Simplifying Investing - Accounts vs Holdings
Now that you are ready to invest, some of the fear and anxiety around the topic should have eased. But there are likely still a lot of unanswered questions about how to tactically approach investing for long-term success. In this article we will dive into the difference between accounts and the holdings (investments) that are in those accounts.
Accounts
The first thing to understand about investing is the difference between an investment account and investment holdings. An investment account is similar to any other account like a checking or savings account – it just holds money. A 401k is an example of an investment account. You can have a 401k account, but if you aren’t investing the money in that account, you really just have a savings account. The money in the account, and the dividends, should all be invested in order for that account to grow to a nest egg that can sustain you through retirement.
401k
The first accounts you should invest your dollars in are tax-advantaged retirement accounts, like a 401k. If you’re not already getting your full employer 401k match, stop now and go set that up. Make sure the money is invested in low cost index funds or a target date retirement index fund. More on that here.
Although a 401k is a great investment account, we actually recommend a couple other accounts before investing more than what gets you the full employer match before putting additional dollars into a 401k in most cases.
Roth IRA
A Roth IRA (Individual Retirement Account) is another excellent investment account. If you meet the requirements to open a Roth IRA, we recommend maxing out this account before investing more in your 401k. Roth IRAs have a few advantages over traditional 401ks:
Tax-free growth – with a Roth IRA, you pay taxes on the money invested before you invest. But these dollars have the ability to grow tax-free meaning you don’t have to pay taxes on the money when you use it in retirement.
Investment options – with your 401k, your investment options will be limited to what your employer offers in the plan and you will be stuck with the fees associated with those options. With a Roth IRA you will have more options for investing and can typically find options with much lower fees than what is offered in your employer-sponsored plan. We recommend sticking with index funds and target date retirement index funds with low fees in your Roth IRA.
Emergency use – this seems to be a little-known advantage of a Roth IRA, and should be used with extreme caution (ideally, not used at all). Your principal contributions can be withdrawn from your Roth IRA with no penalty. This means that your Roth IRA can be used as a backup to your regular emergency fund (which you should have before investing).
HSA
The next account to look to is a Health Savings Account. This is a type of account offered to people on a high-deductible health insurance plan. Essentially rather than paying a high premium, and having a low deductible, these plans give you the option to pay a lower premium and put additional money into a Health Savings Account for medical expenses. That money can then be used for qualifying medical expenses and to meet your deductible and out of pocket max.
What many people aren’t aware of, is that their HSA can actually be used as an excellent retirement account, because the dollars in this account can be invested to grow tax-free.
If you qualify for a Health Savings Account, and if your families’ medical needs align with the use of this type of account, we recommend maxing this account before putting more money into a 401k.
HSAs are considered a triple-tax-advantaged account, meaning there are three ways of getting a tax break with these accounts. 1. You don’t pay taxes on the money you put into the account. At the time of this writing, the maximum annual contribution to an HSA is $3,850 for individual coverage and $7,750 for family coverage - that’s a big tax break. 2. You don’t pay taxes when you use this money for qualified medical expenses. 3. Interest and earnings on your investments are tax-free.
We recommend keeping at least enough cash in your HSA to cover your deductibles if not your out of pocket max – the rest should be invested (in low cost index funds or target date retirement index funds).
Other
Once you’ve maxed out your Roth IRA and Health Savings Accounts, you can now look at putting additional money into your 401k, opening a brokerage account (this is just a regular investment account with no tax advantages), investing for your kids in 529s, real estate, etc. We’ll get into these types of investments in the future.
Holdings
Now that we’ve covered the accounts that you can utilize, let’s talk about what sort of investments you’ll be putting your hard-earned dollars toward. Most people are aware of the terms “stocks” and “bonds”. These are typically the options you are looking at when considering investment funds. Let’s talk about stocks first.
A stock is essentially a small piece of a company. When you buy a share of a company, you are now an owner of that company. Every company’s stock or share price is different and based on a myriad of factors that we won’t get into in this article.
Next is bonds. In simple terms, a bond is an instrument used by companies and governments to raise money by borrowing from investors. An issuer (company or government) would owe the holder (you, the investor) the money back plus whatever the terms of the bond are. Bonds are typically more stable than stocks and are used to keep an investment account more stable through the ups and downs of market volatility.
Many of the options you have in your 401k will be funds, rather than individual stocks or bonds. This is a good thing – we do not recommend investing in individual stocks. We like to simplify this process and use funds.
There are two types of funds that you will usually have available, mutual funds and index funds. These funds are like buckets of stocks and/or bonds. Mutual funds are actively managed, meaning someone chooses which stocks and bonds to place in the bucket. Index funds are passively managed – they track a specific index of stocks or bonds and systematically place them in the bucket. The S&P 500 is an example of an index fund – it tracks the approximately 500 largest companies in the United States – by buying this fund you are automatically buying stocks in the 500 largest companies in the U.S. rather than having to go buy individual stock in those companies.
The statistics show that passively managed index funds actually beat actively managed mutual funds the vast majority of the time when looking long term.
There are many strategies that can be used to diversify the holdings in your accounts to make sure you have a good balance of stocks and/or bonds.
There is a good argument, especially for young people, to go all in on stocks. A portfolio of 100% U.S. stocks like VTSAX (Vanguard’s total stock market index fund) can actually be a really good option for someone who is young and isn’t going to be swayed by market fluctuations. We have a small investment account that we put money in for each of our kids that is 100% U.S. stocks.
The argument against a 100% U.S. stock allocation is that you’re missing out on the international market. You could opt for a still simple, but slightly more diverse option like the 3-fund portfolio. This is where you would buy just 3 funds and allocate a certain % to sit in each of them. For example: 50% U.S. stocks, 40% International, 10% bonds. With this approach you would need to rebalance your portfolio every year or so to make sure you’re staying within your desired percent allocations.
Note: without manual rebalancing, notice the inconsistency of asset allocation year over year. This could lead to more volatility in a portfolio than desired.
This last option is our personal favorite because it is the simplest form of asset allocation. Target date retirement index funds.
JL Collins, author of “The Simple Path to Wealth”, calls target date retirement funds the “simplest path to wealth”. Fees may be slightly higher, performance may fall slightly short of an all stock allocation on a good year, but these funds are passively managed, automatically rebalanced, and perfectly suited for the simple, stress-free path to financial independence.
The idea behind these funds is that as you get closer to retirement, you want a less-aggressive portfolio that will be less swayed by market volatility (more money in bonds and less in stocks as you near retirement age). With a target date retirement index fund, you set it and forget it. No need to rebalance or worry that you have too much money in one type of investment, it will automatically rebalance for you.
