The longest journey begins with a single step. That adage is particularly applicable to the retirement planning process. Unless we inherit a nest egg, most of us begin the retirement savings journey with a very modest sum.
Although the terms “saving” and “investing” are often used interchangeably, these words have different meanings. “Saving” refers to setting aside money, which may or may not earn interest. “Investing” refers to exchanging dollars for ownership shares in companies (stocks or equities) that an investor expects to increase in value. Thus, the stockholder is vested in the company. Stocks may also yield shareholder dividends along the way.
Beyond stocks, individuals can invest in bonds issued by an entity. Bonds function as loans for investors or loans to companies or municipalities. Assuming everything goes as planned (bonds occasionally fail to pay off), bondholders receive their principle back when the bond matures.
In addition to stocks and bonds, individuals can deposit funds into an interest-earning bank account. We recommend that our clients include stocks, bonds and cash in their journey toward retirement. How much money should be allocated to each asset class? Although performance the past few years has deviated from historical trends, stocks tend to be more volatile than bonds on an annual basis. Over the years, stocks have also delivered a higher return on investment compared to other asset classes.
Bonds tend to be less volatile than stocks on an annual basis. However, bonds have historically yielded lower returns than stocks. Again, recent history has fluctuated from the “norm”.
Cash or money market accounts are not subject to volatility, but deliver almost zero return on investment. The asset classes described above reflect generalized trends and do not guarantee future performance.
Individuals new to the stock market commonly select mutual funds, exchange traded funds (ETFs) or individual positions. Based on minimum deposit requirements, most new investors start with mutual funds. As ETFs have lower fees, investors should consider these types of investments when their savings reach the threshold eligible for ETF products.
Unfortunately, individuals often fail to consider tax diversification. After-tax accounts mean that taxes have already been paid taxes on invested funds. Employees eligible for 401k or 403b plans can choose to have their employer withhold money from their paycheck. Most of the time these accounts are tax-deferred and individuals pay taxes on the initial principle and earnings growth at the time of withdrawal. Individuals who qualify for a Roth IRA pay taxes on the funds deposited in the account, but earnings grow tax-free.
Congratulations on choosing to begin the journey of funding your retirement. Start by determining the percentage of income you will set aside to fund your retirement. Next, determine how to allocate your contributions based on asset classes and volatility. Finally, determine the most advantageous tax treatment.
Tax advice provided by CPA’s affiliated with Financial Enhancement Group, LLC.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.