An estimated 50 per cent of American workers haven’t saved enough money for retirement. A little time spent planning now could mean the difference between a relaxing retirement and working for most of your golden years. Over the course of two years I have written few posts on retirement planning. This guest post talks about the ideal asset allocation in your retirement account as per your age. Enjoy the post from Rose.
Your age, or more specifically the number of years until you retire, is one of the main factors to consider when deciding how much you need to secure your future. You should also bear in mind that the more money you have in your nest egg at an early age, the quicker you can retire.
When should I start planning for retirement?
Not many young people think about retirement in their early 20s but, it is wise to start planning for retirement when you begin your career. It is always a good idea to take advantage of any retirement schemes that provide tax relief and sometimes employers will also contribute to your 401 (k) or 403 (b) and provide matched contributions.
As always with investments, the aim is to make as much money as possible with as little risk as possible. Your risk appetite will change depending on your age and, as well as early planning being vital, it is also important to regularly review all of your investments and ensure that they still meet your needs.
401(K) retirement plan
This is one of the most widely-used retirement schemes and it is a qualified plan which means it is eligible for tax benefits. Eligible employees can take advantage of tax deferral on their salary reduction contributions into the 401(K) retirement plan. These contributions can be made before or after payroll taxes have been paid.
Employers offering this plan may make matched contributions or even offer some form of profit-sharing. The tax is deferred on any earnings accrued under this scheme, which means that you won’t pay taxes until you retire, when you will likely be in a lower tax bracket.
There are some restrictions to this plan:
- There is often a cap on the amount of salary deferral contributions an employee can make.
- You should also be aware that there are restrictions on when and how you can withdraw your money from a 401(K).
- You may have to pay a penalty if you choose to withdraw your money before reaching the retirement age set out in the plan.
- Your investment choices are limited to a group of pre-picked products. Alternatively you may have no investment choice at all in which case professionals appointed by your company will manage your retirement investment.
IRA retirement plan
The US government offers two different types of Individual Retirement Account which provide tax relief: Traditional IRAs and Roth IRAs. An IRA can be used to maximize your tax-free investments if you have reached the contribution limit in your 401(K).
You have more investment choice with an IRA and these accounts may consist of a number of different types of investment including, stocks and shares, bonds and mutual funds. The determining factor when deciding which type of IRA to choose is whether you expect to be in a higher or lower tax bracket when you retire.
With a Traditional IRA, your contributions into the account are tax deductible and you pay tax on the distribution when you retire. This is the best choice if you expect to be in a lower tax bracket when you retire as your tax payment will be deferred until retirement.
With a Roth IRA, you pay tax on your contributions into the account but no tax is payable when you receive your distribution. This type of account is suited to people who will be in a higher tax bracket when they retire.
Restrictions on a Traditional IRA are as follows:
- You must meet the eligibility requirements.
- All withdrawals from these IRAs are subject to income tax.
- The money in this type of account is not available for emergencies as you will need to pay any taxes and penalties before you can withdraw any cash.
- If you don’t make a withdrawal by the age of 70½ then the IRS can confiscate half of the mandatory amount.
- You may be subject to an early distribution penalty if you withdraw funds before the age of 59½. There are a limited number of exceptions to this penalty.
Disadvantages of a Roth IRA include the following:
- Eligibility is limited by income.
- Funds held in a Roth IRA cannot be used as collateral for a loan.
- In order to fully realize the tax benefit, you would have to live long enough to withdraw and spend all of the money.
- You are gambling with future income tax rates – if they are reduced then you may end up paying more than if you used a Traditional IRA.
So how should I allocate my assets?
It depends on your age and your risk appetite. Below is a just a guide to help you decide on your ideal strategy.
With higher risk comes greater potential reward. At such a young age, you can afford to take on more risk and aggressively invest by selecting a greater proportion of high risk assets to make up your investment portfolio.
Even if some of your high risk investments do not perform as well as hoped, you have many years to recoup any losses and make a profit.
The general rule of thumb is that you should subtract your age from 100 and this is the percentage of your investment capital that should be used to invest in stocks. So, if you are aged 20-30 then 70-80 per cent of your capital should be invested in stocks, with the rest used for lower risk investments. You can afford to use some of your capital to buy higher risk stocks which will offer a greater potential return.
As you move into your 30s, you should aim to invest more moderately, with 60-70 per cent of your capital in stocks. The remaining 30-40 per cent should be invested in lower-risk investments such as bonds and mutual funds.
For a higher return on your bond investments you could invest in corporate bonds, which pay out more than government bonds. A mutual fund pools your money with that of other investors and invests it in a mix of stocks, bonds and cash.
