The Pyramid of Retirement Investing

by TK on March 28, 2021

If you want to retire comfortably, you must start investing in your retirement now.  However, there is a technique to getting optimal returns on your investments without risking too much.  That is what this article deals with—how to allocate your retirement funds.

When I think about retirement investing, I think of it as a three-tier approach.  I call it the pyramid of retirement investing.  It contains most important elements of retirement investing.

The Pyramid’s Base (First Level of The Pyramid)

401k: This is the most important component of any retirement portfolio, whether you are 25 or 55.  If you have not started a 401k plan yet, do so now.  A 401k plan gives you free money to invest in—you can’t beat that.  That is because for every dollar (up to a certain amount), your employer will match your investment.  To find out how much your employer will match, you will have to talk to your human resources department.  For 2012, the annual maximum you can contribute to your 401k plan is $17,000 (of your own money).  If your employer matches even 1/4 of that, that is $4,250 in free money.  On top of the matching contributions from your employer, your 401k will earn money from the investments of your choice.  I like to diversify my investments according to market conditions.  When I feel there is a down market, I put most my money in fixed income.  In a bull market or an impending bull market, I like to have my money spread evenly between small cap stocks, large cap stocks, and international stocks.

For 401k plans, I recommend at least contribute up to the amount that your employer will match.  If your employer is willing to match up to 5% on every paycheck, the contribute 5% every paycheck.  For higher income earners and people that don’t necessarily need that much access to cash, I recommend maxing out the yearly IRS limit.  Again, the 401k contribution limit is $17,000 for 2012.  If you are over 50 years old, the limit may be higher (catch up contributions).

Here are some numbers for you to look at:

Fund 401(k) for 30 years
Annual Income of $ 40,000.00- increasing 5% per year
Beginning Balance= $ .0
Contribute 25% of Salary - Invested Every Two Weeks
Your Employer will match 100% up to 5% of salary - Every Two Weeks
Annual Interest Rate = 8% - Compounded Daily

Balance at the end of 30 years: $2,510,810.46

By the end of the 30 years, you will have well have $2,510,810.46 in your 401k account!  That’s a huge chunk of change so you can see why it needs to be at the very crux of your retirement plan.  The best thing about 401k plans are that it is tax deferred so you won’t pay a penny of it until you are ready to withdraw it.  Another great thing about it is that it is taken right out of your paycheck so you won’t even notice.  To play with the numbers a little bit, go to this 401k calculator.

A 401k is also an asset that is protected from creditors.  So anything you have in there is protected in an event of bankruptcy.

The Second Level

On the second level, we have:

IRA accounts: IRA accounts are another type of self-directed retirement accounts.  Like a 401k, there is a maximum contribution limit to your IRA account.  In 2012, the contribution limit to an IRA account is $5,000 if you are under 50 years old, and $6,000 if you are over 50 years old.  There are two main types of IRAs, Roth IRA and Traditional IRA.  The main difference between the two is when the tax is taken.  You can sign up for an IRA account with any brokerage firm.  IRA accounts are not meant to be a big part of your retirement plans, but it adds some diversification to your portfolio.  You have a lot more investment options with an IRA (as opposed to a 401k).  You can even invest in gold and other precious metals with an IRA.  With an IRA account, you are free to choose individual stocks, something you cannot do with a 401k.

Mutual funds: Mutual funds should definitely be apart of your retirement portfolio if you are not an experienced stock investor.  Your risk appetite determines what type of mutual fund you want to put your money in.  A mutual fund hedges risk of investing by investing in a bucket of assets, rather than one.  Mutual funds are great if you are not a stock expert, want your funds managed by a professional, and want returns that at least par the market. Another great advantage mutual funds have is that they are liquid assets.  A mutual fund can be taken out anytime without penalty.  Mutual funds are very liquid investments and believe any great retirement portfolio needs a good mix of liquid and non-liquid assets.  I personally don’t invest in mutual funds because I have been investing in stock for years so I like to invest in my own bucket of stocks.

 

Top Level Of The Pyramid

The last and top level of the pyramid is:

Stock Investing: Stock investing should be approached with caution.  I call it the last frontier of retirement planning.  Don’t get me wrong, you should definitely invest in stocks.  But you should only invest in stocks once you have invested in all the investment vehicles in the lower level of the retirement investment pyramid.  Stock market investing carries more risk than mutual fund investing because you are investing in single stocks instead of a bucket of stocks.  Therefore, if you do not diversify your stock portfolio, there is nothing to hedge your risks.  Because you are investing in stocks on your own accord and do not have a professional helping you, you should know a little about how the stock market works and some of the basic ratios used before you venture out to invest in stocks.  Stock investing can be very lucrative if you select wisely.

Fixed Income Investing:  Fixed income and bond investing adds diversification and can provide constant and secure return on your investment.  The return on investment for fixed income is typically less than that of other types of investments but it is more secure and constant.

How Much Should I Allocate To Each?

There isn’t a specific number because everyone earns a different amount and wants different things from their retirement.  But I would aim to allocate 40% of your gross income to retirement investing.  I understand that might be hard for some people so the minimum I would save for retirement investing is 20% if you want to live well in your retirement.  Out of your retirement income, you should first try to max out your 401k.  After maxing out your 401k, you should then allocate 60-70% of your leftover retirement investing funds to the second tier and then the rest to the top tier.  That’s how I would do it.  Whatever you do, just remember that the first thing you should do when it comes to retirement investing is to invest in your 401k.  If you take anything away from this article, it should be that.

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