Instant rewards: Upfront tax breaks

Spend money today and you may get some instant gratification. Put some of that same money into a retirement account, and you may yawn with excitement and then get stressed choosing investments.

Retirement accounts really should be called tax-reduction accounts. If they were, people may be more eager to contribute to them. For many people, avoiding higher taxes is the motivating force that gets them to open the account and start the contributions.

If you’re a moderate-income earner, you probably pay about 25 to 35 percent in federal and state income taxes on your last dollars of income. Thus, with most of the retirement accounts described in this chapter, for every $2,000 you contribute to them, you save yourself about $500 to $700 in taxes in the year that you make the contribution. Contribute five times as much, or $10,000, and whack $2,500 to $3,500 off your tax bill!

Whenever you’re working for an employer, always be sure to check with your employer’s benefits department because some organizations match a portion of employee contributions. Be sure to partake of this free matching money by contributing to your retirement accounts.

Ongoing tax breaks on your investment earnings

After you place money in a retirement account, any interest, dividends, and appreciation add to the amount in the account without being taxed. You get to defer taxes on all the accumulating gains and profits until you withdraw the money, presumably in retirement. Thus, more money is working for you over a longer period of time.

The percentage tax rate that you pay in retirement need not be less than your tax rate today for you to come out ahead by contributing to retirement accounts. In fact, because you defer paying tax and have more money compounding over more years, you can end up with more money in retirement by saving inside a retirement account, even if your retirement tax rate is higher.

Additional tax credits for lower-income earners

In addition to the upfront tax break you get from contributing to many retirement accounts, lower-income earners may receive a special Saver’s Tax Credit worth up to 50 percent on the first $2,000 of retirement account contributions. This tax credit amounts to free money from the government, so you should take advantage!

As you can see in Table 3-1, this retirement account contribution tax credit phases out quickly for higher-income earners, and no such credit is available to single taxpayers with adjusted gross incomes (AGIs) above $32,000, heads of household with AGIs above $48,000, and married couples filing jointly with AGIs above $64,000. (Note: This credit isn’t available to taxpayers who are claimed as dependents on someone else’s tax return or who are under the age of 18 or are full-time students.)

Retirement account penalties for early withdrawals

Some folks are concerned about the early withdrawal penalties when contributing to retirement accounts. Specifically, if you withdraw funds from retirement accounts before age 59½, you have to pay not only income taxes on withdrawals but also early withdrawal penalties — 10 percent in federal plus applicable state charges. (Withdrawing from a SIMPLE plan within the first two years incurs a 25 percent penalty, which decreases to 10 percent thereafter; I talk about SIMPLE plans later in this chapter.)

The penalties are in place to discourage people from raiding retirement accounts. Keep in mind that retirement accounts exist for just that reason — saving toward retirement. If you could easily tap these accounts without penalties, the money would be less likely to be there when you need it during retirement.

If you have an emergency, such as catastrophic medical expenses or a disability, you may be able to take early withdrawals from retirement accounts without penalty. (Before considering any withdrawal, take the time to understand the conditions under which you can take a penalty-free withdrawal and what those penalties are.) You may withdraw funds from particular retirement accounts free of penalties (and, in some cases, even free of current income taxes — for example, from a Roth IRA) for educational expenses or a home purchase.

What if you just run out of money because you lose your job or your small business fails? Although you can’t bypass the penalties because of such circumstances, if you’re earning so little income that you need to tap your retirement account, you’ll surely be in a low tax bracket for the year. So even though you pay some penalties to withdraw retirement account money, the lower income taxes that you pay upon withdrawal — as compared to the taxes that you would have incurred when you earned the money originally — should make up for most or all of the penalty.

Know also that if you get in a financial pinch while you’re still working, some company retirement plans allow you to borrow against a portion of your cash balance. Just be sure that you can repay such a loan; otherwise, your “loan” becomes a withdrawal and triggers income taxes and penalties.

