Knowing: Account Types
Tax Efficiency: Investing in a tax efficient way is, believe it or not, very simple! For young people, the account of choice is the ‘Roth IRA.’ It may sound foreign, but it’s quite simple. Let’s say Smart-Eliza wants to invest a dollar for the long run. She will need to open an account with an investment firm. This could be Vanguard, Wealthfront, Betterment, or many others. You’ve probably heard of Charles Schwab or Merrill Lynch. Doing this is completely analogous to opening a savings account at a bank.
Once Smart-Eliza chooses a firm and opens her account, she will need to choose which type of account to open. This is where we recommend an IRA (Individual Retirement Account). There are two types of IRA: Roth and Traditional. We generally recommend the Roth, but will briefly describe the (few) differences below.
A simple clarification before a little more detail:
Eliza opens an IRA, the IRA is held by an investment firm, some company authorized to invest money on Eliza's behalf. It's similar to the way a bank holds a savings account. Inside of that account, the IRA, Eliza chooses (or the advisor chooses) where the money gets invested.
The arrows show flow of money:
Eliza --> Investment Firm --> Roth IRA --> Index Funds, Stocks, etc.
Roth IRA: Unlike traditional investment accounts, called brokerage accounts, a Roth IRA receives special treatment from the government. When Smart-Eliza contributes that $1.00 to her Roth IRA, she will leave it there for many years. She will withdraw, say, $1.50 when she’s older. Because the dollar was invested in a Roth IRA, Smart-Eliza will not pay taxes on the $1.50.
It may not sound like such a big deal, but as always, a little bit goes a long way. Imagine investing for decades, earning more than $1,000,000, and then having to pay the U.S. Government hundreds of thousands of your dollars! The Roth IRA allows the magic of compound interest to work unhindered. It also excuses the account from being taxed year-to-year, as traditional accounts are.
If Gambler-Ross opened a traditional brokerage account, he would likely buy and sell different stocks during a year. On any profit he makes on those sales, he would capital gains tax. His profits would shrink each year, drastically reducing the magical, beneficial effects of compound interest. If he chose to invest in a Roth IRA, however, he would pay no tax on his profits from buying and selling stocks (though we don't recommend doing that anyway).
Traditional IRA: Contributions to a Traditional IRA, as opposed to a Roth IRA, are tax-deductible. If you earn $50,000 in 2016 and contribute $5,000 to a Traditional IRA, the government will only charge you income tax on $45,000. This is called a tax-deferred account. Imagine again that you are at retirement with a $2,000,000 portfolio. A 30% income tax rate would mean you paying the government $300,000 for each million you saved. Ouch!
Roth IRA: Investors who expect to pay higher income tax rates at retirement than during their investing years should choose a Roth IRA and vise-versa for the Traditional. Don't worry, it isn't one or the other. You could do half-and-half, or create a Traditional account in your 30s after socking away in a Roth in your 20s. For detailed comparisons, click here, or here, or here.
Some extra rules apply to the Roth IRA:
- Because of the incredible financial benefit that this type of account brings, the government limits total annual contributions to your IRA account(s) to $5,500 for investors under 50 years old, and $6,500 for older investors.
- Additionally, an investor can only withdraw money from the Roth IRA if she is withdrawing contributions, not earnings. So if Smart-Lydia invests $1,000, and it grows in value to $1,500, she will only be allowed to withdraw the $1,000. If she takes a distribution of Roth IRA earnings before she reaches age 59½ and before the account is five years old, the earnings will be subject to taxes and penalties unless she uses the money to buy her first home, pay for college education, etc. For this reason, among many others, we always recommend investing money that you won’t need in the short run.
Here's what 40 years of making the maximum annual contribution would look like (blue line), compared to several other choices:
*The graphs on this page assume an annual return of 8% on investments in a broadly diversified portfolio of index funds. The annual return on funds in a savings account is set at 0.06%, the U.S. national average. Returns are compounded annually and not adjusted for inflation.