Investing 101 – Part 3: Accounts You Can Invest In (US Edition)

So we now have a grasp on some of the basics of investing and it’s now time to dig into the various accounts that you can choose to open up. If you missed the first two posts of our Investing 101 Series you can find them here first:

• Investing 101 – Part 1: Introduction
• Investing 101 – Part 2: Compound Interest

When it comes to investing, it’s important to note that you’ll need to decide on two things:

1. What type of investment account to open up
2. What funds to fill that account with

That’s really it.

It sounds simple, and really, it is.  Yet because we aren’t taught what to do and there are SO many accounts and WAY MORE funds to choose from, investing can seem intimidating to most people.  Today’s post will focus on the various types of ACCOUNTS you can choose to invest your money in.  Another post will be entirely focused on what FUNDS you can fill these account up with.

Dolla Dolla Bills Y’all

Most people reading this likely have some cash on hand either in their wallet or in a special drawer at their home. There comes a point though when you don’t want to have all this cash on hand from your pay check. So where do you store it?

Enter in the Big Banks

Most people open up a checking and sometimes a savings account with their local big bank of their choosing (eg. Bank of America, Chase, Wells Fargo, etc. in the States or TD, RBC, BMO, Scotiabank, CBIC etc. in Canada). Most of these banks offer direct deposit where your pay check can get automatically funded from your employer into your bank account to save you an extra step of having to deposit the check yourself.

Great, grand. This is nothing new to most people reading this.

But what happens when you are able to grow that gap of your income and your expenses (because you are subscribed to blogs like this to learn how to be a valuist badass) and you see that checking account starting to grow?

First off, pat yourself on the back for not having a negative balance!

Secondly, pay off any debts you may have that have an interest rate higher than 6%. Most mortgages these days have interest rates closer to 3% so no need to kill this off ASAP unless you’re very debt adverse like us. But if you have consumer credit card debt or high interest rates on any student loans I’d suggest tackling those first before trying to become a millionaire in the stock market. Note: if your company offers any sort of company match (be it in a 401k for Americans or Group RRSP for Canadians) make sure you’re investing in that match or else you’re giving away free money!

Third, have a sufficient emergency fund stashed up. My personal suggestion is to have at least 6 months of your current expenses stocked away in a high interest savings account. A savings account with your local branch big bank is not the same as an online high interest savings account. Most big banks offer savings accounts, but have you ever actually looked to see what interest rate they are providing you?

Let’s take a look at two big banks, TD Bank from Canada and Bank of America from the States.

Here is the table for the list of interest rates TD is offering for their savings accounts:

And below is a similar list of interest rates offered by Bank of America for their savings accounts:

Guys, these interest rates are TERRIBLE! The whopping 0.05% interest rate at TD means that for every $1,000 in that account, you will make $5. Five freaking dollars are you kidding me?! Bank of America is no better giving 0.03-0.06% (aka $3-6 for every $1,000) depending on the account.

These banks are taking your money and lending it out to others at 5-20% interest (depending on the product) and then you get a measly 0.05% return for choosing them as your savings account. No wonder why banks have a solid earnings reputation, they literally are making money off of every customer they have! (On a side note, I do understand why investing in individual bank stocks as part of the Canadian dividend tax credit makes sense. These suckers aren’t going anywhere. Although I do hope more and more online-only low fee banks continue to make headway.)

High Interest Savings Accounts

Instead of keeping your emergency fund with a big bank where you can’t even keep up with inflation, I’d suggest Googling “best high interest savings account” and doing some research for your country to see who is offering the best rate (these banks are always trying to one-up each other so the best rate/bank today will be different tomorrow. Ratehub tends to be a good site to compare different rates but look elsewhere too to ensure you’re not missing anything. Beware of ads and sponsored posts/links that may be bumped up to the top of the list but aren’t really that stellar. Personally, we have our Canadian high interest savings account opened with Motive in their Savvy Saver account which we earn 2.8% interest. (No, we are not getting paid by them. Let’s make this clear upfront. We have no financial motive to anything here. We are simply trying to show you what’s out there. Do your own research!)

