You’ve made the life-altering decision to become an investor. The realization that investing, not saving, is the way to wealth has hit you hard, and you’re itching to get in the game. But before you can throw your dough in the market, you must open a brokerage account. And that requires hitching your wagon with one of the many firms that dot the landscape. There are veterans aplenty, from Schwab and Fidelity to Vanguard and Ameritrade. And then there are the young guns, hungry to steal market share. We’re talking about the likes of Robinhood, Tastyworks, and a whole host of robo-advisors led by Betterment and Wealthfront.
With trading commissions now squashed to zero, we’ve effectively reached a level playing field on the cost front. Who you choose becomes a matter of their ancillary offerings, such as trading platforms, tools, and support. If you’re stressing over who to select, if the bounty of choices has you paralyzed, then read the next sentence carefully. You cannot go wrong. There’s no cost to opening a brokerage account, no penalty for trying one out. Furthermore, you can open as many accounts as you want. Through trial and error, you will discover which one you like best.
Now we’ve come to the heart of the matter. Once you’ve settled on a broker and move to open an account, you’ll be greeted with an alphabet soup of choices. There are dozens of account types from IRAs and solo 401(k)s to UGMA’s and UTMA’s. Each boasts unique properties and is appropriate in the right type of situation. Some provide tax advantages, and others don’t. Some require reams of paperwork, and others can be opened in a few short minutes.
This month’s newsletter aims to familiarize you with some of the more familiar account types and how they might benefit you. Before embarking on our journey, let’s make one thing clear. We’re not accountants, and none of this constitutes tax or investment advice. Some of the accounts provide tax advantages but never forget that laws and limits are always changing. If you are wondering which ones are best for your situation, then consult a professional.
Our descriptions below are intended to outline the general contours of each account type.
Individual & JTWROS
We’re kicking off our adventure with a brief look at the simplest accounts to choose from: Individual and Joint Tenants with Rights of Survivorship (JTWROS).
The Individual account has a single owner. As such, it’s probably the most common account type we see traders use. It lacks any tax-advantaged status, meaning that you will owe taxes for any realized capital gains or dividends received throughout the year. Don’t worry about tabulating all the profits and losses, though. Your broker should compile all the statements and deliver them to you. You can put money in or pull it out of the Individual account at any time without penalty or consequence. These days it’s effortless to link a brokerage account to your bank so you can seamlessly move money from one to the other through an Automated Clearing House (ACH) transfer.
If you’re old school and want to cut a check, you can do that too. And if timing is of the essence and you don’t want to wait the day or two that it takes for the ACH transfer, you can also wire the money. Your bank will probably charge you a fee to process it, though.
Some brokers have minimum funding requirements, but it’s not a lot. And, quite honestly, if you can’t afford to deposit $50 to $100 into your brokerage account, you probably shouldn’t be investing just yet anyway.
Individual accounts offer the most flexibility when it comes to trading privileges. If you possess the proper risk tolerance for it, you can get access to trading on margin (borrowed money) and options.
Finally, you can identify primary and contingent beneficiaries that will receive the assets you own in the account upon your death.
The Joint Tenants with Rights of Survivorship (JTWROS) has all the trappings of an individual account with a single exception. It can have two or more account owners, such as a husband and wife. Both parties have an undivided interest in the account. Thus, if the husband dies, the account becomes the wife’s sole property (and vice versa).
All other characteristics mentioned for the individual account apply to a JTWROS account.
Other standard accounts include Tenants in Common, Community Property, Tenants by the Entireties, Guardianship or Conservatorship. Each is appropriate in the right situation, but today’s attention is better spent focusing on the more common account types.
Individual and JTWROS accounts can play a role in building wealth for your eventual retirement. They’re liquid and offer unfettered access without penalty. But they don’t boast any tax advantages. That means all dividends received and gains realized along the way will be pared down by the taxman.
Many successful investors complement their taxable portfolios with tax-deferred or tax-free ones. These fall under the banner of retirement accounts.
