In this article, I am going to go through some of the vehicles for saving and investing. By vehicles I generally mean accounts and types of accounts. Usually for saving, especially your emergency fund, you will be looking to a bank. This is because you want the safest place to put your money, one that is FDIC insured. The FDIC, Federal Deposit Insurance Corporation, insures each depositor in a bank for at least $250,000.
On the flip side, investments are usually done in brokerage accounts or within retirement accounts.
Let’s go through several of these types of accounts:
Bank Savings Account
You probably already have a checking account (or similar) at a bank, savings and loan, or credit union. In the same vain, you can have a savings account. Check out this savings account from Fitness Bank. A savings account is not going to pay you a tremendous amount of interest, perhaps no more than 2% and often significantly less, but it gives you a separate account that you will not pay bills from. It shows you your progress towards your emergency fund. You should save no more than 6 months worth of expenses in your savings account.
Remember that a bank savings account is FDIC insured to $250,000. Savings and loans and credit unions have similar insurances.
Money Market Mutual Fund
If you want to try to squeeze out a bit more interest, you could look at money market accounts from the bank, similar to savings accounts, or money market mutual funds. You can buy this kind of mutual fund direct from the mutual fund company or through your brokerage account (details coming). This kind of fund usually holds short term debt and pays dividends based on the debt’s interest or dividends.
Money market mutual funds do not guarantee principle, so you could potentially lose money. This rarely happens but it could. And it could happen at the worst possible moment, when you need it the most. Just like homes never go down in value (sarcastic), these funds have never actually lost money to date.
A brokerage account holds both cash and stock. A brokerage accounts is SIPC insured, which mostly protects you from a bad brokerage company. If you lose money in a stock, you have lost money.
A straight brokerage account is a non-retirement account. It is not protected from taxes in other words. If you earn dividends, they are taxed. If you sell a stock for a profit, the profit is taxed.
A brokerage account can be useful as a secondary savings if you cannot make use of a retirement account or if you are saving for something that you would buy before retirement.
A 401K account is an employer sponsored retirement plan for employees of the company. Note that any company can sponsor a 401K, even your small business generally. Just so that you know, you can only contribute to a 401K up to a maximum amount, even across 401K accounts. For instance, if you have a 401K for your small business and one through an employer, you cannot contribute double the maximum.
A 401K is tax protected so you don’t have to worry about dividends or trading within it. It will however be taxed an additional 10% if you withdraw for any unapproved reason. You can borrow up to 50% usually up to a maximum, and pay interest to yourself.
Most 401K plans have approved investments and most employers only offer mutual funds or company stock. Avoid investing too much in company stock as it is a stock that could increase or decrease in value as any other stock could. Even if you know your company well, you may not know it well enough.
Individual Retirement Account (IRA)
An IRA is a retirement account but is mostly for personal use. A straight IRA will allow pretax contributions up to a maximum, across all IRAs. An IRA can be administered by a trading company, such as Etrade or Schwab, and looks a lot like a brokerage account. Very little paperwork is required.
If your IRA is a brokerage IRA, there are few restrictions to what you can invest in, similar to a brokerage account. IRAs are tax protected and if you withdraw for the wrong reason, you could incur the 10% tax penalty.
Note that there are IRAs for all kinds of investments, such as gold or collectibles. Please take care if you are doing anything unusual. Also note that IRA maximums are across all of your IRAs. You can deduct your contributions depending on your income and access to a 401K. You can always contribute the maximum but it may not all be deductible.
A Roth IRA is similar to a normal IRA, except you cannot deduct your contribution and your withdrawals are tax free after retirement. You are still limited in your contribution across all IRAs and Roth IRAs have maximum contributions by income.
I like Roth IRAs because it generally eliminates taxes in retirement when you really don’t want income interfering with your social security payments, assuming that social security will be available. It can still be difficult to pay taxes with a limited income either way.
Because you are paying taxes on the way in to a Roth IRA, I feel that the contribution is more at the same amount of money. For instance a $10,000 contribution may be taxed at 25% so you are contributing $12,500… that’s the way I look at it anyway.
I did leave out some retirement vehicles such as the SEP IRA, Simple IRA, HSA, or 403(b), but if you are really interested in them you can check out info on the internet.