Investing for Retirement: The Ultimate Guide

yellow road sign on which is printed what's your plan for retirement?

There are few more important things to do throughout your working life than saving and investing money for retirement. Few of us have pensions anymore, and Social Security won't provide enough income for a comfortable lifestyle, so it's largely up to us to ensure that we have enough savings to support ourselves when we're no longer working.

Here's a comprehensive guide on how you can best save and invest for your retirement. Share it with anyone else who might need this guidance and revisit it yourself periodically to make sure you're still on track.

You'll find the following topics addressed below:

  • How much income do you need in retirement?
  • How to calculate how much money to save for retirement
  • The power of long-term investing for retirement
  • Are you ready to invest for retirement?
  • Kinds of retirement accounts -- 401(k)s, IRAs, and more
  • Fees
  • Asset allocation
  • Kinds of retirement income -- dividends, annuities, and more
  • How to retire early

How much income do you need in retirement?

A good way to start your retirement planning is by estimating how much income you'll need each year to reach your retirement goals. You may need less income than the average retiree if you live somewhere with a low cost of living, have inexpensive hobbies, and don't need much medical care. If your plan involves traveling the world or golfing every day, or if you expect high healthcare costs, then you may need far more than average. Regardless, it's important to ballpark how much money you'll need each year, as that will help you figure out how much money you need to save before you retire.

Here are some factors to consider:

  • Your expected expenses: Most American retirees need less income than they needed while they were working. Many of them no longer have a daily commute, and some have paid off their mortgages; getting rid of those two expenses alone could save someone great sums of money. Again, though, every retiree's situation is different. And while some of your costs will likely decline, you can expect your healthcare costs to rise as you age. According to Fidelity Investments, the average 65-year-old couple will pay $280,000 out of pocket on healthcare during their retirement. Make sure you consider every expense you're likely to face as a senior.
  • Longevity: If you expect to live longer than average, then you'll need your savings to last a longer-than-average time. If you're very fit and eat well and have many relatives who made it to their 90s, you'd do well to have an extra-large retirement account, as there's a good chance it will have to support you for a long time. Retiring at 62 and living to 95 means 33 years of retirement!
  • Inflation:Inflation is often ignored, but it can really shrink the purchasing power of your future dollars. If the income you live on in retirement is truly fixed and stays so for decades, you may face difficulties in your later years. Over long periods, inflation has averaged about 3% annually -- enough to make something that costs $100 now cost about $181 in 20 years.

There's no one-size-fits-all way to arrive at your estimated income need. You might start with the rule of thumb that you'll need about 80% of your current income to maintain your current lifestyle. Thus if you earn $65,000 annually, you'd aim for an income of $52,000 in retirement. However, it's a bit risky to rely on such a rule without crunching a bunch of numbers and taking into account factors such as the ones above.

How to calculate how much money to save for retirement

Once you arrive at an estimate of how much annual income you'll need in retirement, how can you use that to determine how big your nest egg should be when you retire? Well, first consider all your expected sources of retirement income. Imagine, for example, that you want $52,000 in annual retirement income to start. Perhaps you're expecting $25,000 from Social Security. If so, then your savings need to provide the remaining $27,000. (You can get an idea of what to expect from Social Security by signing up for a "my Social Security" account at the Social Security website .)

At this point, you might employ another rule of thumb, the 4% rule . It's not perfect, but it can give you a rough idea of how much money you might need to save, and that can be a good place to start. The 4% rule states that if you withdraw 4% from your nest egg in your first year of retirement, and then adjust that for inflation each year, you stand very little chance of exhausting your savings.

Based on that guidance, you can easily figure out what your target savings amount might be: Just multiply your desired annual income by 25. In the example above, that means your savings goal would be $27,000 times 25, or $675,000.

If you're very risk-averse, you may plan to withdraw just 3% annually, in which case you'd multiply your desired income by 33, arriving at a savings goal of $891,000. If you're confident that inflation will remain low and your investments will perform well for you, you might plan to withdraw 5% annually, in which case you'd multiply your desired income by just 20 for a savings target of $540,000. Be careful, though, as the stock market and the economy never behave exactly as we expect. It's best to use the 4% rule as a rough guide but then adjust the results, taking into account your personal circumstances, needs, risk tolerance, health, expected longevity, and so on.

