Planning for your financial future is all about strategy – you want to make sure you’re working as smartly as possible. Work smart, not hard as they say. That could mean using the right ‘tool’ for a particular job, which I believe is not appreciated enough in personal finance.
It’s not smart to put all your money in one investment because diversification helps you achieve results while protecting against the downsides of things you can’t predict. Diversification in how and where you invest your money can also protect you from the vicissitudes of life and ensure you have a complete financial toolkit when retirement arrives.
The following three investment accounts are essential financial tools that can serve different purposes and come with their own pros and cons. Using them can 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 the retirement accounts, right? But don’t get tunnel vision and overlook a normal brokerage account.
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Most retirement accounts have tax benefits, but they also force you to keep the money locked up until later in life. Otherwise, they charge fines for accessing the funds too early.
Life is unpredictable, and you may find yourself wishing you had the flexibility that a regular brokerage account offers. You can access it whenever you like, and there are no income limits or ceilings on your contributions. You put the money in and it grows and you take it out.
You pay capital gains tax on profits, but that’s life. The brokerage account can be collateral in the loan (often called a margin loan), which is in part how Elon Musk funds his pending purchase of Twitter. Financial flexibility is a tool that you should at least want to have in your back pocket, even if you don’t intend to use it. You never know!
2 – 401(k) Retirement Plan
Previous generations used to put 30 or 40 years into a job and retire comfortably with a pension. Unfortunately, those days are mostly gone, and today’s workers need to do the heavy lifting in preparing for life after leaving the workforce.
Primarily employers’ retirement plans have turned into a 401(k). Employees put pre-tax income on them, as their savings grow until retirement. Money taxes are paid when people withdraw their money at retirement.
Because pre-tax money is entered into the account, contributing to your 401(k) will reduce 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 game is free money. If you earn $100,000 annually and contribute 5% to your 401(k), a 5% match means your employer will get another $5,000. That’s a 10% savings rate on your salary!
You can configure a 401(k) plan through your employer to automatically extract money from your paycheck and invest it. In other words, out of sight and out of mind.
3. Ruth Era
Short for “Individual Retirement Account,” IRAs are a supplemental investment account that helps save you. A Roth IRA is a special retirement account that allows U.S. investors to contribute to “take it home” salaries, income you have already paid taxes on.
That money grows until retirement, and because you’ve already paid taxes on contributions, you don’t pay any taxes when the money goes out. Roth IRAs are flexible as well, allowing you to withdraw your contributions (not profits) at any time without penalty, as long as you meet certain requirements.
The ability to circumvent taxes on your winnings is very useful as the government determines 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 are under 50 and $7,000 if you are 50 or older.
Diversify your savings
Each of these investment accounts has different tax benefits and allows you to access your funds at different times. By spreading your money across all three, you’ll have a versatile, flexible egg that you can use to your advantage when the time comes.
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