Savings Outside of Work

Full participation in your employer’s 401(k) plan is just the first part of saving and investing that you will need to do in order to set yourself up for a successful retirement. A successful young investor will also begin to save and invest in a personal account that is not subject to withdraw restrictions like your 401(k) account is. In the following sections, we will walk you through how to choose an account provider, what types of accounts these brokerage firms provide, and what an ideal investment allocation would be for young investors.

CHOOSING YOUR ACCOUNT PROVIDER

First off – let’s choose the company we wish to do business with. Brokerage firms act as an agent who buys/sells securities and holds the investments on your behalf, and many of them have similar offerings. So, close your eyes and pick one, right? Not so fast. It is critical for young investors to choose a low-cost provider since if you choose a firm that has a menu of annual fees, transaction fees, and high trading costs then this will result in us keeping less of the money we have worked hard to save.

In general, many of the largest wealth managers (Merrill Lynch, Morgan Stanley Smith Barney, UBS, Wells Fargo) choose to focus their business on having a financial advisor deliver advice to wealthy clients (generally $250,000+ in investable assets). However, they also allow their advisors to work with young investors through a “discount” online trading platform. But, since they are in business to make money, they have to make it profitable for them to have their advisor spend time with you and handle your accounts.

These larger brokerage firms charge a plethora of fees that discourage a financial advisor for working with clients that are not wealthy in order to make a profit of these small accounts. Annual fees can be charged to clients with less than $250,000 invested at up to $150 per account. Trading costs can be as high as a minimum of $95 per each trade if you traded with the financial advisor ($20 if you received no advice and used their online platform), and in some cases with an additional $5 on top of every trade as a “transaction fee”.

The lesson here is simple – choose a discount online broker to act as custodian for your investments. The time will come when your financial picture becomes much more complicated when children, homes, and much more money comes along…and then is the time when you can consider working with a professional to sort everything out. For the time being, you can read free educational material to set yourself up to have enough money in five to ten years when it makes sense to pay to work with a professional.

There are many companies that participate in the “discount online retail brokerage” industry (meaning firms that provide a cheap way for you to manage your money yourself online), including Charles Schwab, Fidelity Investments, and TD Ameritrade as the industry leaders. In the next sections we will break down what account types are available as well as some important information about each of these firms, and then you can choose a provider yourself.

Account Types:

Before we look at each provider let’s do a brief rundown of some of the major types of accounts that you will likely encounter at any firm. You will see there are many account types available, but many of them have to do with businesses, estates, and trust accounts – all of which will likely not apply to young investors.

  • Standard Brokerage Account: This is just your basic personal investment account where you are able to buy, sell, or hold basically any type of investment (though we’ve discussed why we should focus on stock investments). There are no limits to how much you can contribute to it and how and when you can withdraw money from it (unlike retirement savings accounts like 401k or IRAs). Any income received off of these “taxable” accounts like dividends and interest will be taxable to you. You will also be taxed on any gains you realize when you sell any investments that have appreciated in value. Most firms offer an “enhanced” brokerage account that comes with check writing capabilities. This can be a convenient feature, but generally, it may be best to keep a wall between your investments and cash reserves from your bank account so you don’t unintentionally overspend and draw down your investment assets.  
  • Traditional IRA Account: The following several accounts are IRAs (Individual Retirement Arrangement) that are investment accounts designed for saving for your retirement outside of your work’s 401(k) plan. The Traditional IRA involves “pre-tax” contributions and withdrawals are taxed at your marginal income tax rate in retirement.

Generally, if your employer doesn’t offer a 401(k) program then it is wise to open either a Traditional or Roth IRA to begin saving for retirement. For those of us covered by a retirement plan at work then you will likely be unable to contribute to a Traditional IRA due to tax laws (however, you may be eligible to contribute to a Roth IRA).

For 2018 you are allowed to contribute up to $5,500 each year into your IRA account (whether it be Traditional or Roth – the combined limit is $5,500 across both types of accounts). If you withdraw money from this account without a qualified exception (permanent disability or select qualified higher education expenses for example) before you are 59.5 years old then you must pay a 10 percent penalty in addition to all income taxes. With Traditional IRAs you are required to start taking distributions once you turn 70.5, a feature that is not present in a Roth IRA.

