The Basics of Saving for Retirement
I know, I know, I've waited to long to have "the talk" with my daughter who is a Junior in college. But something else always came up. The time never seemed right and I felt awkward, but I finally sat down with her and told her what I wish I'd known at her age about finances. I would be much further along in retirement savings if I'd just known these facts.
You can work hard all your life, put lots of money into your savings, but can still end up with a poor retirement if you don't save well. Save wisely and you can enjoy a wonderful retirement.
The Four Percent Rule. The typical rule of thumb is that you can take out 4% of your money every year for your retirement. So if you need $40,000 dollars a year from your savings, you will have to save one million dollars by retirement age. That's a lot of money and it doesn't just happen.
General Tips
1. Don't buy toys on credit. Credit cards carry a huge interest rate and you will be losing money every time you have a balance at the end of the month. Pay your credit cards off at the end of the month. Buy clothes at Goodwill, eat frugally, take local vacations, drive an old car, use a Windows computer - do what you must, but never carry a balance on your credit cards.Your home and cars are the only things you should buy on credit. Save up your money so you don't have to buy cars on credit.
2. Use a Credit Union. Banks are made to provide profits for their owners, the stock holders. Banks try to wring every last cent from you. Credit Unions belong to the depositors and hence try to serve you, the depositor. That being said, sometimes banks can provide services like ATMs everywhere that make them worth a second look, but remember banks live to make other people money.
 |
| Bankers circling to figure out ways to charge more fees |
1. You get paid for risk. Since inflation runs about 2% a year, if you put your money in the bank in a risk-free FDIC insured account at 0.05% interest, you are losing money every year. You need to take more risk to earn more money.
2. What is the stock market? When you own a stock, you own a little piece of the company. When the company makes a profit for the year they will pay you a tiny part of that profit which is called a dividend. If a company has a million stock shares, and you own one stock, you will get one-millionth of their profits for the year. Although some companies don't pay dividends, but let their stock price rise instead. Either way you can make money.
3. Stocks are risky. If the company goes bankrupt you can lose all the value of your stock. But with greater risk comes greater reward. The stock market averages about 8% returns a year.
4. What are stock funds? Stock funds are composed of a group of other stocks. It's like a basket of baskets; when you buy a stock fund (big basket), you buy a small piece of multiple stocks (little baskets). Two types of funds exist, managed and indexed. Managed funds buy stocks based on the opinion of a highly paid stock picker. Index funds buy stocks based on an list, like the 500 biggest companies in the stock market (the S&P 500 list) or the 1000 biggest companies (the Schwab 1000).
Index funds will almost always beat managed funds because managed funds have a higher expense, like 1-2% of all your money, while index funds may only charge you .03% of your money invested in them. Over the decades this tiny difference can amount to over a hundred thousand dollars.
Don't invest in individual stocks, buy index stock funds. Individual stocks are fun to play with, but they're not stable enough to warrant high-stake investments.
You can buy stocks and bonds at a company like Vanguard or Schwab. You create an account and send them money and they will buy and hold the stocks and bonds for you.
4. What are bonds? Companies borrow money from investors by selling bonds. They are like government savings bonds - you buy them now and can redeem them later with interest. While bonds earn interest and are safer than stocks, they don't earn as much potential profit. When a company goes bankrupt the bond holders get their money before stock owners, less risk so less reward. Government bonds are the safest investment, but only pay about 1.5 - 2% returns.
What percentage in stocks? One rule of thumb is to have the percentage of stocks the same as (120-your age), so at age 50 you should have 70% of your savings in stocks, both domestic and foreign. When you are 20 you should be 100% in stocks, since you have a lot of time to ride out the ups and downs in the market.
John Bogle, founder of the Vanguard Group which champions low cost index funds recommends this set of funds:
40% in the Vanguard Total U.S. Stock Market Index Fund
20% in the Vanguard Total International Stock Market Index Fund
40% in the Vanguard Total Bond Market Index Fund
The S&P 500 in 2008 was around 1500 and dropped to 700. Many of my friends sold their stocks and lost half their investments. If they would have been patient, they would have made all that money back and then some since the market has recovered to 2500.
8. Real Estate. You can invest in real estate, but it takes time to manage. Your own home is typically, but not always, a good investment. Another way to invent in real estate is a Real Estate Investment Trust (REIT), which is like a stock, but it invests in real estate like apartments, shopping malls, office buildings, and homes. This is the simplest way to own real estate.
9. Invest in ways that minimize your taxes. Your work will typically have a Retirement 401(K) plan that will allow you to invest money without it first being taxed. They will typically match a part of your investment, like the first 4% of your salary. You get to deduct the amount you invest from your income so you don't have to pay taxes on it, yet. When you retire you will pay taxes when you pull money out, but the money has grown for 30 years without paying taxes.
If your company doesn't offer a 401K, you can invest in an IRA, or a ROTH account. If you invest in an IRA, it is untaxed going in, allowing for compounding interest on the full amount you put in, but taxed when you withdraw money from the account. If you invest in a ROTH account, money is taxed going in, but considered non-taxable income when withdrawn.
10. How much to save?
As a general rule you should try to 15% of your salary for retirement. The following table shows how far along you should be at a particular age to be on track.
| Age | Save this multiple of your salary |
|---|---|
| 30 | 1x |
| 40 | 3x |
| 50 | 6x |
| 60 | 8x |
| 67 | 10x |
In Summary
Save 15% of your salary for retirement every month in a mix of domestic and international stock index funds and bond funds into your company 401K or a ROTH account.
Planning and saving for your future is hard work, but your 65 year old self will thank you.
