Introduction to Retirement Savings

This is a guest post from the author over at Growing Savings, you can check out their site here:

Most people look forward to the day when they can step out of the rat race, take their nose off of the grindstone, and "retire". In fact, even though the entire concept of retirement was invented by the government during the Great Depression to get older people out of the workforce and make room for younger folks, most Americans think that retirement is every person's God-given right. The truth is, the government's Social Security and MediCare programs will only get you so far, and you'll never be able to completely retire unless you save and invest wisely and in sufficient amounts to cover your expenses when you're older.

The absolute, most important element in saving for retirement is to start early. This allows us to take full advantage of what is called "compounding". The idea behind compounding is very simple: your initial principal earns interest, and that interest is added into the principal, which earns more interest, which is added into the principal, which earns even more interest, and so on and so on.

The interest compounds on itself year after year. Starting early allows the process to work longer and longer - the more time you give your money to grow, the more money you'll make. To illustrate, let's say that you've invested $1000 at 5%. The first year, you'll earn $50, so at the end of that first year you'll have $1050. The second year, you're earning 5% on all $1050, which is $52.50. Add that together and, at the end of the second year, your grand total is now $1102.50.

In year three, 5% of $1102.50 is $55.13, so at the end of that third year you have accumulated $1157.63. If you allow that money to sit there and compound like that for 20 years, you'll end up with $2653.30, but if you give it 30 years you'll have $4321.94, and 40 years will leave you with $7039.99. The difference between 20 and 40 years is twice the time, but almost three times the money. As you can see, the process accelerates with time.

Now, of course you can't retire with just a $1000 investment. But if you put $1000 away every year for 40 years, starting at age 20, you'll find yourself 60 years old with $133,879.75. It's hardly a fortune, but if you wait until you're 40 to start saving the same amount, you'll turn 60 with only $37,372.55. Obviously, the more you can put away the more you'll have at the end, but every year that you wait you short-circuit the compounding process.

The next issue is two-fold, first: where to put that money so that you can earn that interest, and second: how to keep the greedy government from taking it away from you. To take the second part first, the two main vehicles for protecting your money from taxes are 401ks and IRAs. A 401k is offered by an employer to an employee, so if you are an official employee of a particular company, ask if there is a 401k available for you to take advantage of.

Under the plan, you can have money taken out of your paycheck and put into an investment of your choice, effectively reducing your taxable income and thus reducing the amount of income tax that you'll be required to pay. Some employers will even contribute extra money to the fund, "matching" your contribution by a certain percentage. Usually, in that situation, the more money you put away, the more the company will add. This account allows you to save on your taxes now; but when you retire, you will pull the money out and, of course, have to pay income tax on it then.

The government also allows you to use IRAs (Individual Retirement Accounts) to save on taxes. There are three basic types of IRAs: the Traditional, the Roth, and the SEP (Simplified Employee Pension). In a Traditional IRA, you are allowed to put up to $5000 (more if you're over 50) away and reduce your taxable income by that amount, and then when you retire you pay income tax as the IRA pays the money out to you - just like a 401k.

The SEP IRA works exactly the same, except it's designed for small businesses or independent contractors who are not official employees of any company and allows those people to put potentially more than $5000 away. Since those kinds of people won't have access to a 401k, the SEP provides an alternative. Basically, if you work for a company then you'll probably have a 401k, and if you are your own boss, then you'll have a SEP (if you're smart).

The Roth IRA is a little different. It allows you to put $5000 away, but doesn't give you any tax deduction on the money up front. You will pay income tax on the money, but then when you retire you can pull the money out tax-free. These different IRAs give people a choice to bite the bullet now so they won't have to pay taxes later, or pay the taxes at retirement, when they might be in a lower tax bracket. As with anything, it's probably a good idea to have a little bit of both.

This brings us to the main question: Where do you put your money? We've all heard the answer - diversification - but what are all of these "diverse" options? Obviously, the stock market is the big one, and the best way to invest in company stocks is through the mutual fund.

Instead of investing in the stock of one company, and praying that that one company doesn't go under (this is the mistake that the victims of Enron made), a mutual fund invests in a group of stocks. There are many different kinds of mutual funds that invest in different kinds of companies. You may have heard the terms "Large Cap", "Mid Cap", "Growth", or "Income".

The first two refer to the size of the companies included in the fund - "small cap" means small companies ("cap" stands for "capitalization", which is a fancy way to express how big the company is), "large cap" means large companies. "Growth" funds refer to the philosophy of the fund managers and will invest in companies that are expected to grow in size and, in particular, grow the value of their stock. "Income" funds invest in companies that pay shareholders a regular (it could be monthly, annually, or quarterly - which means every 3 months) reward for holding their stock. This reward is called a "dividend", which can be paid in cash or as additional stock.