The power of long-term investing for retirement

It's helpful to have a good sense of just how much your money can grow for you. For starters, take a look at the table below, which shows how much you could amass if your nest grows by an annual average of 8% annually. (A rate of 8% is used here because the long-term average growth rate of the stock market, before inflation, has been close to 10%, so an 8% rate is a bit more conservative.)

Calculations by author.

You can see that the longer you can let your money grow, the faster it will grow, and each extra year (or five years) can make a big difference. The table also shows that you can amass a significant sum even over a short period if you're socking away a lot each year. Meanwhile, relatively small annual investments can add up to a lot if they have enough time to grow. The bottom line is that the more you can save, the better off you'll be in retirement.

Regarding the assumption that your investments will return 8% per year, the stock market has posted average annual gains of close to 10% over several decades, but that's far from guaranteed, and over 10 or 20 years, it might average much less than that (or a lot more than that). And if you're investing primarily in CDs or bonds, you won't average anywhere near 8% anytime soon.

The table below shows how your money might grow at different average annual growth rates, assuming annual investments of $10,000:

Calculations by author.

Go ahead and aim for 10% gains, but prepare for less. Only invest in companies that you have researched, keep up with, and have great confidence in. If you're not interested in being an active investor, you can opt for low-fee, broad-market index funds. Even Warren Buffett has recommended them for most investors. Good examples include the SPDR S&P 500 ETF (NYSEMKT: SPY) , Vanguard Total Stock Market ETF (NYSEMKT: VTI) , and Vanguard Total World Stock ETF (NYSEMKT: VT) . Respectively, they will distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market. There are index funds targeting bonds, too, along with other segments of the market.

Are you ready to invest for retirement?

Before you start investing for retirement, there are a few important to-dos to check off your list. Here are a few questions to ask yourself:

  • Are you saddled with any high-interest rate debt, such as that from credit cards? If you are, you need to pay that off first. There's little point trying to earn 10% or even 15% annually from the stock market while paying 15% to 30% annually in interest on debts.
  • Do you have an emergency fund fully loaded, or do you know how you'll be able to handle an unexpected big expense? Don't put the only extra dollars you have into long-term retirement investments, as you might need that money on short notice.
  • Are you sure you won't need any of the money you invest in the stock market for at least five years, if not 10 or more? You want to be able to ride out any downturn and not have to sell when prices have fallen.
  • If you're married or partnered, have you discussed your retirement goals and plans? Are you both on the same page and committed to the same plan?

Next, if instead of just sticking with simple, low-fee index funds, you want to actively select, buy, and sell individual stocks, you'll need to make sure you're ready to invest that way -- for example, by understanding basic principles of investing, learning how to read financial statements, and being willing to do a little math. You'll also need to learn how to value stocks so that you can spot undervalued ones that are likely to appreciate significantly.

And here's a little reassurance: Over the long run, stocks tend to outperform other investments -- by a lot -- and that's true for low-fee broad-market index funds. Check out the following data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar between 1802 and 2012:

Source: Jeremy Siegel, Stocks for the Long Run .

If you're interested in a more relevant investment time frame than 210 years, Siegel's data shows stocks outperforming bonds in 96% of all 20-year holding periods between 1871 and 2012, and in 99% of all 30-year holding periods.

Kinds of retirement accounts

Next, understand that there are many different kinds of accounts in which you can build wealth for retirement. For example, there are tax-advantaged accounts such as IRAs and 401(k)s, and there are regular brokerage accounts that offer no special tax breaks. There are bank savings accounts and money market accounts and certificates of deposit (CDs), too.

401(k) accounts -- and how to make the most of them

A 401(k) account -- much like a 403(b) account -- is provided by many employers to their employees, and it's often managed by a big financial company such as Fidelity Investments or Vanguard.

As with IRAs, there are two main kinds of 401(k)s: traditional 401(k)s and Roth 401(k)s . With a traditional 401(k), you contribute pre-tax money, reducing your taxable income for the year and thereby reducing your taxes, too. (Have taxable income of $70,000 and a $10,000 contribution? Presto -- you'll only report $60,000 in taxable income for the year.) The money grows in your account over time and is taxed at your ordinary income tax rate when you withdraw it in retirement.

With a Roth 401(k), you contribute post -tax money that doesn't reduce your taxable income at all in the year of the contribution. (Taxable income of $70,000 and a $10,000 contribution? Your taxable income remains $70,000 for the year.) Here's what makes the Roth 401(k) great, though: Your money grows in the account until you withdraw it in retirement -- tax-free .