  • Roth IRA Account: Roth IRA contributions are made after-tax, and all of your withdrawals in retirement are tax-free. You can’t contribute to a Roth IRA if your income is above certain levels due to the tax advantages of these accounts. For 2018 for single tax filers if your income is over $135,000 then you can’t contribute to a Roth IRA, and if your income is between $120,000 – $135,000 then the amount you can contribute phases down from $5,500 to $0. The phase-out for Married filing jointly couples is $189,000 – $199,000. Another advantage to a Roth IRA in addition to the withdrawal tax benefits is that you have more flexibility in withdrawing money from the account before retirement. You are allowed to take out your original principal (the money you initially invested) at any time with no penalty, and you are not required to take money out of the account at any time in retirement.
  • Rollover IRA Account: A “rollover” refers to when you leave an employer in which you had a 401(k) account, and then you choose to move that account from your employer’s plan into your own brokerage IRA account. Generally, if you are young and have had several jobs over time then it is wise to rollover your 401(k) into an IRA once you leave a job. This way you will have all of your accounts in one place and don’t have to call three previous employers to check up on your prior 401(k) investments. Or, you can just move your old 401k into your current 401k if your plan allows. This account type effectively operates the exact same as a Traditional IRA account, but it is titled to categorize the funds as previously being held in a qualified retirement plan like a 401k.
  • Inherited IRA Account: These accounts are for the unfortunate case that someone close to you passed away and you were a beneficiary of their IRA account. You can either transfer the money into an Inherited IRA Account where you can withdrawal money at any time (no 10 percent early withdrawal penalty, but you must pay income taxes on the full amount of each withdrawal), take the money as a lump sum (and pay income taxes on it all), or if you are a spouse you can transfer it into your personal IRA account. Generally it is best to keep inherited IRA money in a tax-deferred status (ie keep it in an IRA) so it can keep growing tax-free and you can spread out the required distributions from the account and the resulting tax burden over time, but in this case it is best to consult a financial advisor or an estate attorney to review your options. If the inherited account doesn’t come from your spouse, you are required to begin annual withdrawals within one year from the date of death to enjoy lifetime deferral of taxes. Otherwise, it all must be withdrawn and taxes paid within five years.
  • 529 college savings accounts: For those of us with little goofers of our own running about this is a great account to start saving for their college education expenses. Contributions are made into the account after taxes but if withdrawals are made for qualifying expenses (tuition, room/board, books etc. at any qualified university) then there are no taxes paid on the gains received on the investments over time. If you take money out for other purposes you must pay a 10 percent penalty and income taxes.

A 529 plan is a vehicle run by the state which offers basic investment options (much like your 401(k)), and an Education Savings Account lets you choose your own investments. Contributions are limited to the Education Savings Account version at $2,000 per year until the child turns 18, while the 529 plan you can gift up to $15,000 per year per spouse to each child’s account without gift taxes ($30,000 per couple to each child) and the account balance can grow as high as over $300,000 depending on the state. A 529 plan is simple and should suit your kid fine for college savings. Visit www.savingforcollege.com to review state options for 529 plans. You can participate in any state’s 529 plan, but there may be tax benefits and incentives for participating in your state’s plan. The 2017 Tax Cuts and Jobs Act now also allows up to $10,000 per year to be distributed for private K-12 education costs.

Contribute early and often (set automatic monthly deposits of $100+ to take the thinking out of the savings process) in order to receive the benefits of compounding! Choose a fund that primarily invests in equities if your child is far from college age, and then choose a more moderate investment style to lower risk once they approach college age (go from 80 percent stocks/20 percent bonds when they’re young to 60 percent/40 percent when they enter their teens, and even more conservative with a higher fixed-income/bond allocation while they are in college).

Brokerage Account Providers:

 

In order to keep costs low, we are going to suggest one of the following three discount custodians for you to do business with to manage your savings and investments outside of your job’s 401(k) savings plan. All of these firms will serve as a custodian of your assets – meaning they will hold any assets you buy in an account in your name and they will provide you with statements and trade confirmations regarding activity in your account. They will also serve as your broker in that they will place your investment buy and sell orders for a small fee. Generally, you won’t go wrong with any of these companies since they all focus on keeping investor costs low and are the most established discount online brokers available. There are several operational fees associated with these accounts that vary among the firms like account closing fees, overdrafts, wire requests etc. Please review each website’s material in detail and call the representatives at the firm if you have further questions when opening an account.

Charles Schwab & Co., Inc.

Fidelity Investments

TD Ameritrade, Inc.