Now that you have a solid handle on your cash and have begun building a credit history, it’s time to start putting your money to work for you. In particular, I’ll talk through three types of investment accounts:
- Brokerage accounts
But first, an important realization…
You’re already investing! So first, save for emergencies
If you have placed money in a savings account, then you have technically begun investing. This is because a savings account will usually provide earnings at a predictable and openly-stated interest rate. In the case of my recommended account, the Ally Bank Online Savings Account, this is 1% APY.
In fact, you should use your savings account (or create a separate account since Ally allows for that) to build an emergency fund (also known as a rainy-day fund) for unexpected expenses. The exact amount varies in situation, but for most working-class people, 3 to 6 months of expenses should see you through. Do this before continuing with investing for the future so that you can stay financially self-sufficient!
Once you have established a buffer, then you can begin to save for the future. The investment accounts I discuss in the rest of this page serve as a complementary and long-term counterpart to the basic savings account because they generally have a higher rate of return and provide certain tax benefits.
Save for retirement with a 401k and IRA
When saving for retirement, you generally can place money into two accounts:
- A 401k is a retirement account that is sponsored by your employer.
- The account is provided by a financial services company of your employer’s choosing.
- You can choose from a selection of investments/funds that the employer and the provider have allowed for your account.
- In most cases, you can contribute up to $18000 per year to a 401k.
- Some employers offer a match of your donation, meaning that up to a certain contribution limit (not necessarily the $18000 yearly contribution limit), your employer will put in some fraction of the money you put in. For example, a “50% match up to $9000” means that for the first $9000 you contribute, your employer will contribute $1 for every $2 you put in (for a max of $4500 total).
- An individual retirement account (IRA) is an account that you can open on your own.
- You can open one or multiple IRAs with any financial provider.
- You have full control over the investments that you make with the provider.
- In most cases, you can contribute up to $5500 per year to an IRA ($6500 per year if you are over age 50).
- There is no match because this account is not tied to any other person or entity.
Let’s settle the Traditional vs. Roth debate with an easy litmus test
If you’re familiar with retirement accounts already, then you may have heard that they come in two flavors, each with different tax implications:
- Contributions to a traditional account are pre-tax, meaning that your contribution amount is deducted from your paycheck before taxes are applied. However, taxes are applied at the time of withdrawal.
- Contributions to a Roth account are post-tax, meaning that your contribution amount is deducted from your paycheck after taxes are applied. However, no taxes are applied at withdrawal; the money grows tax-free.
Why does this matter? Well, your income level at a point in time places you into a certain tax bracket, which dictates how much of your income will go towards taxes. So, here’s an easy way to determine what kind of account you should open:
If you think you will be in a higher tax bracket at retirement than the one you are in now (i.e., you will be making more money in the future), then you should open a Roth account. Otherwise, you should open a traditional account.
Since most new college grads are just starting in the workforce, it is likely that they will move to a higher tax bracket in the future. This is why Roth accounts are recommmended so often. However, keep in mind that employers may not offer an option to open a Roth 401k. This is why IRAs are useful: anyone can open a Roth IRA.
There is one exception to this: if you are above a certain income level, you may not be able to contribute the max amount (or at all) to a Roth account. In that case, you may want to open a traditional account.
Strategy: 401k match, IRA, rest of 401k, other
Note: do not contribute to retirement accounts if it will impact your day-to-day life. Only contribute if you are in a financial position to save off some money for the distant future and not touch it! Similarly, don’t complete all of these steps if you are not financially able; stop at a place that is comfortable for you!
Step 1: Max out 401k match. This is because an employer match is essentially “free money” if you were planning to save for retirement anyways. If your employer does not offer a match, you can skip this step.
Step 2: Max out IRA contribution. This is because an IRA gives you more flexibility with your investments while allowing you to shelter growth from taxes.
Step 3: Max out 401k contribution. The contribution limit for a 401k is usually greater than the match limit, so if you have come this far and are able to contribute more, fill up the rest of your 401k.
Step 4: Move to other investments. This includes brokerage accounts where you pay taxes upon any earnings. We will talk about this soon.