Another advantage of 401(k) accounts is their high contribution limits. For 2018, you can contribute up to $18,500 to a 401(k) account, plus another $6,000 if you're aged 50 or older. For 2019, the limit rises to $19,000, plus another $6,000 for the 50-and-up crowd. Even if you can't sock away the maximum, aim as high as you can, because the more you save and invest, the more you'll have when you retire.

You can compare your employer's 401(k) plan with other companies' plans at BrightScope.com . If your plan is a good one, make good use of it. If it's not, you should at least contribute enough to it to receive any available employer match and then contribute any leftover money you can to an IRA (more on those shortly) or other retirement account.

Here are some features of a good 401(k) plan:

  • A meaningful company match. A common matching scheme is when a company matches 50% of a worker's contributions of up to 6% of salary -- effectively offering a maximum match of 3% of pay. (So if you earn $75,000 and contribute 6%, or $4,500, your employer will add another $2,250 -- that's $2,250 of free money, a guaranteed 50% return on your investment.) The average total company match was 4.7% as of 2016, per the Vanguard Group.
  • Low fees. The fees your 401(k) plan charges you make a huge difference to your ultimate investment results, yet more than a quarter of Americans are not aware of what they're being charged in their 401(k)s, per a TDAmeritrade survey. If your plan's fees are high, let your human resources department know that you're not happy about that. One way to keep fees low is to favor index funds when you invest the money in your account, but even some index funds charge too much. If your S&P 500 index fund is charging you 0.70% or 1%, for example, know that many such funds charge 0.25% or less.
  • A promising menu of mutual funds. While you can invest in just about any stock or mutual fund in an IRA, a 401(k) will typically offer you a very limited menu of investment options. The funds on offer should have not only good track records, but also low fees. One of the best things to see is a variety of low-fee index funds that track various broad market indexes, such as the S&P 500, the whole U.S. market, or the whole world market. You may also like to see target-date or "life cycle" funds, which allocate your money across various stock and bond index funds according to when you aim to retire, adjusting the allocation (i.e., reducing your stock exposure and increasing your bond exposure) as you approach retirement.
  • A short vesting schedule. Your employer might be exceedingly generous in the matching funds it grants you, but how soon you actually take possession of that money matters, too. Thus, check the vesting schedule -- i.e., when those dollars actually become yours. Per a 2017 Vanguard report, 45% of 401(k) plans studied had matching funds vest immediately, which is optimal. But about 30% of plans had a five- or six-year vesting schedule. That's bad news for people who leave the company before their money vests.
  • Auto-enrollment. Some 401(k) plans will enroll employees automatically. Ideally, you'll also get to start participating as soon as you start work, and not three to six months later. Many auto-enrolling plans will start you off at a relatively low level of participation. Be aware of how much of your income is going to your 401(k) and make sure the percentage is as high as you want it to be.
  • Auto-escalation. Another great trait of a 401(k) plan is auto-escalation, where your contribution percentage is increased every year, often without your even noticing it. This can help you build wealth more quickly. If your plan doesn't offer this feature, just aim to increase your saving percentage on your own. Many of us need to be saving 10% or even 15% or more of our income, so don't settle for small annual increases -- aim big, so that you can get to your needed percentage as soon as possible. If you can immediately start saving 10% or 15%, do so.
  • A Roth option. Employers are increasingly offering the option of a Roth 401(k) account , which accepts only taxed, not pre-tax, contributions. Give it serious consideration, as it offers the chance to withdraw money from your account in retirement tax-free . More than half of employers with retirement plans were recently offering Roth 401(k)s -- but your employer may not offer that option yet. If so, let your human resources department know that you'd like it to be offered.