Another strategy to meet a short-term financial emergency is to withdraw money from your individual retirement account (IRA) and return it within 60 days to avoid paying penalties. I don’t generally recommend this maneuver because of the taxes and potential penalties invoked if you don’t make the 60-day deadline. (I discuss IRAs in detail later in this chapter.)

In the event that your only “borrowing” option in an emergency is a credit card with a high interest rate, you should save three to six months’ worth of living expenses in an accessible account before funding a retirement account to tide you over in case you lose your income. Money market mutual funds, which are similar to bank savings accounts, are an ideal vehicle to use for this purpose.

If you accumulate enough funds to retire “early,” you have a simple way around the pre-age-59½ early withdrawal penalties. Suppose that at age 52 you retire and want to start living off some of the money you’ve stashed in retirement accounts. No problem. The U.S. tax rules graciously allow you to start withdrawing money from your retirement accounts free of those nasty early withdrawal penalties. To qualify for this favorable treatment, you must commit to withdrawals for at least five continuous years, and the amount of the withdrawals must be at least the minimum required based on your life expectancy per IRS tables.

Guidelines for saving (but not excessively)

On average, most people need about 70 percent to 80 percent of their pre-retirement income to maintain their standard of living throughout their retirement. For example, if your household earns $60,000 per year before retirement, you’ll likely need $42,000 to $48,000 (70 percent to 80 percent of $50,000) per year during retirement to live the way that you’re accustomed to living.

Note that 70 percent to 80 percent is just an average. You may need more or less.

• If you currently save little or none of your annual income, you expect to have a large mortgage payment or growing rent in retirement, or you anticipate traveling or doing other expensive things in retirement, you may need 90 percent or perhaps even 100+ percent of your current income to maintain your standard of living in retirement.
• On the other hand, if you now save a high percentage of your earnings, you’re a high-income earner, you expect to own your home free of debt by retirement, and you anticipate leading a modest lifestyle in retirement, you may be able to make do with, say, 60 percent of your current income.

Over the years, I’ve seen some clients “over” contribute to retirement accounts. I don’t literally mean that these well-intentioned folks broke the contribution limit rules. I’m talking about unusual situations where people have contributed more to their retirement accounts than what makes good financial and tax sense.

For example, it may not make sense for a taxpayer who is temporarily in a low tax bracket (or one who owes no tax at all) to contribute to retirement accounts. Ditto for people who have a large estate already and have piles of money inside retirement accounts that could get walloped by estate and income taxes upon their passing. Few people, of course, have this perhaps enviable “problem.”

When in doubt, and if you have reason to believe you should scale back on retirement account contributions, consult with a competent financial/tax advisor who works for an hourly fee and doesn’t sell products or manage money. Read Chapter 13 for details on finding such an advisor.

If you’ve never thought about what your retirement goals are, looked into what you can expect from Social Security, or calculated how much you should be saving for retirement, now’s the time to do it. My book Personal Finance For Dummies (John Wiley & Sons, Inc.) goes through all the details and even tells you how to come up with more to invest and do it wisely.

Maximizing your retirement plan’s value

To get the most from your contributions as an employer, consider the following:

• Educate your employees about the value of retirement savings plans. You want them to understand how to save for the future and to value and appreciate your plan. I know some companies, for example, that provided copies of my book Personal Finance For Dummies (John Wiley & Sons, Inc.) to employees to do just that.
• If you have more than 20 or so employees, consider offering a 401(k) or SIMPLE plan, which allows employees to contribute money from their paychecks. (I discuss both of these plans later in this chapter.)

Eligible small employers can claim 50 percent of the costs to set up and administer a retirement plan to a maximum of $500 for the year. The employer’s plan must cover no more than 100 employees who make at least $5,000 per year. You claim this credit on IRS Form 8881, “Credit for Small Employer Pension Plan Startup Costs.” (Find this form at www.irs.gov/pub/irs-pdf/f8881.pdf.)

