31 Days to Financial Independence (Day 23): Investing for Retirement

31 Days to Financial Independence” is an ongoing series that appears every Thursday on The Simple Dollar. You might want to start this series from the beginning!

Last time, we put a capstone on our discussions of how to spend less money and how to earn more money by looking at how they come together to form a “gap” between your income and your spending.

That “gap” is a very powerful tool. You can use that gap to pay off debt, something we discussed earlier in this series, and you can also use it to build toward your future by investing.

One of the most common goals that Americans have with their investing dollars is to secure a healthy retirement, one in which they can maintain something close to their standard of living and survive increases in health care costs while receiving good care. No one wants to live a hand-to-mouth existence in their final years and retirement planning is an incredibly powerful way to avoid that. Social Security alone won’t be enough.

On top of that, the options for Americans to save for retirement are pretty unclear to the vast majority of citizens. The easy route, for those who have it available, is to simply contribute to a 401(k) plan in your workplace, but those often have fees and expenses that eat up a significant portion of the money you earn in the account. If your 401(k) earns an average of 5% a year and it’s slurping away 1.5% in fees, you’re barely beating inflation.

What do you do, then? What’s the game plan for turning a person’s financial “gap” into adequate retirement savings?

Exercise #23: Building an Investing Road Map to Retirement

Here are several steps you can follow that will give you the best chance of having a good retirement. These are time-tested ideas, drawn from a wide array of personal finance, investing, and retirement books; the single most useful volume I’ve found on retirement savings is The Bogleheads’ Guide to Retirement Planning by Taylor Larimore, Mel Lindauer, Richard A. Ferri, and Laura F. Dogu, which I recommend as follow-up reading.

Understand the uncertainties that come with retirement savings. Many investment and personal finance websites will talk as though saving and investing for retirement is a magical solution that will simply take care of you if you throw enough money at it. As painful as it is to say it, that’s simply not true.

The future is uncertain. If investments and government policies continue along as they have in the past, then there are definitely clear steps you can take to have a secure retirement, but it doesn’t take a visionary person to see that we’re in an era of great change. The institutions we relied upon on the past aren’t necessarily going to continue in exactly the same way in the future.

For starters, we don’t know the future of the American economy or any economy. It seems pretty certain that innovation and worker efficiency will continue, but will that translate into financial security for investors and citizens? I expect it will over the long run, but I also expect the ride to be bumpy.

Another factor is that we don’t know what government policies will look like going forward. Will taxes go up? Will taxes go down? What will be the cutoff between tax brackets? What will inflation be like, and how will the government respond to it? Will changes in trade policies change the prices we pay in stores?

No one can predict the answers to these questions with any certainty even over the short term, let alone the long term.

So what can you do? The best strategy available for people who can’t or don’t wish to devote most of their life to studying investments is to simply hedge your bets by diversifying. Don’t put all of your eggs in one basket. Instead, assume that some things will go up in value and others will go down and by having a little bit of money in a lot of things, it will balance out and go upwards at a gentle rate over time with little effort.

Know what accounts and options are available to you. So, we know we need to save for retirement, and we know that those savings need to be split up among lots of different things. How do we do that? There are a number of options available for people who wish to save for retirement.

For many people, the most obvious method for saving for retirement is through the retirement plan offered through their workplace. There are many such plans, but they generally fall into three main categories.

Some plans are pension plans, like FERS – the Federal Employee Retirement System. These are plans that essentially offer a guaranteed benefit in retirement depending on the years of service to the employer. These used to be common offerings from businesses, but are now largely nonexistent; they’re mostly just offered by local, state, and federal government these days. If you have one of these, that’s great! It’s one of the best perks of being a government employee!

Other plans are pre-tax savings plans, like a 401(k), 403(b), or TSP. These plans allow you to contribute money directly from your paycheck before taxes are taken out; in effect, it reduces the amount of income you’ll be taxed on, which means that you’ll pay less in taxes this year. However, when you make withdrawals from that account when you’re retired, you’ll have to pay taxes on those withdrawals as the money comes out. There are usually tight restrictions on non-retirement uses of the money, ones that come with stiff tax penalties if you violate them.

In still another group are post-tax savings plans, which are usually prefaced with the word “Roth.” This includes Roth IRAs, Roth TSP, and Roth 401(k)s. In these accounts, you make contributions out of your take-home pay – there’s no reduction in your taxable income. However, when you do eventually retire, you can take withdrawals from those accounts tax free, including the investment gains you earn over the years. Plus, in general, it’s much easier to access funds in a post-tax plan than a pre-tax plan if you need it for other uses.

Retirement savings strategy usually involves mixing contributions among post-tax and pre-tax savings plans unless there are additional factors involved.

Focus on maximizing contributions today rather than focusing on seemingly insurmountable long term goals. Many people get stuck in the trap of worrying about the huge mountain of money that they feel that they must have when they retire. “How will I ever save up $1.6 million?” is a common refrain, because those are the kinds of numbers offered up by retirement calculators.

My philosophy is that you shouldn’t worry about those big numbers. Instead, worry about your contributions right now. If you contribute plenty right now, you will make it to where you want to go.

