If you’ve kept up with JumboCash, you know about different asset classes and investing strategies. Now it’s time to talk about the best account in which to implement those strategies. Different account types offer distinct advantages to bolster your returns, so understanding which account fits you best can have a large impact on how much money you keep after taxes.
Anyone can simply open a brokerage account with a company such as Fidelity, Charles Schwab or E*TRADE. However, as I discussed in last week’s article, you incur a capital gains tax if your investment appreciates in value. If you have money you want to invest over a shorter time horizon, a brokerage account might be the right fit. Over a longer time horizon, though, retirement accounts help you pocket more cash.
The most widely-known account types relate to retirement. They are broadly known as Individual Retirement Accounts, or IRAs. If you are comfortable setting aside money now, and not touching it until you retire, these accounts have massive tax advantages that can generate you a high return in the long run.
The first important retirement account is a traditional IRA. Here’s how a traditional IRA works: You contribute pre-tax dollars to the account, you select investments within the account and the money grows tax-free until you withdraw it when you retire (which is called a distribution). The term pre-tax means that your contribution is tax deductible; the money is not taxed before it enters the account. Currently, the contribution limit for a traditional IRA is $6,000 per year.
The second key retirement account is a Roth IRA. The tax advantage of the Roth IRA is the opposite of the traditional IRA: money is taxed before you contribute to the account, but you can withdraw it tax-free when you retire! The maximum annual contribution is also $6,000.
Each account also has a “catch-up” provision, where the maximum annual contribution increases to $7,000 for those over 50. However, just because there is a “catch up” provision doesn’t mean you should procrastinate investing! You can save a paper until the night before and still get an A, but you can’t avoid saving for 30 years and expect to have $1 million when you retire. Try to contribute early and let your money compound.
In a brokerage account, if you sold shares of a mutual fund at a gain, you would have to pay taxes on that gain; with IRAs, you can sell the stock without paying taxes, but the money remains in the account, where you can re-invest it in another mutual fund.
In either IRA, you still pay a tax — the key is that you can choose when you pay the tax. With a traditional IRA, you get a short-term tax break, as your contribution is tax deductible, but your distributions from the account are taxable in the future. With a Roth IRA, you have to wait for your tax break: you cannot deduct contributions from your income, but you get to take your money out of the account tax-free! If you’re prepared to invest for the long term, a retirement account could be the right way to get started.