Whether your company's 401(k) plan is great or just decent, here's how to make the most of your 401(k):

  • Participate! You're leaving a lot of potential tax savings and retirement wealth on the table if you're ignoring a 401(k) account.
  • Max out employer matches. Be sure to at least contribute enough to your account to grab any available matching funds from your employer.
  • Don't have too much money in your employer's stock. Many employers make it easy to invest in company stock with your 401(k) contributions -- and some will make their matching contributions in the form of company stock. Yes, your employer is likely the company you know best. But even great companies can become money-losing investments. If you're depending on your employer for your income and your retirement savings, you have a lot of eggs in that one basket. Try not to keep more than, say, 10% of your net worth in company stock.
  • Don't cash out your 401(k). Cashing out your 401(k) account when you change jobs is generally a bad idea. Even if you're collecting just $20,000, that money could have kept growing for you. If it grew for 25 more years at an average annual rate of 8%, you'd end up with about $137,000. It's often best to roll over the funds in your 401(k) into an IRA, where the fees might be lower and investment options broader. You may also be able to have the funds transferred directly to your new employer's 401(k). Another option many have is to convert those 401(k) funds into an annuity that will pay regular monthly sums in retirement. Just be sure it's a fixed annuity and not a variable or indexed one, as those are problematic.
  • Don't borrow from your 401(k). Borrowing from retirement accounts is generally a bad idea unless it's an emergency and you really have no better option. That's another way of short-changing your financial future.

Individual retirement accounts, or IRAs

You can open an IRA through any good brokerage , and as with 401(k)s, there are two main types: the traditional IRA and the Roth IRA .

For 2018, the regular IRA contribution limit is $5,500 -- plus $1,000 for those 50 or older. Limits are occasionally increased to keep up with inflation. IRA limits rise to $6,000 for 2019, plus $1,000 for those 50 and older. Within your IRA, you can invest in mutual funds, ETFs, individual stocks, bonds, and a host of other kinds of investments.

There are a few other kinds of IRAs to know about if you're self-employed and don't have a nice 401(k) plan offered by your employer, complete with matching funds. For example, you can instead save for retirement with a SEP IRA . (The term SEP IRA is short for Simplified Employee Pension IRA.) SEP IRAs have much more generous contribution limits than regular IRAs. For 2018, the limit is 25% of your net income, up to $55,000. (It can be a little tricky figuring out exactly how much you can contribute, so using tax-prep software or a tax pro can help.) You can set up a SEP IRA at most major brokerages.

There are also SIMPLE IRAs , with contribution limits for 2018 of $12,500 -- plus $3,000 for those 50 and older.

A word about fees

It's worth repeating how important it is to keep the fees you pay as low as possible. Imagine two investments, with one charging an annual fee of 1.5% and the other charging just 0.5%. That one-percentage-point difference may not seem like a big deal, but over long periods, it can be -- and the table below makes that clear. It shows how annual $10,000 contributions would grow at an annual average of 8% versus 7% -- a one-percentage-point difference. Over 30 years, you'd lose out on roughly $200,000 just because of that seemingly small difference!

Source: Author calculations.

Know that with broad-market index funds, such as those that track the S&P 500, you can find plenty of options charging less than 0.25% annually, and sometimes considerably less than that. A typical actively managed mutual fund, meanwhile, might charge you 1% or more annually, with some charging more than 1.5%.

Asset allocation

For best results when investing for retirement, you'll want to spread your money over at least a few asset categories (that's called asset allocation ) -- and you will want to adjust the balance from time to time. Here's a simplified example: You may decide that you want to be invested 50% in stocks and 50% in bonds, but after five years your stocks have grown at a faster clip, and your portfolio is now 60% stocks and 40% bonds. If you still want a 50-50 allocation, you'll need to sell some stock holdings and add to your bonds.

Over time, many people like to pare back the proportion of their portfolio that's in stocks and add more bonds in order to protect their retirement assets and income from market volatility. One rule of thumb is to subtract your age from 110 and invest that percentage of your portfolio in stocks. So if you're 60, you'd be 50% in stocks and 60% in bonds and cash. The old rule was to subtract from 100, but with people living longer, some experts suggest subtracting from 110 or even 120 if you're not risk-averse.

Stocks, bonds, and cash are the classic investments that make up most savers' asset allocation plans. But within stocks, you should also diversify across domestic, international, large-cap, mid-cap, and small-cap companies. You may also want some real estate, perhaps through real estate investment trusts , which own portfolios of real estate, trade like stocks, and typically pay generous dividends. As you devise your asset allocation, keep your goals in mind. For example, are you currently more interested in growing the value of your portfolio or in generating income? The former might have you focused on rapidly growing companies, while the latter would favor dividend-paying stocks.

Below is one allocation model that someone might use if they're planning for retirement and are still a decade or more away from it. Note that the best allocation for you might differ a lot or a little, depending on your personal circumstances, risk tolerance, and so on:

Source: The Motley Fool.

