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Retirement, Investment & Savings Accounts Explained

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Ok so you’ve identified what you want out of life, set some goals, and now you are ready for the how part of the equation.

Chances are you’ve at least heard of all the things I’m going to discuss below, but in case you missed the explanation of them, or needed them laid out more simply, I’m going to do my best to put them into easy to understand terms. Let’s dive in!

Three important Pieces of Advice

One very important place to start is understanding that maximizing your available income is the best way you can make your money work for you. It doesn’t mean making more money (although that’s always nice). It means taking strategic action to get the most from the money you are currently making. And one of the biggest ways to do that is finding ways to reduce your yearly income taxes. We are not talking tax fraud, we are talking taking advantage of tax favored investment accounts and available tax deductions.

By far the biggest chunk that comes out of your paycheck is taxes. Understanding the options that are available to you, legally, to reduce the size of that chunk means more money in your hands out of each paycheck – and also potentially more money in your savings.

Another important piece of advice is the importance of diversifying where and how you save your money. The different types of accounts all offer different types of advantages. There’s no reason to limit yourself on the types of accounts you use, and a diversified portfolio means less risk overall.

And lastly, save for your retirement first, BEFORE saving for your kid’s college tuition. The thought is that you don’t know what will happen with your kid and college. They may not go to college. They may get a scholarship. College may be free by the time they go. And worst case scenario, they can take out a student loan. But, Lord willing, you will want and need to retire one day without a doubt, and you will need money to do that. Take care of yourself first so you will be able to take care of them later. It’s the same as the oxygen mask on the airplane protocol.

So let’s talk about tax favored accounts and the various types of savings and investment accounts you can choose from.

Retirement Accounts

  • 401K – A retirement account, typically offered by your employer, to which you can make pre-tax contributions. The contribution is taken out before you receive your paycheck, and your paycheck will be decreased by the amount of your contribution. Taxes are deducted when you withdraw your money in retirement, based on the tax bracket you are in at that age.
    • Roth 401k – Like the above, except you contribute your money after taxes. When you withdraw the money in retirement it is tax free.
    • Company Matching – some companies offer 401k matching as part of their benefits, up to a certain percentage.
      • For example: Let’s say your company offers a 4% 401k match and you choose to contribute up to that match max. On your $2000 paycheck, 4% will be deducted before taxes are taken out, equaling $80. That $80 will be deposited into your 401k account. Then your company will also contribute $80 (matching your 4%) into your 401k account.
      • WHY IT IS SO IMPORTANT TO AT LEAST CONTRIBUTE UP TO YOUR COMPANY’S MATCH – By not at least contributing up to the company match percentage, you are essentially giving up free money. It’s like giving up a raise each year. Your company considers that match as part of your compensation plan, but you are just leaving that available money on the table.
  • IRA – Stands for Individual Retirement Account. These are investment accounts with tax advantages. They are often utilized if a company does not offer a 401k option, or if someone wants another avenue to save money for retirement in a tax favorable way. They have set annual contribution limits, currently $6000 per year if you are under 50, and $7000 a year if you are over 50.
    • Traditional – Very similar to the setup of a traditional 401k, except you use your taxed income to make contributions to your IRA account, then you can deduct those contributions from your income taxes. When you withdraw your money in retirement it will be taxed according to your current tax bracket. This type of IRA is considered favorable if you are currently in a high tax bracket and think you will be in a lower bracket at retirement, meaning when you are taxed on that money, it will be taxed at a lower rate.
      • 401k – employer makes the contribution for you pre-tax
      • Traditional IRA – you make the contribution, and deduct on your income taxes
      • NOTE: Your income level, how you file your taxes, and whether your work offers a 401k option will affect whether you can receive a full deduction or partial on your taxes.
    • Roth – You contribute you after-tax income, and you are not taxed on your investment gains. You will also not have to pay any taxes when you withdraw your money in retirement. This is favorable if you don’t want to have to guess how much will be taken out in taxes when you go to withdraw money at retirement. You are also not required to make withdraws at any time, and you can contribute no matter your age.
    • NOTE: There are income limitations for contributing to a Roth IRA. If you make more than the income limit range you may only be able to contribute up to a reduce amount, or not at all.

