold Corona or pina colada, don't forget to thank Smart Money Seed!

For more retirement advice (and some overlapping advice), check out the second episode of the Smart Money Seed Podcast!

PS: The earmuffs actually didn't even really stay on that well. Beauty hurts.

1 comment:

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