It’s official: You’re one of the umpteen million Americans growing a nest egg for retirement. Now what?

How do you actually run this contraption? How much should you put in, and when? What kinds of investments should you consider—and in what proportions? When should you pull the cash out, and how fast?

Start Early, Take It to the Max

The most important piece of advice I can share with you about retirement accounts is to begin contributing as soon as possible. Time, not genius, is the great wealth-builder.

Here’s an illustration that bowled me over when I first saw it. Susie Sunrise, 22, tucks away $3,000 a year in her IRA for seven years, then never saves another dime. Marsha Midday doesn’t set up an IRA until age 35. But she faithfully deposits $3,000 a year for the next 30 years. Both ladies earn 8% on their investments.

At age 65, which contestant do you suppose has the bigger balance?

Roll the drums…it’s Susie! Her account is worth $461,637, versus only $367,038 for Marsha. Start early. I launched IRAs for all three of my daughters soon after they got their first summer jobs as teenagers.

If starting early isn’t an option for you anymore, the best way to make up for lost time is to contribute more.

It just seems liks common sense. Yet millions of Americans don't take full advantage of the smartest retirement strategy (and most obvious tax dodge) out there. The following are the 2008 contribution limits for various types of tax-sheltered retirement accounts:

• IRAs: $5,000
• SIMPLE plans: $10,500
• 401(k), 403(b), 457 and SARSEP: $15,500
• Keogh Plans (self-employed): $44,000

Taxpayers who are at least age 50 before the end of 2008 can increase their contribution limits by the following amounts for the following plans (called the catch-up contribution limit):

• An additional $5,000 for 401(k), 403(b), salary reduction SEP plans and 457 plans.
• An additional $2,500 for SIMPLE plans.
• An additional $1,000 for IRAs (both traditional and Roth IRAs).

Investing Your Retirement Money

Profitable Investing subscribers often ask me, “What kind of investments should I own inside my retirement accounts?” As we’ll see in a moment, the answer depends to a large extent on your stage in life. It’s worth bearing in mind, though, that retirement accounts are tax-sheltered. You want to take full advantage of that feature.

If you are in your 20s and 30s, I suggest using your retirement accounts to hold investments that tend to generate a lot of short-term capital gains. (Short-term gains, where you buy and then sell in 12 months or less, are taxed at the same high rates as wages and salaries.) Mutual funds of the “aggressive growth” variety fit in this category.

In addition, if you plan to trade stocks or mutual funds frequently, a retirement account can save you a pretty penny in taxes. Most brokerage firms, including discounters like Schwab and TD Waterhouse, welcome self-directed retirement accounts.

As you move into your 40s and 50s, you’ll probably be ready to shift to a more conservative investment stance. It’s still OK to use your retirement accounts as a trading vehicle, but you can also benefit by accumulating bonds and dividend-paying stocks in a tax-protected format.

For people in this age bracket, I recommend storing up high-yield investments (like REITs and utilities) inside a retirement account. That way, your plump interest and dividends will escape Uncle Sam’s bite.

Five Years to Retirement: A Fork in the Road

Once you get within about five years of your projected retirement date, you’ll need to make a basic decision. Have you got enough to live on in retirement without immediately tapping your tax-sheltered accounts? In other words, will your taxable investments, your pension (if any) and Social Security be enough, together, to pay your bills?

If you’re lucky enough to say yes to this question, I encourage you to allocate your retirement accounts along a growth-and-income track—about 70% stocks and 30% fixed income. (Our main Profitable Investing portfolio is laid out for this purpose, with the goal of keeping your money growing at close to double-digit rates far into the future.)

On the other hand, if you’re nearing retirement and you know you’ll need the money in your tax-sheltered accounts soon, the five-year mark is your signal to shift even more strongly toward an income posture. I find a 50-20-30 strategy optimal (50% in high-dividend banks and utilities, 20% in real estate and master limited partnerships and 30% in bonds or bond equivalents).

50-20-30 (or something close to it) is an allocation that should work well for most retirees in the decades ahead. It assumes the stock market will continue to grow, but it doesn’t count on the outsized—and unsustainable—returns we saw in the 1990s.