A good mix of mutual funds that invest in companies of all sizes, all industries, from all parts of the world, and with a variety of philosophies - growth, income, aggressive, conservative, value (stocks that have dropped in price relative to their worth) will insure a diversified portfolio. But there's more to investing than stocks. Bonds are another major player in the savings game.

A bond is issued by a government or company in order to raise capital. You give them the money, they give you the bond, and they agree to pay you back at a particular date plus interest. Bonds issued by entities that are considered safe, which means that you have a pretty good guarantee of them being able to hold up their end of the bargain, usually have a pretty low rate of return. Higher risk bonds, including "junk" bonds that have low ratings, can have bigger paybacks - but you run a greater risk of the company (or government) going under, disappearing, and never paying you back at all. Once again, having a good mix through a couple of bond mutual funds can buffer your savings if the stock market takes a hit.

Some income funds invest in both bonds and companies that pay regular dividends. A fund like that will generate steady income, and if the stock market goes down, only the stocks portion of the fund will go with it while the bonds will continue to churn out slow and steady income. The downside is, of course, that if the stock market goes up a huge percentage, the bonds won't go with it. They'll continue their slow, steady, and low-percentage return.

Probably the safest of all investments is the Certificate of Deposit. This is an agreement between you and a bank, where you give the bank a certain amount of money and they agree to pay you back at a later date, plus interest. It's similar to a bond, but a bond is often part of a larger market where it can be bought, sold, and traded, and the CD is not. Once you enter into the CD agreement with the bank, that money is locked away and you can't get it until the CD "matures" - unless you pay a hefty fee. Like ultra-safe bonds, CD interest rates are usually pretty low. You won't make a lot of money on the deal, but it's a safe and sure way to make your money work for you. Also, CDs are insured by the federal government (FDIC), which makes them even safer than all bonds except the ones offered by the government itself.

Another category for retirement savings is real estate. Most people are already heavily invested in this category simply because they are paying a mortgage, and since we'll all need a place to live when we retire, buying and paying off a home is probably the single most important investment any of us will ever make.

For many people, the equity they have built up in their home is also the single biggest portion of their savings. This isn't a bad idea, because home values usually go up steadily over the long run. The old saying is "they aren't building any more land," so if you own a piece of property and maintain it, most likely you won't lose money. Plus, if you spend your whole life paying rent, then all of that money is completely wasted, so you may as well buy a home or a condo - as long as the mortgage payment is affordable for you.

Real estate investing can also take many other forms. You can buy a second home and rent it out, or buy a plot of land and sit on it in the hope that its value will increase. Or, to invest smaller amounts of money, there is the Real Estate Investment Trust (REIT). A REIT is an investment group that buys, sells, develops, rents, or manages various kinds of real estate.

They might own apartment buildings or shopping malls, or invest in residential development or even own hospitals. They are also required by law to distribute 90% of their income to their shareholders, so they usually produce a steady stream of income (although the share value can still fluctuate with real estate values). Like stocks, REITs can be purchased individually or through mutual funds that own several different REITs. They're a good way to increase your diversification.

Another place to put retirement savings is commodities, such as precious metals and oil. Gold and silver have historically retained their value, and we've all seen how valuable oil can become. Typically, when stock prices go down, investors flee to the security of commodities because they are things that people actually use. Silver and copper are extensively used in manufacturing; corn, sugar, and wheat feed the world; and oil provides much of the world's energy. Once again, many mutual funds invest in commodities.

The next question, of course, is how to start actually putting money away. With today's online brokerages like E-Trade and Scottrade, all it takes is a few minutes on the computer to open an account. Link the account to your checking account, or drive over to your local Scottrade office and hand them a check. If you're more comfortable talking to a professional manager, call up a place like Edward Jones or Charles Schwab and make an appointment. Your local bank may even be able to help, especially with CDs. Many people start saving simply by waiting until they have an extra $1000 in their account and then opening a 5 year CD. All you have to do is officially designate that an IRA and you're on your way.

This by no means is a complete list of possible retirement investments. Art, antiques, and jewelry can sometimes be the best performing assets a person may own. Collectibles like coins and stamps, even baseball cards and comic books might pay off handsomely many years in the future. The most important thing is to have a wide variety of assets working for you, generating income, and compounding while you're hard at work. Don't bury yourself in debt, and don't procrastinate. Start now, and you'll set yourself up for a long and happy retirement. And don't forget to eat right and get regular exercise - it would be a shame to die before you have a chance to spend all of that money.