This article is the introduction to the series.  When we talk about retirement, there are a couple of factors that are important to understand:

1. Retirement does not just mean “quit working.”  On this site it really means finding financial freedom to do what you want to do. That could be reduced or no work hours. Or it could mean starting a business, volunteering, or opening a daycare for grandchildren.  Retirement is just a convenient word for that, but financial independence is the real goal.
2. Reality matters here. If you do not have enough money already saved and invested to be financially independent with a portfolio growth of 6 – 10% annually over ten years, then you won’t be done in ten years.

Before we get started on investing, let’s do some pre-work. Specifically we need to determine the following:

• Are you debt free or nearly debt free?
• What is your risk tolerance?
• How much money do you need to be financially independent?

Are you debt free or nearly debt free?

With 10 years left to go before retirement, you should be on your way to being debt free with the exception of a mortgage. This isn’t easy, and it isn’t reality for everyone. However, it is where you need to start.  Debt quickly cancels income, which hurts your ability to accumulate wealth. Debt represents risk to you. Paying off debt gives you a guaranteed return matching your interest rate (unless the interest is deductible for you). Aside from overextending yourself and not having cash on hand (an emergency fund), there is little risk to paying off debt.

Some people want to compare the interest rate with the return on investments they could have.  Usually they forget risk in that equation.  For example, if you have a home equity loan at 8% from rates before the housing market crash, payments to that loan “earn” 8% while the stock market jumps up and down.

But really the bottom line is that you cannot feel financially independent with significant debt, and debt makes getting there that much more difficult. A mortgage is the only debt that you should not pay off before investing, since the home tied to the mortgage will gain value over time.

What is your risk tolerance?

This is a huge factor in deciding what to invest in. Many people moved happily along with their 401(k)’s until the 2001 tech crash and the latest recession turned them into “201(k)’s”.  If you have a low tolerance for risk, your investments need to reflect that. However, the sobering truth is that if you tolerate no risk in your portfolio, you will get little to no growth relative to inflation. Your entire contributions will need to support your financial freedom. A lot of people have moved their retirement investments into cash and conservative investments because of low risk tolerance. No one gets wealthy by investing without risk. Whether that risk is by investing time and energy into a new business, focusing intensely on your career, or putting money in the stock market.

Let’s say you are open to risk. Is there such a thing as too risky?  There absolutely is. Bernie Madoff and Enron have shown us this. No one person, no one stock should have all of your money, ever! They key is to spread the risk across areas that you are comfortable in.

So pick where you are at with one of the following (this will be important in future editions of this series):

• Conservative – You don’t ride roller coasters, and you tremor in fear at the thought of your retirement investments looking like a roller coaster.
• Moderate – You enjoy the thrill rides and roller coasters, but only on a few vacation weekends out of the year. You aren’t willing to put half of your money “at risk.”
• Aggressive – You realize what goes up can and will come down, you don’t read the news or you disregard the news, and you believe in the economic machine of our global economy

How much money do you need to retire / be financially independent?

This is not as difficult a question as it seems. Though you can save more to be comfortable and to reduce risk, the simple answer is that you need enough money so that the earnings meet or exceed the income of your “day job”. You can get buy with a bit less if you have no debt at all and most of your income is going to increasing your savings. A common suggestion is that you be able to replace 80% of your pre-retirement income. My suggestion is aim for 100% and re-evaluate every 5 years. If at that point you can replace 80% or more and are comfortable with that amount (for the rest of your life) then you are set.

Types of Investments

We are almost at a point where we can start looking at investments. When we talk about investing, while keeping in mind your risk tolerance, we must identify the key requirements of any investment that you make:

• You must understand the investment. You don’t have to understand it enough to run a mutual fund, for example. But you must understand what it invests in, how it grows, how the management company makes its money, and how the financial adviser that suggested it makes his/her money.
• You must accept volatility. Only a bank account, money market account, or a CD is going to have a guaranteed or nearly guaranteed rate of return.  Assuming you decided that your risk tolerance is at least enough to allow some growth over inflation, you will have to accept volatility in the market of whatever the investment is.

There are many people who are quite savvy about investing and meet both of these requirements hands down. This article series  is not really intended for that audience — those folks already know how to make money in the market, likely in both down and up markets. If you like your ETFs, your hedge funds, your variable annuities, and your gold, you won’t like my plan.  But if you are like the majority of people out there, you have a cursory knowledge of most investments and you do not want to become an expert in many different investments. So it really comes down to just a few investment types that I would recommend:

• A U.S. Market Index Fund
• An emerging market index fund (foreign markets like Brazil, China, India)
• Real Estate (either a Real Estate Investment Trust, REIT, or renting out property)
• Guaranteed fund, CDs, Money Markets, and Savings Accounts

Whoa!  I left a lot off of the list, right?  I don’t believe so. The reality is that investments beyond this group get more difficult to understand and manage. As we get into the remaining articles in this series, we will cover these investment types in more detail.If you wish to get more fancy than these options you certainly can. But my plan, and my recommendation to anyone, for the most part sticks within these categories.  I will describe later in the series some ideas on how to get a bit more aggressive, or how to “try out” other investments within your retirement portfolio. But as we cover this series the biggest question will become: what kind of mix of investments do you need?  This all comes down to your risk tolerance and the years you have left until financial independence / retirement. And that is why I am covering these topics in stages. So keep an eye out for the next article in the series!

