One area where there is a general consensus is that the earlier you start, the better (to take advantage of compound interest ). Determining the optimal investment allocation is important, too, and is best decided with your financial adviser.
I'm using four "buckets" to stash my retirement savings because I've learned that having more than one retirement funding stream is key to my financial stability. I hope my strategy can give you some ideas of how you might diversify your own retirement savings.
Why it's important to diversify your savings
I still remember one of the first meetings I ever had with my financial adviser. Among other things, he talked to me about different "buckets" of savings. He used the analogy of rowboats in a race and talked about how at different times, different boats may be ahead.
He used an example of the market crashing right when you hit retirement. If all of your savings were in the stock market, then you would have to sell at a loss to get the income for your retirement. A better strategy would be if you had some of your savings in other buckets. That way, you could draw down one of them and give the stock market "rowboat" time to come back ahead. Although I considered myself fairly well-versed in financial planning, I had never thought about it that way.
When you're younger, it may make more sense to just invest in index funds in a Roth IRA with the vast majority of your savings. This is because you may be in a low tax bracket currently and you have a long enough time horizon for index funds to approach their historical norms. The closer you get to retirement, though, the more important it is to have different buckets of savings.
The first bucket where I'm putting my retirement savings is in tax-exempt accounts. These are accounts like Roth IRAs and Roth 401(k)s. With a tax-exempt account, you pay taxes today on the money you contribute and then all contributions and growth on the account are available to you, tax-free, when you reach retirement.
Tax-exempt accounts are great for younger people and/or people who are in lower tax brackets. If you're in a 10% tax bracket now and estimate you might be in a 30% tax bracket later in life when you're ready to retire, a Roth IRA makes a lot of sense. Why take the tax deduction now (as you would with a tax-deferred account) and save 10% when you could let that money grow tax-free and take it out later and save 30%?
The second bucket I am using for my retirement savings is tax-deferred accounts. I have four different types of tax-deferred accounts that I personally am using:
- Employer 401(k): 401(k) accounts are great, especially if your employer provides matching funds .
- Traditional IRA: I have typically prioritized funding a Roth IRA over a traditional IRA, but I do have a few traditional IRAs that have been converted from my 401(k) accounts with former employers
- SEP IRA: Because I have a small business, I also contribute to a SEP IRA , which is another type of tax-deferred account
- Whole life insurance: While there are arguments to be made for term life versus whole life insurance , I have some of both. The cash value of whole life insurance is also tax-deferred
All four of these types of accounts are tax-deferred. That means that you can receive a tax deduction for contributions to 401(k)s or traditional IRAs. But when you withdraw from those accounts at retirement, you'll pay taxes then.
Another bucket for retirement savings is taxable investment accounts. With a taxable account, you pay taxes as you go. For example, if your taxable account is invested in the stock market, you would pay capital gains taxes on any gain that you have when you sell a stock. These could be short-term or long-term capital gains, depending on whether you have held the stock for longer than one year.
Generally, you should maximize tax-exempt and tax-deferred accounts before you worry about taxable accounts. That is because for most people it will be more advantageous to either get a tax deduction now or be tax-exempt when withdrawing.
However, most tax-exempt or tax-deferred accounts have either income or contribution limits. So depending on your financial situation, you may have more money you want to save than you're able to contribute to one of those accounts.
One type of taxable account would be liquid savings accounts, such as where you might have your emergency fund. While you would want to keep your emergency fund separate from your other taxable investment accounts, you do pay taxes on any gain or interest you get from your savings.
Real estate investments
The final bucket where I have some of my retirement savings is in real estate. I have three single-family rental homes as well as three small commercial buildings. Each of these has a positive monthly cash flow. And while I don't make a ton of money each month, they are helping to pay down the mortgages on these properties while still providing a net positive monthly income.
In addition to the monthly cash flow, these properties should hopefully appreciate in value. Most importantly, the income and appreciation that comes from these properties is not tied to the stock market. So if I need cash in retirement during a stock market downturn, I have the ability to sell or do a cash-out refinance on one of these buildings.
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