Planning your financial future is about strategy – you want to make sure you’re working as smart as possible. Work smart, not hard, as they say. That can mean using the right “tool” for a given job, which I think goes under-appreciated in personal finance.
It’s not very smart to put all of your money into a single investment since diversification helps you achieve results while protecting against the downside of things you can’t predict. Diversifying how and where you invest your money can also protect you from life’s curveballs and ensure you have a complete financial toolbox when retirement arrives.
The following three investment accounts are essential financial tools that can serve different purposes and come with pros and cons. Using them could make your golden years your best years.
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1. Taxable brokerage account
It’s easy to hone in on retirement accounts when saving – that’s why they’re called retirement accounts, isn’t it? But don’t get tunnel vision and overlook a regular brokerage account.
Most retirement accounts have tax-advantaged benefits, but they also typically force you to keep the money locked up until much later in life. Otherwise, they charge penalties for accessing the money too soon.
Life is unpredictable, and you could find yourself wishing you had the flexibility a regular brokerage account offers. You can access them whenever you want, and there are no income limits or ceilings on your contributions. You put the money in, it grows, and you take it out.
You pay capital gains tax on the profits, but such is life. A brokerage account can even be collateral in a loan (often called a margin loan), which is partially how Elon Musk is funding his pending purchase of Twitter. Financial flexibility is a tool that you should at least want to have in your back pocket, even if you don’t intend on using it. You never know!
2. Employer retirement plan 401(k)
Previous generations used to put their 30 or 40 years into a job and retire comfortably with a pension. Unfortunately, those days are mostly gone, and today’s workers need to do the heavy lifting in preparing for life after leaving the workforce.
Employer retirement plans have primarily shifted to the 401(k). Employees put pre-tax income into them, where their savings grow until retirement. Taxes are paid on the money when people make withdrawals in retirement.
Because it’s pre-tax money going into the account, contributing to your 401(k) will reduce your tax bill each year by lowering your taxable income. Additionally, many employers encourage retirement savings by offering an employer’s match – often between 1% and 5% (sometimes more) of your salary. The match is free money. If you make $100,000 per year and contribute 5% to your 401(k), a 5% match would mean your employer is kicking in another $5,000. That’s a 10% savings rate on your salary!
You can configure a 401(k) plan through your employer to have the money taken out of your wages automatically and invested. In other words, out of sight and out of mind.
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3. Roth IRA
Short for “individual retirement account“IRAs are a supplementary investment account that aids your saving. A Roth IRA is a particular retirement account that lets US investors contribute “take-home” pay, the income you’ve already paid taxes on.
That money grows until retirement, and because you already paid taxes on the contributions, you don’t pay any taxes when the money comes out. Roth IRA accounts are also flexible, allowing you to withdraw your contributions (not the profits) at any time without penalty, as long as you meet a few requirements.
The ability to circumvent taxes on your gains is so beneficial the government limits who can use them and how much. There are income limits to use a Roth IRA, and in 2022, you can only contribute up to $6,000 per year if you’re under 50 and $7,000 if you’re 50 and older.
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Diversify your savings
Each of these investment accounts has different tax benefits and allows you to access your money at various times. By spreading your money around all three, you will have a diverse and flexible nest egg that you can use to your advantage when the time comes.
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Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Twitter. The Motley Fool has a disclosure policy.
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