I want to share with you all how I choose to invest. In order to do that, we first need to get back to basics.
Today I want to start with the accounts that I use.
Your investment accounts are basically the buckets in which you hold your investments.
This sounds like it should be simple. You open an investment account in the same way that you open a bank account. You put money into it and then you buy your investments.
It’s not quite that easy, however.
The government gives all sorts of different tax benefits to different people for different things. In order to get those tax benefits, you need to keep your investments in specific types of buckets. This means that you can end up with multiple buckets that you open yourself and multiple buckets that are opened by your employers.
Today I want to run through the accounts that I use and how they could help you.
First up, I have a 457(b) plan from my employer. This is very much like a 401(k) plan, but it is mostly accessible to employees of state and local government.
The 457(b) and the 401(k) are accounts that are opened by your employer. Generally, you can send money to this account straight out of your paycheck. This means that the money automatically goes into your investment account before the check even gets into your hand (or gets direct deposited into your checking account).
The big benefit of these accounts it that they are tax deferred. This means that for tax purposes, you get to act as if you haven’t actually earned that money yet. If you make $60,000 a year and contribute $18,000 to a 401(k), the IRS treats you as if you have only earned $42,000 for income tax purposes.
Instead, you get to invest this money and grow it for as long as you want before paying taxes when you withdraw the money from the account.
Because these tax benefits are great, there is a limitation on how much money you can put into your 401(k) or 457(b) each year. For 2017, that amount is $18,000 (plus an additional $6,000 if you are over 50 years old). The contribution limit adjusts with inflation, so that cap is raised every few years.
One catch with a 401(k) is that if you withdraw money from your account before you are 59.5 years old, you will have to pay taxes and a 10% fee. This is the government’s way of encouraging you to keep that money set aside for retirement.
This penalty does not apply to 457(b) accounts, which allow you to withdraw money penalty free as soon as you have left that employer.
While a 401(k) is set up by your employer, an IRA is an account that you can set up for yourself.
Personally, I use Vanguard because they have great investment options with very low fees. (They also have an easy “How to open an IRA” tutorial.)
You can choose to open a Traditional IRA, which functions much like a 401(k) for tax purposes, or a Roth IRA. With a Roth IRA, you pay taxes on the money in the year that you put it into the account, but you don’t pay any taxes when you take the money out. Given how much that money can grow over time, this is a great benefit.
Like the 401(k), the IRA has an annual contribution limit that adjusts with inflation over time. In 2017, that limit is $5,500 (plus an extra $1,000 if you are over 50 years old).
My problem is that there are income limits for being able to use a Roth IRA or get tax benefits from a Traditional IRA. Due to my law school loans, my wife and I currently file our taxes as Married Filing Separately. The income limit for Married Filing Separately is $10,000.
I make more than $10,000 a year.
So I use what is known as a “backdoor” Roth.
And yes, I am aware of how sketchy it sounds. On the one hand, it is perfectly legal. On the other hand, it still seems pretty sketchy. Here’s how it works:
If you are over the income limit, you can still contribute to a Traditional IRA, but you can’t take a tax deduction for that contribution.
Under an entirely separate rule, you can roll any money in a Traditional IRA over into a Roth IRA as long as you properly pay taxes on that money at the time you roll it over.
When you combine these, it means that I can contribute money to a Traditional IRA early in the year and not claim a tax deduction. I can later roll that money into a Roth IRA, only paying tax on any earnings my money has made while it was in the Traditional IRA.
Boom. Now I have money in a Roth IRA.
Again, this is perfectly legal. Whether it should be or not is an entirely different question, but while it is it is a useful investment tool.
I also have a taxable investment account.
This is the account that is parallel to a checking or savings account. It is simple, easy to set up, and easy to manage. There are no contribution limits or income barriers or hurdles to jump through.
There are also no tax benefits.
Because of this, it makes sense to work on filling up your other accounts first before moving on to a taxable account.
I use Vanguard for this account as well. I can access my taxable account and my IRA through the same user interface and I can see the balances together on my home page. I get the same investment options and pay the same low fees in both accounts.
If you’re interested in opening up a Vanguard account, you can do so here.
Health Savings Account
Last on the list today is my Health Savings Account.
It is not last because I find it to be the worst. In fact, as far as tax benefits go, the HSA is better than any of the other accounts.
The HSA is an investment account that you get access to if you have a High-Deductible Health Plan for your health insurance.
When you contribute money to this account, it is tax free going in, tax free while it is growing, and tax free when you withdraw the money to pay for health care expenses. Also, if you contribute to an HSA through your employer, you avoid paying Social Security and Medicare taxes, which you can’t avoid through any other account.
Like the other tax-advantaged accounts, this one comes with a contribution limit that rises with inflation. In 2017, this is $3,400 for individuals or $6,750 for families.
I placed this account last on my list because I cannot currently contribute to it.
As noted above, HSAs are only available to those with a High-Deductible Health Plan. While the tax benefits of HSAs are unparalleled, this is not the only consideration when deciding which health plan works best for your family.
This year, in anticipation of higher medical costs, we switched from our HSA-eligible plan to a lower deductible, higher premium plan that covers more. Under my old high deductible plan, I paid $70 per week for physical therapy. Under my new plan I pay absolutely nothing. Before deciding which insurance plan is best for you, think through what you anticipate your medical needs will be in the coming year.
Even though I can’t contribute to my HSA anymore, the money that I did contribute is still there and still growing. I can take it out at any time or I can leave it there until I need it for long-term care costs in my old age. I also can pick up contributing again if and when my family switches back to a high deductible plan.
So those are the places that I invest. What about you? What are your go-to accounts? Did I miss any? Do you have any questions about investment accounts? Join the conversation in the comments!