Questions New Investors Are Afraid to Ask: Part 3

Dear Readers,

In the past two columns, I’ve introduced different types of investments and the concepts you need to understand to put them to work. First, you need to know why asset allocation (how you divide your money between stocks, bonds, and cash) and diversification (having a broad mix of each of these types of investments) are crucial to your long-term success. Then you need to understand the differences between core investments and how they work together.

So, let’s say you know you’re looking for long-term growth, and you’ve researched and chosen a couple of mutual funds. Are you ready to buy? Not quite. There are a few more things to consider: what type of account to open, the impact of taxes, and how to keep your portfolio healthy—and, hopefully, growing.

Why the type of account is important

When you’re simply putting money aside, whether for a rainy day or for something special in the next couple of years, a bank savings account can work just fine. You’ll only make a small amount of interest, but you will have easy access to your money.

An investment account is very different. It’s offered through a brokerage firm and allows you to buy and sell investments like stocks and bonds. There may be an initial minimum deposit and account fees, depending on where you open your account. And some firms also charge a commission to buy and sell certain investments, so you’ll want to do some comparison-shopping to be sure you get the best value for your needs.

The financial institution is one decision, but you also have to decide what type of investment account best suits your goals: a taxable brokerage account, a tax-advantaged account—or both. The type of account will determine how much you can invest and when, and how your earnings will be taxed. Taxes are important because after all, it’s not just what you gain, but what you keep, that matters. Let’s break all of that down according to some common goals.

Taxable accounts for “anytime” investing

A brokerage account is the most flexible. Although remember, investing is for goals that are at least five years in the future. This allows you to weather the volatility of the stock market but benefit from the growth stocks provide. There are no limits on how much you can invest in these accounts and no timing considerations other than your own. You can invest as much as you want at any time and make unlimited withdrawals. That’s pretty straightforward. The tax rules, however, are a little more complex.

In a savings account, you pay income taxes on interest income whether or not you withdraw the funds. In a taxable brokerage account, taxes are a bit more complicated. You’ll pay income taxes on interest income, but you’ll pay either short- or long-term capital gains tax on any money you make when you sell an investment that’s gone up in value. In addition, you’ll pay long-term capital gains tax on qualified dividends.

Short-term capital gains are taxed at your ordinary income tax rate and apply to investments you’ve held for a year or less; long-term rates are generally lower than ordinary income rates—currently 0%, 15%, or 20% depending on your income. They apply to investments you’ve held for more than a year.

Tax-advantaged accounts for retirement and more

Tax-advantaged accounts are tailored to a specific goal like retirement or college savings. Earnings grow tax deferred to help you grow your money, but penalties apply to early or non-qualified withdrawals. There’s more to take into consideration, including contribution limits, tax benefits, and withdrawal rules, depending on the account. Here’s an overview of the most common tax-advantaged accounts.

• Employer-sponsored retirement account—With a 401(k) or other employer-sponsored account that allows voluntary contributions, those contributions can be made automatically from your paycheck, and you may get an upfront tax deduction. Annual contribution limits are sizeable—$20,500 for tax-year 2022, plus a $6,500 catch-up for those age 50 or older for some plans. Note: Some employers will contribute or match a certain percentage of your 401(k) contributions; you should always take advantage of this extra money.

• Individual retirement account (IRA)—As an individual with earned income, you have a choice of a traditional or Roth IRA (although a Roth IRA has income limits). Each has the same general annual contribution limit—currently $6,000 with a $1,000 catch-up for those 50 and older. Special contribution rules apply to Roths. With a traditional IRA, you generally get an upfront tax deduction on contributions, and withdrawals are typically taxed as ordinary income. With a Roth IRA, there’s no upfront deduction, but both earnings and withdrawals are tax-free, as long as you’re at least 59½ and have held the Roth for five years. So if you think you’re going to be in a higher tax bracket when making withdrawals, the Roth is likely the better bet.
• Health Savings Account (HSA)—If your health plan has a high annual deductible ($1,400 for individuals, $2,800 for families in 2022), you may qualify for an HSA. HSAs let you make annual deductible contributions (currently $3,650 for an individual; $7,300 for a family), and earnings grow tax-deferred. Withdrawals for qualified healthcare expenses are tax-free.
• 529 College Savings Account—This is a state-sponsored program that allows parents, family members—anyone—to invest in education. There is no federal upfront tax deduction, but earnings grow tax deferred and withdrawals are tax free for qualified education expenses.

How to stay on top of your investments

Once your investments are up and running, take a long-term view. That doesn’t mean you can ignore them, however. The closer you are to using the funds, the more you want to monitor your investments. You’ll want to re-examine your asset allocation and possibly rebalance.

Basically, rebalancing means looking at the percentage of stocks, bonds, cash, and other investments in your portfolio to make sure it aligns with your risk preferences and time to invest and making changes if necessary. For instance, if stocks have done well, it might be time to sell some and use the proceeds to buy bonds. If bonds have had an exceptional year, it might be time to sell a few in favor of stocks. This is the strategy the largest institutional investors, such as university pensions, use and will help you keep your overall plan on track.

When to get help

Even when you understand investing, it pays to get help once in a while. A periodic consultation with a financial professional can help you deepen your knowledge and refine your decisions.

But whether you work with a financial advisor or go it alone, the main point of these last three columns is this: Don’t be afraid to ask questions. Be persistent, get the information you need—and get started.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.