Checking out your choices

If you own a small business, you have lots of retirement account choices. The following sections discuss “IRS-approved” retirement accounts, explain how to determine whether you’re eligible for them, and cover some nitpicky but important rules.

Considering fund advantages

Mutual funds are simply pools of money from investors that a mutual fund manager uses to buy a bunch of stocks, bonds, and other assets that meet the fund’s investment criteria. The best exchange-traded funds (ETFs) are quite similar to mutual funds — specifically, index mutual funds. Each ETF generally tracks a major market index. (Some ETFs, however, track narrowly focused indexes, such as an industry group or a small country.) The most significant difference between a mutual fund and an ETF is that to invest in an ETF, you must buy it through a stock exchange on which the ETF trades, just as individual stocks trade. (I talk about index mutual funds and ETFs later in this chapter.)

Because efficient funds take most of the hassle and cost out of deciding which companies to invest in, they’re among the best investment vehicles available today, especially in retirement accounts. Also, funds enable you to have some of the best money managers in the country direct the investment of your money.

The following list highlights the main reasons for investing in funds rather than individual securities:

• Low cost: When you invest your money in an efficiently managed fund, it should cost you less than trading individual securities on your own. Fund managers can buy and sell securities for a fraction of the cost that you pay. Funds also spread the cost of research over many, many investors. The most efficiently managed mutual funds cost less than 1 percent per year in fees. (Bond funds cost much less — in the neighborhood of 0.5 percent per year or less.) Some of the larger and more established funds can charge annual fees less than 0.2 percent per year; that’s less than a $2 annual charge per $1,000 you invest.
• Diversification: Funds generally invest in dozens of securities. Diversification is a big attraction for many investors who choose funds because proper diversification increases the chance that the fund will earn higher returns with less risk. Most funds own stocks or bonds from dozens of companies, thus diversifying against the risk of bad news from any single company or sector. Achieving such diversification on your own is difficult and expensive unless you have a few hundred thousand dollars and a great deal of time to invest.

• Professional management: Fund investment companies hire a portfolio manager and researchers whose full-time jobs are to analyze and purchase suitable investments for the fund. These people screen the universe of investments for those that meet the fund’s stated objectives. Fund managers are typically graduates of the top business and finance schools, where they learned portfolio management and securities valuation. Many have additional investing credentials, such as Chartered Financial Analyst (CFA) certification. The best fund managers also typically possess more than ten years’ experience analyzing and selecting investments.

  For fund managers and researchers, finding the best investments is a full-time job. They do major analysis that you lack the time or expertise to perform. Their activities include assessing company financial statements; interviewing company managers to hear the companies’ business strategies and vision; examining competitors’ strategies; speaking with companies’ customers, suppliers, and industry consultants; attending trade shows; and reading industry periodicals.

• Achievable investment minimums: Many mutual funds have minimums of $1,000 or less. Retirement account investors can often invest with even less. Some funds even offer monthly investment plans so you can start with as little as $50 per month. ETFs have no minimums, although you need to weigh the brokerage costs of buying and selling ETF shares (although some firms waive transaction fees on increasing numbers of ETFs).
• Funds to fit varying needs: You can select funds that match the risk/reward ratio you need to meet your financial goals or that you’re comfortable with. If you’re relatively young and expect your money to grow over a long period and you can handle some down periods, choose mostly stock-focused funds. If you don’t want investments that fluctuate as widely in value, consider investing more in bond funds. (I talk about both types later in this chapter.)

• High financial safety: Fund companies can’t fail because the value of fund shares fluctuates as the securities in the fund change value. For every dollar of securities that they hold for their customers, mutual funds have a dollar’s worth of securities. The worst that can happen with a fund is that if you want your money, you may get less money than you originally put into the fund because of a market value decline of the fund’s holdings.

