Investment accounts boil down to two categories: (1) taxable brokerage accounts and (2) retirement accounts. Within retirement accounts there are Roth IRAs, Traditional IRAs, 401(k)s, and more! Retirement accounts have yearly contribution limits while taxable accounts are unlimited. It is always a good idea to “max out” retirement accounts first when new to investing because they offer great tax advantages.
So which retirement account do I need to open first? If your employer offers a 401(k) (or similar retirement plan like a 403(b) etc.) and an “employer match” you should at least contribute up to the match. Otherwise you are leaving free money on the table, and that’s not good for anyone! Once you have done that, we recommend opening up and maxing out contributions to a Roth IRA. You cannot contribute to a Roth IRA if your gross income exceeds $139,000 for 2021. If you exceed the Roth IRA income limit, never fear, open up and max out a Traditional IRA. These accounts both have a $6000 yearly contribution limit.
If you qualify for an HSA (Health Savings Account) via a high-deductible health insurance plan, your next step should be to max out your HSA contribution which is $3,550. HSAs are incredible tax-sheltered investment vehicles which allow you to access pre-tax dollars for medical expenses at any time and are available for unlimited withdrawal at retirement completely tax free.
For the overachievers out there, if you can still afford to invest more, or if you are chasing FI/RE, you’ll want to completely max out your 401(k), which has a contribution limit of $19,500 for 2021, before starting to put money in your taxable brokerage.
TL;DR
Order of Operations for the Beginner Investor:
- Contribute to 401(k) up to Employer Match
- Max out Roth IRA/Traditional IRA
- Max out HSA (if you qualify)
- Max out 401(k)
- Contribute to Taxable Brokerage
Well, that depends on your current and future tax brackets and whether you have met your annual IRA contribution limit ($6k for 2020 for folks under 50 years old). A friend recently asked us whether they should open an IRA (tax-sheltered) vs individual (taxable) brokerage account for investing. Because she is a twenty-something year old student, we suggested that she max out her Roth IRA for the year before opening a taxable account. Keep in mind that you have until April 2021 to meet your $6K limit on IRA contributions for the 2020 tax year, so the IRS has their own schedule for IRAs that gives folks extra time to contribute. A Roth IRA means that she will fund her retirement account with after-tax dollars. What does this mean and why does this matter? When you sell your Roth IRA holdings, you won't be taxed on your profits (like you would with a taxable account). That means MORE money for her when she retires. This tax-sheltered account means that she has paid taxes on this money already, so she doesn't have to pay more to the IRS in the future. She chooses to pay taxes now because she is in a relatively low tax bracket right now, she will pay relatively low taxes on the funds she adds to her Roth IRA so why not get it out the way sooner than later. She could decide to contribute to a Traditional IRA instead, but that means that she would need to pay taxes on her contributions and the profits when she sells her stocks at retirement age. The amount of taxes could be higher if she happens to be in a higher tax bracket due to more income when she’s older. The Traditional IRA can be advantageous for those who are currently in a relatively high tax bracket now and anticipate being in a lower tax bracket by retirement age. Investing is for the long-term not next year - invest in your future by contributing to a Roth IRA. This money will be tax free when you withdraw it in the future.