Investing

Understanding Different Types of Retirement Accounts

money banknote - hourglass-types of retirement accounts

The basic idea behind any retirement plan is to put some money into different investments and to live off what those investments generate in retirement.

How much your retirement portfolio will grow depends not only on the amount of money you save but also on your choice of retirement accounts.

You can choose from three different types of retirement accounts:

The 401(k) and traditional IRA. These are tax-deferred accounts.
The Roth IRA and the Roth 401(k) plan. These are tax-free accounts.
Brokerage investment or savings bank account. All earnings on your investments are taxable.

The most common ways retirement accounts are opened:

Through your employer
Through yourself, if you are self-employed
Through financial institution on your own

Employer-Sponsored Retirement Account – 401(k)

Account

401k plans are retirement plans offered by employers. And a 401k account is tied to your employer because the employer sponsors the plan. A 401k is just the name of your retirement savings account where you save money for retirement.

Contributions

A 401(k) plan is the most common tax-advantaged retirement plan. Your contributions to the plan are made automatically with your pre-tax dollars. Compared to other retirement plans, a 401(k) plan allows high contribution amounts of up to $19,500. And if you are age 50 or older, the catch-up contribution is an additional $6,500. So, you can save a total of $26,000. (in 2021). Your employer may or may not match a portion of what you invest. But if an employer match is available take it because it is free money for you.

The best part is that your contributions will grow tax-free for many years which allows the compound interest to kick in and start working its magic. After all, a 401(k) plan helps your retirement savings grow as in a tax-sheltered account.

Withdrawals

You will start paying taxes on money invested only after you retire. If you withdraw money before the age 59 ½ you will pay a 10 percent penalty fee and taxes on your withdrawal. At age 72 you will be forced to start taking money out of tax-deferred accounts because IRS is eager for you to pay taxes on the money. If you do not take your RMD (Required Minimum Distributions) on time, you will face a 50 percent penalty fee.

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Self-Employed Retirement Account – Solo 401(k)

Solo 401(k) or Self-Employed 401(k) is an individual retirement plan for someone who is self-employed and does not have any full-time employees besides a family member. Solo 401(k) rules are similar to a regular 401(k), but a bit complex to set up. You can open an account with any online brokers. But you will need an Employer Identification Number (EIN), an account application, and the company rules for your 401(k).

Traditional IRA Retirement Account

Account

The traditional IRA, which stands for Individual Retirement Account, works the same as a regular 401(k), but no employer is involved. You can open an IRA on your own with any online brokers. Online brokerages such as Fidelity, Schwab, and Vanguard are good choices. And you can have both 401(k) and IRA accounts.

Contributions

In 2021 you can contribute up to $6,000 a year or $7,000 if you are over 50. The money that goes into an IRA account must be from the earned income (money you make from working and not as gift money).

The contributions for IRAs are much lower than for 401(k) plans. And there is no employer matching contribution since there is no employer sponsoring the plan.

Traditional IRA and Roth IRA rules from IRS

Withdrawals

If you take money out of your IRA before you reach age 59½, you will face a 10 percent penalty fee (the same as with a regular 401(k). In addition to that, you will have to pay federal and state income taxes you owe on the withdrawal.

There are a few exceptions to this rule. You can avoid the penalty if you withdraw the money for the following reasons:

Buying a home for the first time
Disability
Qualified education expenses
Health insurance (if you are unemployed)
Medical expenses that were not reimbursed

At age 72 you will be forced to start making withdrawals from your traditional IRA (the same as 401(k) rules).

If you want to learn more about IRA and Roth IRA retirement accounts, I recommend reading my post: Do You Know the Difference Between IRA and Roth IRA?

Roth IRA Retirement Account

Account

Roth retirement accounts basically mean that you pay taxes upfront when you put the money into the account. But you will pay zero taxes when you take the money out.

Contributions

You are only allowed to put money into a Roth IRA if your income is below a certain limit. If you meet that criteria, your annual Roth IRA contributions in 2021 are $6,000 for people under the age of 50 and $7,000 for people over 50.

If you can contribute to a Roth IRA, it is a great way to save more money for retirement. Unlike a traditional IRA or 401(k), the IRS does not require you to make RMD withdrawals from a Roth IRA account. The money can sit and grow there as long as you want it. And it can be passed to your heirs.

Withdrawals

If you turn 59 ½ you can withdraw money from your Roth IRA tax and penalty-free. However, you may have to pay taxes and penalties on earning in your Roth IRA if you have had it less than five years.

But if you are age 59 ½ and older and met the five-year holding requirement, you can withdraw money from a Roth IRA account with no taxes or penalties.

