Last week we talked about how to retire early using the FIRE method (Financial Independence, Retire Early). Now that we understand the method for retiring early or simply the method for saving for retirement effectively by choosing a retirement goal, time to retirement, and savings rate, we can now delve into how you should invest the money that you intend to save. Let’s walk through the best investment options you can choose for retirement that are tax-advantaged and will take advantage of the magic of compound interest.
You can see below the priority of investments that I believe is the best mix for your retirement account that is simple and will allow your money to grow enough to reach your retirement goal.
Are there other ways to invest your money? Absolutely. Could you make more money with other investments? Definitely. But this is a simple process that I’m going to follow to plan for my retirement and insure that I have $1,000,000 in the bank when I retire. Feel free to follow this guide completely or pick and choose what you think works best for you.
I would say that this plan is more heavily weighted on risky assets, but I will also show you some investments that are basically risk-less as well.
Check If You Have An Employer 401K Match
Your first order of business is to take advantage of your employer 401k match. Your employer is giving you FREE money. When does that ever happen? Look at their policy to see how much free money you can get.
For example, my employer matches 50% of the money I contribute up to $2,500 every year. So if I take advantage fully I can get $2,500 a year, which doesn’t seem like a lot, but if I take advantage of this every year for 30 years, the employer match will be worth $255,183.
This method is the easiest way to get money for retirement without even trying.
There are 2 main options for where you should store your retirement money:
Retirement Accounts You Should Contribute To
1. Roth IRA
Now that we have have money from our employer match, we need to put that money in a Roth IRA if the company has it as an option (if they don’t, you should put your employer match in 3. Roth 401K).
You can only take use a Roth IRA if your modified adjusted gross income is less than $137,000 if you’re single (contributions are reduced starting at $122,00) and $203,000 if your married filing jointly (contributions are reduced starting at $193,00).
If you’re qualified, you always want to put your retirement money in a Roth IRA first, unless you are within a few years of retirement. Why? Because you are taxed when you first contribute the money to a Roth IRA, that means that your money grows tax-free so that when you take out your money during retirement you don’t have to pay taxes.
When you’re young or far from retirement, most people assume that their tax rate is going to be higher in the future than it is now because they will probably be making more money the older they get and at the peak of their career. So paying taxes now would be cheaper than paying taxes later because you have a lower rate.
This idea is benefit #1 of the Roth, but benefit #2 is even better: your money is growing, growing, growing for all of those years, but you’ll never get taxed on those gains (compared to a standard 401k where you don’t pay taxes when you contribute, but have to pay taxes on all the gains your investments made plus the initial investment itself).
Every year you’re only allowed to contribute $6,000 if you’re under 50 and $7,000 if you’re over 50 (as of 2019), so you need somewhere else to put your retirement money, and that’s when the Roth 401k comes in.
(Learn more about the Roth IRA here to tackle your particular situation).
2. Roth 401K
Once you have contributed to your Roth IRA (or you are not eligible to contribute to a Roth IRA), you then should contribute to a Roth 401K. The Roth 401K is also taxed today and grows tax-free. Unlike the Roth IRA, the Roth 401K has no income limitations, and the Roth 401k has higher contribution limitations: every year individuals can contribute $19,000 and you can contribute an additional $6,000 a year if you’re 50 or older.
You can access the funds in both the Roth IRA and Roth 401K when you’re 59 1/2. DO NOT withdraw any of your funds before this age (and remember that you need to have each account for 5 years if you want to withdraw without receiving a penalty fee). If you withdraw early, you will receive a penalty and forfeit all that money that was going to grow because of compound interest. It simply isn’t a smart move unless you’re in a dire situation and need money. Don’t cash out your Roth because you want to go on a trip around the world (I’ve heard of people doing this).
So remember the game plan is contribute first to the Roth IRA (if you’re eligible) and then to the Roth 401K. More than likely once you’ve calculated how much you need to save every year to contribute to your retirement accounts to meet your retirement goals (see how to go through that process here), you’ll see that you need to save more than the Roth IRA contribution limit ($6,000) and have extra money to contribute to the Roth 401K.
