Roth IRA or taxable brokerage account
If you already have a fully funded emergency fund and are contributing regularly to a retirement account like a 401(k), you’ve got a head start.
Only about half of American families participate in the stock market in some way, according to a study by the St. Louis Fed. As for millennials (23 to 38), about 60% have no direct or indirect exposure to the stock market.
Most financial experts recommend that before you jump into the market, you should save up to three to six months in living expenses. That way, if you run into trouble, you have money on hand, rather than having to cash out your investments or be forced to pay a penalty to access the money saved in a retirement account. .
Experts are also urging people to regularly contribute 15% of their earnings to retirement accounts, or at a minimum, enough to meet any employer.
But if you’ve checked both of these boxes and you still have money left over at the end of the month (beyond what you spend on your fixed expenses), it can be difficult to figure out what to do with it.
Don’t get me wrong, that’s a good problem to have.
Understand why you are investing
Take the time to assess your finances and goals. Do you have debts to repay? If so, focus on those before creating another investment account. You don’t have to be completely debt free, but you should have a responsible plan in place to take care of these commitments over time.
If you’re debt-free or already working to pay off your balances, focus on your future goals. Do you want to buy a house? Start a family? Start your own business? Add an extra cushion to your retirement? Also look at when you would like to achieve your goals.
“The time horizon is the driving factor here,” Ron Guay, financial planner at California-based Rivermark Wealth Management, told CNBC Make It. Why you want to invest impacts how you should invest. If you have a short-term goal – like buying a house within the next three years, for example – experts say you should look for a more conservative investment like bonds, or even keep the money in a savings account at high yield.
Most people should start with a Roth IRA
If your goal is retirement or long-term wealth accumulation, Guay recommends storing any additional savings in a Roth IRA, which is a tax-free investment account. Unlike 401(k) contributions, any money you add to a Roth is added after taxes have been taken out of your paycheck. But the money can grow, and you don’t have to pay income or capital gains tax if you withdraw correctly.
Morningstar personal finance director Christine Benz also recommends investing in a Roth IRA before opening a brokerage account. “Investing in something that gives you tax relief will almost always be better than investing in a taxable account,” she told CNBC Make It.
“I think a taxable account is something to explore after you’ve funded your 401(k) and your IRA,” adds Benz, saying a brokerage account is best suited when you need better access to your money and for goals that may have a shorter time horizon than the 30-40 years that most millennials have until retirement.
Roth IRAs also offer investors great flexibility, experts say. One of the beauties of the Roth, says Guay, is that you can withdraw all the money you put into the IRA at any time without taxes or penalties. And after your account has been open for at least five years (or you’ve reached age 59.5), you can withdraw any investment income without incurring the typical 10% penalty.
Additionally, most Americans face a retirement deficit. The progressive Economic Policy Institute think tank found that Americans between the ages of 56 and 61 had a median balance of $21,000 in their 401(k) accounts in 2016, which is the most recent data on file. . This total reflects nearly 30 years of savings.
The younger generations are not faring much better. Older millennials (32 to 37) have about $1,000 saved in their 401(k)s. Spending more money on your retirement is therefore almost never a bad idea.
When a brokerage account makes sense
Roth IRAs can be great, but there are some restrictions to consider when investing in these accounts.
First, there’s a limit to how much you can invest: in 2020, you can set aside $6,000 in a Roth IRA and allow it to grow tax-free. Second, you can only make full contributions to these accounts if your adjusted individual adjusted gross income is less than $124,000 this year ($193,000 for those who are married and filing jointly).
Plus, due to contribution limits, you can’t accumulate a huge nest egg overnight, and any returns are locked in for at least five years. This can be a problem if you’re saving for a purchase you want to make in less than five years, like buying a car, putting down a down payment on a house, planning a big wedding, or planning a can’t-miss international vacation. .
If you’re saving for a purchase you plan to make in less than five years, or if you’re earning too much to contribute to a Roth IRA, consider using a taxable brokerage account to grow your money. risky investments to avoid paying penalties. Another option is to open a high yield savings account.
Of course, you can invest in both places and have the High Yield Savings Account in addition to your Emergency Savings Account. All major brokerages, including Fidelity, Schwab and Vanguard, allow customers to set up a Roth IRA account and a taxable account at the same time, said John Crumrine, CFP and founder of North Carolina-based Brunswick Financial, at CNBC Make It.
“Getting these in place is sometimes the biggest hurdle for new investors,” he says. But once the accounts are open, you can set up an automatic transfer to split your monthly contributions between the two accounts.
“For most investors, ultimately having a mix of taxable, tax-deferred, and tax-exempt accounts gives them the most flexibility for whatever the future throws at them,” Crumrine says.
Don’t miss: Here’s how to finally start investing in 2020
Do you like this story? Subscribe to CNBC Make It on YouTube!