Four Investment Accounts Young Investors Should Know About
Knowing which investment accounts to store your money can be challenging. We detail four investment accounts that can aid you in growing your wealth over time.
By SJS Investment Services Intern Jake Matthews.
You probably remember working your first job. The feeling after receiving your first paycheck is both rewarding and refreshing. But now, how do you store your hard-earned money? How do you protect your money from inflation? What steps should you take now to save for retirement?
Knowing which investment accounts to store your money can be challenging. Yet, the rewards to investing can be tremendous over your lifetime. Choosing the right investment accounts to use at a young age can be the first step in building generational wealth. Below, we detail four investment accounts that can aid you in growing your wealth over time.
IRA: Roth & Traditional
One of the most popular investment accounts is the Individual Retirement Account (IRA), which offers tax advantages to encourage U.S. workers to save and invest for retirement. There are two types of IRAs available to most income-earning U.S. workers: Roth IRA and Traditional IRA.
Roth IRAs and Traditional IRAs are subject to many of the same rules. In any given year, as long as you have enough taxable income, you can contribute up to $6,000 ($7,000 if age 50 or older) to a Roth IRA and / or a Traditional IRA. You can open a Roth IRA or Traditional IRA at many large brokerage firms in the U.S. (such as Schwab, Vanguard, and Fidelity), and can invest in a very broad range of investments including mutual funds, ETFs, stocks, and bonds. While the money is held in your Roth IRA or Traditional IRA, you do not pay taxes on any dividends or realized gains on your investments. Any money you withdraw before age 59 1/2 may be subject to income taxes and a 10% penalty.[1]
There are important differences between a Roth IRA and Traditional IRA. For a Roth IRA, you contribute after-income tax money, and any investment gains that you withdraw after age 59 1/2 are not taxed. If you are a single tax filer, your contribution limit starts declining once you earn $125,000 in a year, and you cannot contribute if you earn more than $140,000.[2]
For a Traditional IRA, you contribute pre-income tax money, and money (both what you contributed and any gains) that you withdraw after age 59 1/2 are subject to income taxes. If you are a single tax filer and have an employer-sponsored retirement plan, you gradually lose the tax advantages of a Traditional IRA once you earn over $66,000 in a year, and lose nearly all of the tax advantages after you earn more than $76,000.[3]
Particularly for young investors, we believe that a Roth IRA is generally more beneficial over the long-term than a Traditional IRA.
401(k): Traditional And Roth
Another popular investment account for young investors is the 401(k), a retirement account sponsored by your employer. While all employers with a 401(k) offer the Traditional option, only some offer the Roth option. 401(k)s are subject to many of the same rules as IRAs.
Unlike IRAs, no matter how much you earn, you can contribute up to $19,500 ($26,000 if age 50 or older) of your income per year to a 401(k). Because 401(k)s are employer-sponsored accounts, many employers will match their employees contributions up to a specified amount. 401(k)s usually have limited investment options (typically a lineup of mutual funds), and are often subject to higher annual expenses than IRAs. Instead of a 401(k), certain employers may offer a 403(b), which has similar rules.[4]
Many investors retire with their 401(k) as their single largest investment account.
Health Savings Account (HSA)
Some employer-sponsored health insurance plans offer for employees to contribute to a Health Savings Accounts (HSA), which allows you to save pre-tax dollars to pay for future medical expenses. Some employers also contribute to the HSA. For an individual, the total employee and employer contributions cannot exceed $3,600 ($7,200 for a family) per year. Some HSA plans allow you to invest in a limited lineup of mutual funds, and any dividends and gains are not taxed as long as they are used for future medical expenses.[5]
Because of the tax advantages, many young investors use their HSA as an investment account for the long-term.
529 Plan
If you plan to go back to school one day or have other qualified education expenses, you can consider contributing to a 529 Plan. You contribute after-income tax money to a 529 account, which can be invested in a limited number of investments. Any money you withdraw from the 529 account is tax-free as long as the money is used for qualified education expenses.[6]
Each state offers a different 529 plan, and you are able to participate in whichever state’s plan is most beneficial to you. Each state offers a different investment lineup, contribution limit, state income tax benefits for residents, and expenses. If you do not use all of the money in your 529 account, you can change the beneficiary to a qualifying family member with no penalty, subject to gift tax rules.[7]
Overall, a 529 account can be a great way to start saving for future education expenses for you or your family.
Benefits Of Compounding Returns
Albert Einstein reportedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”[8] By using these four investment accounts, you can invest to potentially allow your wealth to compound for the long-term while paying less in taxes.