You know that you will first use the money from your 401K match to fund your Roth IRA and Roth 401K and then use the money you have saved from your annual income to fund the accounts.
(Note: I would also look into funding a HSA: Health Savings Account to better both your physical health and financial health. Learn more here about why you should fund a HSA).
Now, you may be wondering what you should actually invest in. My strategy is really simple to follow.
What You Should Invest In
1. S&P 500 Index Fund
The S&P 500 Index Fund follows the stocks of 500 large American companies’ market capitalization. Many people believe that this index is the best representation of the stock market. You can look for other index funds to invest in, but I like this one because of the:
1) High Returns – since the S&P 500 Index’s creation in 1926 to 2018, it has had a 10% return or 7% return after inflation
2) Low Expense Ratio – for example, the Fidelity 500 Index Fund has an expense ratio of 0.02%, which is super low. This means that Fidelity will use 0.02% of its money from its total assets in a year to pay for expenses like administrative, management, and advertising expenses. Look for a S&P 500 Index fund with the lowest expense ratio because expense ratios can eat into your returns.
This strategy is very passive and for the long-term. I am currently 23 years old, so I can withstand the volatility of the stock market. If you are at retirement age, this is more risky. But for me, at such a young age, I have faith in the U.S. economy and stocks to increase in the next 30-40 years because of the historical returns.
2. REIT ETF
REITs are Real Estate Investment Trusts, which are companies that own, and in most cases operates real estate that produces income. These companies own commercial real estate, like apartments, offices, shopping centers, hotels, hospitals, warehouses, etc. Most REITs lease space and collect rent on its real estate. REITs are required by law to pay out at least 90% of its income to investors in the form of dividends, and most pay out 100%. A REIT ETF tracks the whole real estate sector.
I like REITs for our retirement portfolio for 3 reasons:
1) I like the exposure to real estate because it is such a huge part of the U.S. economy and grows just like the S&P 500. You don’t need to go out and buy a house or investment property, you can benefit from the gains of real estate using a REIT. Stock-exchanges REITs, which are the ones we will invest in, are worth about $2 trillion in assets (Nareit). This number is huge and we should take advantage because also…
2) REITs have a higher return than the S&P 500. The average annual return for the last 20 years was 11.8% for REITs and 9.5% for the S&P 500 (Investopedia). Also, remember to choose a REIT ETF with a low expense ratio like our S&P 500 Index Fund.
3) The tax-advantage. Your dividends from the REITs are taxed at your ordinary income. So say I make $60,000 a year in Denver, CO, my marginal tax rate is 22%. The dividends from my REIT would be taxed at 22% instead of being taxed at 15% (which is the long-term capital gain tax rate that would be applied to say stocks). BUT, if you put the REIT in the Roth IRA, you pay taxes when you contribute money now like we talked about before and the money grows tax-free. So you will avoid paying taxes on your dividends and the capital gains tax and reap the high returns of the REIT.
So I wanted to touch on bonds even though this is not a part of my retirement investment portfolio because, again, I’m 23 years old and am comfortable with the risky investments of stocks and REITs over the long-term. However, if you are close to retirement age, consider investing in bonds.
Bonds’ returns are not as high as the S&P 500 or REITs, but it is a strong return at 5-6% with little risk. Particularly, Treasury bonds are basically risk-free because we have faith in the U.S. government to pay us back. You can also invest in highly rated corporate bonds, as well as municipal bonds (and munis are tax-free).
If you want a strong return with more stability, go with bonds over stocks and REITs. I will most likely do the same when I’m close to retirement age.
Overall, here is my perfect allocation of my money every year for retirement today:
Roth IRA: $6,000 in REIT ETF ($1,500 from employer match)
Roth 401K: $1,500 in S&P 500 Index Fund
This is $7,500 out of my pocket and $1,500 out of my employer’s pocket for a total of $9,000. If I do this every year, I should have approximately $1,250,000 by retirement at age 55. That’s the beauty of compound interest! Start investing today!
What’s your retirement plan? Comment below.
This post contains content this is for informational purposes only, and should not be considered legal or financial advice. Please read my Disclaimer for more information.
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