Investing for the Absolute Beginner, Part 3: Which Account Type?
Now that I have covered the reasons to invest and reviewed the different types of investments, in this installment of "Investing for the Absolute Beginner" I will go over the various types of investment accounts in which to hold those investments. I will be covering the 401(k), the Traditional IRA, the Roth IRA, and the taxable account. Each of these account types has its own advantages and disadvantages, and they are not mutually exclusive insofar as they can be used in conjunction with one another for various tax benefits and purposes.
401(k):
What is it?
The 401(k) is your single most important investment vessel for building wealth through investing. A 401(k) is a retirement investment account set up by most corporations (and some smaller companies) to enable its employees to save and invest a percentage of their income for retirement. The distinguishing characteristic of a 401(k) versus other types of retirement accounts is that the contributions are pre-tax, the benefits of which I will discuss below.
Pros:
The pros of a 401(k) account are numerous. First, many companies will match your contributions dollar-for-dollar up to a certain percentage of your income. This is free money that you would be shooting yourself in the foot not to partake of. Over thirty or forty years, those matching contributions, when combined with the power of compounding, can significantly increase your wealth at retirement. You absolutely, positively, must contribute to a 401(k) if one is available to you through your employer.
Another advantage to a 401(k) is that the contributions are pre-tax, which lowers your taxable income for the IRS, which in turn lowers your annual tax responsibility. A lower tax bill means even more money to save and invest!
Cons:
The main drawback to the 401(k) is that the contributions are tax-deferred. This means that you ultimately will pay taxes on those contributions when you take distributions from your account after retirement. Basically you are being taxed on the money at retirement rather than at the time of income. One must be prepared to cover those taxes at retirement, but as long as one's contributions are adequate before retirement then the returns and the company matching more than make up for any loss here.
The other thing to keep in mind about the 401(k) is that there is an annual limit to the amount of money that may be contributed to a 401(k). The 2008 limit is set at $15,500, which means that if you wish to invest more than this you will have to use another account type to invest the difference. The government also allows an additional annual contribution of $5,000 for those who are age 50 or older and who are seeking to "catch-up" on their savings and investing before retirement.
Traditional IRA:
What is it?
"IRA" stands for Individual Retirement Account. There are two types of IRA's, the Traditional IRA and the Roth IRA. Both types of IRAs are designed for individuals to save an invest with significant tax incentives for the long-term. Since the IRA is not sponsored by a corporation there is no matching incentive, but the tax incentives for both types of IRAs make them attractive as a supplemental investment option, or as a primary retirement account if you are not eligible for a 401(k).
Pros:
The main advantage to a Traditional IRA is that the contributions to a Traditional IRA are tax-deductible. As in the case of a 401(k) this has the effect of potentially lowering your current tax bill. Qualified distributions upon retirement will be taxable as ordinary income, so basically with the traditional IRA one sees an immediate tax benefit while still being liable for taxes on the distributions down the road.
Cons:
With both types of IRAs, including the Traditional IRA, there are 10% withdrawal penalties if one takes early distributions from the IRA before the age of 59 ½. This means that the money invested in an IRA is not liquid, since a 10% penalty will do a good job of wiping out any gains that your account may have enjoyed to-date. So when one puts money into an IRA, one must intend to keep it there, locked away, until retirement. Early distributions basically defeat the purpose of retirement investing anyways, so this is not an issue for conscientious investors with the proper mindset.
Another potential disadvantage to the Traditional IRA is that there are mandatory distributions that begin at age 70 ½, with hefty penalties that apply if the distributions are not taken properly. This is a disadvantage to an IRA that is unique to the traditional IRA but not shared by the Roth IRA.
Roth IRA:
What is it?
A Roth IRA is analogous to a Traditional IRA insofar as it is still an "Individual Retirement Account" that carries certain tax advantages over a regular taxable investment account. The key difference is in the nature of the tax benefits. Unlike contributions to a Traditional IRA, contributions to a Roth IRA are post-tax dollars, which means that you do not get to deduct your contributions from your annual tax responsibility. However, a Roth IRA allows your money to grow tax-free and for you to take qualified distributions post-retirement without taxes.