Uncle Sam offers some sweet-sounding incentives to the little people trying to save all their shekels for their latter stages of life.
“How about I allow you to reduce your taxable income today by investing in your future? Throw your dough in an IRA or 401k account, and I promise I won’t touch it till you’re in your seventies. Think of it this way. I’ll avoid taking my cut of the seeds you plant today. And I’ll refrain from raiding your orchards along the way. But, come harvest time when you’re in the eve of life, I’ll take my cut of the fruits. What do you say?
There’s even an alternate deal I’m willing to carve out. Take your hard-earned money and throw it in a ROTH IRA. I’ll tax you today, take a piece of the seed. But then it’s yours forever, tax-free. And, heck, I’m feeling generous. I won’t even make you take money out of the ROTH in your seventies. You can keep it until you die and pass it to your heirs.”
Now, I don’t know about you, dear readers, but both of these arrangements sound tempting enough to partake of. They are illustrative and highlight some of the critical advantages of retirement accounts. Before diving into the details, I must again remind you that circumstances vary. You should consult a tax professional and the latest IRS guidelines to determine if these accounts are appropriate for your situation.
For those that qualify for the benefits of the traditional IRA, it can be an effective way of reducing your taxable income today. For 2020, you can contribute up to $6,000 of tax-deferred income into this account. Furthermore, if you have a non-income-earnings spouse, you could contribute another $6,000 to a separate IRA for them. All-in a married couple has the potential to reduce their taxable income by $12,000.
And if you’re older than age 50, well, Uncle Sam will let you kick-in an extra $1,000 for daring to live so long. That bumps it to $14,000 for a couple. As with all government relationships, there are multiple strings attached and qualifications you need to meet. For starters, you (or your spouse) must have earned income. If you don’t, you can’t just take savings from a prior year and deposit them into your IRAs.
Technically there aren’t any income limits, so even if you pulled in $1 million in earned income, you can still fund an IRA. But there’s a catch! If your income is too high, then the contribution won’t be tax-deductible. The limits depend on various factors, including whether a retirement plan at work covers you or your spouse. Do yourself a favor and don’t sidestep the due diligence on this one.
One of the strings attached is that Uncle Sam wants you to keep the money in the retirement account. As such, he’ll slap your hand with a 10% penalty if you take a distribution before 59 ½. You also will likely owe taxes. Eventually, the government requires you to start taking distributions so they can capture tax revenue from your mountains of cash. These are called required minimum distributions or RMDs and begin in your seventies.
Any broker worth their salt will allow you to invest in stocks, bonds, and options in your IRA account. Some even allow you to dabble in Futures and Forex if you’re so inclined. That said, you won’t be able to short stocks or sell naked options with most brokers.
The Roth offers an intriguing alternative to the Traditional IRA. Instead of getting a tax benefit today, you get one in the future. While the Traditional grows tax-deferred, the Roth grows tax-free. It is the second arrangement outline above where the government taxes the seed, but not the harvest.
This can be particularly attractive if you’re in a low tax bracket today, such as < 20%. Logic suggests that in the future, you could be in a much higher tax bracket. So why not take the Roth route? Pay the tax now and let the account grow tax-free.
The contribution limits are identical to the Traditional IRA. So $6,000 per individual, or $7,000 for those above the age of 50. The earned income requirement is also the same. One difference of note is that you can access your contributions to the Roth at any time without penalty. This greater accessibility is one reason why younger investors might prefer it. It’s hard to tie-up your money for decades knowing that if you ever need to access it, you’ll get punished with a 10% fine. This account type offers a solution to that concern.
However, I’ll hasten to add that we’re talking about the contributions, not the earnings. To access your gains without penalty you must wait until you’re age 59 ½ or qualify for one of a few exemptions.
You have the same investment choices in a Roth as a Traditional IRA. So stocks, bonds, options, futures, and Forex are all fair game.
If there’s a glaring issue with IRA’s, it’s undoubtedly the contribution limits. While investing $12k annually for a married couple might sound like a lot, it won’t grow enough to provide a comfortable retirement for most people. It becomes necessary to complement your IRA investment strategy with other accounts.