A lot of these smaller, online-only, banks are able to provide a much higher interest rate because 1.) they don’t have as much overhead having to staff physical locations and 2.) they don’t have to pay rent for any physical locations. Motive’s 2.8% interest is literally 56 times the amount of interest that TD’s 0.05% provides. That means for every $1 you have in your Motive account, you would need $56 in your TD account to see the same return.

I know the next question you’re probably thinking is, “are these banks safe?”

Typically, the answer is yes. Again, do your research.

If the institution is a member of the Canada Deposit Insurance Corporation (CDIC), then your funds are insured up to $100,000 per customer if the bank should go bankrupt. Similarly in the States, you want to ensure these banks are a member of the FDIC (Federal Deposit Insurance Corporation) which ensures up to $250,000 per person if there is a bank failure.

So not only do these online-only banks offer the best interest rates, but they are safe and reliable and typically offer low to no additional fees or requirements.  Many of them allow you to deposit and withdraw a substantial (if not unlimited) amount per month for no extra fee. 

What’s Next?

Ok now comes the fun part. You now have sufficient savings in check to account for an emergency fund or to save for a deposit for an down payment for a home, etc.

What is the next step?

Now it’s time to dip your toes into the market.

Every person is going to be in a different situation and have a different risk profile so unfortunately there is no one size fits all as to what type of account to open up and what to fill it up with.

Here are a list of different accounts you can choose to open up:

US Accounts:

• Traditional 401k
• Roth 401k
• Traditional IRA
• Roth IRA
• Spousal IRA
• HSA
• 529 Plans
• CDs
• Brokerage

Canadian Accounts:

• TFSA
• RRSP
• Group RRSP
• Spousal RRSP
• RESP
• GIC
• Brokerage

Part 5 of the Investing 101 Series will solely be focused on the tax advantaged accounts so we won’t go into too much detail on those types of accounts on this weeks post.  Stay tuned for that – it’s a LONG post and digs into both the US and Canadian tax advantaged accounts (traditional and Roth 401ks and IRAs in the States and TFSAs and RRSPs in Canada). Today’s post will focus on the US accounts and touch on the general definitions of these different accounts. Part 4 of the Investing 101 Series will be a similar post as today but focused on the Canadian accounts.

Let’s dig in.

US Accounts

Traditional 401k

A traditional 401k is an employer-sponsored plan that gives employees a choice of investment options.  Note that the number of investment choices varies depending on what plan your employer is enrolled in (and it is likely limited).  Employee contributions to a 401k plan and any earnings from the investments are tax-deferred.  This does NOT mean tax free. This means that you will get a tax break this year but then you WILL pay taxes on your contributions and earnings when the savings within the account are withdrawn down the road depending on your tax bracket at the time of withdrawal. Depending on your employer, instead of enrolling in a 401k you may instead have the option of a 403b or a 457b or a 457f.   A 401k is offered to employees who work for at a for-profit company.  A 403b plan is typically offered to nonprofit employees and government workers, including public school employees.  A 457b is offered to state and local government employees. A 457f is for highly paid non-profit employees.

Roth 401k

A Roth 401k is similar to a traditional 401k in the sense that it is an employer-sponsored investment savings account however the main DIFFERENCE is that a Roth is funded with after-tax dollars up to the plan’s contribution limit. This type of investment account is well-suited for people who think they will be in a higher tax bracket in retirement than they are now, as withdrawals are tax free. No one really knows what the tax code will be in the future so it’s a bit of a gamble deciding which 401k account to invest in (traditional vs Roth – if you employer even offers both that is) but most people tend to fall in a lower tax bracket in retirement when they are withdrawing from these accounts (meaning they are living off a lower income in retirement vs their current income today, assuming no changes to the tax structure). However, if you don’t want to deal with taxes down the road whatsoever (many could speculate that taxes will be higher in the future but who knows), go with Roth to get the taxes paid upfront and to be done with it. Not all employers offer a Roth 401k, it’s much more standard to have a traditional 401k offered by your employer.

