Get Smart: 3 Investor Tips To Raise Your Retirement IQ
In the words of Maxwell Smart, we think it’s only fair to warn you: nearly half of all American families have no retirement account savings at all. This is according to 2016 research by Economic Policy Institute (EPI) who found that 401(k)s have failed most workers today. Has the system failed you?
The obstacles to saving money often have more to do with lack of knowledge rather than lack of funds. Studies have found that most people have a limited understanding of basic concepts. Boosting your savings and getting filthy rich can be fairly painless if you understand your part in choosing your investments and allocations. Here are five investment facts you probably don’t know but should, complete with helpful tips so you can start saving money . . . and loving it.
#1: What is the difference between “defined-contribution” plans and defined-benefit plans?
Who do you think is responsible for managing your retirement? We’re not being cheeky here; the answer has changed. Saving for retirement has gotten harder than it used to be because more of the responsibility has been placed on the shoulders of the employee rather than the employer. The reason why has to do with the difference between these two terms:
Defined-benefit (DB) plans: with this type of plan, the EMPLOYER is responsible for funding the promised retirement benefits. If the contributions are insufficient due to lower-than-expected returns, for example, the employers make up the difference. Nice, huh? These were the good ol’ days of the pension plan.
Defined-contribution or DC plans: this type of plan is your typical 401(k) and it is the EMPLOYEE who is responsible for making investment decisions, shouldering risk, and understanding their investment choices. In these and similar plans, it is the employer contributions and not retirement benefits that are determined in advance, which is misleading because employers may or may not contribute anything to these plans.
TIP: If you are ten or fewer years away from retirement, it might be time to reposition a portion of your assets so they are not exposed to risk. To speak to a qualified financial planner about how to do this, GO HERE.
#2: What difference does a tax-deferral make when growing money?
Investing in a 401(k) or an IRA is a choice that you as an investor can make to improve your financial standing. Unfortunately, not all people who have access to these plans take advantage of them. This could mean you’re losing out on thousands of extra dollars that you don’t have to earn because the power of triple compounding does the work for you.
How much more do tax-deferred investments earn as compared to taxable investments? If you invest $1,000 in a stock that grows tax-deferred and averages 12 percent, after 35 years, that thousand bucks would grow to $52,780. If you had to pay taxes on the gains along the way, guess what? That same grand earning that same 12 percent would only grow to $21,813. That’s a free $30,000. Why wouldn’t you want to take advantage of that?
TIP: If you don’t have access to a 401(k) plan through your employer, you can still get tax-deferred growth by opening up a traditional IRA.
#3: What kinds of investments grow tax-deferred?
Typically speaking, market-based investments such as mutual funds and stocks do not grow tax-deferred. Investors pay a special tax rate called a capital gains tax that is usually lower than income tax rates. The exception to this is when these investments are inside of a retirement account such as a 401(k) or an IRA. These accounts get preferential tax treatment by the IRS as a way to encourage investors to save money; however, there are contribution limits and rules about when you must withdraw this money.
There is one type of investment vehicle that does enjoy tax-deferral without the contribution limits: the annuity. Whether you choose the variable, fixed, or fixed-indexed, the earnings that grow inside of an annuity are tax-deferred. This means you don’t have to pay the taxes on the gains until you spend the money.
TIP: If you have a Required Minimum Distribution (RMD) due on an IRA and you don’t need the money for income, investing in a tax-deferred annuity might be a good way to boost your legacy. Talk to an annuity specialist about your options.
It’s often misperceptions that prevent investors from taking advantage of opportunities that could be good for them. With all the noise out there about market returns, it can be difficult to know who to listen to. All investments come with some degree of risk.