Besides your bag, which may be an investment in itself, there are a several specific accounts that are designed to help you financially plan for the future.
Checking & savings
First things first, we have our basic checking and savings accounts. These are not meant for long term planning and are really much more for day to day, short term use. In my savings account I keep just the money that is set aside for short term or emergency use, so there’s enough to cover rent for a few months should I ever find myself in a bad spot, or perhaps to use if anyone in the family (heaven forbid) had an accident and our insurance (human or pet) didn’t cover it, or something similar like that.
High interest savings account
Then there are the high interest savings accounts, determined by the APY: annual percentage yield. That aren’t actually high interest at all… When they’re called high interest, that is purely in relation to how much interest you get on your everyday checking and savings accounts. Do you know how much that is? At Bank of America I get a whopping 0.01% interest rate. That is basically zero. High interest rate accounts typically offer between 0.75% – 1.3%. Which, when you take inflation into account, is actually less than zero because inflation tends to increase at a rate of about 2% (so far over the past 12 months the inflation rate has been 1.73%). Inflation is important to take into account because it is determines general increase in prices of everyday goods and services and the decrease in the purchasing power of our money. More about inflation here – applicable for both Canada and the US. Don’t ever fool yourself into thinking more money is fine in a “high interest” savings account. It is doing nothing but sitting there and over the course of a year (depending of course on the economy that year, but in most cases), actually losing purchasing power.
Then we get into the actual investment accounts, not savings accounts, investment accounts.
Roth IRA (Individual Retirement Account)
The account is named after former Senator William Victor Roth who proposed the account to Congress as part of a retirement planning initiative in 1997. A Roth IRA holds after-tax money and is designed to help you invest. You can make contributions up to a specified amount each year and then invest that money within this account. In 2017, if you are under 50, you may contribute up to $5,500. If you are 50 or over, you may contribute $6,500. Money invested within the account grows tax free; your gains are not taxed, if you withdraw them at the specified age.
Withdrawals from contributions made to the account are tax and penalty-free under age 59. Withdrawals from contributions made to the account and earnings made on the money invested within the account are tax-free after the age of 59.5. Bit of a difference there. If you withdraw from your Roth IRA before 59.5, then your gains are subject to your income tax rate, as well as a penalty fee of about 10%. However, there are some exceptions that allow you to withdraw money early, like taking out $10,000 to put towards your first home.
Traditional IRA (Individual Retirement Account)
This account takes your pre-tax money. You can contribute up to $5,500 until the age of 50, putting that money into investments. Then, when you withdraw the money in retirement, you are taxed on that money at your current tax rate, which presumably is lower in retirement.
This is one reason I don’t love this account. If I plan on being a successful entrepreneur with hopefully several sources of income and passive income, then as I grow older my tax rate is likely to increase. If I were to put money into a Traditional IRA and have legit money at that time in my life, then I’m essentially saving my money in order to give more of it to the IRS in my later years. I don’t really plan on ever being traditionally retired.
However, if you’re in the type of career that provides a pension or you plan on stopping working at a certain age, then this account may be right for you.
Withdrawals are allowed after the age of 59.5, and must be made by the age of 70.5. If you withdraw money early, you incur a 10% penalty fee.
Both the Roth IRA and Traditional IRA are self or advisor-guided investment accounts, meaning that fees paid on investment transactions (like stock market trades), are quite minimal.
401K
The 401K is also an investment account designed to help you save and create money for retirement, but done through your employer. Your employer deducts IRA contributions from pre-tax income and may match or partially match your set contributions.
Three things that I don’t like about this account:
- It’s likely that the money your employer matches is vested, meaning that it only legally yours after having been with the company for a set period of time, say three years. In today’s world, it’s quite frequent that we’re not with a company longer than a couple years, so the 401K might be of great benefit to you.
- If you leave the company before your set amount of time, you may forfeit all matched contributions.
- Because the 401Ks at your company are managed as a large group, they’re managed by an investment firm meaning you a) don’t get to choose your investments and b) are subject to a management fee. Historically, returns on 401Ks are not great.
Having said all of this, if the account does work for you, then the matched contributions are pretty much free money and worth taking advantage of.
I hope this was clear and helpful!