  For added security, a custodian, a separate organization independent of the mutual fund company, holds the specific stocks, bonds, and other securities that a mutual fund buys. A custodian ensures that the fund management company can’t steal your money.

• Accessibility: Funds are set up for people who value their time and don’t like going to a local branch office and standing in long lines. You can fill out a simple form (often online, if you want) and write a check in the comfort of your home (or authorize electronic transfers from your bank or other accounts) to make your initial investment. Then you typically can make subsequent investments by mailing in a check or sending money electronically. Many fund companies also allow you to transfer money electronically back and forth from your bank account. Selling shares of your mutual fund usually is simple, too. Generally, you can do so by calling the fund company’s toll-free number or visiting its website.

Maximizing your chances for fund investing success

I recommend using some straightforward, common-sense, easy-to-use criteria to greatly increase your chances of fund investing success. The criteria presented in this section have proved to dramatically increase your fund investing returns, which is great for your retirement. (My website, www.erictyson.com, has details on research and studies that validate these criteria.)

Understanding and using index funds

In some funds, the portfolio manager and a team of analysts scour the market for the best securities. An index fund manager, however, simply invests to match the makeup — and, thus, the performance — of an index such as the Standard & Poor’s 500 index of 500 large U.S. company stocks. Index funds, which are a type of mutual fund, operate with far lower operating expenses because research isn’t needed to identify companies in which to invest.

With actively managed stock funds, a fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks. An actively managed fund can easily underperform the overall market index that it’s competing against. On the other hand, index funds deliver relatively solid returns by keeping expenses low, staying invested, and not changing investments. Over ten years or more, index funds typically outperform about three quarters of actively managed funds, which can’t overcome the handicap of high operating expenses that pull down their rates of return.

Vanguard (www.vanguard.com) is the largest and most successful provider of index funds because it maintains the lowest annual operating fees in the business. Vanguard has all types of bond and stock (both U.S. and international) index funds. There are some other index providers with low fees and demonstrated success - iShares, Schwab, and SPDR have some worthwhile funds. See my recommended fund sections later in this chapter.

Considering exchange-traded funds

Index mutual funds, which track particular market indexes and the best of which feature low costs, have been around for decades. Exchange-traded funds (ETFs) represent a twist on index funds. ETFs trade as stocks do and offer some potential advantages over traditional mutual funds, but they also have some potential drawbacks.

As with index funds, the promise of ETFs is low management fees. I say promise because the vast majority of ETFs actually have expense ratios far higher than those of the best index funds.

If you can’t meet the minimum investment amounts for index funds (typically, several thousand dollars), you face no minimums when buying an ETF, but you must factor in the brokerage costs of buying and selling ETF shares through your favorite brokerage firm. Suppose that you pay a $10 transaction fee through an online broker to buy $1,000 worth of an ETF. That $10 may not sound like much, but it represents 1 percent of your investment and wipes out the supposed cost advantage of investing in an ETF. Because of the brokerage costs, ETFs aren’t good vehicles for investors who seek to make regular monthly investments.

Here are some drawbacks of ETFs:

• The perils of market timing: Being able to trade in and out of an ETF during the trading day presents challenges. In my experience working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day. In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that’s far easier said than done.
• Brokerage commission every time you trade: With no-load index funds, you generally don’t pay fees to buy and sell. With ETFs, however, because you’re actually placing a trade on a stock exchange, you typically pay a brokerage commission every time you trade. (Note: Some brokers offer certain ETFs without brokerage charges in the hope of getting your account and making money on other investments.)
• Fluctuating prices: Because ETFs fluctuate in price based on supply and demand, when you place a trade during the trading day, you face the complication of trying to determine whether the current price on an ETF is above or below the actual value. With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds.
• Poorly diversified investments: Many ETFs invest in narrow segments, such as one specific industry or country. Such funds undermine the diversification value of fund investing and tend to have relatively high fees.
• Excessive risks and costs with leverage: ETF issuers have come out with increasingly risky and costly ETFs. One particular class of ETFs that I especially dislike are leveraged ETFs. These ETFs claim to magnify the move of a particular index, such as the Standard & Poor’s 500 stock index, by double or triple. So a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for every 1 percent increase in the S&P 500 index. My investigations of whether the leveraged ETFs actually deliver on their objectives show that they don’t even come close. Leveraged ETFs aren’t investments; they’re gambling instruments for day traders. Don’t ever use these, especially in a retirement account, and never offer them to employees if you don’t want to get sued!

