Retirement tips for early-career savers

Life goals

The financial planning profession is undergoing a revolution, with planners migrating from a money-centered orientation to what Certified Financial Planner Roy T. Diliberto calls "financial life planning." The more humanistic movement focuses on what clients want to achieve in their lifetime and helps them to reach those goals by working with them in managing their personal finances.

Quiz people about their financial goals and you'll get general statements about owning a home, raising a family, providing for their children's college educations, traveling and saving for retirement. Financial life planning puts a finer point on these goals, allowing client and planner to build a roadmap to accomplishing them.

When you're in your 20s, it's very difficult to make retirement savings a priority. That's because you have competing goals for your income such as paying down student loans, buying a car, furnishing your apartment, saving for the down payment on a house. But if your employer offers matching contributions to a 401(k) retirement account, take up the offer. Otherwise you're turning away free money that would help you achieve your goals.

Money invested in your 20s has 30 to 40 years to earn a return. Wait until your 40s to start investing for retirement and that money only has about 20 years to grow. You'll need to put a lot more aside to achieve the same nest egg.

My favorite statistic in this area comes from "The Girl's Guide to Retirement" but, don't worry guys, it applies to you, too:

Saving early builds substantial wealth

This assumes that your investments earn an 8 percent average annual return in a tax-deferred retirement account.

Taxes and Investing

If you're saving for retirement, there are a host of tax-advantaged accounts: Roth IRAs, traditional IRAs, plus employer plans such as 401(k), Roth 401(k), 403(b) and 457 plans. They're called tax advantaged because some are tax-deferred, such as traditional IRAs, 401(k) and 403(b) accounts, while others -- the Roth IRA and Roth 401(k) -- are tax-free for qualified distributions.

Contributions to traditional IRAs, 401(k) and 403(b) plans are typically made with pre-tax dollars and qualified distributions are taxed at ordinary income rates when the money comes out of the account. Roth IRA and Roth 401(k) contributions are made with after-tax dollars and qualified distributions are free of federal income tax. Nonqualified distributions, for example, those taken before age 59½ in the case of IRAs, can result in a 10 percent penalty tax.

Take tax breaks on front or back end

• What you know: Today's tax rates • What you don't know: Future tax rates • What to do: Decide on an investment vehicle and get started!

Money can also be invested in taxable accounts. It's called a taxable account because you have to pay taxes on the investment earnings in the year that they are recognized in the account. The taxes vary depending on whether the investment earnings are qualified dividend income, interest income, short-term capital gain or long-term capital gain. The tax code also changes with time, so applicable tax rates on these different types of investment earnings can go up or down. Tax-efficient investing in a taxable account can make sense as an alternative to retirement savings in tax-advantaged accounts.

Once you decide on the types of accounts you will contribute to, you can work on the investments held in these accounts. A 401(k) or 403(b) plan typically has a limited list of investments to choose from, but other retirement and taxable accounts don't face the same limitations. To open IRA, Roth IRA and taxable accounts, you can choose from among banks, brokerage houses or mutual fund firms.

401(k) or IRA?

If your company has a 401(k) plan where the company matches a portion of your contributions, it makes sense to contribute at least up to the limit of the match. After that, where you put your retirement money depends on your income level and investment goals.

Look for flexibility

You may be able to borrow from a 401(k), but not an IRA. But you can withdraw money from an IRA penalty free in certain cases.

I'm an advocate for financial flexibility. Unlike employer-sponsored plans, an IRA or Roth IRA account lets you avoid the penalty tax on early distributions in certain situations. For example, first-time home buyers can tap up to $10,000 of IRA money for a down payment on a home penalty free.

If you are covered by your employer's retirement plan, then your ability to contribute tax-deferred dollars to a traditional IRA may be limited, depending on your Modified Adjusted Gross Income (MAGI). Your ability to contribute to a Roth IRA doesn't depend on whether you are covered by your employer's retirement plan, but eligible contribution limits phase out if your income exceeds a certain level.

If you can't contribute to a Roth because your income is too high and you can't contribute pre-tax dollars to a traditional IRA, you can contribute after-tax dollars to a traditional IRA. It can make sense to do so because the income restrictions on the Roth go away in 2010 and you can then convert your traditional IRA monies on a pro-rata basis to a Roth IRA account.

Don't forget about the spousal IRA or the Retirement Savings Contributions Credit that are allowed up to certain income levels.

Clear as mud? IRS Publication 590, Individual Retirement Arrangements, does a good job of walking you through the rules.

Asset allocation and risk

The common asset-allocation decision among investments is between stocks, bonds and cash, or mutual funds/exchange-traded funds (ETFs) that invest in stocks, bonds or cash. Cash is financial shorthand for money market investments that are short-term debt securities with a final maturity of less than one year. Bank deposits can be classified as cash if they are held in a money market account, checking account or a short-term certificate of deposit, or as bonds if the certificate of deposit has a maturity longer than one year.

Goals and investments

In general, it's appropriate to match short-term financial goals with short-term investments and long-term financial goals with long-term investments.

Your retirement investments face two major risks: principal risk and inflation risk. With principal risk, the risk is that your investments decline in value. Inflation risk involves the decline of the purchasing power of your investments over time. Conservative investors tend to be more concerned about the risk to principal, but they should be just as concerned about purchasing power risk.

A simple illustration with car prices explains why you need to worry about both. If car prices go up by 5 percent each year, a car that costs $30,000 today will cost $38,288 five years from now. Invest $30,000 today for five years in a CD with an after-tax yield of 4 percent and you'll have $36,500. Your insured deposit never faced any principal risk, but you won't be able to afford to buy the car for cash five years from now when you could have today. Take this example out 30 to 40 years and the importance of having your investment returns outpace inflation is magnified.

So you shouldn't hold a lot of cash in your retirement accounts early in your career. Choosing a specific allocation between stocks, bonds and cash is a balancing act between the investor's tolerance for risk and his or her investment goals.

Active vs. passive

Active investors believe they can beat their investment benchmarks through investment selection and/or market timing. There are a host of active strategies that include sector rotation, value investing, momentum investing and market timing.

Active vs. passive

Active strategies: Passive strategies:   • sector rotation • value investing • momentum investing • market timing • tactical asset allocation   • buy and hold • index funds and ETFs

In an extreme example of market timing, someone aims to invest in the stock market when it's heading higher, sitting on the sidelines the rest of the time. The problem, of course, is that investors are generally lousy at predicting future market movements.

A passive investor is willing to accept average performance. Buy-and-hold investors in indexed mutual funds or exchange traded funds (ETFs) are passive investors. Market timers can also own index funds or ETFs, but they actively trade the shares based on their outlook for the market.

Bond investors can try to time the market too. When interest rates go up, bond prices go down. Active bond investors try to avoid being "long and wrong" -- meaning they don't want to invest in long maturities when they expect interest rates are heading higher. They also don't want to be "short and sorry," investing in shorter maturities only to see interest rates head lower.

Tactical asset allocation changes the mix of assets based on what looks cheap or expensive in the eye of the portfolio manager or investor. If stocks look expensive, then the manager lightens up on stock exposure and adds the proceeds to either cash or bonds.

Account fees for actively managed funds are typically much more expensive than for indexed mutual funds. That makes it that much harder for active managers to beat the performance of the benchmark index net of fees.

In the early stages of investing for retirement, a low-cost, no-load, indexed mutual fund that mirrors the holdings of a broadly based market index is a solid investment decision.