You can open a Roth IRA account at any financial institution including online brokerages such as Fidelity Investments, Vanguard, Charles Schwab, and TD Ameritrade.

Roth IRA Contribution Limits from Charles Schwab

Roth 401(k) Retirement Account

Account

A Roth 401(k) is a type of 401(k) that allows you to make after-tax contributions and then when you retire to take tax-free withdrawals. On the other hand, a traditional 401(k) allows you to make pre-tax contributions and get taxable withdrawals in retirement.

Contributions

I recommend you check to see if your plan has a Roth 401(k) option. Everyone should be eligible if the plan has a Roth option. If your employer offers both a Roth 401(k) and a traditional 401(k) you can split the contributions. I have both accounts – a traditional 401(k) and a Roth 401(k) and I split the contributions 50/50.

A Roth 401(k) is one of the best options for you because it does not have income and contribution limits as a traditional Roth IRA. As with a traditional Roth IRA, your contributions come from your after-tax paycheck rather than pre-tax salary as a 401(k). Your contributions and earnings in a Roth are never taxed again if you follow the rules and remain in the plan for at least five years.

Withdrawals

With a traditional Roth IRA, you are not required to take RMDs at a certain age. However, with Roth 401(k) you have to start taking RMDs at age 72. The good news that you have an option to roll the money over from a Roth 401(k) to a Roth IRA.

Both Roth IRA and Roth 401(k) accounts allow tax-free growth on your retirement savings and tax-free retirement income. But there is a difference in rules for taking money out before retirement.

Brokerage account – taxable account

Account

A brokerage account can also be a type of your retirement account where you keep your savings for growth. The main difference between a brokerage account and your other retirement accounts that there are no any tax advantages.

Except for certain select investments, such as municipal bonds, all earnings are taxable. So, if you make money because your investments go up in value or receive dividends, this income will be taxed. In addition to that, you will have to pay capital gains taxes when you sell your investments.

You can open a brokerage investment account at any financial institution including online brokerages such as Fidelity Investments, Vanguard, Charles Schwab, and TD Ameritrade.

Contributions

The good news that there is no limit to how much you can invest in a brokerage account. This account works great for people who want to build wealth through the stock market.

Withdrawals

Also, there is no penalty fee if you decide to withdraw your funds before the age of 59 ½ or forced RMDs at age of 72.

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Putting It All Together

Retirement accounts like 401(k), IRAs, Roth IRAs offer us different tax benefits. Even there are differences between these types of accounts, they basically work the same way in everything else. The main idea is that you make contribution throughout your life so that when you retire you have enough money to live off your investments.

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5 Basic Rules of Investing for Women

by Maggie 2 Comments

a woman is looking at the glass marker board with stock market chart

I know that many women don’t feel comfortable with the idea of investing. The word “investing” seems complicated and out of reach for them. Like one of those things you supposed to understand, but too embarrassed to ask anyone about it. Women prefer to delegate this task to men, without understanding how money is invested, and at the end never learn the basics of investing.

But we women need to learn how to invest because the world is changing. We live longer than men and at some point, we will need to learn how to manage finances. In addition to that many women don’t have enough money saved because they take time off to raise kids or take care of their relatives.

With less money in their saving accounts, but more years to live women need to learn how to make money work harder for them. I know that many of us “invest” when the opportunity presents itself – opening a 401(k) when the company offers us one.

But it will be a mistake to think that if you have money saved in 401(k), IRA or Roth IRA each year it will be enough for your retirement income. You should boost the resources you will need in retirement by creating a personal investment portfolio.

I am sure that most women have 401(k) and save money there regularly.

The question is what should you do with the rest of your savings?

Keeping it in a bank is not going to work, because you’re going to lose money due to the inflation. The best solution would be to open a brokerage account (taxable investment account) and put and invest your savings there.

You can open a brokerage account with any of the major brokerage firms like Vanguard, Fidelity or Charles Schwab.

But before you start on that journey, learn the 5 basic rules of how to invest and build a simple and easy-to-maintain portfolio:

1. Allocate your assets

The phrase “asset allocation” sounds more complicated than it is.

Asset allocation works as a well-balanced diet. To stay healthy, you need to eat the right proportion of meat, vegetables, fruits and bread every day.

The rules are no different when it comes to investing. How you divide your money between different types of investments is one of the most important decision you have to make.

