Investing in the stock market has been a great way to build long-term wealth for almost as long as the United States has been a country. And as retirements continue to increase with people’s lifespans, it’s becoming more and more important to protect your savings from inflation by earning a steady return. Thankfully, investing has never been more accessible than it is today.
The proliferation of online investment platforms and robo-advisors has greatly increased the options for those looking to make their first foray into investing. Should you use a financial advisor or go it alone? What’s the difference between a robo-advisor and an online brokerage account? And what sort of tax protection can a retirement account provide?
Broadly speaking, brokerage accounts can be classified across two criteria: Whether they’re managed by you or another party, and whether they’re taxable or a tax-advantaged retirement account.
Self-Directed Brokerage Account
The self-directed brokerage account is an investment account that gives you complete control of your portfolio. A brokerage firm serves as a custodian of your assets. You’re in charge of doing your own research and choosing your own investments. Note that this doesn’t necessarily mean you’re researching and choosing individual stocks. You can, for instance, fill your self-directed account with actively managed mutual funds, which means that a fund manager will be picking the stocks themselves. But it’s up to you which funds you want to put in your portfolio.
Online brokerages like Fidelity, Vanguard, TD Ameritrade and E-Trade are big players in this space. But virtually all major brokerage firms offer a way to manually choose investments. You’ll often, but not always, pay a commission for buying and selling investments. Robinhood, a relatively new brokerage that exists only as a mobile app, has made a big splash by allowing investors to trade with no fees or commissions. Other brokerages will offer commission-free trading of select mutual funds and ETFs. How much you pay in fees can range from platform to platform, so make sure you do your homework.
Most people choose to manage their self-directed brokerage accounts online through the brokerage’s website. Still, brokerages will generally allow you to make trades over the phone, though they’ll usually charge an extra fee.
In its most basic form, a self-directed brokerage account is a taxable account. This means there’s no deduction or other tax advantages to the account. Any dividends paid out to you will be considered income; any securities you sell at a profit will be taxed as either income or capital gains.
However, there are also self-directed individual retirement accounts (IRAs), which have tax advantages. We’ll discuss IRAs in more detail later.
An investment account with a robo-advisor is a new investment option that’s come along in just the last decade. A robo-advisor is a company that digitally manages client’s investments using proprietary software or an algorithm rather than human advisors. Typically, it invests client assets in a variety of exchange-traded funds (ETFs). The software automatically makes trades and rebalances each portfolio as needed.
When you open an account with a robo-advisor, you’ll answer a series of questions about your financial situation, your investing goals and how risk-averse you want to be with your investments. The robo-advisor will use your answers to tailor how it manages your portfolio.
Because robo-advisors manage clients’ assets digitally, they typically have no need for human advisors. This significantly reduces the cost of robo-advisor services, which is part of why they’ve become so popular. The downside is that you’re not getting tailored financial advice – just a mix of investments.
Robo-advisors have risen greatly in popularity since they first came on the scene following the 2008 financial crisis. Betterment, the first publicly available robo-advisor, has more than $13 billion in assets under management. Wealthfront, Wealthsimple and Acorns are other top robo-advisors, and many traditional brokerage firms have started similar services.
Most robo-advisors offer tax-advantage retirement accounts like IRAs. And if you open a taxable account, many will offer automated tax-loss harvesting to help minimize taxes.
Advisor-Directed Brokerage Account
This is the oldest type of investment account, as financial advisors have been doing business with wealthy investors for about as long as the stock market has been around. If you open an account with a registered investment advisor, the advisor will manage and monitor your portfolio for you, typically charging a fee that’s a percentage of your assets under management.
Working with a financial advisor provides a few benefits. Advisors have expertise that can be difficult to obtain yourself through independent research. They may also have special access to exclusive investment products. They also typically offer financial planning services that encompass your whole financial picture.
More comprehensive services comes with a higher price tag, however. Investing with the help of an advisor is typically the most expensive way to invest. Many advisor firms have account minimums, and their services are generally targeted toward investors with either complex financial situations or hundreds of thousands of dollars to invest. If you’re a new investor and you’re only looking to test the waters of the stock market, this route most likely won’t be the worth the cost.