Preparing to Jump

So, let’s take a look at purchasing stock in a company you’re familiar with for which you can make some educated guesses about its future.  The trick is to identify as accurately as possible the areas of risk the company might encounter.  Examples could include market risk, political risk, management risk and capitalization risk.  You can choose as many areas of risk as you like, but 4 or 5 will typically get the answers you’re looking for.

In our hypothetical example, you live next door to Fuzzy Fungus, Inc (FFI) and know some of the management.  FFI has been around for 25 years, growing slowly, but you hear they’re about to introduce a brand new product. You want in.

Let’s look at some risk factors.

• Senior management are in their mid-50’s and have been running the show for about 10 years – risk is very low, say 5% chance of failure in the next two years.
• FFI is able to raise capital fairly easily, but with the tough lending environment risk of not being to raise money is a little higher than usual, but still only 10%
• They’re depending on a new product to bump revenues, but if it tanks, the revenues could go the other way.  This may be the biggest risk, so we’ll guess it’s around 25%.
• And lastly, this isn’t about guns, cars, oil or healthcare, so the current political climate “shouldn’t” have too much impact, but still let’s say it’s still around 5%.

Now, how do we calculate overall risk and what does it mean?  The answer we get will be a pretty general one, but essentially, we will know if the new product introduction will have a large positive effect on the stock price, given this risk factors we’ve considered.  The calculation is easy.  Simply multiple the chances of success for all of the risk factors to get an overall chance of success. (The chance of success is 1- % chance of failure, expressed as a decimal.)  And the answer –

Management X Capital X Market X Political     = Overall Chance of Success

(1-.05)    X (1-.10) X (1 – .25) X (1 – .05) = 61%

Based on this answer, I would probably continue my research into the company.  If the answer was 40% or less, I would almost certainly pass.

Of course, there are a myriad of other factors you should consider before investing in stocks, but this is a quick way of deciding whether it’s worth a further investment of time, effort. and, most importantly, money.

What to invest in is obviously an important topic as well, but I am not going to cover that in this post. Instead here we are going to talk about the different types of plans. It is important to keep in mind that with most retirement account plans, there are a range of options from conservative to aggressive investments. If you have 10 or more years until your retirement, the most important factor here is that you are contributing to some retirement plan. If you are closing in on your retirement and have less than 10 years left, it starts to become more important where the money is invested. Asset allocation, risk, and all that good stuff is still very important. You do not want to be too conservative early, or too aggressive late. But before we talk about how to invest the money, let’s first cover whether to contribute to a retirement plan and which one to choose.

Should I Contribute to a Plan?

The answer to this should almost always be yes. If you have company matching, at the very least you should contribute enough to get that match.  You may not have the benefit available in the future, and with every paycheck that passes by when you do not contribute enough to get the match, you lose some income opportunity.

Beyond the match, you should contribute as much of your income as possible, targeting 15% or higher, into retirement accounts. But I do believe there is an exception to this, and that is when you have consumer debt, vehicle debt, or high interest student debt. Debt creates a stranglehold on your finances and ultimately your freedom. Some people are able to handle debt and wealth accumulation at the same time. But the reality is that most people cannot handle both simultaneously.

Once the debt is paid off, if you do not have an emergency fund of at least 3 months, you need to get that in place first. Your chances of staying out of debt and continuing to contribute to your retirement is at risk without this savings cushion. After the debt is paid off and the emergency fund is established, you should begin contributing to your retirement above and beyond any match.

If you have to hold off from your retirement savings to pay debt, you must make certain that debt payoff and creating the emergency fund are a one time, relatively short (1-3 year) process. That means that process must be done with intensity. If you can’t pay off debt and get the emergency fund established in that time frame, then consider looking for additional sources of income to attack the debt or cutting back lifestyle to make it work.  Dealing with debt and retirement at the same time is usually extremely difficult unless your income is high enough to handle both. But in that case, attacking the debt first should take very little time.

Preparing for Retirement

How Much Should I Contribute?