Using asset allocation in your retirement fund portfolio

When you invest money for the longer term, such as for retirement, you can choose among the various types of funds that I discuss later in this chapter. Most people get a big headache when they try to decide how to spread their money among the choices. This section helps you begin cutting through the clutter for longer-term investing.

Asset allocation simply means that you decide what percentage of your investments you place, or allocate, in bonds versus stocks and in international stocks versus U.S. stocks. (Asset allocation can include other assets, such as real estate and small business.)

In your 20s and 30s, time is on your side, and you should use that time to your advantage. You may have many decades before you need to draw on some portion of your retirement account assets. If your investments drop over a year or even over several years, the value of your investments has plenty of time to recover before you spend the money during retirement.

Your current age and the number of years until you retire are the biggest factors in your allocation decision. The younger you are and the more years you have before retirement, the more comfortable you should be with volatile, growth-oriented investments, such as stock funds.

Table 3-2 provides my guidelines for allocating fund money that you’ve earmarked for long-term purposes, such as retirement. It’s a simple but powerful formula that uses your age and the level of risk you’re willing to take with your investments.

Suppose that you’re an aggressive type who prefers taking a fair amount of risk to make your money grow faster. Using Table 3-2, if you’re 35 years old, consider putting 15 percent (35 – 20) into bond funds and 85 percent (120 – 35) into stock funds.

Now divvy up your stock investment money between U.S. and international funds. Here are the portions of your stock allocation that I recommend investing in overseas stocks:

• 20 percent for a play-it-safe attitude
• 35 percent for a middle-of-the-road attitude
• 50 percent for an aggressive attitude

If, in Table 3-2, the 35-year-old aggressive type invests 85 percent in stocks, she then can invest about 50 percent of the stock fund investments (which works out to be around 42 percent of the total) in international stock funds. So the 35-year-old aggressive investor’s portfolio asset allocation would look like 15 percent bonds, 42.5 percent U.S. stocks, and 42.5 percent international stocks.

How do you go about implementing such a recommendation? Which specific funds do you choose? As I explain in the next section, stock funds differ on several levels. You can choose among growth-oriented stocks and funds and those that focus on value stocks, as well as funds that focus on small-, medium-, or large-company stocks. You also need to decide what portion you want to invest in index funds versus actively managed funds that try to beat the market.

Deciding how much you should use index versus actively managed funds is a matter of personal taste. If you’re satisfied knowing that you’ll get the market rate of return and that you can’t underperform the market (after accounting for your costs), index your entire portfolio. On the other hand, if you enjoy the challenge of trying to pick the better managers and want the potential to earn better-than-market returns, don’t use index funds at all. Or, invest in a happy medium of both, as I do.

Selecting the best stock funds

Stock funds differ from one another on several dimensions. The following characteristics are what you need to pay most attention to:

