If you haven’t read Parts 1 - 5 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
Now that you've figured out what your goals are and what you're going to need to do to accomplish those goals, it's time to look at the options you have in terms of where to put your money. If you're whipping out your newspaper to check the stock quotes of your favorite companies, hold up a second. Before we can even talk about what to invest in, we need to talk about the different account types through which you can invest. This is probably one of the most confusing areas of investing for many people, so let me see if I can break it down some.
In general, the types of investment accounts you can open fall into two categories: tax-advantaged and non-tax-advantaged. Tax-advantaged account types offer the benefit of reducing your tax liability in some way, though certain limitations usually apply. Non-tax-advantaged accounts usually have fewer restrictions but offer no tax benefits.
Tax-Advantaged Accounts
Generally speaking, most tax-advantaged accounts fall into one of three categories:
We'll spend most of our time talking about retirement accounts, but I hope to cover education savings and medical savings in future posts or series.
Retirement savings account types
Brace yourself, it's a long list (and this isn't even all of them):
Never fear, though the list above may seem daunting, here's what you need to know:
Don't worry if you don't know what any of the above means, we're going to cover each of these in more detail, but before we do, let's briefly take a look at:
Non-tax-advantaged Accounts
Generally, any place to stash your cash that doesn't offer any tax benefit falls into this category. This would include:
Generally, what you need to remember is this: your bank probably pays you about 1-2% (if that) on your savings account, which isn't enough to keep pace with inflation. However, online banks right now are offering savings account rates of 4-5%, which makes them a great place to stash your cash for shorter periods (anything less than 5-7 years). Beyond that time period, you'll want to look at opening a normal brokerage account. Don't worry...it's relatively painless and really cheap (or free). In general, you'll want to make sure you're meeting your retirement goals first (and then some) before packing money into a non-tax-advantaged account, as you'll have to pay taxes on your earnings from these types of accounts. Because this series is aimed at young investors, many of whom have debts to eliminate and may struggle initially with just meeting their retirement savings goals, we'll spend most our time focusing on retirement accounts. However, if you want to open an online savings account, I recommend HSBC Direct or ING Direct. You can compare rates from a host of institutions here. If you want to open a brokerage account, I recommend ETrade or Sharebuilder (more on this later).
Individual Retirement Accounts (IRA)
An IRA is a special type of account that comes in a few flavors, but for now, we're going to focus on the two most common: traditional and Roth.
Traditional IRA
The traditional IRA allows you to invest a certain amount of your income and deduct those contributions from your taxable income (you invest with pre-tax dollars). In an extremely simple example, if you make $50k per year and you invest $4k in an IRA, your taxable income is reduced by $4k, to $46k. However, there are a few catches:
Roth IRA
A Roth IRA is similar to the traditional IRA, but the taxation works in reverse: instead of not paying taxes on the initial contributions and paying taxes on the withdrawals when you retire, as with a traditional IRA, a Roth IRA allows you to pay taxes on your initial contributions and withdraw your earnings at retirement tax-free. There are several other advantages as well:
Which to choose?
This is a very complicated question that depends on future variables for the optimal answer, but in general, you should invest in a Roth IRA if you expect that you will be in a higher tax bracket at retirement than you are now. My personal opinion on the subject is that with the unfunded liabilities our government is currently incurring, they'll have to raise taxes severely in the future to compensate. I like the peace of mind that the Roth IRA offers because I know that I've already paid my taxes on that money and anything I withdraw at retirement is mine to keep. This particular subject (traditional vs. Roth, both for IRAs and for 401k's) is worth delving into deeper in a future post.
What can you invest in with these accounts?
Pretty much anything, provided that the place where you open the account offers it. You can invest in stocks, bonds, mutual funds, index funds, hedge funds, money market funds, real estate, options, etc. Keep in mind that I'm not recommending most of these asset classes, especially when you're just starting out. But it's nice to know that you can choose the best investments for your situation, including down the road when your investing prowess has increased.
The 401(k)
The 401(k) (or 401k, as I'll be calling it) is an extremely common type of investment account, offered through your employer. It's named after the section of the IRS code where it originated. Just as with IRAs, the 401k comes in two main flavors: traditional and Roth.
Traditional 401k
For the purposes of taxation, the traditional 401k works just like the traditional IRA: you invest with pre-tax dollars and are taxed on your savings and future earnings upon withdrawal at retirement. Just like with the IRA, there are restrictions:
However, there are benefits to this account over the IRA:
Roth 401k
The Roth 401k functions exactly like it sounds like it would: contributions are made with after-tax dollars and savings and earnings are withdrawn tax-free at retirement. Generally, the same pros / cons that apply to the traditional 401k apply to the Roth 401k. This account has only been around for a couple years, so a lot of employers don't yet offer it, but if you bug your HR department, they may be able to make it happen.
Matching funds
Many employers offer some kind of matching on 401k contributions. This generally works something like a 50 - 100% match on the first 6% of an employee's contributions, where 6% is a percentage of the employee's salary. So for example, if you gross $4000 / month and you contribute 10% to your 401k (good for you!), that's $400 / month. If your employer offers a 50% match on the first 6% of your contributions, that means that 6% of the 10% you contribute will get a 50% match. In this case, 6% is $240 and 50% of $240 is $120, so your employer kicks in another $120, so your 401k actually gets the $400 + $120 = $520 / month, which is like getting a free 30% return on your first year of investing, plus whatever the market returns. Not bad. There are, however, a couple of things to keep in mind:
Contribution limits
Just as with the IRAs, the contribution limits for both 401k account types is the limit of contributions for both together, not for each. In other words, if you contribute $15,500 to your traditional 401k in 2007, the grand total you can contribute to your Roth 401k in 2007 is $0.
However, accounts of another type are fair game, so you can max out your 401k and a Roth IRA, for example, or a Roth 401k and a Roth IRA. Just keep within the limits for each type (IRA vs. 401k).
Also, keep in mind that the 401k limits apply only to the employee's contributions. Employer contributions can push total contributions above that limit, provided the total does not go above 100% of the employee's total compensation, or $45,000 / year ($46k for 2008), whichever is less. If your employer is piling enough cash in your 401k that this is a problem, please let me know if they're hiring ;-)
Bringing it all together
So now you now about the most basic options for retirement accounts. Which should you choose? Instead of giving you some nonsense about how it depends on your situation and leaving you with more questions than answers, here's some ideas, in order of priority:
Task: Find out what your employer offers and make sure you're taking advantage of any matching offered.
As discussed above, those matching funds are like free money and it's there to encourage you to invest for your future. Take advantage of it. Your HR department will be able to help you determine what your options are and help you sign up. Don't wait. If you're reading this at work, send HR an email RIGHT NOW. If you're reading this in the evening or on the weekend, write yourself a note, send yourself an email, or whatever you need to do to make sure you take care of this next time you're at work. Will you miss the couple hundred bucks per month? Probably. Will you be glad you did this someday? Absolutely.
Note: Now that I'm self-employed, I'm seeing all this investment advice through new eyes. However, I'm going to continue to write this 12-part series for someone with a job. I'll touch on some of the areas that may differ for self-employed folks, those employed by the government, etc. Hopefully in the future I'll be able to dedicate a post or two to investing for those situations.
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.