January 2006 :
Saving for Retirement
in Five Simple Steps
What could be better than starting the New Year on the right financial foot? If you haven’t yet begun a retirement plan, don’t delay – you can do it in five easy steps.
Step One: Start today
Compound interest is the greatest wonder of the universe (so, supposedly, declared Albert Einstein), and the more years you have it on your side the better. With it, interest is calculated on your deposits plus all the accumulated interest from prior periods. Example: save $100 per month for 35 years and you’d have about $216,000 (assuming an eight percent annual return). However, wait ten years to begin and at that same ending point you’d have just $91,000 saved.
Step Two: Use dollar cost averaging
Why spend the effort trying to “beat the market” (which is very difficult) when you could use dollar cost averaging instead? With this technique, all you have to do is deposit the same amount of money at regular intervals into well-balanced investment accounts. If history is any indication of the future, your investments will increase in value over time, without having to guess which stock will outperform the other.
Step Three: Maximize tax-deferred savings
If your employer offers a defined contribution plan, such as a 401(k) or 403(b), take advantage of it! Your contributions reduce your taxable income, the earnings grow tax-deferred, and many employers match a percentage of what you put in. Open an Individual Retirement Account (IRA) too. Contributions to a traditional IRA are tax-deductible (if you’re not a high-income earner or aren’t participating in your plan through work) and the earnings won't be taxed until you withdraw that money at age 59.5. There is no deduction for contributions with a Roth IRA, but if you meet certain requirements, all earnings are tax-free upon withdrawal.
Step Four: Diversify your investments
For safety and growth, keep your savings in a mix of cash, stocks, and bonds. To know what percentage you should have in each, consider your personal risk tolerance, investment goals, and how long you have to retirement. The simplest way to get the blend you need is through mutual funds. Because fund shares represent investments in many different companies, shareholders are able to achieve immediate diversification and efficiently reduce risk. Diversify your nest egg further by investing in various fund types.
Step Five: Review your plan regularly
Retirement plans aren’t static. It is important to review your savings and investment strategy at least once a year. At that point you can change funds, buy or sell securities, adjust your contributions, and make sure the beneficiaries are current.
Planning for retirement is too important to put off – which is why a simple strategy is so critical. The more complicated it is, the less likely you will take action. Once you’ve started, practice patience. Saving and investing for such a large goal takes time. Make 2006 the year you concentrate on the future.