Traditional IRA

A traditional IRA is a type of individual retirement account that lets your earnings grow tax-deferred (similar to a traditional 401k). An IRA is not linked to your employer in any sense but in order to contribute into an IRA you must have earned income in order to contribute. You pay taxes on your investment gains only when you make withdrawals in retirement. There is no age tied to an IRA so technically if your child is employed and earning income, you can set up an IRA for them. And IRA is more flexible in that you can open an IRA account up yourself with any brokerage you chose and can invest in any fund that you choose (whereas the 401k tied to your employer typically has more limited options to chose from).

Roth IRA

A Roth IRA is another tax advantaged savings account. Like the Roth 401k, Roth IRAs are funded with after-tax dollars meaning that the contributions are not tax-deductible for the tax year in which you contribute. But once you start withdrawing funds, the money is tax-free. Like Roth 401ks, Roth IRAs are best when you think your taxes will be higher in retirement than they are right now. Like traditional IRAs, a Roth IRA is not tied to an employer, anyone with earned income can open up a Roth IRA in their own. 

This is a great account for kids/teenagers to open up as their income is likely high very high during these years so they can invest after tax dollars (likely paying $0 income tax for a part time side gig) and have the money grow tax free and pay no taxes when it comes time to withdrawal.

However, there are income limitations so not everyone is eligible to contribute into a Roth IRA.  You must earn less than $122,000 as a single filer or less than $193,000 as a couple to qualify for a Roth IRA.

(Note that there is a completely legal workaround to fund a Roth IRA if you exceed the income threshold – this is called a Backdoor Roth. Essentially the process is that you contribute into your traditional (tax-deferred) IRA, convert the account to a Roth IRA, pay taxes on the amount converted, and file an 8606 tax form. If you already have money saved in a traditional IRA the Backdoor can be a little bit more tricky. Please seek financial advice from a professional for more information.)

Spousal IRA

A spousal IRA is a strategy that allows a working spouse to contribute to an IRA in the name of a non-working spouse to circumvent income requirements. This creates an exception to the provision that an individual must have earned income to contribute to an IRA.

Again, we will dig much further into these tax-advantaged accounts in Part 5 of the series but the key takeaways are:

Traditional vs Roth: Traditional is pre-tax money so you’ll get the tax benefit this year when you file your taxes but owe taxes when you withdraw. Roth is after tax money so you pay taxes on the money now and see the tax benefit down the road when you withdraw from these accounts tax free.

401k vs IRA: 401k is part of an employee plan whereas anyone with earned income can contribute to an IRA on their own.

You can invest in BOTH a 401k and IRA (and we suggest you do). There are limits to the maximum contribution you can invest in a given year (the limits are constantly changing so a simple Google search will tell you how much you can contribute annually). You can contribute to BOTH a traditional IRA and a Roth IRA in the same year if you’d like but you cannot exceed the IRS limit for that year ($6,000 in 2019 +$1,000 catch up for those 50 and older). Similarly, if your employer offers both Roth and traditional 401k plans, you can chose to invest in both. Your total contributions cannot exceed the IRS limits ($19,000 in 2019 + $6,000 catch up for those 50 and older). But within this limit, you can invest a portion in a traditional plan and a portion in a Roth plan (if you choose to do so and if your employer offers both options).

HSA

An HSA stands for a Health Savings Account and some argue that this account is one of the most powerful accounts available to some Americans due to its triple tax advantage.  What I mean by this is that an HSA allows you to put away pre-tax (or tax deductible) dollars into an HSA account and have them grow tax free.  You may use the money tax-free if its for medical costs. You will get hit with a penalty if you use the funds before age 65 for non-medical related expenses.  However, after age 65, you can use the money in this account for anything you’d like, it’s no longer tied to medical expenses only.  Additionally, contributions you make to your HSA on a pre-tax basis avoid Social Security and Medicare taxes.

