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So, you want to have lots of money when you retire?

For most people, the key to a financially secure retirement is to start saving aggressively toward your retirement when you're younger and to invest this money in equities. Over long-periods of time, stocks tend to greatly outperform bonds and other investment choices (Real estate returns can equal those of stocks, but real estate investing is more like running a business than passive investing. So, unless you want the hassles, investing directly in real estate might not be for you. I mention some real estate books below.)

Starting early gives you the benefit of compounding, which I discuss in detail in Becoming An Investor. Most people are unaware of just how powerful compounding is. For example, if you invest $2,000 and it grows at 10% over 35 years, the ending amount is about $56,000. If you wait until right before retirement, you'd need to save nearly the full $56,000 to come up with that money. This is why you should start saving early. The more you procrastinate and the later you get started investing, the more you'll need to save. You'll have fewer years to save, and compounding won't grow your money nearly as much.

Where should you invest your money?

You'll probably be investing the bulk of your money in stocks, but what sort of an account should hold those stocks? There are many good choices. If you're employer has a 401(k), that's usually the best option. 401(k)'s and regular IRA's offer an immediate tax break and allow your money to grow tax-deferred.

If you're younger, you might also want to consider the Roth IRA, which doesn't give you an immediate tax break, but after the money is put into a Roth IRA, it grows tax free. For investors with a long time frame, this should lead to having more money upon retirement.

The one possible catch to the Roth IRA was pointed out by Eric Tyson (who is quickly becoming one of my favorite personal finance columnists) in one of his recent columns. Tyson points out that the government can change the tax laws in the future. Possibly, to help pay down a growing deficit, tax laws could change to place some taxes on Roth IRA withdrawls. Many people have regular IRA's and 401(k)'s, so those probably are a bit safer politically (so, for example, it's less likely there'd be a special extra tax placed upon 401(k) withdrawls). Plus, you've already received the tax benefit. Regardless of this risk, I'd still probably favor the Roth IRA, especially if you anticipate being in a high tax bracket at retirement.

After you've "maxed out" your 401(k) and your IRA, you might want to buy some stocks in a standard non-tax-deferred brokerage account. From a tax standpoint, buying growth stocks is probably most desirable, especially if you purchase quality stocks and hold them a long time (Index funds are also great). You aren't taxed until you sell the stock and then you'll be taxed at the lower capital gains tax rate.

Some people wonder if it's bad to put growth socks into tax-deferred retirement vehicles, because essentially you're partially converting capital gains into ordinary income. Some people argue that as a general rule you should put income investments in tax-deferred vehicles and keep your growth investments outside of the tax-deferred vehicles.

I tend to disagree. While it's true you can shelter a goodly portion of capital gains on growth investments outside of a 401(k) or IRA by just holding the stock, and while it's true that dividends or bond interest are tax at higher ordinary income rates, you might just want to sell a stock.

For example, if you have a growth stock that's gone up 20 times in value and seems a bit pricey based upon earnings, you might want to sell much of the stock and reinvest the money in other stocks.

For example, suppose you've originally invested $3,000. Now, you're holding $60,000 worth of that stock. Relative to the other stocks you hold, that might seem an excessive amount, especially given the high valuation that we assumed. If you sell $30,000 worth of the stock to diversify your portfolio, at a 20% capital gains tax rate, you'd be looking at almost $6,000 in taxes if the stock is held outside a tax-deferred portfolio. But, you could reinvest the full amount if the stock were within a tax-deferred portfolio. (The flip side is that capital losses are better off outside a tax-deferred portfolio. There they can be used to offset capital gains and up to $3,000 in ordinary income. So, a person who makes bad investments consistently might want to keep the money in a regular brokerage account.)

Another reason to put growth investments in your tax-deferred accounts is that this money is being invested for a long time period. Once you have a long time frame, you want the best growth possible regardless of tax consequences.

I also feel that holding some income investments outside of tax-deferred portfolios is a good idea. While taxes really hit bond interest and dividends, you might find that you need the money. For example, if you lose a job, you probably want to sell bonds to provide you with income to live on. If you're semi-retired, you might partially depend upon dividends and bond interest to meet regular living expenses.

A few years ago many financial experts suggested investing in growth stocks and selling shares to meet current income needs. This has always been bad advice, because it overlooks the fact that the markets drop and you might need to sell shares really cheap. As I discuss in Becoming An Investor, this essentially amounts to dollar cost averaging in reverse. You wind up selling more shares at low valuations.

Finally, many 401(k)'s limit your investment choices. Quality stock funds or stock index funds will probably hold most of your investments and you probably won't be able to purchase individual stocks. By the same reasoning above, actively managed funds are best within a tax-deferred portfolio. Index funds are great either inside or outside a tax-deferred portfolio.

Peter Hupalo, Author of "Becoming An Investor"

Becoming An Investor
Becoming An Investor

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