Cracking Open Your Piggy Bank

Finally, the day dawns when you’re ready to tap your retirement account. If you’re in a traditional IRA or 401(k), that date can come as early as age 59 ½ (optional) or as late as April 15 of the year after you turn 70 ½ (mandatory).

For Roth IRAs, there’s no required starting date or minimum distribution. If you wish, you can squirrel up the money for the rest of your life and pass the account to your heirs free of income tax (but not necessarily estate tax).

Regardless of the type of plan you’re in, I advise you to put off taking distributions as long as possible. Draw down your taxable resources before dipping into your tax-deferred accounts.

Fortunately, in 2002, the IRS eased the minimum distribution requirements for traditional IRAs and 401(k) accounts. Now, for example, a 70-year-old can assume a life expectancy of 27.4 years for his or her first distribution. The age of your beneficiary (typically your spouse) doesn’t matter unless he or she is more than 10 years younger than you.

Divide 1 by 27.4, and you find that you only need to take out (and pay taxes on) 3.65% of your account balance this year. Even at age 80, the required minimum is just 5.35%. See below for the complete table.

Of course, you may not be able to make ends meet on the required minimum. No problem; you’re allowed to take out as much as you want above the minimum.

But if you don’t need the extra money, taking out the minimum should allow your retirement account to grow for many years to come. (All you need to do is earn more on the balance than the percentage you’re drawing out.) Chances are, you’ll have a handsome legacy to pass on to your heirs.

That is, of course, an issue for another time—how to turn a $100,000 IRA into a $2.4 million gift to your grandchild over his or her working life span. For now, though, all the wisdom in the world about managing your retirement account boils down to three simple principles: Save early. Invest wisely. Spend slowly!

IRA Minimum Distributions

To calculate your minimum distribution amount, take your age and find the corresponding distribution period. Then divide the value of your IRA by the distribution period to find the required minimum distribution.

More Income for the Rest of Your Life: The Incredible Dividend Machine

So how should you put those rules into action? Well, our Incredible Dividend Machine is the perfect solution. This one-of-a-kind portfolio is designed to let you earn one or more dividend checks every month of the year.

Better yet, as companies in our Machine sweeten their dividends, the cash flow turns into a flood. Let me show you what I mean: We launched the Machine nearly four years ago. Had you purchased each of the stocks I recommended then, in the suggested amounts, you would have started with a yield of 4.5% on your money. Not bad for an all-stock program (no bonds).

Look, though, what has happened to those stocks over the past 46 months. Assuming you kept the portfolio intact, you would now be drawing about 5.1% yield on your original investment. That’s a total pay hike of 13%.

Every six months, I update the Machine, tweaking for improved performance. Occasionally, I make changes more often if the situation warrants it. If a stock runs up too fast, I may pull it from the active buy list until the price slips back into a more reasonable range. By the same token, if management seems to be fumbling, I won’t hesitate to issue a sell recommendation.

Now let’s step back and see how the whole Machine works together. To receive a check every month, all you need to do is choose at least one stock from each of the dividend cycles in the section below. Companies typically pay their dividends in the same month of each calendar quarter (first, second or third). For each stock in the table, I’ve provided the ticker symbol and current yield.

To spread your risk, buy as many different pieces of the Machine as you can afford. Ideally, no single stock—whether from the Incredible Dividend Machine or any other source—should account for more than 5% of your invested wealth.

If your budget allows you to sample equal dollar amounts of all 23 stocks, you’ll draw a yield of 5% from the whole portfolio. That’s more than a 30-year Treasury bond. Moreover, as we’ve already seen, your Machine stocks are likely to boost their dividends over time, whereas a bond’s payout normally remains fixed until maturity.

Bonds, in other words, are great for safety. But if you hope to live it up a little in retirement, I invite you to step into the Incredible Dividend Machine.

January–April–July–October Cycle

February–May–August–November Cycle

March–June–September–December Cycle

Monthly Payers

Mutual Funds You Can Retire On

We are on the verge of the biggest demographic tipping point of the next 10–15 years. Starting in 2007, the number of Americans of retirement age (65 and older) will grow faster than the population in the prime saving and investing years (40–60).