To demonstrate this, the below graph shows what would happen if you contribute the maximum to your Roth IRA ($6,000 in 2021, expected to grow 2.00% annually due to inflation) at the beginning of each year, and invest the Roth IRA in a portfolio that earns a 5.00% annual expected return.
Graph created by Jake Matthews, and reflects hypothetical information based on the assumptions above. Actual investment results may be materially different than hypothetical returns. See Important Disclosure Information.
After 50 years, the above Roth IRA grows to over $1,842,920.47. That’s the power of compounding.
Conclusion
As a young investor, knowing which investment accounts are available to you as well as the associated benefits & tradeoffs can dramatically help you grow your net worth over your lifetime. We believe these four accounts provide a very strong foundation for any investor to begin the journey of saving for their future.
About The Author:
Jake Matthews is a rising fourth-year undergraduate student at Miami University, majoring in Economics & Finance. Jake is a member of Miami University’s Track Team, running the 200-meter and 400-meter. Jake enjoys learning about a wide variety of industries, particularly about alternative investments including real estate, collectibles, and cryptocurrencies.
Jake spent the last ten weeks interning at SJS, helping with client portfolio analyses, investment recommendations, and improving financial planning processes. We are very grateful to have gotten to know and work with Jake this summer, and we wish him all the best as he heads back to college!
Important Disclosure Information & Sources:
[1] “Individual Retirement Arrangements (IRAs)“. IRS, irs.gov.
[2] “Amount of Roth IRA Contributions That You Can Make For 2021“. IRS, irs.gov.
[3] “IRA Deduction Limits“. IRS, irs.gov.
[4] “401(k) Plans“. IRS, irs.gov.
[5] “Health Savings Account (HSA)“. Julia Kagan, 01-Mar-2021, investopedia.com.
[6] “An Introduction to 529 Plans“. U.S. Securities and Exchange Commission, 29-May-2018, sec.gov.
[7] “Complete Guide to 529 Plans“. Julia Kagan, 07-Jul-2021, investopedia.com.
[8] “Why Einstein Considered Compound Interest the Most Powerful Force in the Universe“. Jim Schleckser, 21-Jan-2020, inc.com.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this report that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
Advisory services are provided by SJS Investment Services, a registered investment advisor (RIA) with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.
Suggested Reading
Are You Starting To Invest? Some Considerations
We think having the next generation beginning to invest is a great thing. We believe these points can help you as you start your investment journey.
By SJS Associate Advisor Michael Savage.
During the COVID-19 pandemic, there has been a mass movement by younger people to establish investment accounts.[1] They see the potential value of taking extra cash from work, economic stimulus checks, etc., and putting it to work in investments.[1] Online investment services like our own MarketPlus Online offering, Acorns, Betterment, Wealthfront, Robinhood, and others are allowing younger generations to easily establish investment accounts. For example, online brokers such as Charles Schwab, TD Ameritrade, and eTrade have seen major increases in new account openings in 2020, with some online brokers experiencing year-over-year new account growth of more than 100%.[1] Many if not most of these new accounts have been opened by millennials (ages 24-39 in 2020).[1][2]
We think having the next generation beginning to invest is a great thing. They (We) will develop years of experience and knowledge on the markets. We previously wrote about strategies to help create solid investment plans for young professionals, emphasizing the following:
Building off of the above, investors have experienced a lot over the past year. 2020 has been one of the most volatile years - in particular, March was the most volatile month - in U.S. stock market history.[3] Many growth stocks have experienced a lot of volatility, and yet have grown significantly over the past year.[4] Other stocks have not experienced similar success.[4] Particularly over the short-term, so much can happen in the stock market that doesn’t necessarily align with what is happening in the economy and society at large, as partially evidenced by how global stock markets have provided positive returns in 2020 despite the COVID-19 pandemic and associated shutdowns.[5] We think investors can learn a lot from uncertain and volatile times, and we believe the below points can help you on your investment journey.
![Sources: Statista, U.S. FBI Internet Crime Complaint Center. See Important Disclosure Information for additional details.[4]](https://images.squarespace-cdn.com/content/v1/5ee8ee8eb4fb337e3b806c1e/1609182572909-N6UBJ0ISN3EN0KXY735C/2020.12.29+Starting+To+Invest+-+Some+Considerations.png)
Invest For The Long-Term
Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…. He who doesn’t, pays it.“[6] We believe that the longer you invest in a well-designed portfolio, the more you can increase your chances of positive expected returns and higher portfolio values.
For example, Warren Buffett, the famous 90-year-old investor with an estimated net worth around $85 billion in 2020 (even after donating $37 billion to charities since 2006), has repeatedly said, “If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.“[7]
Beware of Taxes and Dividends
Dividends may seem like the best thing about investing. Lets say you have a stock worth $10 and you receive a dividend of $1. At first glance you may think “Hey, I just got a free dollar!”.