This site does a great job of breaking down IRA’s and explaining all of the income and tax deduction limitations, as well as other types of IRAs for those who are self-employed or own small businesses.

Health Spending Accounts

  • FSA – Stands for Flexible Spending Account. These are accounts offered by employers which allow employees to make pre-tax contributions up to a certain annual limit, which they can use throughout the year to pay for qualifying medical or dental costs. This includes things like co-pays, medical equipment, bandages, prescription medicines and thanks to the new CARES (Coronavirus Aid, Relief, and Economic Security) act, now also includes over the counter drugs needed for quarantine and social distancing, no prescription required.
  • HSA – Stands for Health Savings Account. These are similar to FSA’s in that they are offered by employers and employees can contribute to them pre-tax, and use the funds for things like medical, dental and vision expenses. They were created for people who have high deductibles with their insurance plan. Because of this there are eligibility requirements based on your insurance plan.

NOTE: You may be surprised what is covered under these. You can usually inquire through your doctor’s office, pharmacist, or plan administrator to see if something is covered. You may be able to pay for things like reading glasses, sunscreen, or even pregnancy tests and Botox. It’s worth asking!

Stock Investment Accounts

  • Mutual Fund – You can think of mutual funds sort of like a beginner step into the stock market. They are made up of contributions from many individual investors, and the pool of money collected is then invested by a professional money manager into thinks like stocks, bonds, and other assets. You don’t have to assume the responsibility of buying, selling and trading stocks. In fact, you don’t HAVE to understand the stock market much at all. You can leave that up to the professional money manager that handles your fund.
    • As an investor you will experience the gains and losses proportionally to that of the fund.
    • Because the money is invested across a wide range of securities, this is called being diversified, you will typically experience smaller losses overall. You aren’t putting all of your eggs in one basket, so if one asset has a bad quarter, it won’t ruin your whole portfolio.
    • You receive income from these funds in the form of dividends and capital gains (what the fund gains from selling securities).
    • They are traded once a day, after the market closes.
    • You can choose how much risk you are comfortable with. High risk = (usually) high gains or high losses. Low risk = low gains or small losses

Read all about mutual funds and how they work here.

  • ETF – Stands for Exchange Traded Fund. Similar to mutual funds in that they are a collection of securities, but different than mutual funds, ETF’s are marketable securities which means they carry a price and can be bought and sold. They are listed on the exchanges and traded like regular stocks every day.
    • Offer fewer broker commissions than buying individual stocks.
    • They hold multiple underlying assets versus just one like a stock. Good for diversification.

Learn more about ETF’s here!

Savings Accounts

  • Money Market Account – Also called Money Market Deposit Account. These are offered by financial institutions like banks and credit unions.
    • You have easy access to your money, and can usually write checks or make debit card purchases from these accounts, within the given limits (such as a certain number of withdrawals each month).
    • They are insured by the FDIC
    • The financial institution will often require a fee and a minimum deposit and balance amounts.
    • They have the potential to earn higher interest rates than typical savings accounts because they have the ability to invest in things like government securities and CD’s which savings accounts cannot do.
  • Money Market Mutual Fund – These are a type of mutual fund, with the main difference being that where typical mutual funds vary in risk from low to high, money market funds ONLY invest in super safe investments, such as Treasury Bills, that produce a steady but low return.
    • They have the potential to earn higher interest rates than typical savings accounts because they have the ability to invest in things like government securities and CD’s which savings accounts cannot do.
    • They are NOT insured by the FDIC
    • They are subject to being effected by interest rate fluctuation.
    • Typically offered by investment fund companies with no guarantee of principle
    • They are highly liquid (means you have access to your money) and low risk so they are a great place to hold money for a short time until you are ready to invest it elsewhere.

Money Market accounts and funds are a great next step beyond a classic savings account because they are relatively safe in regards to risk, and they have the potential to earn more than typical savings account interest rates.

Download my Financial Planner Worksheet to help yourself work through setting those financial goals and taking steps towards financial freedom.

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