If you’re consistently saving a double-digit percentage of your income for retirement, then congratulations. You’ve taken a huge step toward ensuring that you’ll have a comfortable retirement.
However, it’s only the first step; the next is to invest that money wisely so it will grow enough to support you when you’re no longer working. If you’re making any of these common investing errors, then you may come up short despite your diligent saving.
Not investing in stocks
Yes, the stock market is a scary place. I still remember the gut-wrenching experience of checking my 401(k) balance after the stock market crash of late 2008.
Despite the risks, stocks offer everyday investors the best long-term returns, and if you don’t include them in your portfolio, then you will find it difficult — or even impossible — to save enough to finance your retirement.
Investing entirely in stocks
Of course, you can have too much of a good thing, and stocks are no exception. Splitting your money between stocks and other investments helps to mitigate your losses when the stock market takes a dive. Bonds are particularly helpful as a second investment, because they tend to move inversely to stocks: When the stock market goes down, bonds generally gain value, and vice versa. So no matter what the economy is doing, some part of your retirement savings will be gaining value.
As you get closer to retirement, it’s important to shift more and more of your money out of stocks and into bonds, because if a market crash happens at that point, your portfolio won’t have time to recover before you’re ready to retire. A good formula for allocating your assets is to subtract your age from 110 and keep that percentage of your money in stocks, with the rest going into bonds.
Not using an IRA or 401(k)
You could just stick your retirement savings into a regular brokerage account and invest it there. But if you did that, you’d miss out on the enormous tax advantages that come with an IRA or 401(k).
All flavors of dedicated retirement savings vehicles allow you to receive dividends (from your stocks) and interest (from your bonds) without having to pay taxes on that money as it comes in. You’re also free from paying capital gains taxes on any sales made within these accounts.
Tax-deferred retirement savings vehicles, like the traditional IRA and 401(k), also give you a tax break on the money you contribute to those accounts. With 401(k)s, your contributions are made with your pre-tax wages, and with IRAs, you can deduct your contributions from your taxable income when filing your tax return.
You’ll have to pay taxes on the money you withdraw from those accounts during retirement, but by then the money you contributed will have had years to grow tax-free. Roth IRAs and 401(k)s basically give you the opposite tax advantage: You pay taxes on the money you put into these accounts, but you don’t have to pay any taxes on qualifying withdrawals.
Not considering the tax treatment of your investments
Retirement savings accounts aren’t the only way to get a tax advantage on your investments. Certain types of investments are exempt from state taxes, federal taxes, or both. For example, Treasury bonds are subject to federal taxes but exempt from state taxes; municipal bonds are exempt from federal taxes and may be exempt from state taxes if you live in the state that issued the bonds.
Because of the tax advantages that these investments offer, they also tend to pay a slightly lower rate of return than similar investments that don’t enjoy such tax breaks. This can still work out to be a good deal for investors, especially if you’re in a high tax bracket.
However, such investments don’t generally belong in a tax-advantaged retirement account; anything you put in such an account gets tax breaks, so if you put something like municipal bonds in your IRA, you’ll get the lower rate of return without actually getting any special tax advantage in return.
If you’re able to reach the annual contribution limits on your retirement accounts, then fill them with taxable investments and put tax-exempt assets in a standard brokerage account.
On the other hand, investments that tend to be subject to high taxes should definitely be held in a retirement account, not a standard brokerage account. For example, REITs are required to pay high dividends, so if you keep REITs in your standard brokerage account, you’ll incur hefty dividend taxes. Keep REITs and other dividend-paying investments in your IRA or 401(k) to keep that from happening.
When in doubt, ask for help
Picking the right retirement investments to maximize returns and minimize taxes and other expenses can get complicated. Even experienced investors may want to get the opinion of a financial advisor with experience in retirement planning. A single meeting to go over your retirement portfolio and make any necessary corrections won’t cost much compared to the money you can save.
— Wendy Connick
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Source: Motley Fool