Simply put any retirement portfolio is called an investment portfolio or a collection of investments. Although, any investment portfolio is a combination of main asset classes:

Stocks (equities)
Bonds (fixed income)
Cash

Moreover, any investment portfolio is usually divided into sub-asset classes:

Large-cap stocks
Mid-cap stocks
Small-cap stocks
Domestic stocks
International stocks

Additionally, each asset class and sub-asset class is divided into categories:

Individual stocks
Individual bonds
Mutual funds
ETFs (exchange-traded funds)
Others

Different type of investment can be broken into different categories. This is called diversification. The idea behind the diversification is to spread the risk and do not put all your eggs in one basket.

A well-designed investment portfolio will include several categories.

Also, it will be organized by age, your risk tolerance and how soon you need the money – short or long-term investing goals.

2. Invest in stocks for long-term

a clock w/a toy-frog sleeping on the pile of money

How you allocate your savings between stocks, bonds, and cash will affect the rate of return you earn on your money. The more your investments earn, the less money you will need to save for the future.

Most of the times stocks outperform any other kind of investments. However, stocks are considered a volatile investment and have their ups and downs. To stay invested in stocks we need to ride out the down times.

Unfortunately, we have less time on our side when we are in our 50s or 60s. It was much easier for us when we were in our 30s or 40s and retirement was far away. We were working and accumulating assets and had time to wait for stock market recovery.

When we are only 10 to 15 years from retirement it is harder to make up for our investment losses. And yet the magic power of compounding forces us to stay invested in stocks. The more money you put in and the longer you keep it invested, the faster you’ll reach your target due to the magic of compound interest.

The more money you start with, the more interest it will generate. Keep adding more money to your original investments and you will see how interest grows more interest. The power of compounding will help your invested money grow faster.

However, it’s scary when the market goes down and you see how your portfolio is losing money (only on the paper if you don’t sell out). Frequently, there is short-term volatility on the market and prices fluctuate. Eventually, things calm down and the general trend became positive again. That’s why we make money when we invest for the long-term.

All investments hold some risk. You need to understand the risk and feel comfortable with the amount of money you invest in each category.

There is no one-size-fits-all investing approach for everyone. A lot depends on how much you have already saved for retirement and how soon you are planning to retire.

How I set up my portfolio

a graphic image of a dollar sign and several cubes showing growth

Roman and I have several brokerage accounts with Fidelity Investments and Vanguard. Before starting this blog, I was happy with high exposure to stocks. Usually, I don’t have a sleepless night or start selling out stocks when the market goes down.

The portfolio was set up for 15-years horizon and before we retire at full retirement age. I had a mix of 85% stocks, 10% bonds and 5% real estates.

The stock portion of our portfolio was divided between a 25% allocation to large-cap stocks, 15% in mid-cap stocks and 15 % in small-cap stocks. Another 30% was invested in international and emerging market stocks which gave our investments an additional boost in growth.

However, as we are getting closer to retirement, I want to reduce the exposure to stocks and change the portfolio allocation to 70% in stocks and 30% in bonds. The new allocation will help to protect the capital and yet give us enough exposure to future market growth.

3. Invest in Index funds

There are two types of investments – active investments and passive investments.

Most of us don’t need a complicated investment plan that requires more choices and frequent changes. And most of us would prefer something simple and easy to maintain. Investing in mutual funds are often better and easier than in individual stocks or bonds because funds offer diversification which means greater safety for your money.

Mutual funds

Let’s start with mutual funds. Mutual funds represent the pooled money of thousands of investors. Most mutual funds have professional managers who are actively involved in selecting the investments for their funds.

Those funds are called actively managed. Actively managed mutual funds come with high management fees because the portfolio manager attempts to beat the market.

Index funds

Many people following legendary investor Warren Buffet and his advice to invest in index funds. Index funds are mutual funds which are fixed to match a benchmark or index.

The result is the index fund manager doesn’t’ seek to do better than the index but just to replicate it. That’s why it’s called passive management.

Index funds do better for the investors because the actual cost of investing is less than in an actively managed fund.

You can read more about mutual fund types and categories:

Mutual Fund Types and Categories to Build a Better Portfolio

4. Re-balance your portfolio

women at the computer analyzing a company growth

After you have created your portfolio, it will need your attention from time to time. A buy-and-hold portfolio, which I strongly advocate, cannot just maintain itself. With time the asset allocation in your portfolio becomes uneven and you’ll need to re-balance it and get back to your original target allocation.

What does it mean re-balancing a portfolio?

Here is a simple example. You set up your target allocation with a mix of 60% stocks and 40% bonds. With time your portfolio might change to 70% stocks and 30% bonds. In this example, your stock allocation has risen beyond its original set point. You could re-balance it by selling stocks and buying bonds to bring it back again to 60/40 ratio. It means putting all your investments back in place.