The 2019 contribution limits for HSA holders is either $3,500 for an individual or $7,000 for a family.  HSA holders 55 and up can save an extra $1,000, so either $4,500 for an individual or $8,000 for a family. For 2020, the limits are going up by $50 for the individual coverage and $100 for family coverage bringing them up to $3,550 and $7,100 respectively.  

There is a caveat.  In order to open an HSA, you must be enrolled in a high-deductible health plan.  So depending on your health (and your family), you may not enroll in a high deductible health plan and thus cannot access an HSA.   

If you pull the money out for non-medical related reasons, you’ll pay income taxes and a 20% penalty which is in effect until your 65.  I’ve heard about a few unique strategies regarding HSA accounts among other members of the FIRE community.  Christina and Amon from Our Rich Journey are in a similar boat as us and are planning to use their HSA account as part of their post-65 withdrawal plans rather than for medical related expenses even if medical expenses come up before then to take the utmost advantage of the triple tax advantage. Personally, I do not even count my HSA account into our FIRE calculations and view it as icing on the cake after age 65 to help supplement any additional costs due to aging.  Additionally, Kim over at The Frugal Engineers wrote a guest post for Go Curry Cracker explaining how they are using their HSA account to pay for their daughter’s education costs.  You can hold on to your medical receipts, pay for these costs not using your HSA at the time to allow for the funds within the HSA continue to grow with it’s great tax advantages, and then years down the road you can withdraw and link the withdrawals to the previous medical expenses from years past.        

529 Plans

A 529 plan is a tax-advantaged savings plan designed to help pay for education. 529s were originally designed to pay for post-secondary education costs, however due to more and more early education coming at a hefty price tag in the States, it was expanded to also cover K-12 education under the Tax Cuts and Jobs Act (which in and of itself is an entirely different rant I could go on as the cost of education in the States is beyond ridiculous).

There are two major types, prepaid tuition plans and savings plans. Prepaid tuition plans allow the plan holder to pay in advance for the beneficiary’s tuition and fees at designated institutions. Savings plans are tax-advantaged investment vehicles, similar to IRAs but earmarked for education (and similar to RESPs in Canada). 

I use the term beneficiary instead of child above because a 529 plan allows a person to grow their savings on behalf of a beneficiary, be it a child, grandchild, a spouse or even yourself. With the insane cost of education in the States these days, I personally view a 529 as a good way to invest in a child’s education. Others would argue that they are too limiting and would prefer to invest on their own terms.  That’s fine too as long as you ensure that other investment truly is for education as it was originally intended to be. If you open up a non-529 plan for your child’s education but end up tapping into it 7 years down the road to fix your leaky roof then that’s where a problem arises.

The average annual cost of in-state tuition plus room and board for 2018-2019 was $21,370 at a public four-year college or university and $48,510 at a four-year private college or university according to The College Board. That’s insane! That is PER YEAR, so you could be looking at $80,000-$200,000 grand after 4 years of college is up.  And that does not take into account any extra costs for graduate degrees, term abroad costs, fraternity/sorority fees, extracurriculars, etc.  And that is the CURRENT costs, college tuition costs are increasing WAY faster than inflation so I can only imagine what the costs will be 18 years from now.  Hopefully politicians are able to control this insane issue.  I bet any reader from Europe (if there are any, please comment below) would have a VERY hard time imaging having this much debt due to education.  I also hope there is a shift away from the importance of a formal post-secondary degree in the near future thanks to so many great free educational resources available online.

And I am proof that these numbers are true. I went to a four year private liberal arts college from 2004-2008 that cost $40,000/year (the annual cost for tuition at this same school now costs $53,019/year + room and board of $13,119, plus $1,500 for books and supplies, and $471 for misc other fees totaling $68,610 per year – like I said, it’s insane). I received a scholarship for half the tuition so that reduced that cost down to $20,000/year or a total of $80,000 for 4 years. My dad didn’t think 529s were worth it back in the day so my parents didn’t have an education fund for me (they did invest in one pre-paid in-state tuition that my brother ended up using). So our deal was that my parents would pay for half of my tuition ($40,000) and I would pay for the other $40,000. And that was just for undergrad. I then tacked on another $25,000 for grad school and ended up with $65,000 in student loans. After 2.5 years of interest, I ended up paying $70,000 in student loans when all was said and done. (Side note: if I just paid the minimum payment of $350/month on these student loans, after 25 years the loans would finally be paid off and I would have paid over $120,000 in interest to Sallie Mae!)