Professional asset managers use sophisticated software to manage their funds. There are numerous mutual funds to choose from and you can afford to choose a higher risk fund at this stage.
Your investments should be increasingly moderate as you enter your 40s, as pension fund risk should be reduced as you approach retirement. You should reduce your investment in stocks to a maximum of 50-60 per cent of your capital. It may also be prudent to ensure that you are holding stocks in companies with a proven track record, to further reduce the risk.
The rest of your capital should be invested in lower-risk investments. You should consider choosing government bonds instead of corporate bonds – while these offer lower payouts they are less risky than corporate bonds. You should also look to invest in lower-risk mutual funds.
From the age of 50 upwards, your priority should be maintaining your nest egg and avoiding any losses. It is important to remember that there is no such thing as a risk-free investment, but you can take a number of steps to reduce the risk.
You should invest conservatively, with a maximum of 40-50 per cent of your capital remaining in stocks. To reduce the risk as much as possible, these stocks should be in reliable companies which are based in stable countries.
Your remaining 50-60 per cent should be invested in low risk assets. Government bonds are considered very low risk because they provide fixed interest payments and return of the capital sum invested on a specific date. US Treasury bonds are considered to be one of the safest investments as the US government has never defaulted on its payments.
If you are buying government bonds then you should ensure you are investing in a politically stable country and also be aware of fluctuations in the exchange rate which will affect any profits if you invest abroad.
Whatever your age, it is important to regularly review your investments to ensure that they still meet your needs. Here’s one calculator at CNN money that suggest your ideal retirement saving mix for a particular age. This might be helpful for you.
Readers, if you have any suggestion on ideal retirement asset mix and/or retirement strategy, at your age, or, have any other suggestion to put forward, please do not hesitate to share with us.
Anton Ivanov says
This is a great starting point for beginners trying to construct a solid retirement portfolio. I’ve used a number of free online asset allocation calculators when I was starting to invest. They all give slightly different results, but you can get a general picture of what you should be aiming for.
It’s also important to rebalance your portfolio regularly to make sure it’s still on track and to shift your asset allocation to more conservative investments as you age.
Midlife Finance says
I’ll be 40 this year and it’s hard to shift asset allocation. I’m used to one style of investing and shifting to a more conservative style is going to take a lot of time.
Thomas | Your Daily Finance says
I think this is great if you have the right amount of money at a certain age. I have seen people who are in their late 50s with only 50-100k saved. I don’t think you can have the same approach as if you had 500k-1mil save at that age.
Paul @ The Frugal Toad says
I’ve got 7-10 years before I retire and have 75% in equities and 25% in bonds. By retire I mean move on to the next phase of my life which with luck will involve creating passive income streams!
[email protected] says
Didn’t know of that rule of thumb for 20-30 year olds–very cool. Great breakdown here.
Little House says
I’ve gotten a late start to retirement planning. When I was in my 20’s, an employer in his 40’s warned me about waiting but I didn’t listen! Now, I have to play catch-up and hope that my pension plus a small retirement fund will be enough. My employer offers a 403(b) without a match plus a pension. They also offer a 457, but I don’t know much about the 457 except that I can contribute the same amount to it as I can the 403(b). Now that I have a contract with the employer, I’ll be contributing this year.
Eric J. Nisall - DollarVersity says
Regarding the Roth disadvantage of tax rate uncertainty–unless you think that you will have less taxable income in retirement than when you are in your prime years, then it’s not a disadvantage. And, if you think that way, you’re pretty much saying that you aren’t going to be all that successful during your working years.
**added benefit of the Roth: no RMD, so you can take out as much or as little as you want over time, allowing for added growth as time goes on.
I hate the so-called “rules” for investment allocation and age. Age really has nothing to do with how you should be investing. Sure, ideally in the early years higher risk can lead to higher returns in the long-run, but that’s complete crap. Everyone has a different feel for how their money should be allocated, and how much risk they are willing to take on. No one should be doing anything they aren’t comfortable with just because someone else says they should.
MMD @ IRA vs 401k Central says
This is a great outline for someone just starting out. The only two suggestions I would make would be:
1) To max out your savings as much as possible the younger you are. This will help you leverage the power of compound interest.
2) Don’t forget about your taxable accounts. While retirement accounts are great for long term investing, using your taxable accounts can help you prepare for early retirement if that is something you plan on doing. Plus it can have lower than normal taxes on the capital gains and dividends if you hold them longer than a year.
Some of the best guidelines are the ones that are easy to follow. This is very easy to remember and shouldn’t steer anyone too far off course.