Retirement Planning: Invest More, Worry Less

Investing before retirement is important for several reasons. Firstly, it allows individuals to take advantage of compound interest, which enables their savings to grow exponentially over time. The earlier one starts saving, the more time their money has to grow, resulting in a larger nest egg for retirement. This is especially beneficial for those in their 20s, who may have fewer financial responsibilities and more time to let their investments accumulate. Additionally, people tend to have higher expenses after retirement, such as healthcare costs, and longer life expectancies, so investing beforehand ensures they have enough funds to cover these costs. Social security benefits may not be sufficient, and other sources of income, such as part-time work or investments, may be necessary to maintain their desired standard of living.

Compound interest

For example, if you invest $1,000 in a long-term bond earning 3% interest per year, at the end of the first year, your investment will grow by $30. You will then earn 3% on $1,030 in the second year, which equates to $30.90. While this may not seem like a significant increase, the effect of compound interest becomes more apparent over a longer period. After 39 years, your investment will have grown to around $3,167, and by the 40th year, your investment will be worth $3,262.04—a difference of $95 in a single year. This demonstrates the power of compound interest, where your money grows at an increasing rate.

The benefit of compound interest is further emphasised when comparing different starting ages for retirement savings. For example, if you start investing $250 a month at 25 years old with an average annual return of 8%, you will have accumulated $878,570 by the time you retire at 65. However, if you start investing the same amount at 35 or 45, you will only accumulate $375,073 or $148,236, respectively. Therefore, starting early and taking advantage of compound interest can significantly boost your retirement savings.

Time is on your side

When it comes to investing for retirement, time is a powerful asset. The earlier you start, the more time your investments have to grow, and the less you'll need to invest each month. This is due to the magic of compound interest.

Compound interest is interest earned on both your initial savings and the earnings generated from those savings. Over time, this can lead to exponential growth in your investments. For example, investing $1,000 in a bond with a 3% interest rate will give you $30 in interest at the end of the first year. In the second year, you'll earn interest on the initial $1,000 plus the previous year's interest of $30, resulting in a total of $30.90 in interest for that year. This process continues, and the longer you invest, the more significant the impact of compound interest.

Let's look at a more extended example. Starting at age 19, you invest $2,000 a year for eight years, and then you stop contributing. Assuming an average annual return of 10%, by the time you're 65, your investments will have grown to $1 million. On the other hand, if you wait until age 27 to start investing the same amount annually, and continue for 38 years, you'll end up with only $800,000. That's a difference of $200,000, just by starting eight years earlier and investing for a shorter period.

The power of compound interest is why financial advisors recommend starting to save for retirement as early as possible, even in your 20s. It may seem daunting, but it's important to remember that even small contributions can make a big difference over time. Additionally, if you have access to an employer-based retirement plan or a 401(k), take advantage of it. Many employers will match a certain percentage of your contributions, giving your savings an extra boost.

While it may be tempting to focus on enjoying your income in the present, especially when facing student loan debt and high living costs, remember that time is your greatest ally when it comes to investing for retirement. The earlier you start, the more time your investments have to grow, and the less pressure you'll feel later on to invest larger sums. So, take advantage of compound interest and give your money the time it needs to work its magic.

Employer-based retirement plans

Retirement plans offered by employers are a great way to save for retirement, especially if you start early in your career. These plans are often tax-advantaged and can include different types of group healthcare plans and retirement savings plans. Employer-sponsored plans such as 401(k) and HSA cover a range of services, including retirement savings and healthcare. Employees who enrol in these programs benefit from discounted services, while employers typically benefit from tax breaks and a way to attract and retain valuable employees.

A 401(k) plan is a defined contribution plan that allows employees to elect to defer receiving a portion of their salary, which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. There is a dollar limit on the amount an employee may elect to defer each year, and employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.

