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Now that you know how the stock market works, it’s time to put that knowledge to work.
And to do that, you’ll need to fund an investing or retirement account.
It might seem daunting when you look at the alphabet soup of account options, but it’s one of the most important parts of the investing process. Between a 401(k), IRA, 529, 403(b), HSA, Roth IRA, or just a plain old brokerage account, finding the right one for you might seem daunting.
This lesson will help you weave through the various account types and develop a plan to consistenly fund your account. Making sure you’re consistently putting money into your account is almost as important as what you do with it once it’s there.
First, let’s cover some of the most common types of accounts.
A 401(k) is one of the most common types of retirement plans because it’s sponsored by employers. Companies used to offer their employees pensions as a retirement benefit, but as costs ballooned they’ve shifted to 401(k)s, named after their place in the tax code. 401(k) plans are tax-advantaged, which means you can contribute part of your salary to the account before paying income tax. Not only does this mean the money goes in tax-free, but you can also reduce your tax burden by contributing enough to move down a tax bracket.
Another perk of 401(k) plans is that employers often match employee contributions. The national average for matching contributions is 3%. If your company matches up to 3% of your contributions, then if you contribute 3% of your pacheck to a 401(k) plan the company will add the same amount. That makes a 401(k) plan one of the best options for funding your retirement.
The downside of a 401(k) is that you might be limited in your investment options. Companies partner with advisory firms like Fidelity or Voya who may only offer a few funds to choose from. This can be less than ideal, but you can call the company managing the 401(k) and see if you can be approved to buy stocks through your plan.
Another type of retriment account, the individual retirement account (IRA), allows you to fund a tax-advantaged retirment account on your own. IRAs are offered through a numbre of financial institutions, including banks and online brokerages. That also means you’ll have the full range of investment options available to you instead of what your employer offers.
But there are two types of IRAs with some important differences.
The traditional IRA let’s you deduct your contributions from your income so you don’t have to pay taxes on what you contribute. When you retire and are ready to collect the money in the plan you’ll pay regular income tax on it. But once the money is in the account you can’t withdraw it before retiring without paying a penalty and income taxes on it.
The benefit of the traidtional IRA is you can defer paying taxes until you retire. Since you’ll be investing your money and growing it over time, putting more money in early will lead to having more later. Paying taxes first could eat into how much you deposit and how much you grow over time.
But sometimes paying taxes first makes more sense.
The Roth IRA doesn’t let you deduct your contributions from your income taxes, but you won’t pay income taxes when it’s time to distribute the money. That’s great news if you expect you’ll make more money as you get older. You might wind up paying a higher tax rate on your money in retriement than you would have when you contributed to your IRA. A Roth let’s you contribute at your current tax rate instead.
Plus, we simply don’t know what future tax rates will be. Using a Roth IRA eliminates that uncertainty, allowing you to make more concrete plans.
Another benefit of the Roth IRA is that you don’t have to pay a penalty to withdraw your contributions early. Because they’re already taxed, you won’t need to pay income tax either. While it’s better to let your retirement account grow, using a Roth IRA could give you some flexibility in the case of a financial emergency.
The last account we’ll cover is the traditional brokerage account. These are not tax-advantaged so you won’t get to defer taxation on your money and you’ll have to pay captial gains taxes when you net a profit on a trade.
But a traditional brokerage account is also an essential supplement to meeting your financial goals. If you need to grow your wealth to remodel your home or plan an expensive vacatoin, then a tax-advantaged retierment account won’t help. You’ll need an account that let’s you withdraw your money without paying a penalty and that’s a traditional brokerage account.
Now, le’ts talk about managing cash flow.
As we said before, getting money into your accounts is nearly as important as what you do with it once it’s there. And with the number of possible accounts to fund it might be tricky figuring out where to put your money. The last thing you want to do is to neglect funding an account because you weren’t sure which one was right for you.
So, we’re making it simple. Below, we’ve outlined a good rule of thumb on how to plan your funding and a few tips on making sure you consistently keep putting money in. You should still do your own research, and if you have a unique situation you might want some additional help, but this should get you started.
If you employer offers matching contributions to a retirment acount, it makes the most sense to fund that account first. After all, that’s as close to free money as you’ll get. The best way to do this is to set up automatic eposits that come straight from your paycheck. That way you don’t have to deal with moving money around (or be tempted to spend it elsewhere).
Once you’ve done that, then you’ll want to fund both types of IRA accounts.
You’ll likely have to open these accounts outside of your work’s retirement plan, which means you’ll have to consistently move money into them. The best system is to set up automatic withdrawals from your checking or savings accounts to make sure money is consistently going into these accounts. Similar to deductions from your paycheck, this makes sure the accounts stay funded and keeps you disciplined from spending the money on something else.
After all, investing will help grow your money to reach your goals, but there won’t be enough money to grow if you aren’t consistently funding your accounts.
If you expect that you’ll be in a higher tax bracket when you retire, then aim to hit your $6,000 contribution limit to your Roth IRA before funding your traditional IRA. This way you’ll pay taxes at the lower rate this year instead of paying a higher income tax rate on your distributions once you retire.
If you’ve maxed out your contributions to every plan available to you, then keep investing through a traditional brokerage account. There’s no limit to how much you can invest this way, but you’ll have to pay taxes on capital gains when you sell stocks for a profit. The good news is you’ll be able to use your money from this account to meet other goals, like buying a new car, a vacation home, or to travel.
And since a regular brokerage account works just like your IRA accounts, we’ll show you how to get started by opening one up in the next lesson.