Human capital vs. financial capital. Your human capital is your income-earning ability. Early in adult life, it’s your most valuable asset. Academic economists view the income from human capital as similar to the interest earned from bonds. To diversify your human capital “bond,” you might invest heavily in stocks when you’re younger. During your working years, your goal is to convert your human capital into financial capital—meaning a huge pile of savings—so that one day you can retire. As you approach retirement, consider increasing your portfolio’s allocation to bonds, so you have interest income to replace your human capital’s earned income.
Stocks vs. bonds. When you buy a stock, you become a part owner of a business, and benefit from the dividends paid and any share price appreciation. When you buy a bond, you are lending money, and you receive interest in return for letting someone else have the use of your money. Stocks are sometimes referred to as “equities,” while bonds are often called “fixed income.”
Asset allocation. This is your portfolio’s mix of the four major asset classes: stocks, bonds, cash investments such as savings accounts and money-market funds, and alternative investments like hedge funds and gold stocks. For instance, a portfolio might have 50% stocks, 35% bonds, 10% alternative investments and 5% cash.
Savings, investment returns and time. How much you amass for retirement and other goals depends on the interaction of three factors: the amount you save, the annual investment returns you earn and the number of years over which you save and collect investment returns. Want to accumulate more money for your goals? You might make use of one or more of these three levers—by aiming to save more, earn higher returns and invest for longer.
Three-legged stool. Retirees have traditionally relied on three key financial resources: Social Security, traditional employer pension plans and personal savings, such as money in 401(k) plans and individual retirement accounts. With the disappearance of many traditional pension plans, most workers today rely solely on Social Security and personal savings.
Defined benefit vs. defined contribution plans. An employer’s defined benefit plan pays you monthly income in retirement, with the size of that income typically hinging on your salary and the number of years you worked for the employer. These plans—which are increasingly rare—are funded by the employer. By contrast, defined contribution plans are typically funded partly or entirely by employees. Common types include 401(k) and 403(b) plans.
Individual retirement accounts vs. 401(k) plans. To fund an IRA or 401(k), you need earned income, and your annual contributions can’t exceed the amount you earn. Both IRAs and 401(k) plans come in two flavors: traditional accounts, where you can get an initial tax deduction but all withdrawals are taxable as ordinary income, and Roth accounts, where there’s no initial tax deduction but all withdrawals are tax-free.
You don’t need to meet any special requirements to fund a 401(k) plan, beyond working at the employer in question. By contrast, to fund a Roth IRA or deduct your traditional IRA contributions, you need to meet the applicable IRS rules. Another difference: A 401(k) plan may offer a matching employer contribution—not something you can get with a traditional or Roth IRA.
Taxable vs. tax-deferred accounts. With traditional tax-deferred accounts such as 401(k) plans, IRAs and variable annuities, all taxes are deferred until money is withdrawn. This benefit comes with two costs. First, withdrawals before age 59½ typically trigger tax penalties. Second, withdrawals are taxed as ordinary income, which can mean a federal rate as high as 37%.
With a taxable account, there are no restrictions on how much you can invest or when you can withdraw, plus there’s the chance to take advantage of the low tax rate on long-term capital gains and qualifying dividends. The downside with taxable accounts: You have to pay taxes each year on all dividends, interest and realized capital gains.
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