Good things come to those who wait. This is true in multiple aspects of life. However, in today's world where information, entertainment, and consumerism are delivered at incredible speeds, waiting is often seen as a negative. But not everything can be delivered overnight – long term investment success being one of them. Choosing to save a percentage of your income and making daily choices to live on less than you make is the most common way for everyday Americans to retire with dignity.
Long-term investors go through three phases of finance: accumulation, preservation, and distribution. Preservation and distribution are both important, but they are optimized with proper planning and decision-making during the accumulation phase. The accumulation phase requires patience and fortitude because progress is very slow in the short term, but you are planting seeds that will make a significant impact on your investments and the taxes you will be subject to pay in retirement.
The most important things to focus on in accumulation are systematically saving the right percentage of your income and building tax diversification amongst your investments.
During accumulation, the amount you are contributing to your investments on an annual basis will most likely be more impactful than the return your investments create. Choose investments that match your time horizon and risk tolerance, but do not get discouraged when the investments do not generate a high return every year – just keep making contributions. Your average return becomes most important in the preservation phase – this is when your investment return becomes more impactful than your annual contribution.
Accumulation is also the best time to start building tax diversification within your investments. Most long-term investors have great savings habits and are motivated to see their savings grow over time, but they rarely think about the tax consequences of taking money out during the distribution phase. And if you have not done the planning prior to retirement, you will be forced into a tax rate that you have little to no control over.
The three main types of investments accounts include tax-deferred, Roth, and taxable. Tax-deferred contributions go into the account tax free and grow tax free, but distributions are taxed at ordinary income rates and must come out after age 59 ½ to avoid early withdrawal penalties. Roth contributions have already been taxed and grow tax free, and all distributions after age 59 ½ are tax and penalty free. Taxable accounts are taxed each year based off the dividends, interest, and realized capital gains that are generated, but you are not taxed on the distribution amount, and you can take a distribution at any age without a penalty. Pros and cons to the tax treatment are prevalent for each type of account – to have the most control over your tax rate in retirement, investors should spread their savings among each type of account.
The exponential variable in the compound interest formula is time. The earlier you start saving, the more impactful the end result will be. Use the time you have to your advantage.
Financial Enhancement Group is an SEC Registered Investment Advisor. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.