A 529 plan doesn’t just cover tuition. According to the IRS, it covers eligible expenses, including “computer technology or equipment.” These include desktop computers, laptops and any device controlled by the computer (such as a printer). 

There are two main types of 529 plans: the college savings plan and the prepaid tuition plan. Let’s dig a little further…

Savings plans

Under a college savings plan, amounts are contributed up to the dollar limit of the plan ($15,000 per individual in 2019). The assets in a college savings plan may be used to cover eligible expenses at any eligible educational institution.

Savings plans, which are only offered by States, are similar to IRAs in that they are tax-advantaged ways to invest money in the long term. Plan holders usually have the option to invest in a range of mutual funds. These funds may be target date funds to the date the beneficiary is expected to start their education in an attempt to reduce risk exposure as that date approaches. Since the investor (likely you, dear reader) bears the risks of the investments, the amount that is eventually available for eligible education expenses will be affected by the rate of return on the investments.  Aka there is no guarantee that the amount you have contributed over the years will cover the full tuition costs (or fingers crossed, markets do well and/or the beneficiary ends up with loads of scholarships and you have ample amount of coverage).

Prepaid tuition plans

Prepaid tuition plans are offered by States and higher education institutions. In a way, you can view them as futures contracts, as they allow the plan holder to prepay for one or more semesters at designated colleges or universities at current prices. This shields them from inflation in tuition costs, which has historically been much steeper than broader measures of inflation. Check out this article from CNBC, or this one from Forbes, or this one from Business Insider, and here’s another one from CNBC. That then leads to a whole other discussion of if college is even worth it or not.  I’ll be writing a whole post in the future on my thoughts on that.

Unlike the assets in the college savings plan, which can be used to pay for qualified expenses at any eligible educational institution, assets in a prepaid tuition program are usually used toward expenses at a predetermined educational institution, or an educational institution from a predetermined list. Should the beneficiary decide to attend an educational institution that is not included on the predetermined list, the current market value of the prepayments may not be sufficient to cover the cost of comparable tuition at the other educational institution. This means the beneficiary may need to cover the difference out of pocket.

There is one non-state prepaid plan, called the Private College 529 Plan, that allows holders to prepay tuition for a collective list of private schools. One problem with this plan, as with state plans, is that the choice of schools is limited. If the beneficiary does not get into and attend one of the selected schools, the funds may be rolled over into another plan, causing them to forfeit most of their gains. Alternatively, they can be transferred to a family member of the beneficiary or rolled over into that beneficiary’s plans, which involves no penalty.

Earnings from a 529 plan are exempt from federal income taxes, providing withdrawals are used for qualified educational expenses. Distributions that are not used to pay for qualified educational expenses are subject to taxes and a 10% fee, with exceptions for circumstances such as death and disability. Contributions to a 529 plan do not reduce your federal income tax burden by lowering your taxable income. However, more than 30 states provide tax deductions or credits for contributions in a 529 plan.

The type of plan you choose—whether a college savings plan or a prepaid tuition program—is generally determined by which features and benefits you find attractive. For instance, do you want the beneficiary to be free to choose an educational institution that is to his or her liking, or are you happy to have the beneficiary attend an institution chosen from a predetermined list?

Regardless of which 529 plan you choose, the important thing is that you make a choice and start early. For college savings plans, starting early increases the compounding effect of the earnings on contributions. And for prepaid tuition programs, the cost of tuition is usually less if prepayments are made earlier. And again, if you feel either of these options is too limiting and you’d rather set aside money in a taxable account for your child’s tuition, by all means, that’s a great plan too.  The point is to start early and commit to investing into your child’s education (if you chose this is a worthwhile endeavor in the first place).