Pros:
The advantages of the Roth IRA over the Traditional IRA should be clear: your money is allowed to grow and compound, and then you are allowed to take distributions from those gains without any taxes. And over the course of a lifetime, this can amount to a hefty amount of money for which you do not owe any federal taxes.
The Roth IRA does not require mandatory distributions, unlike a Traditional IRA, which gives you a greater control over your investments post-retirement.
While there are other tax advantages to the Roth IRA that are beyond the scope of this introductory article, it is the tax-free growth and withdrawals that make the Roth IRA the preferred type of IRA for the vast majority of retirement investors.
Cons:
The central disadvantage to the Roth IRA is the lack of a tax-break at the time of contributions. If one has a moderate income, then one's tax responsibility can take a sizable bite out of the disposable money that one has available to invest. For this reason, I hold that it is best to combine the Roth IRA with a 401(k) to "smooth out" one's tax responsibility over the course of his or her lifetime.
Another disadvantage to the Roth IRA and the Traditional IRA together is that the annual contribution limit for an IRA is currently set at $5,000 for the 2008 tax year ($6,000 if you are age 50 or over). This means that if you wish to invest more than $5,000 annually, you will either need to use a 401(k), which has a higher contribution limit, or use a taxable account without the tax benefits. The good news is that the annual contribution limit has steadily been increasing from year to year, so this may be less of a factor as the limit is raised periodically.
Taxable Investment Account:
What is it?
A taxable investment account is, as the name indicates, an account in which you may buy or sell investments, but on which one is required to pay federal taxes.
Pros:
The chief benefit to a taxable account is the liquidity of the investments. Investments can be bought and sold without concern for violating any age restrictions, unlike a 401(k) or an IRA. This makes a taxable account ideal for short to medium term investments that one is planning on utilizing before retirement.
Cons:
The negatives for a taxable account, as opposed to a retirement account, are as a result of the tax responsibilities of a taxable account. Since taxable accounts are not tax sheltered, one is required to pay taxes on dividends and on any capital gains that are made when one sells securities within a taxable account. This means that one must be mindful of one's tax responsibility when dabbling with buying and selling stocks or other investments (e.g. day-trading) within a taxable account.
The spoonful of sugar that makes the tax medicine go down, is that the capital gains taxes are significantly lower if one has held the investments for over one year before being sold. This encourages a healthy buy-and-hold strategy that I subscribe to, and allows one to enjoy the benefits of long-term stock market gains at a lower tax rate. My own advice here is that one should stick to individual stocks that one plans to hold for at least a year to enjoy the lower capital gains tax rate (such as the Citigroup [NYSE: C] shares that I bought last week).
Conclusion:
Now that you should have a basic understanding of each of the basic investment account types, I have a few closing remarks to make some sense out of all of this:
First of all, any savings and investing is better than none. It is probably better to do long-term investing badly than not at all. Do not have a fear of making a mistake, since the mistake is always fixable when you have had a chance to learn more about what is best for your unique situation. The most important thing is to develop the habit of saving and investing a portion of your income regularly and reliably. If you do this, you will see the benefits, no matter which account type you use!
Second, the 401(k) company matching is the most powerful element of all above to maximize your wealth before retirement. The sooner you start, the more time your money has to be matched and to compound. So if you are not currently enrolled in your company's 401(k), let me give you the same advice my uncle Mike (my retirement investing guru) gave me: Don't be dumb! 401(k) matching is free money that you would be just plain dumb not to take advantage of after knowing better! Enroll or start an account now!Third, the order of operations ought to be that you should max out your 401(k) contributions to obtain the company match. Then any additional retirement savings is probably best served inside of a Roth IRA for the retirement tax benefits. Then if you wish to dabble in trading individual stocks, do it sparingly and make sure that you are keeping your retirement savings your top financial priority. Stock trading is fun, but retirement accounts are a more reliable way to ensure a sound financial future for yourself.
That about does it for installment three of "Investing for the Absolute Beginner". In part four I will be discussing the various options you have for how to choose a brokerage company (online or otherwise) and go about starting your first investment account, so be sure to check back for part four of the series. Until then, happy investing!
Here are the entries in this series: -Part1- -Part 2- -Part 3-