• Company location: Stocks and the companies that issue them are classified based on the location of their headquarters. Funds that specialize in U.S. stocks are, not surprisingly, called U.S. stock funds; the rest are called international or overseas funds.
• Company size: Another dimension on which a stock fund’s stock selection differs is based on the size of the company in which the fund invests: small, medium, or large. The total market value — capitalization, or cap for short — of a company’s outstanding stock defines the categories that define the stocks that the fund invests in. (Note: The following definitions can change over time.)
  • Small-cap stocks are usually defined as stocks of companies that possess total market capitalization of less than $2 billion.
  • Medium-cap stocks have market values of $2 billion to $10 billion.
  • Large-cap stocks are those of companies with market values greater than $10 billion.
• Growth stocks versus value stocks: Stock fund managers and their funds are categorized by whether they invest in growth or value stocks.
  • Growth stocks have high prices in relation to the company’s assets, profits, and potential profits. Growth companies typically experience rapidly expanding revenue and profits. These companies tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay no or low dividends.
  • Value stocks are priced cheaply in relation to the company’s assets, profits, and potential profits. Value stocks tend to pay higher dividends than growth stocks and historically have produced higher total returns.

Putting together two or three of these major classifications, you can start to comprehend those lengthy names that are given to stock funds. You can have funds that focus on large-company value stocks or small-company growth stocks. You can add U.S., international (non U.S.), and worldwide (global) funds to further subdivide these categories into more fund types. So you can have international stock funds that focus on small-company stocks.

You can purchase several stock funds, each focusing on a different type of stock, to diversify into various types of stocks. Two potential advantages result from doing so:

• Not all your money rides in one stock fund and with one fund manager.
• Each of the different fund managers can look at and track particular stock investment possibilities.

The following sections describe the best stock funds in different geographic categories. Note: With stock funds, you have the option of investing in ETFs as well as traditional mutual funds.

Investing in the best exchange-traded funds

Like the vast majority of investors, you don’t need to complicate your life by investing in ETFs. Use them only if you’re an advanced investor who understands index funds and you’ve found a superior ETF for a given index fund that you’re interested in.

The most significant difference between a mutual fund and an ETF is that to invest in an ETF, you must buy it through a stock exchange on which the ETFs trade. Unlike a mutual fund, you can trade ETFs during the trading day rather than simply at the market closing price.

Use the buy-and-hold mentality that I advocate in my investing books. Don’t hop in and out of ETFs because you’ll inevitably pay more in taxes, earn lower returns, and incur higher brokerage fees. Also, you should buy only the ETFs that track the broader market indexes and that have the lowest expense ratios. Avoid those that track narrow industry groups or single small countries.

Check whether the ETF you’re considering is selling at a premium or discount to its net asset value (which is the value of all the securities an ETF holds). You can find this information on the ETF provider’s website after the market’s close each business day.

The best ETFs, like the best index funds, have low expense ratios. My top picks among the leading providers of ETFs include the following:

• iShares: BlackRock is a leading provider of these cost effective ETFs based upon indexes from Russell, Morningstar, S&P and Dow Jones. (www.ishares.com; 800-474-2737).
• State Street Global Advisor SPDRs: This group utilizes indexes from Dow Jones, MSCI, Russell, and S&P. (www.ssgafunds.com; 866-787-2257).
• Vanguard: Historically, Vanguard has been the low-cost leader with index funds, and now it has low cost ETFs as well. (www.vanguard.com; 800-662-7447)
• WisdomTree: Developed by Wharton business professor Jeremy Siegel, these ETFs have higher fees but offer a broad family of index choices for investors seeking stocks that pay higher dividends. (www.wisdomtree.com; 866-909-9473)

Balancing your act: Funds that combine stocks and bonds

Some funds — generally known as balanced funds — invest in both bonds and stocks. These funds are usually less risky and less volatile than funds that invest exclusively in stocks. In an economic downturn, bonds usually hold value better than stocks do.

Balanced funds make it easier for investors who are skittish about investing in stocks to hold stocks because they reduce the volatility that normally comes with pure stock funds. Because of their extensive diversification, balanced funds are also excellent choices for an investor who doesn’t have much money to start with.

