05/ What type of investment account is right for you?
Now that you know how much you plan to invest each month, you will need to decide what kind of account (or accounts) will you choose for your investments. Note that these options are available in the United States only. If you live outside the United States, check with tax and/or investment professionals to help you determing what account types are best for you where you live.
401k: The first question to ask is whether you have a 401k plan at work. If you do, you should use it, especially if your employer gives you some kind of matching contribution. If your employer does offer some kind of matching contribution, you should maximize your contributions at least up to the amount that you maximize the match.
If you do have a 401(k) plan at work, then you may not be eligible to invest in an IRA at the same tax year.
Because your 401k at work makes you ineligible to invest in an IRA, if you want to make any investments beyond what you put into your 401k, you may have to invest in an investment account that is not tax-advantaged. A tax-advantaged account is an account that allows you to avoid paying some form of tax, such as capital gains tax and/or deferred income tax. The assets in an account that is not tax-advantaged may be subject to taxes that normally apply to investments, such as capital gains tax.
A drawback to a 401k plan is that it may limit your investing choices. For instance, it may not allow you to invest in individual stocks. But if your 401k plan at least allows you to choose ETFs, our VIP Membership will provide direction for you on what ETFs to choose.
Once your employment ends, you should be able to roll your 401k account into an IRA (see immediately below for a discussion of IRAs).
IRA: An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. Before we discuss how to choose the right account for you, let us define the 4 main types of IRAs:
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SEP IRA - A Simplified Employee Pension Individual Retirement Arrangement is a variation of the Individual Retirement Account. SEP IRAs are adopted by either the self-employed or by business owners to provide retirement benefits for themselves and their employees.
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Traditional IRA - You make contributions with money you may be able to deduct on your current tax year's tax return, and any earnings can potentially grow tax-deferred until you withdraw them in retirement. Many retirees find themselves in a lower tax bracket than they were in pre-retirement, so the tax-deferral means the money may be taxed at a lower rate.
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Roth IRA - You make contributions with money you've already paid taxes on (after-tax), and your money may potentially grow tax-free, with tax-free withdrawals in retirement, provided that certain conditions are met.
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Rollover IRA - You contribute money "rolled over" from a qualified retirement plan into this traditional IRA. Rollovers involve moving eligible assets from an employer-sponsored plan, such as a 401k or 403b, into an IRA.
If you do not have a 401k plan at work, you may want to consider an IRA (individual retirement account). An IRA will allow you to invest up to $6,000* in a tax-advantaged account (or up to $7,000* if you have reached age 50 or above); or, in the case of a SEP IRA, your annual contributions cannot exceed the lesser of 25%* of compensation or $57,000* (*These are 2020 numbers. The figures may be different in later years).
SEP IRA: If you want to invest in an IRA, you should first consider a SEP IRA, which is a type of IRA, because it may offer the best opportunity for maximizing your annual contributions, as described above. However, SEP IRAs are limited to self-employment income. If your sole source of income is your employer, you may not be eligible for a SEP IRA unless your employer sets one up for you to use.
Roth vs. Traditional: If you are not eligible for either a 401k plan or a SEP IRA, you must then choose between a Roth IRA and a Traditional IRA. The simplest way to determine which of these two retirement accounts will give you the greater yield (after taxes) is to use this calculator. Keep in mind, however, that there are some reasons you might want to choose a Roth IRA regardless of what the calculator tells you:
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Roth IRAs don't have required minimum distributions during the lifetime of the original owner
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Roth IRA assets may pass to your heirs tax-free
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Tax rates now (in tax year 2020) are relatively low. So, the amount you save now with a tax deduction might not be very much compared to the benefit you might receive from a Roth IRA.
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You have no way of knowing what your tax rate will be when you retire. We could have a very different tax system, and you might owe a lot more deferred taxes on a traditional IRA than you are able to anticipate now. The tax calculator has no way of anticipating changes to tax law.
Taxable Account: There might be reasons to also open an account that is not tax-advantaged in addition to or in lieu of one of the tax-advantaged accounts described above. For instance, if you want to sock away $10,000 per year, but you can only put $6,000 per year into your IRA, you might consider opening up a taxable account and put $4,000 into it annually (while continuing to put $6,000 into your IRA each year). Also, some people are not eligible for a tax-advantaged account. So, there are legitimate instances in which it does make sense to open a taxable account; however, you should definitely choose to invest in a tax-advantaged account, such as a 401k or an IRA, if that is a viable choice.
One advantage that a taxable account has is that you can access your money whenever you want without paying an early withdrawal penalty to the IRS. However, when you do sell a stock or a fund (ETF), there may be capital gains taxes to pay.