The main reason for re-balancing your portfolio is to reduce the risk. For example, if your portfolio becomes overweight in stocks it has come to be more aggressive. And as you grow older you might prefer to keep it conservative to preserve your investments. Otherwise, if you are planning to retire next year and suddenly the stock market falls 40%, as it happened in 2008, you can say good-bye to your retirement.

Many financial experts recommend looking at your portfolio every year or two. I prefer to look at our portfolio and re-balance it every year in December. It makes easier to keep track of all our investments.

It’s good to remember that buying and selling stocks or bonds involve transaction costs. Moreover, selling your shares means that you have to pay capital gain tax.

5. Investment fees

When you invest your hard-earned money in a mutual fund it comes with a certain percentage of fees. You have to pay people running mutual funds for research, trading costs, and advertising. Understand what you’re investing in and remember to keep your investment fees low, otherwise, it will reduce your profits.

As the saying goes, “It isn’t what you make, it’s what you keep”.

Paying a higher management fee does not guarantee a better return on your money. Yes, you have to pay a management fee, but you’re better off paying the lowest fee possible.

Most of the experts recommend Vanguard as a low-fee index funds provider. Fidelity Investments and Charles Schwab also match Vanguard’s pricing for index-based approach. Yet in comparison, the Vanguard has the lowest cost funds across the board.

Take-away thoughts

My final advice for women who learn how to invest is “don’t make yourself crazy and keep investing simple”. Don’t invest in some sophisticated investments you don’t understand. Create a simple and easy-to-maintain portfolio of stocks and bonds.

The good news that you don’t have to become an expert. However, understanding the basic rules of investing will help you to become comfortable with your future investment decisions.

My personal goal for investing is simplicity and I try to follow a great quote from someone very smart:

“Keep it simple: as simple as possible, but no simpler” – Albert Einstein

The intent of this post is to be only educational and provide a simple guideline for a very complicated matter. I would recommend discussing your investment strategies with an accountant, financial planner or tax professional.

How to Set Up Your Retirement Portfolio?

by Maggie Leave a Comment

woman and man are looking at the horizon and way to find a road

Reaching the age of mid-50s brings changes to our lives and especially the way we look at our retirement savings and investment portfolios.

For most of us, when we hit the mid-50s it’s like a wake-up call to start getting our retirement plans in order. Avoid thinking about retirement is not an option anymore. By this time, we’re no more than 10 or 15 years from our retirement date, unless you did an awesome job and retired by 50.

As 50+ women, we are at this good point of life when we still have time to look at our finances and make necessary improvements. On another hand, we already have a realistic idea of how we want to spend our golden years and how much money we need for it.

If you’re planning on working until your full retirement age, you still have 10 years to save and invest until you need access to your retirement accounts. This age gives you enough time to accumulate more money in your retirement portfolio and make some changes.

There is no one-size-fits-all investing approach for everyone at any age. There are a lot of factors to consider before deciding. A lot depends on your age and risk tolerance. Let’s assume that you need to set up a new retirement portfolio or modify the one you have already created.

How to start? What do you need to know?

Start with asset allocation

hi-rise glass buildings in financial district

The simple way to look at asset allocation is how your portfolio is divided between stocks, bonds, and cash.

There are three main asset classes:

equities (stocks)
fixed–income (bonds)
cash

The question is why asset allocation is so important for investing?

Asset allocation is an investment strategy which brings a different level of risk and rewards over time. That’s why you need to have a certain percentage of each asset in your retirement portfolio.

The final goal of allocating the investments to different classes is to reduce the risk and increase a return on your money.

What you invest in is all about your personal goals and risk tolerance. When you’re in your 20s or 30s you might prefer all your retirement savings in stocks. Why? You have time to recover the setbacks of the markets. Moreover, you’re probably not in your prime earning years yet and your income will increase in the future, allowing to compensate for any monetary losses.

When you’re in your 50s and 60s the timeline horizon changes together with the risk tolerance. At this age, you have to start thinking about preserving capital rather than making big profits in the markets. You don’t have time to recover your investments from market downturns.

You need to set up your retirement portfolio based on your age and risk tolerance.

Retirement portfolio based on your age:

You need to decide how much money to invest in stocks and how much in bonds?

The most popular rule of asset allocation is to subtract your age from 100 and invest that portion in stocks.

If you use this formula the list below gives you various options on how to set up your portfolio based on the previous calculations:

50 years old: 50% stocks and 50% bonds
55 years old: 45% stocks and 55% bonds
60 years old: 40% stocks and 60% bonds

However, many financial advisers say that we should change the base number from 100 to 110 and even to 120. The new numbers are based on studies showing that we live longer with every year.

Knowing that stocks outperformed bonds over the long run, we need to have a greater allocation towards stocks. Why? Because stocks provide growth to our investments.

