Part 2: A Comparison of Investment Account Types

Where do you invest your money once you have decided to save and invest?

You decided to begin investing in the stock market, but before you open up an account with a broker you need to know what type of investment account you should open. There are a lot of choices; you have a traditional brokerage account, a traditional IRA (Individual retirement account), a ROTH IRA, a 401(k) available through your employer…what is the difference in all these account types and where should you prioritize your investments?

 

First, you need to understand the differences between all the accounts. Here we will discuss the 4 major types of investment accounts that will be appropriate for our readers.

 

401k through your employer

 

Your 401k (for federal employees, this is your TSP) has one very special and unique feature – free money. Generally, your employer will offer a match to your contributions up to a certain amount. For example they may match “up to 5%”, meaning that if you invest 5% of your paycheck into your 401k, your employer will also put 5% in, for a total of 10% of your paycheck invested. You can invest more than the match of course, but it will not result in a larger contribution from your employer.

 

Because of the free money from your employer, contributing up to your employers match should be your ultimate saving priority. If all you can save is 5% of your paycheck, be sure this 5% is toward your 401k, so you can get your free money.

 

In a 401k your contributions come out of your paycheck before your paycheck is taxed. You pay no taxes now, but you will pay taxes when your make withdrawals from your 401k in retirement. For many, this is a great benefit because in retirement you do not have as much income, so your tax bracket is much lower.

 

This is an important point for many. For example, let’s say you make $87,000 per year. Anyone in the U.S. with income over $86,350 is in the 28% tax bracket. If you contribute $10,000 into your 401k, your taxable income drops to $77,000, putting you down into the 15% tax bracket, potentially saving you a lot of money come tax time. We will discuss this in much greater detail in later articles, for now just know that contributions in 401ks lower your taxable income.

 

401k does have a slight disadvantage compared to other account types (most notably a Roth IRA). In a 401k, if you need to withdrawal money from the account before age 59 ½, you pay income taxes on the amount withdrawn plus an additional 10% penalty. There are several exemptions to this additional 10% such as educational expenses, medical expenses or a home purchase which will not be discussed in detail in this article. There are also generally options for loans from your 401k, which may be a smarter option if you absolutely have to take money out. However, it is most beneficial to consider money in your 401k as trapped there until retirement. If you have learned anything so far from Begin To Invest, it should be that time is money when dealing with compounding interest and your investments. So let your money in your 401k continue to work, don’t consider it your savings for a car or house down payment. It is solely your retirement savings.

 

Your investment options in a 401k vary from employer to employer. Generally they consist of a wide variety of mutual funds and the employer’s company stock.

When deciding how to allocate your contributions consider cost of the mutual funds and keep them in funds with as low of expense ratio’s as possible and balanced between stock and bonds. Also, be careful not to overweight your 401k with shares in your employer’s company stock. This is a common problem, and the disastrous affects have been shown in cases such as employees of Enron.

 

In the case of Enron, senior managers often encouraged employees to put as much money as possible in their 401ks into Enron stock. For a while, Enron’s stock performed very well, likely causing more people to put even more money from their 401ks into Enron stock. Many held 100% of their retirement savings in Enron stock. When the day of reckoning finally came for Enron, the company’s stock collapsed and employees not only lost their jobs, but also their entire retirement savings.

 

Your current income is dependent on your employer, don’t let your retirement savings also be. A common rule of thumb that I like to follow and advise on Begin To Invest is that you should not have more than 5% of your investments in any single stock, and this most certainly includes your employer’s stock.

 

Some random, final quick facts on 401ks:

 

  • 401ks have a $17,000 per year limit on contributions for those under 50 years of age. For those over age 50, you have an additional $5,500 of “catch-up contributions” to add, for a total of $22,500.
  • Starting at age 70 ½, there are required minimum distributions for 401ks. Here, you are required to withdrawal a certain amount of money from your 401k, or pay a penalty. The amount is determined by the tax codes in the IRS and varies person to person.

 

Major takeaway – always contribute up to your employer match, or else you are turning down free money.

 

 

Traditional IRA


In traditional IRAs you put money into the account after paying taxes, but you can write off the contributions each year on your taxes. Like our example in the 401k section, if you make $87,000 a year, and contribute $5,000 into a traditional IRA, you taxable income is effectively $82,000.

 

The tax benefits of traditional IRAs are similar to 401ks in that you pay taxes upon withdrawing money, commonly described as ‘deferring’ taxes.

 

Again like 401ks, traditional IRAs have a penalty for withdrawing money prior to age 59 ½, so they should not be used as emergency funds, savings accounts or savings for a big purchase.

 

Investment options in traditional IRAs have become very complex lately, as you can hold nearly anything in an IRA. You will see companies offering gold or other precious metal IRAs, banks typically offer IRAs that hold CDs and almost all brokers offer IRAs where you can purchase any mutual funds or stocks. We will detail asset allocation specifics in later articles, but because of the withdrawal penalty and tax free growth of IRAs, I believe IRAs make most sense with a broker, buying stocks and bonds instead of CDs or precious metals like the banks would like you to think.

