Part 6 - Accounts

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:

1. Retirement savings
2. Education savings
3. Medical savings

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):

• Traditional IRA
• Roth IRA
• 401(k)
• Roth 401(k)
• 403(b)
• Keogh plans
• SEP IRA
• SIMPLE plans
• etc, etc, etc...

Never fear, though the list above may seem daunting, here's what you need to know:

• IRAs are accounts that you can open for yourself. Almost everyone qualifies for a Traditional IRA or a Roth IRA (we'll dig into these later).
• 401k's and 403b's are plans usually offered through your employer. Most larger companies offer their employees a traditional 401k or 403b plan, and Roth 401k plans are increasingly being offered as well.
• Keogh plans, SEP IRAs, and SIMPLE plans are for self-employed folks or those working at smaller companies that can't afford the overhead of a traditional 401k program.

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:

• Checking accounts
• Savings accounts
• Most money market accounts
• A normal brokerage account
• Your mattress
• etc, etc, etc...

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:

1. In general, the money can't be withdrawn without penalty until the account owner reaches 59.5 years of age. There's a list of exceptions, most of which are related to financial hardship and certainly not something you would want to plan for.
2. You MUST start withdrawing the money at age 70.5.
3. When you actually withdraw the money at retirement, the withdrawals are treated as normal income and taxed as such.
4. For 2007, you're limited to $4000 in contributions per year if you're under age 50. This will increase to $5000 in 2008.
5. If your household is covered by an employer-sponsored retirement plan, then there are income limits for the IRA, but they're messy and complicated. Essentially, if you make less than $50,000, you're safe. More on this later...

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:

• Higher income limits: Single filers can contribute if you make less than $99k. Joint filers can make up to $156k. This is simplified, but that's the general idea.
• There are no required withdrawals at age 70.5, as with the traditional IRA.

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:

• Employees can only contribute $15,500 per year. This will remain at $15,500 for 2008 and then be indexed to increase with inflation, in $500 increments.
• Distributions be taken starting at age 70.5.
• Employees may have fewer investment options, depending on where the accounts are opened (which is up to the employer).
• If you leave the employer, you have to deal with what to do with the account. Options are generally to rollover into an IRA, leave the account with the old employer (you still own the funds), or rollover to a new 401k at your new employer.

However, there are benefits to this account over the IRA:

• No income limits
• Your company may offer matching funds. More on this below.
• Your HR department can usually help you setup this type of account very easily

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:

• Employer contributions are often not fully vested, which is a fancy way of saying that they're giving it to you, but they'll take it back if you leave too soon. Typically, contributions are fully-vested after a few years, but check with your HR department.
• If you invest in a traditional 401k, your employer can still match funds, but their contributions are provided on a pre-tax basis, just like the traditional 401k. Those contributions (and their earnings) will be taxed whenever you withdraw them upon retirement.
• Most importantly, you have to actually contribute to get the match. Many employees, for whatever reason, never bother to get this setup and miss out on a lot of free money. Don't let this be you. Even if you don't really like your employer's 401k plan options or you have your own retirement plan all setup and in operation, do take advantage of any free matching funds. It's almost always not worth it to skip that free money.

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:

• If your employer offers matching, contribute just enough to get the full match. I would recommend going with the Roth 401k if your company offers it.
• If you still have money left to invest and your 401k investment options are good (we'll cover what constitutes good later), I would continue to fund the Roth 401k up to the limit.
• If your company does not offer the Roth 401k or you don't like their investment options, I would open a Roth IRA (or traditional IRA...Roth is my personal opinion) and max that out (we'll talk about where to do this later).
• If you've maxed out the IRA and the 401k is either fully maxed out or just enough to get the matching (depending on whether you like their investment options) and you STILL have money to invest, congratulations. Keeping in mind that you should probably also be saving for things like education, healthcare, downpayment for a house, etc, if you still have money that you want to invest for retirement, your next step should be to open a non-tax-advantaged account like a traditional brokerage account. However, I would NOT recommend this for retirement savings unless you've already maxed out your IRA and 401k, or your 401k options are really bad and you've maxed out your IRA and at least gotten the full matching on the 401k.

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.