We already mentioned contributing at least enough to get the company match.  If you have none of the consumer debt mentioned and are able to contribute beyond that, how much should you save? You should consider contributing as much you are able up to 15% of your total household income. You can go beyond that if desired, especially if you are looking to retire early. But 15% is a good guideline for what should be “good enough.”  This of course does depend on a few factors such as when you start saving for retirement. If you start saving early, 15% may seem like too much. But if you can manage it, I would stick with 15% or higher. If you started saving later and are closer to retirement age, you are going to have to save beyond 15%.

In future topics we will discuss determining how much money you might need. This is a more concrete and realistic way to determine how much you need to save. For now, 15% is just our guideline to get started.

Which Plan Should I Choose?

Once you have decided how much to contribute, choosing the plan itself has some challenges.  Income limitations, investment options, fees, and taxes are all considerations for where you should put your money. So let’s go through the most common available options

IRA (Individual Retirement Account, a.k.a. Traditional IRA)

An IRA is a pre-tax (or deductible) investment option. The investments in the account grow tax free, however taxes are taken on all distributions from the account. In 2009, the contribution limit for Traditional IRA’s is $5000 for those under age 50. For ages 50 and older, the contribution limit is $6000.  This limit is shared with the Roth IRA. That is, you cannot contribute more than this limit in a Traditional IRA and a Roth IRA combined.

When should you contribute to a Traditional IRA?

• If you have reached your contribution limit in other retirement investment options, and you still have money to to contribute to a tax deductible retirement account.
• If you have no company match in a 401(k), contribute to the Traditional IRA first, then contribute to the 401(k).
• If you believe that taxes will go down in the future, invest in a Traditional IRA over a Roth IRA.

In general, since I don’t recommend guessing where taxes are headed (though it seems clear they can only increase with the significant debt we now have), if you have the option to invest in a Roth IRA and a Traditional IRA, you may want to split the investment in half. This gives you a hedge against taxes without guessing incorrectly on which direction they go.

Traditional and Roth IRA’s can be opened at many financial institutions. However, usually banks are not the best place for these retirement vehicles.  I specifically like Fidelity and Vanguard for opening IRA’s because of their low fees on some of the best mutual fund investment options, and because of their range of investment options.

Roth IRA

Unlike the Traditional IRA, the Roth IRA is an after tax investment. But the investments in the Roth IRA grow tax free and you do not pay any taxes on distributions (unless they are early distributions).  The contribution limits are the same as the Traditional IRA with one notable exception.  With a Roth IRA there are contribution limits based on Adjusted Gross Income (AGI).  For married couples with an AGI of $166,000 or less, they can contribute up to the full $5000 each. There is a phaseout (reduced contribution limit) between $166,000 to $176,000.  Above an AGI of $176,000. a married couple cannot contribute to a Roth IRA.  For single filers, the phaseout range is $105,000 to $120,000.

When should you contribute to a Traditional IRA?

• If you have contributed up to the company match of your 401(k) and you are eligible for a Roth IRA.
• If you cannot contribute to a 401(k) or SEP-IRA.
• If you believe that taxes will go up in the future, invest in a Roth IRA over a Traditional IRA.

Like with the Traditional IRA I don’t recommend guessing where taxes are headed. But, given the advantage of being able to take tax free distributions out at retirement, the Roth IRA and Roth 401(k)’s are my favorite plan. And except for the company match, I prefer the Roth IRA over the Roth 401(k) because it gives you more control over your money.

Traditional and Roth IRA’s can be opened at many financial institutions. However, usually banks are not the best place for these retirement vehicles.  I specifically like Fidelity and Vanguard for opening IRA’s because of their low fees on some of the best mutual fund investment options, and because of their range of investment options.

401(k) / 403(b)

401(k)’s and 403(b)’s are pre-tax or tax deductible employer sponsored retirement plans. While most of the contributions are made by the employee, companies may match a certain amount of employee contributions. Employer matching has of late been a benefit that many companies have cut back on.  A 403(b) is a very similar retirement investment, however it pertains primarily to employees in public education and some non-profit entities. In this section we refer to 401(k) but a 403(b) should have the same considerations.  The one likely negative difference of the 403(b) is that they reportedly have significantly higher fees. The best 403(b) provider in terms of fees is TIAA-CREF, so if that is your option then you are ok here.

The contribution limits for 401(k)’s, if your employer offers one of them, is $16,500 for 2009. For those individuals 50 and older, the limit is $22,000 when “catch-up” contributions are included.  This limit is shared with the Roth 401(k) if it is offered by the employer. That is, the total contributions to the Traditional 401(k) and the Roth 401(k) cannot exceed this limit.

Other limitations apply that may affect your eligibility for 401(k)s. For instance, some employees deemed “highly compensated employees” are not eligible to contribute to 401(k)’s. The income threshold for this depends on the contributions of lower income workers in a company versus the deferrals of higher income workers.

When should you contribute to a 401(k)?