 

 

Final quick facts on traditional IRAS:

  • Just like 401ks, at age 70 ½ you must start withdrawing money from your traditional IRA or face a penalty.
  • There is no income limits to contribute to a traditional IRA. No matter your taxable income, you can contribute to a traditional IRA.
  • The maximum you can contribute is $5,000 per year. (Read the next section on Roth IRAs for more details.)
  • You can only contribute to a traditional IRA (or Roth IRA) if you have earned income. Meaning, if you only make $2,000 in 2012, you can not contribute more than $2,000 into an IRA.

 

 

Roth IRA

 

Roth IRAs are a bit of a different animal than traditional IRAs. Money is contributed into a Roth IRA after taxes, and contributions are not tax deductible. However there is one quality that makes Roth IRAs really superior to every other investment vehicle. All gains inside a Roth IRA grow absolutely tax free, and upon reaching age 59 ½ can be withdrawn without paying a single dollar in taxes.

 

Consider the significance of this for a minute; we have detailed in another article what it takes each month to save up a million dollars . If you did this in a traditional IRA, upon withdrawal, you would then have to pay taxes on that million dollars…which is quite a sum! Many hundreds of thousands of dollars could potentially go to taxes!

 

But if that money was saved and invested in a Roth IRA instead of a traditional IRA, that entire million dollars would be yours and poor Uncle Sam would get nothing. This is the difference in “tax deferred” traditional IRAs and “tax exempt” Roth IRAs. That one word can save you hundreds of thousands of dollars.

 

Roth IRAs also have another benefit that is very handy to all investors, but in particularly young investors who may not have a large enough emergency funds built up yet. Original investments can be withdrawn without penalty, but capital gains can not. To make this clear, consider this example:

 

Ben invests $5,000 into a Roth IRA and buys an index fund and in 5 years it grows to $7,000 (a gain of $2,000). After those 5 years, Ben loses his job and his car breaks down. He now desperately needs money for a new car. Thankfully he can withdrawal that $5,000 from his Roth IRA without penalty, but he can not withdrawal the total $7,000. The $2,000 of increased value (gains) is the only part that is penalized if withdrawn. All original contributions can be withdrawn without penalty.

 

In addition, up to $10,000 in gains can be withdrawn if used for a first time home purchase, if the money has been in the Roth IRA for at least 5 years.

 

For this reason, part of one’s emergency funds can be allocated into a Roth IRA, where you can get a better return than the 0.01% interest checking accounts give these days. See our articles on proper asset allocation for a much more detailed explanation.

 

Like a traditional IRA, a Roth IRA opened up at a broker allows investments into any mutual fund, ETF or company stock.

 

All of these benefits come together to make the most important vehicle for savings for any investor, particularly young investors as your investments can grow tax free for decades. All dividends (normally taxed at 15%, and soon could rise to 40+ % depending on the extension of the “Bush tax cuts”) are tax free, and money can be withdrawn in an emergency.

 

There are several limitations to Roth IRAs. Individuals can only contribute into a Roth IRA if their taxable income is under $110,000. Remember, investors can lower their taxable income by increasing contributions into their 401k or contributing to a HSA (health savings account), to name just a few options. Married couples can not have a combined taxable income greater than $173,000 and contribute to a Roth IRA.

Limits change every so often for IRAs and ROTH IRAs and should be confirmed with the IRS. Limits are stated here.

 

 

The annual limit of contributions to any kind of IRA is $5,000. Meaning you can contribute up to $5,000 in a Roth IRA per year, or $5,000 in a traditional IRA per year, or $2,500 in a Roth IRA and $2,500 in a traditional IRA, but together they can not go above $5,000.

 

Some final quick facts about Roth IRAs:

  • Annual contribution limits to IRAs are $5,000, but if you are over the age of 50, you can contribute an additional $1,000 for a total of $6,000 per year.
  • Roth IRAs have no mandatory withdrawals at age 70 ½ like a 401k or traditional IRA.
  • You can only contribute to a Roth IRA (or traditional IRA) if you have earned income. Meaning, if you only make $2,000 in 2012, you can not contribute any amount greater than $2,000 to a Roth IRA. After you contribute up to your employer’s match in your 401k, maxing out your Roth IRA should be your next priority.

 

 

Traditional Brokerage Account

 

The most basic brokerage account, there are no immediate tax benefits and honestly no real reason to open this type of an account unless you are: 1) Maxing out your Roth IRAs each year and 2) Maxing out your 401(k) each year.

 

If that is the case, since this type of account offers no tax benefits, it is important that your specific investments are tax-friendly such as Municipal bonds. We will discuss tax conscious investments in later articles.

 

 

Conclusion

 

This is a lot of information to absorb if it is new to you. For a quick summary that will apply to most readers, after you have an appropriate emergency fund set up, your investment priority is as follows:

 

1)      Up to your employers match for your 401k

2)      $5,000 per year in a Roth IRA

3)      Max out your 401k, recall that maximum annual contribution is $17,000 per year. So if step 1 causes you to contribute $5,000 to your 401k, this step results in an additional $12,000.

4)      Any additional money able to be invested should be in a traditional brokerage account in tax conscious investments.

 

If you have taxable income greater than $110,000, a regular IRA should be substituted instead of a Roth IRA as you are not eligible to contribute to a Roth IRA.

 

 

Part 3 of our “Getting Started Series”, found here, talks about deciding where to open up a retirement account and some basic initial investments in your new retirement account.

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