A Roth 401(k) is another type of employer-sponsored retirement savings account that is funded with after-tax money. Withdrawals in retirement are tax-free, provided certain conditions are met. A traditional individual retirement account (IRA) is also an option for retirement savings. Contributions to a traditional IRA are made with pre-tax dollars, and you get a tax deduction when you file your taxes. However, when you withdraw the money in retirement, you will have to pay applicable taxes. There is also something called a required minimum distribution (RMD) where you will be required to withdraw a specified sum every year and pay income taxes on it.

A Simplified Employee Pension Plan (SEP) is a relatively uncomplicated retirement savings vehicle. It allows employees to make contributions on a tax-favoured basis to individual retirement accounts (IRAs) owned by the employees. Under a SEP, an employee must set up an IRA to accept the employer's contributions.

Tax-efficient strategies

There are several tax-efficient strategies that can help you maximize your returns and keep more of your money. Here are some strategies to consider:

• Live in a tax-friendly state: Eight states in the US have no income tax: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. New Hampshire taxes only interest and dividends. Moving to one of these states can help you save on taxes during retirement.
• Reassess your investments: Municipal bonds, qualified dividends, and losses on the sale of securities can help offset capital gains and reduce your tax burden.
• Avoid or postpone required minimum distributions (RMDs): If you are 73 or older, you can avoid paying taxes on RMDs from your traditional IRA by transferring the funds directly to a charity, up to $100,000 annually. Alternatively, you can invest in a qualified longevity annuity contract (QLAC) within your IRA or 401(k) to postpone RMDs and ensure you don't run out of retirement income.
• Be strategic about Social Security benefits: If you don't need Social Security at full retirement age, consider delaying the receipt of benefits until age 70. This will boost your monthly benefits, and you won't have to pay taxes on them right away. The portion of Social Security benefits that is taxable depends on your other income, so consider ways to control your adjusted gross income (AGI) and limit the sale of securities.
• Choose the right investment accounts: Tax-efficient investments, such as municipal bonds, tax-managed funds, and exchange-traded funds (ETFs), are better suited for taxable accounts. Less tax-efficient investments, such as corporate bonds, are better off in tax-advantaged accounts like IRAs and 401(k)s, where they can grow tax-free.
• Take advantage of employer-based retirement plans: If your employer offers a 401(k) or Roth 401(k) plan, contribute as much as you can. Many employers will match a certain percentage of your salary, giving you an extra boost to your savings.
• Consider a Roth IRA: While contributions to a Roth IRA are made with after-tax dollars, your investments grow tax-free, and qualified withdrawals in retirement are tax-free as well.
• Compound interest: The earlier you start saving for retirement, the more compound interest can work in your favor. Even small contributions can make a significant difference over time.

Diversification

There are four primary components of a diversified portfolio: stocks, bonds, short-term investments, and international stocks. Stocks represent the most aggressive portion of a portfolio and provide the opportunity for higher growth over the long term. Bonds provide regular interest income and are generally considered to be less volatile than stocks. Short-term investments include money market funds and short-term certificates of deposit (CDs), which are conservative investments that offer stability and easy access to your money. International stocks are issued by non-US companies and often perform differently from their US counterparts, providing exposure to opportunities not offered by US securities.

The benefits of diversification include reducing risk, increasing risk-adjusted returns, creating better opportunities, and making investing more enjoyable. However, diversification can also lead to lower portfolio-wide returns and higher costs due to transaction fees and brokerage commissions. Additionally, managing a diverse portfolio can be cumbersome and complicated, especially for inexperienced investors.

The key to successful investing is learning how to balance your comfort level with risk against your time horizon. Investing your retirement nest egg too conservatively at a young age carries the risk that your investments won't keep pace with inflation and may not grow enough for retirement. On the other hand, investing too aggressively when you're older can leave your savings exposed to market volatility, which could erode the value of your assets when you have fewer opportunities to recoup losses. Therefore, diversification is particularly important for older investors and retirees who need to preserve their wealth and manage risk.

Frequently asked questions