The truth to the matter is you didn’t. If a company pays $5 million in dividends, then the enterprise value (market value of equity + market value of debt) of that company would decrease by $5 million dollars. The stock value declines, in your case, by $1 to create an equal transaction. So, theoretically you still have a stock worth $10.
But we aren't done yet. Within taxable accounts, that $1 dividend will then be taxed. If your dividend income is taxed around 20%, that leaves you with $0.80. So in reality your $10 just turned in $9.80.
Additionally, if you sell a stock for a capital gain, you may end up paying taxes on the gain. You also pay more taxes if you held the stock for < 1 year.
While selling a stock for a gain may make sense under various circumstances, and while dividends can help prevent companies from spending too much money, young investors should be careful with taxes and dividends within taxable accounts.
Contribute to and Invest via a Traditional IRA and / or Roth IRA
To decrease the amount of taxes you pay, contributing to and investing via a Traditional IRA and / or Roth IRA can help you set yourself up for long-term success in the future.
Depending on your current income, when you contribute part of your income (up to $6,000) to a Traditional IRA, you don’t pay taxes on the contributions and growth until you begin withdrawing some time after turning 59 1/2. When you contribute part of your income to a Roth IRA (up to $6,000), you pay taxes now on the contribution, but do not pay taxes on the contributions and earnings as long as you wait until 59 1/2 to withdraw. This website from the U.S. IRS summarizes important information about IRAs.
Beware of Margin Trading
Margin means borrowing money, often to invest. Margin trading can amplify your gains, but it also amplifies your losses, particularly during volatile market periods like March 2020.[3] Additionally, investors usually have to pay interest on the margin, thus decreasing investment returns. Margin usually ends up hurting investors when they are not cautious using it. Just be aware that you are paying interest on the cash you borrow, and stay on top of it.
“Free Trades” Are Great, But Don’t Get Carried Away
Many investing platforms offer “free trades“, meaning that investors don’t have to pay a commission per trade. However, there are still less obvious costs to any stock trade, including bid-ask spreads, moving market prices, wash sales, capital gains taxes, etc. On its own, paying no commissions means lower costs for investors. However, since they no longer pay commissions, many investors are trading more and more, thus paying more of the less obvious costs. Additionally, increased trading can decrease the habit of investing for the long-term. Therefore, we advise people to not get carried away by “free trades.”
Summary
Starting to invest can be really valuable at a younger age. Your portfolio can grow or decline over time, and you will learn more and more as you keep investing and keep up with what is happening in the markets. We want you to be aware of what you are paying to enter the markets, do your due diligence on any investment service before opening an account, and remember that nothing is free or guaranteed.
If you would like to discuss how to better design and implement your investment portfolio, please reach out to us. We are always happy to listen and assist.
Important Disclosure Information And Sources:
[1] “Young investors pile into stocks, seeing ‘generational-buying moment’ instead of risk.“ Maggie Fitzgerald, 12-May-2020, cnbc.com.
[2] “Robinhood’s Addictive App Made Trading a Pandemic Pastime.“ Annie Massa & Sarah Ponczek, 22-Oct-2020, bloomberg.com.
[3] “The Craziest Month in Stock Market History.“ Nick Maggiulli, 01-Apr-2020, ofdollarsanddata.com.
[4] “Growth versus value: Will the tides change?“ Vanguard, 02-Sep-2020, vanguard.com.
[5] “Performance Derby: Global Markets.“ Ed Yardeni & Joe Abbott, 25-Dec-2020, yardeni.com.
[6] “Albert Einstein - Compound interest.“ Quotesonfinance.com.
[7] “How Warren Buffett’s winning investing strategy can be applied to any purchase you make.“ Emmie Martin, 04-May-2018, cnbc.com.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Advisory services are provided by SJS Investment Services, a registered investment advisor with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide legal or tax advice. Please consult your legal or tax professionals for specific advice. This material has been prepared for informational purposes only.
Hyperlinks to third-party information are provided as a convenience and we disclaim any responsibility for information, services or products found on websites or other information linked hereto.
Suggested Reading
Saving as a Young Professional: Give Yourself Options
Wise decisions and actions today can often give you more options tomorrow. To that end, we will revisit some strategies behind a solid investment plan.
By SJS Associate Advisor Catherine Stanley and SJS Managing Director & Senior Advisor Jennifer Smiljanich, CFP®.