This generational shift will make a profound impact on the stock and bond markets. Stocks overall will likely notch lower returns than we saw in the 1980s and 1990s, at least through the end of the next decade (2018–2020). At the same time, dividend-paying stocks will sparkle, driven up by income-seeking retirees.

Bond yields will also remain lower than many gurus now assume. Reason: Retirees, with their conservative mindset, will turn to bonds for a cushion against stock market volatility. Bonds also allow the income seeker to capture higher cash yields than those afforded by money market funds and short-term bank deposits.

I'd like to take some time now to address the mutual fund investors among us who may be near or in retirement. Do you own the appropriate funds?

Answering that question takes a little thought. Not all retirees are in same financial situation. Some can accept greater month-to-month (and even year-to-year) fluctuations in their portfolios than others can.

Some need to earn more income from their investments than others do. Ultimately, these issues are more important than whether you own funds from Fidelity, Vanguard or some other family.

Since one size doesn’t fit all, I suggest that you begin with our basic model portfolio allocation (70% stocks, 30% fixed income) and make the necessary tweaks to fit your own circumstances. As a broad guideline, I recommend that you:

• Add 1% in equities for every year you’re under age 57,
• Add 1% in equities for every $200,000 in your portfolio value above $1 million; and
• Subtract 1% from your stocks for every year over age 70, then an additional 2% for every year over 80.

Once you’ve found the allocation that fits you best, you can go on to consider the most appropriate mutual funds for your situation. As a thrifty Yankee, I prefer no-load (no sales charge) funds. Over the long pull, when you adjust for sales charges, no-load funds generally outperform their “loaded” brethren.

Let’s assume, at this point, that you’re ready to build a portfolio of no-load funds for retirement.

Which funds should you buy right now?

Our Fund Supermarket Portfolio, which I update every other month in our Profitable Investing newsletter supplement, is a good place to start.

It’s composed of funds you can buy through leading discount brokers, usually without paying a transaction fee.

Our current portfolio allocations break down as follows:

Fund Supermarket Portfolio

Cash You Can Never Outlive

Annuities are an age-old concept. Most investors nowadays buy the deferred version of the product. With a deferred annuity, you put money in and the annuity’s earnings accumulate tax-free until you begin making withdrawals.

For a different twist, I suggest that retirees consider an immediate annuity. You deposit a lump sum, and the insurance company starts cutting you monthly checks immediately—for life.

What’s the benefit of immediate annuitization? For starters, assuming you’ve chosen a fixed annuity, you know exactly what dollar amount you’ll receive and for how long. You can never outlive the cash. No dividend cuts to worry about, either. As long as the insurer remains solvent, your checks can’t be reduced. Even if the insurance company goes belly-up, all 50 states and the District of Columbia sponsor guaranty associations that generally pick up the tab.

(To qualify for coverage, though, you should limit your deposit to $100,000 per insurer.)

Another handy feature: Part of each monthly payment is treated as a tax-free return of capital.

Of course, there are caveats. When you die, the annuity payments cease. Your heirs get nothing, unless you specify that the annuity is to continue for a minimum number of years. The trade-off, if you select the “life with term certain” option, is that you receive smaller checks and the tax-free portion shrinks.

Unless you’ve got no heirs to provide for, I strongly recommend life with term certain. Example: On a deposit of $100,000, blue chip First Colony Life will pay a 65-year-old male, in good health, $550.42 per month for life, with 20 years of payments guaranteed even if the annuitant passes on. That’s $6,605 a year of spendable cash, substantially more than I would advise most retirees to withdraw from, say, a bond fund with a starting balance of $100,000.

What to do now: To maximize your annuity income, I suggest creating a “ladder” of multiple annuities, some with longer and some with shorter guarantee periods. (The shorter pay more, naturally.)

For a higher yield, you might also steer a portion of your annuity money to a fraternal or religious organization. As long as the organization belongs to a state guaranty association (a fact you should confirm in writing), you’ll enjoy the same protection against default as you would with a commercial insurer.