You’re ready to begin investing. Where do you start?
July 10, 2015
There are two parts to this answer, the type of account you want to open and the type of investment(s) you want in that account. For this discussion, we are going to use Josh as an example. He is in his twenties and makes $40,000 a year working for a medium-sized business that does not provide retirement benefits.
Account options
Josh first needs to decide what type of account he wants to open. The type of account he chooses will have two major effects on the investments in it. It may affect his taxable income, the tax status of the investments and possibly his ability to access these funds without penalty. His three most common options are an Individual Brokerage Account, an IRA and a Roth IRA
Individual Brokerage Account
This is a complicated name for a simple, basic account. This account is a taxable account in which he can buy and sell securities. The costs and services of this account vary depending on the company the account is held with.
Traditional IRA
Individual Retirement Accounts are meant for retirement savings. If Josh chooses this account, it is to begin investing for his retirement. The federal government set up these special accounts to help Americans save for retirement by giving them tax breaks. Funds that are deposited into this account are pre-tax income that is then sheltered from taxes until they are withdrawn. The investor pays income tax on the amount withdrawn at the investor’s current income tax rate. The tax code limits the amount of money that can be deposited in the account each year and who may deposit funds in an IRA based on income. When a traditional IRA owner reaches the age of 70½ the tax code requires them to begin taking Required Minimum Distributions (RMDs) from their account. The government wants their cut of your money before you pass it on. Any distributions (withdraws) from an IRA account before the investor reaches age 59 ½ are subject to a 10% penalty except in certain circumstances. For more details see the IRS IRA Online Resource Guide at http://www.irs.gov/retirement/article/0,,id=137320,00.html
Roth IRA
Roth Individual Retirement Accounts are named after Senator Roth. They differ from traditional IRAs in that they are funded with after-tax money. Because the government already got their cut they do not require RMDs.
Simple Investments
The basic investment options that Josh has to choose from include cash, stocks, and mutual funds. Once he deposits money into an account it will likely be placed into a money market fund. The money market fund is a cash equivalent that is meant to try to give investors some return on cash when it is not invested elsewhere. When an investment is purchased the money market is sold and the proceeds of the sale are used toward the purchase.
Stocks
Buying a share of stock is buying a portion of a company. The shareholders are the owners of the company. The total value of a company is equal to the stock price times the number of outstanding shares of stock. Some companies are more stable than others but no company is absolutely safe from going out of business. If this happens the stock price falls to zero and the stockholders lose all of the money they invested.
Mutual Funds
If you don’t have a lot of money to spread around, a lot of time to devote to investment research or just money you are willing to gamble with you may want to look into mutual funds. A mutual fund is an investment fund that is set up to help smaller investors to purchase a lot of different investments while sharing the overhead costs of trades and professional research and management. This way an investor with a few thousand dollars can buy a similar set of stocks as an investor with hundreds of thousands of dollars. Some mutual funds own stocks, some stocks, and bonds, some even own other mutual funds. There are more than 20,000 mutual funds to choose from so you can probably find one that owns most anything you are looking for.
The Decision
Josh has decided that he is going to save toward his retirement through maximizing his contribution this year by depositing $5000 into an IRA. He believes that he is in a lower tax bracket now than he will be when he retires so he is choosing to pay his taxes now and contribute to a Roth IRA. He sat down with an investment advisor who gave him a risk tolerance questionnaire to help determine how risky he could stand to be with his investments. The results showed that Josh was about average. This meant that individual stocks are too risky of an investment for him with a $5,000 portfolio. He deiced to buy a mutual fund. For diversification, he chose a mutual fund that owns other mutual funds. Today Josh has made many important decisions but the best decision that Josh made was to start saving.
For more details about investment options, you can see other articles at http://www.examiner.com/x-8367-DC-Personal-Finance-Examiner