If you own a small business, especially one where you may be the only employee, then the next account should be of particular interest to you.
If you love the idea of reducing your taxable income today, and you want to squirrel away a lot more than the $6,000 IRA limit, then you might fall in love with the Solo 401(k). It’s also sometimes referred to as an Individual 401(k). As I said in the lead-up, you must own a business and be taking payroll from it.
Because it operates like the Traditional IRA, all contributions chip away at your taxable income today, and the invested funds grow tax-deferred. But while the IRA is limited to $6k, you can deposit as much as $19,500 on the employee side, and even more if you want to make employer contributions. Depending on how much you’re taking in payroll, the total contributions could be as high as $57,000 for 2020. Being strategic with an account like this allows for some serious control over how much your tax bill is year to year.
There is a lot more paperwork required to establish a 401(k) with your business than the few simple steps needed to create an IRA. Additionally, since you must fund it through your payroll, there’s a more significant hassle factor. But if you have a competent accountant, they should be able to help you.
You should have access to the same trading products (including options) as you have with an IRA account.
Path of a Hypothetical Investor
The final section of our newsletter explores the path of a hypothetical investor named Sam. It provides insight on which accounts might be used by an investor at varying stages of their investing lifecycle.
Stage 1: Age 21: Single and Short-sighted
Sam is in the beautiful situation of being able to invest in his future. He lives within his means and has leftover capital each month to purchase assets with. As a result, he opens up an Individual account and deposits as much cash as possible each month. It grows over time, mainly as a function of these systematic contributions. The stocks purchased pay dividends and increase in value over time.
Because of his youth, retirement seems light-years away, and Sam is more interested in having access to his capital for whatever potential opportunities might come his way. Retirement accounts aren’t even on his radar.
Stage 2: Age 24: Married, no kids
Sam marries Wendy. For a time, they have dual incomes and no kids. It’s the perfect time to sock away money for an eventual house purchase and future children. He promptly opens up a JTWROS account and has Wendy fund it using her income. Meanwhile, Sam is continuing to throw as much of his excess capital as possible into his existing account. Wendy is, of course, now the primary beneficiary named on his account.
Stage 3: Age 28: Married, Two kids
Fast forward four years. Both accounts have grown, as have their respective incomes. But with two kids now on board, Wendy decides to leave the workforce to be a full-time mother. At the same time, they use a big chunk of their investments as a downpayment on a new home.
The desire to save money for their kids’ college enters the equation. After researching 529 plans and their accompanying tax benefits, Sam opts for the greater flexibility of continuing to invest through taxable accounts. He earmarks a portion of his monthly contributions into his Individual account for his children.
At the same time, Sam & Wendy revisit the best way to plan for retirement. Sam is older and somewhat wiser. His friends and co-workers commonly speak of tax-advantaged accounts. Not wanting to live beneath his privileges, he decides to open a ROTH IRA account for himself and Wendy.
Stage 4: Age 38: A Newly Minted Business Owner
Sam has been maxing out two IRAs for ten years now. On top of that, his income was high enough to allow additional contributions to his Individual and JTWROS accounts. He owns a successful small business and is looking for other avenues to reduce his taxable income and invest even more toward his eventual retirement. The Solo 401(k) is a perfect fit.
Stage 5: Age 60: Retirement on the Horizon
Sam is fast approaching the end of his accumulation phase. Along the way, he took advantage of multiple account types from Individual and JTWROS to Roth IRAs and Solo 401(k)s. He’s entering retirement with five total accounts. Two are taxable, two are tax-free, and one is tax-deferred. Having multiple account types will provide greater flexibility in optimizing withdrawals for tax purposes.
This month’s newsletter introduced you to a thread worth tugging on. Do some research. Ask your broker questions about the different account types. If you’re not using tax-advantaged accounts and can do so, then what are you waiting for? Every year that passes without you maxing out your contributions is an opportunity lost.
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