One of the things that many people wonder about is what accounts to invest in first. There are so many choices now, with online brokerages making it easy to open trading accounts. However, before you begin investing a great deal in a regular investment account, it’s a good idea to take stock of your tax advantaged options. Retirement accounts offer chances for you to reduce your tax liability while you save for the future, so money you want saved for long term should go there first.
Tax Advantaged Investment Accounts
Tax advantaged investment accounts are those that provide some way for you to save money on taxes. This advantage comes either now, in the form of lowering your taxable income, or later, in allowing you to withdraw money tax free. These accounts are usually associated with retirement plans. IRAs and 401ks are the most popular tax advantaged retirement accounts — and for good reason.
For those looking to lower their taxable income, a Traditional IRA or a 401k can be great choices. The contributions you make are taken out of your income before taxes are figured, so the amount of income that you make is considered lower for tax purposes. This can be a way to keep you in a lower tax bracket. It is worth noting that if you have a 401k, you can still open a Traditional IRA. And, if you have a spouse, he or she can open a Spousal IRA — even if he or she is a stay at home parent.
If you are more concerned about seeing your money grow tax-free, you can take advantage of Roth options offered on IRAs and 401ks. With a Roth option, your contributions come out of income that is already taxed. But, you do not pay income tax on withdrawals you make later in life.
The good news is that you can open a variety of accounts. In the simplest sense, you could have a 401k, a Traditional IRA, and a Roth IRA for you and another set for your partner. If you own some sort of business, there are additional tax advantaged retirement accounts that you can use for investment purposes.
Maxing Out Your Tax Advantaged Accounts First
If your company offers a match, the first thing you should do is contribute so that you get the maximum match. That is free money that you receive for investment purposes, and you should take advantage of it.
Plan out your next money move based on your individual retirement goals and needs. If you are concerned about getting a bigger tax break now, and aren’t worried about paying income tax on your withdrawals, max out your 401k and open a Traditional IRA and max that out (if you can).
If, however, you want to limit your tax liability in the future, you should look into Roth options. If your company offers a Roth 401k, this can be a good choice. However, many companies have been slow to offer this relatively new product, so if a Roth 401k isn’t an option, contribute just enough to your 401k to get the maximum company match, then open a Roth IRA for you and a Roth IRA for your partner. Then max out those accounts with the $10,000. (Remember, though, that there are income limits to the Roth IRA. Once you make a certain amount, your ability to contribute to a Roth IRA phases out.) After you have maxed out your Roth accounts, you can go back and contribute more to your 401k or to a Traditional IRA.
It is also worth noting that 529 college savings plans also come with tax advantages, and some come with state income tax deductions. These can also be worked into your investment plan, if you know that someone (your children or yourself) will use the account for education expenses.
Finally, if you actually manage to max out all of your possible tax advantaged accounts, it is time to put money in other investment accounts. By focusing on your tax advantaged accounts first, you can save a great deal of money in taxes.
Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.
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Good article but I would add say that I feel more strongly about the ROTH IRA now than I did 5 years ago. With all this government debt accumulating, there is no way taxes are going anywhere but up. To have the advantage of a tax free account is tremendous.
A good strategy might be to contribute to your 401K and make sure you get your employers full match (if you get a match), then divert to a ROTH. It would be fantastic to max out both, but if you cannot, I would put some in a ROTH as opposed to only a 401K.
I love 401ks, because it actually takes money out of your paycheck before you even have access to it. It’s amazing how adaptable we are when our income seemingly reduces.
Never mind the tax advantages and match. The pay yourself first effect is reason enough for me to think everyone should max out their 401ks.
When I started investing, I simply opened up a brokerage account and started trading stocks. I ended up doing decent, but once you factored in taxes and fees my returns we’re a lot lower.
I learned a lot about allocation and diversification, but I didn’t know the first thing about asset location.
Great intro article.