So, how much is “enough” to contribute? No matter your age, you should be striving to put away at least 10% of your income into retirement. If you’re 40 or over and haven’t contributed before, you need to be contributing even more. There is no magic threshold that defines “enough” for the reasons stated earlier – the future is too hard to predict. However, the more you contribute, the more likely you are to have a comfortable retirement or even a cushy one. The less you contribute? The more likely you are to have a very uncomfortable retirement or to find yourself working until a very old age.

Make sure, as your first step, that you’re getting every dime of employer matching into your retirement savings. The absolute first thing to consider when thinking about where to put your retirement savings is whether or not your employer offers a retirement savings plan and, if so, whether or not they match your contributions at any level.

If your employer matches your contributions, that’s where you should be putting your retirement savings almost every time. There is almost no move you can make that will surpass the value of your employer matching your contributions.

Thus, the first move you should make in saving for retirement is to contribute to your employee retirement plan up to the level that’s required to get every dime of matching contributions from your employer.

If your employer does not offer matching funds, then, naturally, skip this step.

Fund a Roth IRA for you and your spouse as your next step, if eligible. The next option to consider is a Roth IRA, which should be your target for any additional savings you want to make beyond what’s described in the above step.

A Roth IRA account is quite easy to set up with almost any investment house. I personally recommend Vanguard, simply because that’s what I use myself for my own Roth IRA and other investments. Setting up a Roth IRA there – and with the other investment firms I’ve looked into, such as Fidelity – has been almost as easy as setting up an online bank account. You just fill out a few forms online, click a few times, and you’re done.

Most Americans are eligible for a Roth IRA, which allows an individual to contribute up to $5,500 per year in post-tax money (meaning money that’s actually arrived in your checking account after getting paid and having your taxes taken out). The exception is that you can’t contribute more than you earn, meaning you earn less than $5,500, and that you can’t contribute if you earn more than the income limit. For individuals, that limit is $117,000; for married couples, it’s $184,000. That level of income puts you in the top tier of American earners; the vast majority of Americans are well within the contribution limits.

As I stated earlier, your goal should be to contribute at least 10% of your salary to retirement (and ideally more), so you may find yourself contributing a small portion to a Roth IRA or you may find yourself fully funding it.

Return to a pre-tax plan if you want to still save more. If you want to contribute even more to retirement and you’re already getting every dime of matching money from your employer and fully funding both your Roth IRA as well as your spouse’s Roth IRA, turn back to your employer’s pre-tax plan. It might not be perfect, but the tax benefits it offers are likely to be more beneficial to you than simply putting your money in a savings account or any other non-retirement account.

If that option isn’t available to you, you do still have quite a few additional options. You can use a traditional IRA, which is a great option if you aren’t eligible for a Roth IRA due to too much income but don’t have an employer-based retirement plan. You can use a normal taxable account to stow additional retirement savings in; you’ll have to pay long term capital gains tax when you finally tap that account in retirement and there aren’t any other tax benefits, but you’re free to do whatever you wish with it without any additional tax penalties. You can also consider a Solo 401(k) if you’re self-employed.

Know what to look for in investment options. Once you’ve figured out which account or accounts that you’re going to be contributing money to, the question then becomes centered around investment options. Almost all retirement accounts that you contribute to offer a number of options with regards to where to invest your money inside that account, but those can be overwhelming.

Obviously, analyzing investments can quickly turn into a rabbit hole of time and energy. You can dig deeper and deeper and deeper and become more and more and more indecisive and never make a decision. In fact, it’s that very indecisiveness that keeps people from saving sometimes.

My advice to most retirement savers is to keep things as simple as possible. Focus on just four things: the amount of time the fund has existed, the average annual rate of return, how volatile the fund is, and the expense ratio. You don’t want to invest in a fund with a short history, nor do you want to invest in one with a high expense ratio. If you’re close to retirement, you’ll want a low volatility, but if you’re decades away, volatility doesn’t matter. After that, you can mostly compare the average annual rate of return. This is a good way to compare several investments at once, but you’ll want to make sure your money is split at least somewhat among several different investment types.

When in doubt, choose balance in the form of a target retirement fund. This is usually the easiest way to balance all of the concerns in the previous paragraph. Just look for a target-date retirement fund that comes as close as possible to the date you’re planning on retiring and contribute everything to that fund. The fund automatically splits your investment among various types and automatically lowers your volatility as you get closer to retirement.

Target retirement funds aren’t perfect and many people might do something slightly different if they spent extensive time studying their investment situation. However, it will be reasonably close to what most people would pick.

Focus on today! If I can offer one piece of retirement advice for anyone, it’s this. Focus on today. Focus on what actions you can take right now to put a little bit of money away for retirement. Set up automatic contributions to a retirement plan and stick with them. Don’t give into the temptation to cash in your retirement savings and find other ways to solve your financial problems. When you get a raise, focus on ratcheting up your savings rather than ratcheting up your lifestyle.

You don’t have to sacrifice a great life today for a great retirement tomorrow. You just need to keep your future self in mind when you make decisions and be willing to give up the unimportant little things for the more important big things sometimes.

While there’s no guarantee of a perfect retirement for anyone, following those steps will go a very long way toward securing the best possible retirement you can have.

Next time, we’ll take a look at specific strategies for investing for education.

31 Days to Financial Independence: The Complete Series

Trent Hamm

Founder & Columnist

Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.