Investing is not as scary as it seems. While all investments carry risk, not all are equally risky.
Before you hit the stock market with a tax-advantaged account, you can invest without taking too much risk and in places that could bring you more rewards.
Most retirement and related accounts invest in the stock market, but through a combination of stocks, bonds, certificates of deposit, mutual funds, and other types of investments. The benefit of investing through these types of accounts is that they are tax-free (or tax-deferred), which leaves more money in your pocket. Before you play the market through a standard brokerage account, here are the investment accounts you should maximize.
1. Maximize your 401(k) match
Having a company-sponsored retirement plan is one of the easiest ways to start investing.
The 401(k) contributions are made from your pre-tax salary and invested in predetermined funds, which takes all the guesswork and maintenance out of the investment. Better yet, some companies offer an employer match, which is when your employer contributes extra money to your retirement fund.
When you max out your 401(k) contributions, your employer will match your contributions up to a certain percentage, sometimes around 6%. The more money you can make from your business, the more you’ll have when it’s time to retire. If your company doesn’t offer a match, see if they have a plan available. At a minimum, maximize your 401(k) contributions. For 2020, you can contribute up to $19,500. 401(k) account managers at many companies have tools to help you determine what contribution rate will get you the maximum contribution.
2. Open an IRA
If you’ve reached your maximum contributions for your work-sponsored retirement plan or don’t have one available, open a retirement account.
Individual retirement accounts, or IRAs, are best for people who don’t have a 401(k) option at their business, are self-employed, or are looking for more ways to invest their cash. The two most popular are traditional IRAs and Roth IRAs (named for Senator William Roth, the main sponsor of the 1997 legislation that established the mechanism). The main difference is how the taxes are levied. For traditional IRAs, contributions and earnings are tax-deferred, but your distributions are taxable when you retire. Required minimum distributions are triggered when you reach age 72, which is when you must make minimum withdrawals from your account. Roth IRAs are subject to tax on the contribution or when you add funds to your IRA, and your earnings and distributions are tax-free. Roth IRAs don’t have RMDs, so you don’t need to withdraw them unless you want to.
While you can have as many IRAs as you like, you can contribute only the annual maximum.
For 2020, the maximum is $6,000. Roth IRAs are also subject to income limits. For 2020, your modified adjusted gross income must be less than $124,000 if you file single ($196,000 if married filing jointly) in order to contribute the full $6,000. If you’re over the income threshold but still want a Roth IRA, you can open a traditional IRA and then convert it. This is called a backdoor Roth IRA.
3. Contribute to a health savings account
An HSA is a savings account that is specifically for health-related expenses. HSA contributions, earnings, and distributions are all tax-free. If your employer offers an HSA, you can make contributions directly from your paycheck. HSAs are not FSAs (see below); FSAs are only offered through employers, while you can get an HSA on your own.
If you don’t use the money in your HSA this year, you can roll it over to the next year. That way, you can use it when a health need arises. HSA funds aren’t just for emergencies; you can use them for most health, dental, and mental health needs. For 2020, you can contribute up to $3,550 for individuals (or $7,100 for families).
HSAs are only available if you have a high-deductible health plan. If you have any medical needs and need a lower deductible, an HSA may not be the best investment for you. But if you don’t have many health needs and want to save in case one comes up, this type of account may work for you.
4. Open a flexible spending account
Some companies offer flexible spending accounts, sometimes called flexible spending agreements. FSAs allow you to contribute a portion of your income to qualified expenses, such as health care or dependent care.
The FSA money must be used before the end of the year, though it’s up to individual employers to grant a grace period to use it or lose it.
Due to COVID-19, many child care centers are closed, followed by many summer camps. That prompted many FSA providers to allow you to temporarily stop contributing if you planned to use your FSA for childcare-related expenses. Maximum contributions vary depending on your purpose. For example, if you use it as a health savings plan, you can contribute up to $2,750 (this amount is the same for families or single filers). For dependent care, you can contribute up to $5,000 for both individuals and married filing jointly.
5. Contribute to a 529 plan
A 529 savings plan is an education savings plan that works like a Roth IRA. Your after-tax contributions are invested in different types of investments, such as mutual funds. Earnings and distributions are tax-free as long as they are used for qualified education expenses.
Expenses are not limited to just tuition and fees; You can also use it for room and board, moving, equipment, and other related supplies. If you spend it on expenses that don’t qualify, you could face a 10% tax penalty.
If you open a 529 plan for your child but don’t use it, you can transfer it to another family member (including yourself). You can use the funds to pay for college, but 529 funds can also go toward K-12 educational expenses, such as charter or private schools.
There are also 529 prepaid college plans, which allow you to pay for your child’s tuition in advance at the going rate. Since college costs rise each year, locking in fees, for now, could prevent you from paying more by the time your child enters college. But they are only good for public colleges and universities in the state and are not widely available. There are currently 18 prepaid tuition plans in the US.