Never in a thousand years could we have imagined what it would be like to personally live through the upheaval of this 2020 global pandemic! While there are some silver linings, to be sure, many of us, to some degree, have been affected by feelings of fear, isolation, disruption, limitation, and boredom. Some of us are left feeling a little vulnerable, and it might not feel good.
But sometimes, uncomfortable feelings can serve as a catalyst, and can move us to take action that might not occur during times of “business as usual,” when we may feel happy and at ease. The uncertainty of our world today can open us up to thinking about how we can make our life a little safer, better, or a bit more comfortable in the future. Ironically, one of the greatest things we can do in an attempt to ensure a better future is to acknowledge that something should be done, and to start as young as possible with a plan to make it happen.
The something referred to here is saving and investing for your future. For young professionals in their 20s and 30s, the future, and the idea of retirement can seem very far off and too hard to predict. Not knowing where to start can seem overwhelming, to the point where doing nothing is an easy default.
Although we never know what tomorrow will bring, we do know that our future self will want to be able to choose from options. One of the ways for this to happen is for young professionals to start a savings and investing plan today, so that the power of time and compounding may work on your side. Wise decisions and actions today can often give you more options tomorrow. We hope the uncertainty of this pandemic, and knowing you have someone at SJS to talk to, may nudge you to start your savings and retirement plan. If you’ve already started, well done!
To that end, we will revisit some of the tried and true strategies behind a solid investment plan.
Live within your means
Simply put, spend less than you earn. By doing so, you can save to take care of future YOU! There are many thoughts on how much you should save, but according to George S. Clason, author of The Richest Man in Babylon, at least 10%. Mr. Clason states, “A part of all you earn is yours to keep. It should be not less than a tenth no matter how little you earn. It can be as much more as you can afford.”[1]
There are many good budgeting tools available to help you track how much you are spending to live within your means.[2] If you don’t know how much you spend, this is a good place to start!
Automate your savings / investing so it has priority
For every paycheck, set up an automatic transfer to your savings or brokerage account. Making YOU important enough to come first is very affirming!
Start young, start early, start now!
I mentioned the power of compounding before, and I cannot explain it any better than this powerful graphic. Take a look, and trust that you are doing yourself a huge favor by acknowledging its power and harnessing it for your own good. Save as soon as you can, as much as you can, and let time and interest on interest help build your nest egg!
Be prepared
By doing some pre-planning and using the tools available to you, you can increase the likelihood of staying on track.
Have a Plan B. Set aside funds in case of an emergency. Ideally, your emergency fund should be between 3-6 months of living expenses, kept in a safe, liquid vehicle such as a savings account or money market account.[3] So when your next “uh, oh” moment comes along, you will be ready.
Don’t just save. Invest for retirement. With investing, you will need to learn about the trade-off between risk and reward. Investments that give you higher returns may potentially get you to your retirement goal sooner, but they inherently come with greater risk. On the other hand, the safest of investment vehicles, such as a US Treasury bill, probably won’t earn enough return to outpace inflation over time. Find the right balance for you! Seek out a CFP® professional or trusted investment adviser to help you set a plan that meets your needs and stay the course. If you have a long-term plan and stick with it, then the daily volatility in the market may be just noise.
Maximize your resources. If your employer has a 401(k)-matching plan, take advantage of it to the greatest extent that you can…matching funds are free money! Consider making IRA contributions if you can. Pre-tax contributions to retirement plans and IRAs may decrease the amount of tax you pay on your income each year, and the funds will grow tax-deferred, compounding over the 30+ years you have until retirement.
Start a 529 education savings plan as a way to use compounding to help pay for your child’s college education. There is often a state tax deduction or credit available for 529 plan contributions, varying by state.
Starting your savings and investment journey today means you’ll have to balance today’s current enjoyment with tomorrow’s future enjoyment. Decisions or circumstances along the way may create diversions from the path, but if you have a strategy, you can always come back to it. The goal is to stay on track so that over time, future You will appreciate that you gave yourself options to choose from. At SJS, we are happy to have these conversations with you, and to help guide you to an investment plan for the long-term that you can stick with.
Important Disclosure Information and Sources:
[1] The Richest Man in Babylon. George Clason, 1926, Berkley.
[2] “10 Simple and Free Budgeting Tools.” Maryalene LaPonsie and Lars Peterson, 21-Jun-2019, money.usnews.com.
[3] “Emergency Fund: What it Is and Why It Matters.” Margarette Burnette, 20-Mar-2020, nerdwallet.com.
Advisory services are provided by SJS Investment Services, Inc.., a registered investment advisor with the SEC. Registration does not imply a certain level of skill or training. SJS Investment Services does not provide tax advice. Please consult your tax professional for specific advice. This material has been prepared for informational purposes only. There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.