Retirement Account – 401(k)
A 401(k) plan is the most well-known type of defined contribution plan. A defined contribution plan is a retirement account where you contribute a set amount at regular intervals. In retirement, you withdraw money from the account as needed. This is opposed to a defined benefit plan, such as a pension, where you receive a set payout in retirement for the rest of your life
401(k) plans are employer-sponsored. That means you’ll need to work for a for-profit company that sponsors a plan in order to have access. One of the plan’s key benefits is that contributions are tax-deferred. You divert a percentage of your pay into your 401(k) before it faces any income tax, and then you don’t pay any taxes until you withdraw the money down the line. This has two benefits. First, it reduces your taxable income in the moment. Second, since you’ll likely have a lower income in retirement, you may be in a lower tax bracket.
You’re responsible for setting up your plan, deciding how much of your paycheck to deposit and choosing investments. Some employers offer to match contributions up to a certain percentage of your salary. If this is your case, it’s in your best interest to contribute at least up to that percentage, since not doing so would effectively be turning down free money.
Retirement Account – Traditional IRA
An Individual Retirement Account (IRA) is a retirement account you open yourself. A Traditional IRA is tax-deferred. Similar to a 401(k) plan, you can contribute a portion of your pre-tax earnings to your IRA. Then you can invest the money in a portfolio of mutual funds, ETFs, stocks, bonds and other investments. Once you reach the age of 59 ½, you can take money out of your IRA without penalty. When you take money out, it will be taxed as ordinary income.
With a 401(k), the tax deferral happens automatically, because your employer removes your contribution before the government taxes it. With an IRA, you’ll have to manually deduct your contributions. Each year at tax time, you can deduct whatever you contributed to your IRA from your taxable income.
There’s a limit imposed by the Internal Revenue Service on how much you can contribute to IRAs and deduct. In 2019, that limit is $6,000, or $7,000 if you’re over 50 years old. However, you may not be able to take a full deduction if you have a 401(k) or other workplace plan and your income exceeds certain levels. For single taypayers with a workplace retirement plan, the deduction starts to phase out at $64,000, and disappears for incomes above $74,000. The IRS has more information on deduction rules and limits for different tax-filing statuses.
Retirement Account – Roth IRA
A Roth IRA differs from a traditional IRA in one key respect. Instead of contributing pre-tax dollars and paying income tax once you retire, you contribute after-tax dollars to your Roth IRA, but can then take tax-free income in retirement. This means you won’t be able to deduct your contributions from your taxable income.
While you miss out on a tax break during your working years, there is a big advantage to a Roth IRA. Since your contributions will appreciate and earn interest in your IRA, you can expect to have more in your account once you retire than just the sum of your contributions. That’s the whole idea of investing in the first place! So when the time comes to start taking income from your Roth IRA, you don’t just get to take out your original contributions out tax-free – you also won’t have to pay taxes on all the extra money you earned.
That gives a Roth IRA a big edge over a traditional IRA, where every cent you withdraw is subject to income taxes. This also means that a Roth IRA is at its most valuable when you open it at a young age. If you allow more time for the interest to compound, you’ll earn more tax-free money. Plus, if you contribute when your salary is lower, it means the tax you paid on those contributions was lower.
Your contributions will still be subject to the same annual contribution limits of $6,000 (or $7,000 for people over 50). And there are income limits on contributing regardless of whether you have a workplace plan. Single taxpayers with a modified adjusted gross income will see the contribution limit start to phase out at $122,000. If you make more than $137,000, you can’t contribute anything to a Roth IRA.
Tips for Investing Responsibly
- If the idea of managing your own portfolio is overwhelming, consider finding an expert, like a financial advisor, to help you. SmartAsset’s free advisor matching tool can help you find a qualified local advisor to guide you. Just answer some questions about your financial situation and goals. Then, the program will identify up to three registered investment advisors in your area who suit your needs.
- When it comes to protecting your portfolio against risk, achieving the right asset allocation is the most important thing you can do. By investing in several different asset classes and across different economic sectors, you’re not putting all your eggs in one basket. Investing in the right index fund or an exchange-traded fund (ETF) is an easy way to diversify your holdings.
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