Saturday, April 13, 2013

Where to Put Your Money: Taking Accounts into Account

Will you take a gut check?

More often than not, my sporadic trips to the public library are considerably humbling experiences. What weighs on me is not the homeless gentleman reading Dostoevsky across the room or the fact that I can only pronounce the first names of most authors (C.S. and J.K. are easy, but J.R.R. is pushing it). It is certainly not the fact that I spend the majority of my time at the Richmond Public Library looking at their selection of 196 DVDs even though there are 2,861 times as many books (see charts below).


Perhaps what is most humbling about my infrequent, non-educational trips to RPL is the selection that I wind up bringing back home with me. As I walk through the aisles, I find myself struck by the titles of certain books. Authors are required to dedicate significant strategic planning to their book titles. You see, they know that readers are looking for a title which will call their name – a title that says, “I can relate to your situation.” So I gather an armload of satisfactory books and head to the checkout counter. A smile slowly creeps onto the wrinkly features of the librarian’s aged face. I look down, wondering what she is smirking at, and realize with horror that all of my selections are from the unfortunately popular “Complete Idiot’s Guide” series.

And thus begins the facial expression battle.

I give her a smile which says, “trust me, I know a lot of complete idiots,” but she retorts with a furrowed brow and pursed lips claiming, “I’ve seen your kind – you’ll never be able to pronounce Dostoevsky.”

“Well at least I don’t shush people for a living.” My face sneers back.

“That does nothing to rectify the fact that cavemen check out more cultured volumes than the pidder-padder you are reading. I bid you good day.”

Her face seems to now be stuck in a patronizing, toothy grin. She knows she has won this battle. I give her a series of quick eyebrow raises and squint my eyes to let her know that this is not over, then gather my books and walk out.

Diversifying Accounts

One of the books I checked out that day was Personal Finance for Dummies 7th Edition. About halfway through the book was a chapter entitled “Building Wealth through Investing,” a portion entirely dedicated to where to invest and what the benefits were of spreading your wealth. So then what is the difference between an IRA, a brokerage account, and a savings account? Are there benefits tied to each one?

Liquidity is a term that refers to your money’s accessibility at any given time. If an asset is highly liquid (like cash), it means that the investor is able to utilize these assets quickly if needed. Certain accounts fall into the category of liquid accounts:

  • Checking Accounts: The money you put in your local branch is easily accessible. Cash in your checking account can be used immediately, but these accounts rarely accumulate interest and they are often subject to fees. This is due to the fact that the banks cannot rely on cash levels to be steady for investing purposes.

  • Brokerage Accounts: This is somewhat of an “investment checking account”. Cash is deposited here for use in purchasing funds and securities.  The brokerage firms bring in revenue by trade commission - so they will not typically charge fees, but it is important to understand all the small print before jumping in with a particular brokerage firm.

For these accounts, I recommend putting your money in solid, established investments such as "blue chips" or utilities. The purpose of this liquidity is that assets can be ready at a moment’s notice. Companies such as General Electric (GE), McDonald’s (MCD), and Johnson & Johnson (JNJ) see steady growth year over year and dish out some decent dividends, to boot. Barring a catastrophic blow to the company, your money should be safe to grow and withdraw in the near OR long-term. Downside damage will be minimal compared to smaller companies.  Some examples of accounts with less liquidity, in exchange for other benefits are:
  • Savings Accounts: These are typically tied to checking accounts and have limited monthly withdrawals. Although the yields (percent they pay back to the customer each year) are higher here than checking accounts, some of the highest payouts these days are only about 1%.
  •  Certificates of Deposit: A CD is essentially the next step up from a savings account. Similar to savings accounts, these are insured – making them essentially free from risk. When you agree to invest in a CD, you are handing you money over to a bank or other financial institution for a previously agreed-upon period of time. Because your money is locked away, rates of return are often higher here than savings accounts, but yields higher than 2% are hard to find. This really isn’t even enough to keep up with inflation – which was measured last month at an annual rate of 2%.
  • 401(k): A 401(k) is offered by employers and comes with a smattering of significant benefits and limitations. There are four things to recognize up front about 401(k) accounts:
1.    Benefit – Free Money: Most often, employers will match contributions to this account fifty cents on the dollar up to 6% of total contributions. Just look at the following example:
§  Average lifetime salary: $50,000
§  Paycheck contribution: 5% ($96.15)
§  Company match: 2% ($38.46)
§  # years until retirement: 30 years
§  Average Annual Growth Rate: 10%
§  This is compared to the $75,000 you would pocket if you just held onto the cash.
2.    Benefit – Hands Off: Generally you can just pick a plan that suits your situation and leave it. Fund managers will handle the rest.
3.    Jury’s Out – Tax Deferral: The money you put into this account grows tax-free until you are ready to take it out. This does NOT mean, however, that the funds will not be taxed at all. Depending on tax legislation, you could end up paying out proportionally more in the end.
4.   Limitation – Money can only be invested in plans that the company picks out. You do not have the autonomy that comes with a traditional retirement account.
5.    Limitation – Withdrawing before age 59½ draws penalties.
  • Individual Retirement Account (IRA): Last, but not least are IRAs. IRAs allow you to save and invest while allowing your earnings to grow tax-free. You can contribute up to $5500 per year to this account and, much like a 401(k), early withdrawals come at a steep price. There are two main types of IRAs:

1.     Traditional IRA: This account allows you to deduct contributions on a yearly basis as money is added to the account. Essentially this account allows you to save more on the front end, while withdrawals are still taxable.
2.     Roth IRA: By contrast, contributions to this account are not deductible come annual tax time. The tax savings go into effect during retirement when withdrawals start to be made. I personally prefer this IRA account due to the fact that Uncle Sam can’t get his grubby hands on whatever growth I am able to churn out of my hard-earned retirement funds, but it is mostly psychological. Financially, there should be limited difference in the money you pocket – it is really a matter of preference and planning. 

So there it is – a long-winded introduction to major accounts. It is never too early to start investing, so find the account that is right for you and start planning for your future! 

Next Post: These stocks are healthier than a triathlete vegan on a diet. How?

1 comment:

  1. So pleased to.know I have such a wise and clever nephew! Loved the library scene and could picrure it in my mind. You have your moms way with words and I look forward to reading and learning more!