CDs

A certificate of deposit (CD) is a product offered by banks and credit unions that offers an interest rate premium in exchange for the customer (you) agreeing to leave a lump-sum deposit untouched for a predetermined period of time. 

Similar to the high interest savings accounts we discussed above, shopping around is crucial to finding the best CD rates because different financial institutions offer a surprisingly wide range. For example, your brick-and-mortar bank might pay a very low rate even for long-term CDs while an online bank or local credit union might pay three to five times the national average. Some of the best rates come from special promotions, occasionally with unusual durations such as 13 or 21 months, rather than the more common terms based on 3, 6, or 18 months or full-year increments, so again do your research here.

We’ve found that rates for CDs and GICs (Canadian equivalent) have been very similar to high interest savings accounts so to us it’s a no brainer to put money into a high interest savings account which can be accessed at any time vs a CD or GIC which is tied up for a certain duration. With the current interest rates that CDs or GICs are offering, I’d see no benefit to them compared to a high interest savings account. 

Brokerage Accounts

A brokerage account is a taxable account (no special tax advantages like a 401k or IRA in the States or RRSP or TFSA in Canada) that ANYONE can open at ANY time. The biggest pro to a brokerage account is the flexibility. You can open a brokerage account with any company that you’d like (Vanguard, Fidelity, Charles Schwab, etc. in the States or Questrade, Wealthsimple, Qtrade, TD Direct Investing, etc. in Canada) and select any of their available funds to invest in (be it an individual stock, individual bond, index funds, target date index funds, ETFs, etc. – and don’t worry we will have an entirely separate post on all the TYPES of FUNDS you can choose to invest in).

So you have a ton of options here with a brokerage account. The downside of course is there is no tax advantage to these funds. But you can access (aka sells funds within your portfolio) at any time without a penalty (you just pay taxes on the gains depending on your tax bracket for the year you sell). 

Luckily, for those in Canada and the US there are ways to access your tax-advantaged accounts (some with more loopholes involved than others).  But for anyone reading from Australia knows that only investing in your Super (like a 401k in the States or RRSP in Canada) would not be a wise choice for early retirees as accessing your Super prior to the government mandated age is nearly impossible. 

We are big fans (again) of online brokerage accounts because (again) they tend to have much lower fees.  In the States, we use Vanguard for our taxable brokerage account.  Why?  Because Vanguard’s founder, John Bogle, was the founder of index funds and we loveeeee index funds so we will stay loyal to Vanguard even if these may come at a 0.04% fee vs others being completely free. And in Canada, we use Questrade (more on them in Part 4 of the Series).

This post really got out of control so I will write a similar post next week regarding the different Canadian accounts.  It will look very similar to this post but geared towards our Canadian crowd so stay tuned for that!

Are you familiar with all of the accounts we discussed on today’s post?  Which accounts do you currently have open? Anything I missed? Thanks for tuning in and please comment below 🙂 

Want to check out the rest of the Investing 101 Series?

• Investing 101 – Part 1: Introduction
• Investing 101 – Part 2: Compound Interest

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We believe in stacking up life hacks to keep your enjoyment levels to the max without depleting your bank account.  Here are some ways to further educate yourself and save thousands of dollars over your lifetime by making some simple adjustments:

• How much are you paying for your phone plan?  Canadians, learn more about Public Mobile, and see how we are paying $3/mo for our cell phone plan.
• How much are you paying for internet?  Canadians, learn more about the various Independent Service Providers out there to see who services your area so you can lower your monthly bills.
• How much are you paying for home insurance?  We were able to reduce our rates by 25% by switching over to Square One Insurance.  If you live in BC, AB, SK, MB, and ON, check out Square One for your home insurance, landlord insurance, and/or tenant insurance.  Use this link to receive an extra $15 off your quote.  (Note that you must use this link to start the process to get the $15 off even if you prefer to pay over the phone.)
• How much are you paying for your monthly utility bills?  See how you can likely save on this monthly expense.

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