Chapter 2: Finance Your Goals – Retirement and Higher Education

There are many long-term financial goals, but two of the most common are funding your retirement and planning for your child’s higher education costs.

Retirement
While most Americans will be eligible for Social Security distributions, those benefits are only meant to supplement what you have saved. Very few people can live comfortably on Social Security income alone.

The amount of money you will need to save depends on many factors – everyone’s situation is different, and you may need more or less depending on your unique needs. Financial planners typically suggest retirees will need between 70 and 80 percent of their current annual income when they stop working.

Use this calculator to compute the total amount you would be able to save over time with regular deposits.

Once you know how much you need to save, it is time to start putting money away:

• Defined Contribution Plans. These tax-deferred retirement savings plans have taken the place of many pension plans (where an employer contributes and invests money for you). They include a 401(k) – if you work for a for-profit company – and a 403(b) if you work for a school, non-profit organization, church, or charity. With these plans, you make active contributions to a retirement fund. You have control over the investments, and can choose from a diverse menu of mutual funds.

• Individual Retirement Accounts (IRAs). There are several varieties of IRAs, but the most common are the Traditional and the Roth. As soon as you open an IRA (at a bank, credit union, or brokerage house) you can begin to invest your savings. Stocks, bonds, and mutual funds are among your investment options.

With a Roth IRA, you contribute after-tax dollars, and eligible distributions are tax-free. With a traditional IRA, you contribute pretax dollars and eligible distributions are subject to income taxes.

• Plans for the self-employed. If you own your own business, you have a couple retirement plan options open to you. These include the Simplified Employee Pension, which is similar to an IRA, and a Keogh account, which is similar to a 401(k) plan.

Making regular contributions to these accounts is a money-smart way to save for your retirement. If the account is tax deferred, you don’t have to pay taxes on the investment earnings until you take the money out when you retire (at which time you are likely to be in a lower tax bracket and so will pay less in taxes). If you are able to deduct your contributions from your income taxes, you reduce your taxable income, and pay less in taxes that way. And of course, if the account offers tax-free distributions, you won’t have to pay any taxes on your distributions.

Higher Education
If you have a child, and you want to pay for his or her higher education costs, you have several good savings options from which to choose:

• Coverdell Education Savings Accounts are tax-deferred accounts. While contributions are not tax deductible, they do grow tax-free, and the funds can be withdrawn tax-free as long as they are used to pay eligible schooling costs. Allowable contributions are limited for those making high incomes, and are phased out entirely for very high earners. They may be opened at any financial institution that handles Traditional IRAs, and you can use just about any investment option to build your savings.

• 529 Plans allow you to save for your child’s higher education expenses while greatly reducing your tax liability. As long as the investment is used for qualified education expenses, you won’t have to pay income tax on the earnings, and if you use your own state’s plan you may also qualify for a state tax deduction.

• Roth IRA. You can use the money you’ve accumulated in your Roth IRA for more than just your retirement. Contributions grow tax-free and can be tapped without penalty to pay for qualified educational expenses. Once your child reaches college age, you can withdraw the initial contribution tax- and penalty-free. The earnings, however, may be subject to taxation.

Invest Soon – and Smart
Whether you want to accumulate enough money for retirement, higher education, or any other long-term goal, the sooner you save and invest the better. This way compound interest (interest which is calculated not only on the initial principal but also the accumulated interest of prior periods) can work its magic.

It is important to develop a wise investment strategy as well. Make sure your portfolio (your collection of investments) is diversified for safety and growth. This means that some of your money should be in cash (low interest, low risk investment vehicles), some in stocks (ownership in a company) and some in bonds (loans to a company or government). A good way to achieve diversification is through mutual funds – investment companies that purchase a wide variety of stocks, bonds, and other securities.

The farther away you are from your goal achievement date, the riskier your investments can be since you have time to recover from loss. However, as you near your goal, adjust your portfolio to safer holdings.