Planning your financial future is all about strategy — you want to make sure you’re working as smart as possible. Work smart, not hard, as they say. It can mean using the right “tool” for a given job, which I think is underrated in personal finance.
It’s not very wise to put all your money in one investment because diversification helps you get results while protecting you from the downsides of things you can’t predict. Diversifying how and where you invest your money can also protect you from life’s ups and downs and ensure you have a full financial toolkit when you retire.
The following three investment accounts are essential financial tools that can serve different purposes and have advantages and disadvantages. Using them could make your golden years your best years.
1. Taxable brokerage account
It’s easy to focus on retirement accounts when saving – that’s why they’re called retirement accounts, right? But don’t get tunnel vision and neglect a regular brokerage account.
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Most retirement accounts offer tax advantages, but they also usually require you to keep the money locked away until much later in life. Otherwise, they charge penalties for accessing the money too soon.
Life is unpredictable and you may find yourself wishing you had the flexibility that a regular brokerage account provides. You can access it whenever you want and there is no income limit or cap on your contributions. You put in money, it grows and you take it out.
You pay capital gains tax on profits, but that’s life. A brokerage account can even serve as collateral in a loan (often referred to as a margin loan), which is part of how Elon Musk finances his ongoing purchase. Twitter. Financial flexibility is a tool you should at least want to have in your back pocket, even if you don’t intend to use it. We never know!
2. Employer 401(k) Retirement Plan
Previous generations put their 30s or 40s into work and retired comfortably with a pension. Unfortunately, those days are mostly over and today’s workers have to do the heavy lifting to prepare for life after leaving the workforce.
Employer pension plans have mostly moved to 401(k). Employees contribute pre-tax income, where their savings grow until retirement. Taxes are paid on the money when people make retirement withdrawals.
Because it’s pre-tax money that goes into the account, contributing to your 401(k) will lower your tax bill each year by lowering your taxable income. Additionally, many employers encourage retirement savings by offering an employer match, often between 1% and 5% (sometimes more) of your salary. The match is free money. If you make $100,000 a year and contribute 5% to your 401(k), a 5% match would mean your employer is injecting an additional $5,000. That’s a savings rate of 10% on your salary!
You can set up a 401(k) plan through your employer so that money is automatically withdrawn from your salary and invested. In other words, out of sight and out of mind.
3. Roth IRA
Short for “individual retirement account,” IRAs are an additional investment account that helps you save. A Roth IRA is a special retirement account that allows US investors to pay a “net” salary, the income on which you have already paid taxes.
This money grows until retirement, and since you’ve already paid tax on the contributions, you pay no tax when the money comes out. Roth IRA accounts are also flexible, allowing you to withdraw your contributions (not profits) at any time without penalty, as long as you meet a few conditions.
The ability to avoid taxes on your winnings is so beneficial that the government limits who can use them and how much. There are income limits for using 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 or older.
Diversify your savings
Each of these investment accounts offers different tax benefits and allows you to access your money at different times. By spreading your money around all three, you’ll 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 posts and recommends Twitter. The Motley Fool has a disclosure policy.