Here’s my short list of great balanced funds:

• Dodge & Cox Balanced (800-621-3979; www.dodgeandcox.com)
• Fidelity Freedom Funds and Fidelity Puritan (800-343-3548; www.fidelity.com)
• T. Rowe Price Balanced (800-638-5660; www.troweprice.com)
• Vanguard LifeStrategy Funds, Star, Wellesley Income, and Wellington (800-662-7447; www.vanguard.com)

Finding the best bond funds

Although there are thousands of bond fund choices, not many remain after you eliminate high-cost funds, low-performance funds, and funds managed by fund companies and fund managers with minimal experience investing in bonds (all key points that I address in the earlier section “Maximizing your chances for fund investing success”).

Among the key considerations when choosing bond funds are:

• Bond credit quality: The lower the issuer’s credit rating, the riskier the bond. As with the risk associated with longer maturities, a fund that holds lower-quality bonds should provide higher returns for the increased risk you take. A higher yield compensates you for taking greater risk. Funds holding higher-quality bonds provide lower returns but more security.
• Fees and costs: After you settle on the type of bonds that you want, consider a bond fund’s costs, including its sales commissions and annual operating fees. Stick with no-load funds with lower annual operating expenses.
• Taxability: Pay attention to the taxability of the dividends that bonds pay. When you invest in bonds inside retirement accounts, you want taxable bonds. (Outside retirement accounts, the choice between taxable and tax-free bonds depends on your tax bracket.)
• Type of bond issuer: Bonds can be issued by corporations, government entities, and foreign entities (corporate and governments). While some bond funds hold an eclectic mix, many focus on specific types of bonds (corporate bonds, for example).
• Years to maturity: Bond fund objectives and names usually fit one of three maturity categories: short-, intermediate-, and long-term. You can generally earn a higher yield from investing in a bond fund that holds longer-term bonds, but such bond prices are more sensitive to changes in interest rates. (Duration, which quantifies a bond fund’s sensitivity to changes in interest rates, is another term you may come across. A fund with a duration of six years means that if interest rates rise by 1 percent, the fund should decline by 6 percent.)

The following sections warn you about yield chasing and provide recommendations for short-, intermediate-, and long-term bond funds. Note: With bond funds, you have the option of investing in ETFs as well as traditional mutual funds.

Estimating your investments’ likely future returns

When examining expected investment returns, you have to be careful because you’re largely using historic returns as a guide. Using history to predict the future, especially the near future, is dangerous. History may repeat itself, but not always in exactly the same fashion and not necessarily when you expect it to.

Use historical returns only as a guide, not as a guarantee. Keep that in mind as I discuss the returns on various investments such as bonds and stocks in the following sections. For comparative purposes, I also discuss historic returns from real estate investing.

Compounding your returns

In the preceding section, I discuss the historic investment returns on common investments. During the past century, stocks and investment real estate returned around 9 percent per year and bonds around 5 percent.

Compounding seemingly modest investment returns can help you accumulate a substantial sum of money to help you accomplish your personal and financial goals for retirement.

The stock market can be risky, which logically raises the question of whether investing in stocks is worth the anxiety and potential losses. Why bother for a few extra percent per year? Here’s a good answer to that sensible question: Over many years, a few extra percent per year increases your nest egg dramatically. The more years you have to invest, the greater the difference a few percent makes in your returns (see Table 3-3).

Here’s a practical example to show you what a major difference earning a few extra percent can make in accomplishing your financial goals. Consider a 30-year-old investor who’s saving toward retirement on his $40,000 annual salary. Suppose that his goal is to retire by age 67 with about $30,000 per year to live on (in today’s dollars), which is 75 percent of his working salary.

If he begins saving at age 30, he needs to save about $460 per month if you assume that he earns about 5 percent per year average return on his investments. That’s a big chunk to save each year — amounting to about 14 percent of his gross (pretax) salary.

But what if this investor can earn just a few percent more per year on average from his investments — 8 percent instead of just 5 percent? In that case, he could accomplish the same retirement goal by saving just half as much: $230 per month!