Last week, I wrote a post about why we should invest. If that article convinced you to start investing for your retirement then you are in luck, because this week I will talk about how you can invest in the stock market.
To start investing, first, you will need to open a brokerage account. It is an easy process and you can typically create a brokerage account in a few minutes online (similar to opening an account at a bank).
A brokerage account is a financial account that allows you to buy and sell financial securities (stocks, mutual funds, index funds and other securities). Brokerage accounts work in a similar way like bank accounts where you can deposit money and then use that money for buying stocks. However, unlike bank accounts, brokerage accounts are not protected by FDIC insurance and can suffer investment losses.
I will walk through some factors that are important to me while opening a brokerage account.
Commissions and other expenses/fees: Most of the brokerages allow zero-commission trades on stocks and ETFs. If your broker charges a commission on these trades, it’s time to look for a new broker where you can save on commissions. (pretty much all online brokers offer zero commission trades: Fidelity, eTrade, Schwab and TD Ameritrade to name a few).
Look for other fees as well. Some brokerages charge inactivity fees, subscription fees, or any other extra fees for special accounts. I want to open my account where I am paying zero or minimal fees.
Time taken for transferring funds: If you open a brokerage account with a bank where you have your checking account, the money transfer between the two accounts should be instant. That is important to me because I do not keep extra cash at the brokerage account. So, it may be a good idea to open a brokerage account with your current bank. For example, I have one of my brokerage accounts at the investing arm of Bank of America (Merrill Edge) and I get zero commission trades.
On the other hand, if you open a brokerage account at one of the online brokerages mentioned above, it typically takes about 2-3 days to transfer your funds to and from your bank account.
Fractional Shares: Let’s take a minute to talk about fractional shares. Let’s say you have $500 and you want to invest in Amazon (AMZN). The share price for AMZN is about $3,200 on Dec 17, 2020. So at a brokerage that does not allow fractional shares, you will not be able to invest in Amazon. On the other hand, if you have a brokerage account at one of these brokerages that allow fractional shares, you will be able to invest $500 in AMZN ($500/$3,200 = 0.156 shares). You will be able to buy a fraction (0.156) of an AMZN share.
So, if you are starting with small amounts and want the ability to buy fractional shares, any of the brokerages mentioned in the link are a good choice. I am partial to Fidelity because I have an account with them and Fidelity has great customer service and research tools that I use for decision-making. Cash App (that is owned by Square) also allows fractional investing and the money transfer is instant if the Cash App is linked with your bank account.
Account-minimums: Does the brokerage account require any account minimums? In general you want to open an account where there are no account minimums.
Cash or Margin Account: A margin account means that you are borrowing money from the broker to invest in securities. Borrowing money to invest in the stock market is a recipe for disaster and I don’t invest using margin, ever. You only want to open a cash brokerage account.
When you are opening a brokerage account, you can open a taxable brokerage account or what I call tax-advantaged accounts. A taxable brokerage account means that all transactions in this account will have tax implications on your annual tax returns. On the other hand, these tax-advantaged accounts will not affect your annual tax return while you are working and investing. Some of these tax-advantaged accounts merely postpone your taxes to your retirement years (tax-deferred accounts) and some of these tax-advantaged accounts allow you to invest without paying any taxes (tax-free accounts). No, really! If you follow the rules to use these accounts, you will never pay any taxes on your gains or dividends.
Here is a summary of these accounts
These are the accounts where you don’t pay any taxes while you are working. So, any dividends that you receive and/or capital gains don’t result in any taxes in your working years. However, when you retire and withdraw money from these accounts, you will need to pay taxes on this money at the tax rates applicable to your income at that time.
So, you are merely postponing your tax liability to a later time. The following is a list of tax-deferred accounts that you can use to invest
401K or 403B Plans
- These are employer-sponsored plans where generally your employer matches a percentage of your salary.
- You can generally direct your broker to invest this money (your contribution and your employer’s contribution) in a fund that you like.
- Your contributions are made pre-tax. That means that you don’t pay any taxes on this money while you are working. You can sell any of the funds that you don’t like and buy new funds. You don’t pay any taxes on these sales while you are working.
- In 2020, the limit is $19,500 per year for the employee contribution if you are 49 years or younger. The limit is a little higher if you are aged 50 years or above.
- Usually, the investment choices are restricted as per the employer plan.
- All withdrawals will be taxable at the time of distribution. That is why I call this plan a tax-deferred plan.
- So, to summarize, money goes in tax free, grows tax free, and is taxable at the time of distribution.
Traditional Individual Retirement Account (IRA)
- Similar to a 401K plan, you can make pre-tax contributions to a Traditional IRA.
- You must have earned income to contribute to any IRA.
- In 2020 and 2021, you can contribute $6,000 per person per year to an IRA if you are 49 years old or below. You can contribute an additional $1,000 if you are 50 years old or above.
- There are income limits for contribution to IRAs which you can check at the IRS website.
- Unlimited investment choices. You can invest in any security that is offered at your broker.
- Similar to 401K plans, this is also a tax-deferred plan meaning that you will eventually pay taxes on this money.
I saved this section for last because I believe that these accounts offer maximum advantages. These are what I call tax-free accounts. Let’s dig in
HSA (Health Savings Accounts)
- This is the only account where you never pay any taxes. This account has what I call a triple tax advantage. Money goes in on a pre-tax basis, grows tax-free and you can withdraw it tax-free if you use it for qualifying expenses related to your health visits.
- HSA accounts also have a limit on how much you can contribute (current limit in 2020: $7,100 for married couples). This account is offered by employers and you will need to enroll in a high deductible health plan to take advantage of a HSA plan.
- You can max it out every year and invest in an index fund. Let it grow and this can be used to provide self-health insurance even after your retirement.
- Usually, the investment choices are restricted as per the employer plan.
Roth IRA/Roth 401K
- The difference between a Roth IRA and a traditional IRA is that in Roth you invest post-tax money, it grows tax-free and you never pay any taxes on qualified withdrawals whereas in a traditional IRA, you are just postponing your tax liability.
- The $6,000 (or $7,000 if you are 50 or above) per person per year limit is a combined limit on traditional or Roth IRA meaning you can invest a total $6,000 (or $7,000 if you are 50 or above) in traditional and Roth IRA.
- Unlimited investment choices to invest in a Roth IRA
- Roth 401K is offered through employers where you can contribute post-tax money and withdrawals are tax-free. Not all employers offer a Roth 401K so check with your employer.
- Investment choices in a Roth 401K are usually limited as per the employer plan.
- I prefer the Roth IRA over a traditional IRA account because of its tax advantages. Although there are income limits to open a Roth IRA, you can avoid those income limits by doing a backdoor Roth IRA. I will cover the Backdoor Roth IRA in a future article.
The focus of this article is to invest for retirement. There are a couple more accounts that offer the tax-free feature (529 accounts and Coverdell accounts) that I will explore in a future article.
If you are starting out investing, it is very important to start with the right accounts for your situation so that you can optimize your tax structure. I personally have a regular taxable brokerage account, 403B Plan, HSA and a Roth IRA. Having a Roth IRA can result in tax savings of tens of thousands of dollars over time.
Once you have opened these accounts, decide what stock/index fund you want to buy and you are ready to invest. If you are confused with any of these accounts and their features, feel free to post comments below and I will try to answer your questions in a future article. This is my interpretation of these plans. Do you have a different take on these accounts? If so, let me know by commenting below.