• If you have a company match, contribute at least enough in the 401(k) or Roth 401(k)  to get the match. Whether you have debt or not, it is important to contribute enough to get the match. This provides “free money” in a sense.
• If you have maxed out your eligible IRA contributions and want to put more into retirement.
• If you believe that taxes will go down in the future, invest in a 401(k) over a Roth 401(k).

401(k)’s exist within a plan that is sponsored by employers and managed by an investment company.  Once your money is in a 401(k), you can move it between investments managed by the investment company. You cannot move out of the 401(k) into a more flexible IRA until you leave the company. Some plans do allow a wider range of investments by participating in Self Directed accounts. These allow investing in more stocks and mutual funds than the predefined plans usually allow. For the average investor, the predefined plans are usually sufficient and often better because of lower expenses and fees. We will discuss more about this in a future topic.

Roth 401(k) / Roth 403(b)

The Roth 401(k) and Roth 403(b) are offered at fewer companies than the Traditional 401(k) / 403(b). Like the Roth IRA, contributions are after tax and earnings and distributions are tax free.

If your company offers a match and you contribute to a Roth 401(k), the matching funds will be placed in the regular 401(k) because company matches are always pre-tax (therefore you need to pay taxes on the funds contributed by the company match when you receive the distributions).

When should you contribute to a Roth 401(k)?

• If you have a company match, contribute at least enough in the 401(k) or Roth 401(k)  to get the match. Whether you have debt or not, it is important to contribute enough to get the match. This provides “free money” in a sense.
• If you have maxed out your eligible IRA contributions and want to put more into retirement.
• If you believe that taxes will go up in the future, invest in a Roth 401(k) over a 401(k).

Most of the same rules apply for Roth 401(k)’s as they do for 401(k)’s, with the exception of Roth 401(k) contributions being after tax. My recommendation is always to prefer the Roth 401(k) to the regular 401(k). This allows you to effectively put more money in even at the contribution limit, since it is after tax.

SEP-IRA

The Simplified Employee Pension or SEP-IRA is an employer funded IRA. This becomes a fantastic option if you are self employed, are the sole employee of the company, and have significant profits. A self employed individual can contribute up to 25% of compensation, up to a maximum of $49,000 in 2009. Since the contribution amount has to be the same for all employees, it may be rare to find an employer willing to put aside the maximum 25% for all employees of a company. But for small companies with one or two employees, you can set aside significantly more money with this retirement option than the others.

Since this is a rare scenario compared to other options, this is really only recommended in those situations of a small company with few employees. And for employees other than the owner, this is more of a pension than a self funded retirement option.

Whole Life Insurance

Whole Life insurance is not really a retirement vehicle, but it does offer a savings component. Often it is offered by insurance companies as a way to save money for later in life. The problem is that the investment portion of the policy is not a good investment. You can, with a little bit of work, do much better with the other retirement options.  And the other side of the product, life insurance, is not usually a great deal either. Term life insurance is a much better product if you are looking for life insurance.  Combining savings and life insurance together seems like a great idea, but in this case the sum of the whole is not greater than the individual parts.

Annuities

Annuities are a product that you typically buy with retirement savings that provides a constant distribution over a period of time (a defined period or the life of the annuity owner). Annuities are sold by insurance companies in the form of variable annuities and fixed annuities. The problem with annuities are that they while they are a fairly simple concept, the investment vehicle within them are very complex and fees are generally high.  Variable annuities offer different investment options inside the annuity, giving the potential for a higher overall return from the annuity.

When you should you choose an annuity?

• Ideally I would say never, however:
• If you need a guaranteed monthly check or deposit into your account to support your finances

Really you can do better on your own. But if you don’t have the desire or discipline to manage the money yourself, an annuity is a viable option.

None of the Above

Once your have contributed the maximum to IRA’s and 401(k)’s, what next?  What if you don’t have 401(k) as an option, but you have more money to save than the $5000 IRA limit?  First, if you have children, consider saving in a College 529 plan. If you don’t have children or want to allocate the additional money to retirement, there are many options.  There is nothing wrong at this point at paying down your mortgage or investing in options outside of a retirement account.

Conclusion

The most critical step in preparing for retirement is simply setting money aside.  The investment vehicle helps determine how efficient that money keeps its value or grows, but that is still secondary to the process of saving over long periods of time. And remember that referring to retirement here means more than just socking away money to stop working and live happily ever after. Beyond the traditional retirement, what we are really after here is providing freedom of career choice and  security when you may want to do something else in your life or when you may have no choice but to do something else.

There are certainly more options, limitations, and considerations than covered here. Of course the limits and the options in general are also changed regularly by Congress. Once you have an idea of which option(s) might fit best for you, do some further research on the specific option. Also consider the details of your employer’s plan if you are considering the 401(k) options. And if you have concerns over your options, consult a fee only financial advisor to help create a viable plan.