Kinds of retirement income

Investing for retirement is really all about setting yourself up to have sufficient income when you leave the workforce. That can be achieved in a variety of ways. You might, for example, live off the capital gains you earn by gradually selling off the assets in your retirement portfolio. In addition to that or instead of that, you might build a sufficiently large portfolio of stocks over time and then simply live off of the dividends it generates. Or you might take some or all of your nest egg and buy an annuity (or several). Ideally, you'll have a variety of income streams in retirement (which will, remember, include Social Security benefits ).

Dividends for retirement income

Let's take a look at dividend income, because many people don't realize just how powerful dividends can be. Dividend-paying stocks are not as stodgy and slow-growing as they're often made out to be. Researchers Eugene Fama and Kenneth French, studying data from 1927 to 2014, found that dividend payers outperformed non-payers, averaging 10.4% annual growth vs. 8.5%. If you have $300,000 in dividend payers with an average yield of 4%, you're looking at $12,000 in annual income -- that's $1,000 per month! Plus, healthy companies tend to raise their dividends over time, even as their share prices rise, too.

Remember that while dividend income is hard to beat, it's not guaranteed. Even solid companies can see their fortunes change, and sometimes dividends are reduced or even eliminated. Still, that shouldn't necessarily keep you from investing at least a portion of your nest egg in a bunch of healthy and growing dividend payers,

Fixed annuities for retirement income

Another good retirement-income option for many people is one or more annuities. An immediate annuity can help you avoid running out of money by offering an endless, pension-like income stream.

You may be surprised at how much income you can buy through an annuity -- and the amounts you're offered should increase when interest rates rise, as they've been doing recently. Here's the kind of income that various people might be able to secure in the form of an immediate fixed annuity in the current economic environment. Do your own shopping around, though, to see what kind of income you might expect to receive. You'll get different quotes from different insurers, and you may even be able to negotiate a better rate.

Source: immediateannuities.com.

A deferred annuity is also worth considering. It starts to pay you at a future point, and in exchange for waiting, you get bigger payouts. A 60-year-old man, for example, might spend $100,000 for an annuity that will start paying him $1,032 per month for the rest of his life beginning at age 70.

If you decide to shop around for annuities, then stick to insurers that have high ratings from independent agencies. A high rating indicates that an insurer is financially solid, which means there's little chance it will go out of business and stop paying you the money you're owed.

It can be hard to tell what a good rating is, so check the table below, which lists the highest ratings from the major rating agencies:

Source: Securian.com.

Want to retire early?

As a reward for making it this far down the article, here's a delightful last topic: Early retirement . You might think it's out of reach for you, but if you have a good plan and can save aggressively and invest effectively over enough years, there's a good chance that you can retire early -- or at least earlier than you originally planned to.

Revisit the tables closer to the top of the article. When you first read them, you may have been focusing on how much you could save by age 65, but looking again, you might see that if you ramp up your saving, you can reach your savings goal sooner.

Retiring sooner rather than later can give you more years of retirement to enjoy. Also, the younger you are when you retire, the more active you can be in retirement. If you want to do a lot of golfing or plant a big garden or wander through Europe's grand old cities, it will be easier to do when you're 65 than when you're 75.

You might not have quite enough socked away to retire right now, but there's a good chance that if you get more aggressive about saving and invest your money effectively, you can make your retirement happen sooner. There are actions you can take now and later that can increase your retirement income . For many people, a comfortable early retirement is not impossible.

Investing for retirement is vital, as it prepares you for a long period when you'll likely have no salary and will depend on Social Security and the retirement income you set up for yourself. The sooner you learn about your retirement investing options and the sooner you take action, the greater your future financial security will be. Savvy planning and disciplined saving and investing can net you tens or even hundreds of thousands of dollars more.

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Selena Maranjian owns shares of AbbVie, Amgen, Gilead Sciences, National Grid, Netflix, and Starbucks. The Motley Fool owns shares of and recommends Gilead Sciences, Netflix, and Starbucks. The Motley Fool has the following options: short November 2018 $78 calls on Gilead Sciences, long December 2018 $271 puts on SPDR S&P 500, and short January 2019 $285 calls on SPDR S&P 500. The Motley Fool recommends Amgen and National Grid. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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