By now you may be convinced that you need to be investing
But what should we do about it?
Now may be a good time to get into some more practical advice, so today we’re exploring how to get started with investing.
As a note up front, there are all sorts of ways to invest.
You can buy a business, invest in real estate, trade commodities, and buy gold bars, among many others.
I’m going to be focused on the stock market, which has the best odds for long-term returns, and broad index funds, which are the safest way to invest in the stock market.
With that in mind, let’s dive in.
Choosing Your Accounts
Step one is identifying the type of account that you’d like to use for your investing.
This can feel a bit overwhelming. There are all sorts of different types of accounts and our tax code creates a broad range of numbers and letters to identify them that can be confusing.
It’s worth understanding those numbers and letters, though. These strangely-named accounts are accounts that have different tax advantages.
The government wants you to invest! In order to encourage you, it has created a number of different tax code provisions that include what are called “tax expenditures” for investors. Basically, the government is giving you money, in the form of a lower tax bill, to push you to invest.
The first bucket of tax-advantaged accounts are employer-based retirement accounts. The most common of these are the 401(k), the 457(b), and the 403(b).
These accounts are generally set up through your employer and let you deduct money from your paycheck. Instead of that money appearing in your bank account, the company sends it to your retirement account to be invested. Some employers will even match some of your contributions, essentially giving you more money to invest as a reward for investing.
These accounts are tax deferred. What that means is that any money you put into them does not count as earned income until after you take it out of the account. This can be a huge benefit.
You can lower your tax burden when you are making a lot of money in your prime and instead choose to be taxed on it when you want to withdraw it in your later years when you may be making less. (And if you’re actually making more than you were when you were working, then you’re probably doing quite well and the bill won’t hurt much anyway!)
Because of this tax benefit, there is a limit to how much money you can put into your employer-sponsored retirement account. For 2018, the limit is $18,500 (plus an addition $6,000 for anyone over 50). There is also a 10% early withdrawal penalty if you take the money out of your 401(k) or 403(b) before the age of 59.5. The early withdrawal penalty does not apply to the 457(b).
Another common place for investments is the Individual Retirement Account, or IRA.
The IRA is a retirement account like the employer-based accounts we looked at, but you set it up, contribute money, and direct your investments instead of your employer.
The individual is given more responsibility over these accounts, but is also given far more options. You can set an IRA up wherever you’d like and invest in whatever your brokerage offers. Compare this to employer plans which generally go through a specific company (chosen by your employer) and only have specific offerings.
Personally, I use Vanguard for my IRA. They have great investment options with very low fees. (They also have an easy “How to open an IRA” tutorial.) Fidelity, Schwab, and others also have great options and low fees, so feel free to check out your options and pick whatever works for you.
There are also a number of options for retirement accounts if you are self-employed. I’ll give a quick summary of those, but if you are in this situation I recommend doing a bit more digging before choosing which route you want to go.
With a SEP IRA you can contribute up to 25% of your net self-employment earnings (up to $55,000). The SEP is generally easy to set up and has low fees.
Like an employer-based 401(k), the Solo 401(k) allows you to contribute up to $18,500. However, the Solo also lets you add an extra 25% of net self-employment earnings (up to $55,000). This account lets you save more money than the other accounts, but is also significantly more paperwork and generally has higher fees.
As befits the name, the SIMPLE IRA is easy to set up, generally has low fees, and allows you to contribute up to $12,500 per year without figuring out any percentages of your earnings.
Most of the accounts that we’ve discussed above are also available as Roth accounts.
Where the standard retirement plans are tax deferred, Roth accounts are the opposite. Instead of avoiding taxes when you contribute the money and paying them when you withdraw, Roth accounts allow you to pay the taxes when you contribute the money and pay nothing when you withdraw.
There is a lot of debate in the personal finance world over whether traditional accounts or Roth accounts are more beneficial.
Team Traditional argues that you should defer taxes as much as possible in your prime earning years. They say that you’ll probably be making less money in retirement, and anyway you can choose how much to withdraw and in what years to maximize your tax benefit.
Team Roth argues that the devil you know is better than the one you don’t. Maybe your earnings will actually be higher in retirement. Maybe taxes will go up between now and then and you’ll be better off paying today’s lower rates.
I am going with a mix of the two. This allows me to take some of the benefits now, defer some of the benefits until later, and have flexibility over what type of money I withdraw at what time in my later years.
The Back Door Roth
Both Traditional IRAs and Roth IRAs have an income limit beyond which you cannot contribute and enjoy the tax benefits of those accounts.
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 you can contribute money to a Traditional IRA early in the year and not claim a tax deduction. You can later roll that money into a Roth IRA, only paying tax on any earnings the money has made while it was in the Traditional IRA.
This process is colloquially known as the Back Door Roth.
It sounds sketchy (and kind of is), but it is perfectly legal. Whether it should be legal or not is an entirely different question, but while it is it’s a useful investment tool.
Health Savings Account
Our last tax-advantaged account today is the Health Savings Account.
Unlike the other accounts that we’ve discussed, the HSA is not for retirement savings. Instead, it is for health care costs.
If you have a high-deductible health insurance plan, defined as a plan with a deductible of at least $1,350 for an individual or $2,700 for a family, you will have access to an HSA. The idea is that people with higher deductibles should be given an incentive to save up for unexpected costs that will hit them harder than people with low deductibles.
The HSA is often confused with the FSA, or Flexible Spending Account. Money in an FSA must be spent in any given year or it disappears. Money in an HSA can stay in the account indefinitely.
With an HSA you get a triple tax benefit. You don’t pay taxes when you deposit the money. You don’t pay taxes on the growth of the money. You don’t pay taxes when you withdraw the money to pay for healthcare costs.
If your high-deductible plan covers your whole family you can contribute up to $6,900 this year, while an individual can contribute up to $3,450.
These accounts are usually opened through your employer, but you can open them on your own if the situation calls for it.
Our final account today is the standard taxable account. This is the simplest, but the least beneficial as far as taxes are concerned.
You can set it up with whichever brokerage you want, invest in whatever you want, and withdraw your money whenever you want. There are no income limits and no hoops to jump through.
There are also no tax benefits. You pay taxes on your income before you put the money in, you pay taxes on the dividends that hit your account as your money grows, and you pay tax on the gains you’ve made when you pull the money out.
My taxable account is with Vanguard for the same reasons discussed above in the IRA section. If you’re interested in opening up a Vanguard account, you can do so here.
Your own mix of accounts can be based on any number of factors.
Obviously the tax benefits are worth pursuing for most people, so strictly by the numbers it makes sense to fill up as many tax-advantaged accounts as possible before getting to a taxable account.
On the other hand, being able to access your money on demand without jumping through hoops or paying penalties certainly has its own benefits, so you may decide to get some money into a taxable account before maxing your other accounts.
I’ve got money in a traditional 457(b), a Roth IRA, a taxable account, and an HSA to which I am no longer eligible to contribute.
Personal finance is personal. Figure out what works for you and your family and get investing!
Join the Conversation!
How did you get started with investing? What accounts do you use? What did you find confusing when you were learning? Let us know in the comments!