Based on new age recommendation subtract your age from 120 and you get a new recommended asset allocation:

50 years old: 70% stocks and 30% bonds
55 years old: 65% stocks and 35% bonds
60 years old: 60% stocks and 40% bonds

Retirement portfolio based on your risk tolerance:

There is a direct link between risk and return on your money or simply put a reward. The greater the risk, the higher the potential return. Less risk, less return.

Do you know what type of investor you are? Are you risk-loving, risk-averse, moderate or something between?

The list below shows how to divide your investments based on risk tolerance:

Aggressive: 100% stocks
Moderately Aggressive: 80% stocks and 20% bonds
Moderate Growth: 60% stocks and 40% bonds
Conservative: 45% stocks and 55 % bonds

The goal of The Aggressive, Moderately Aggressive or Moderate Growth portfolio is to get an as high return on your invested money as possible. That’s why it invested heavily in stocks. Only stocks bring growth or higher return on invested money. On the other hand, it gets your portfolio exposed to market volatility.

The goal of The Conservative portfolio is to preserve the invested capital rather than achieving higher returns. That’s why it invested in bonds. Bonds don’t grow high as an investment but gives us a certain level of capital preservation and reduce the exposure to market volatility and the risk of losing money.

The final goal of any allocation strategy is to maximize returns on your invested money and minimize a certain level of volatility and risk.

How to use the rules of asset allocation?

The good way to start is to be honest with yourself. As I mentioned before what you invest in is all about your personal goals and risk tolerance.

What is your time frame? Do you know how soon you need to have access to your retirement savings?

If you have 10 to 15 years before start withdrawing money from retirement accounts, you might rely on stocks for higher return and growth of your portfolio. Even with the market downturns, you would have some time to recover your money. So Moderate Growth portfolio might the answer to your asset allocation.
But if you’re 5 years away from retiring, you might consider a conservative approach or at least 50% stocks 50% bonds portfolio.

What is your risk tolerance?

Do you remain calm during the market ups and downs? Do you have sleepless nights when you heard the news about the recent market crash?

So, if safety and preserving the capital is your top priority, you might consider increasing your bond percentage. But don’t forget that we still need to have growth in our retirement portfolios to beat the inflation.

Stick with safe investments like money markets, CDs, and bonds if you want to avoid risk entirely. This asset allocation will let you avoid stocks completely, but leave you exposed to inflation.

You need to decide what works for you and what doesn’t. These strategies will be different for people who are already retired or those who are not.

If you’re already retired, these allocations may not be right for you. You will need to take regular withdrawals from your retirement savings. It changes your goal from maximizing returns to bringing steady income for life.

In the end, you should stick with the allocation model which works for you and your personal goals. Just remember, as you age and transition to a new phase of life your retirement portfolio needs to change as well.

If you want to know more about investments, asset allocation and portfolios head to Step-by-step guide to evaluating your investments and performance by Fidelity Investments.

My retirement portfolio asset allocation

table with a laptop computer and women's hand with a cup of coffee

I’m a risk-loving investor with moderately aggressive asset allocation strategy. I have 85% invested in stocks and 15% in bonds, cash, and others. I believe stocks will outperform bonds over the long run, but we’ll see continued market volatility from time to time.

Before starting this blog, I was happy with high exposure to stocks. Usually, I don’t have a sleepless night or start selling the stocks when the market goes down. My retirement portfolios consist of individual stocks, mutual funds, ETFs and some bond funds. Typically, I set up the trailing stops for all my individual stocks. This way it helps me to capture the gain when the market goes up and limit the loss when the market is down.

However, I started to feel that I need to simplify my portfolios and change the asset allocation from Moderately Aggressive to Moderate Growth. My goal is to start re-balancing our portfolios to meet 70% stocks and 30% bonds and cash allocation. This change will help to preserve the capital value of all portfolios and yet give me enough exposure to future market growth.

Putting it all together

Hopefully, this post will give you a basic idea how to set up your own retirement portfolio, create an asset allocation strategy and find methods to improve returns while reducing risks of losing money.

If you are ready to start, learning is a must. You want to take your time, do your research and make wise decisions. Set your goals, read the books and expand your mind with good information. All the knowledge you gain today will affect your financial well-being for years to come. You need to understand what you’re investing in. It doesn’t need to be complicated. It could be simple and easy steps to follow. Invest your time and energy to plan for the future and learn how to improve it.

How to set up your portfolio based on asset allocations article is not a recommendation and serves only as a guide. The opinions voiced in this material are for general information only. I am not providing any specific advice or recommendations to any of my readers.