Summary/TL;DR
My three favorite accounts for long-term wealth building are employer retirement accounts, Roth IRAs, and brokerage accounts. Employer retirement accounts and Roth IRAs qualify for specific tax breaks which make them exceptionally powerful long-term wealth building vehicles, although they suffer from inflexibility as a consequence. Brokerage accounts, despite having no specific tax advantages, are infinitely flexible. A balanced combination of all of these accounts is the best formula for long-term success.
Introduction
Perhaps the most common excuse made for not saving is not knowing where to start. There are so many different account types for one to choose from, and an even greater amount of rules and regulations governing each. It’s easy to feel overwhelmed and choose to never begin at all.
In today’s post, I discuss my three favorite accounts for long-term wealth building.
Employer Retirement Plans
The best place to begin for long-term savings is usually the retirement plan offered by your employer, commonly either a 401(k), 403(b), or a SIMPLE or SEP IRA. While each of these account types have nuanced technical differences, the general rules behind all of them are the same – you may contribute funds on a pre-tax or after-tax basis, invest them on a tax-deferred basis, and access funds penalty-free after your age 59½.
The first reason these plans are usually the best place to start is that many employers offer a “matching” contribution, effectively allowing you to double your savings rate! For example, your employer might offer a 100% match on up to 4% of your annual pay, meaning that if you contribute to the plan they will match dollar-for-dollar on contributions up to 4% of your salary. Below is an example of a 25-year-old making $85,000 who begins to contribute 4% of their pay to their employer’s retirement plan, with their employer matching 100% of their contribution. They never increase their savings beyond 4%, but they do receive a 3% raise every year, and their contributions grow at 10% annually:
By the time this saver is 60, their employer plan would be worth almost $3,000,000! Clearly, an account that grows such tremendous wealth from such modest savings is worth an investment in!
Funds you contribute to your employer’s retirement plans are usually invested in a mix of one or more mutual funds. It’s also becoming more common for employers to allow participants to open brokerage accounts within their 401(k) plans so they may invest in individual stocks or Exchange Traded Funds (ETFs). What’s common amongst all of these plans is that it is up to you, the participant, to direct the investment of your contributions! Many people mistakenly assume that their employers or the plan’s recordkeeper (Fidelity, Principal, Empower, etc) invests the funds for them, but this is mistaken. Unless you make investment elections, your contribution will sit in a fund delegated as the plan’s “default”, which may not be aligned with your goals.
The final reason that I like these plans so much is that they automate your savings by deducting contributions directly from your paycheck. Any time a financial task can be automated, it greatly increases the likelihood of compliance.
Roth IRAs
Roth IRAs are qualified retirement accounts that allow savers to compound and distribute earnings on their long-term savings 100% tax-free after being opened for at least 5 years and as long as its owner is 59½ or older. Annual contributions to Roth IRAs are limited to $7,000 (plus an additional $1,000 for those age 50 and older) and are reduced to $0 for “high” income earners, although even they can reclaim their ability to make contributions through the “backdoor” Roth IRA. Inheritors of Roth IRAs are required to distribute funds within a 10-year period, but all earnings will still be tax-free.
Unlike employer retirement accounts, anybody with earned income may open and fund a Roth IRA on their own behalf. Also unlike employer accounts, investments are not restricted in Roth IRAs – you can invest in stocks, bonds, ETFs, mutual funds, options, convertible bonds, preferred stock, real estate… pretty much anything that you can imagine!
The tax-free nature of Roth IRAs make them extremely effective for young savers who have a long time for their contributions to compound. Below is an example of a 25-year old who begins contributing the annual maximum to a Roth IRA until their age 60. Like the example above, I’ve assumed a 10% growth rate on the investments and an annual 3% increase in the contribution limit:
By age 60, this saver will have over $3,000,000 of tax-free wealth that they can use in retirement or to pass on to their heirs! If you have extra money that you need to save for retirement, you can almost never go wrong with a Roth IRA.
Brokerage Accounts
The final account we’ll discuss is the good old brokerage account. Brokerage accounts are also called “non-qualified” accounts because, unlike the accounts discussed above, they do not qualify for any tax advantaged treatment. Investors pay tax on interest, dividends, and realized capital gains paid to the account. In return for this ordinary tax treatment, brokerage accounts have no strings attached. You may contribute as much as you’d like, invest in whatever you’d like, and distribute as much and whenever you’d like penalty free. There are no restrictions with brokerage accounts, and this is why they made the short list for today’s post.
When it comes to long term wealth building, you can’t go wrong with saving into any of these accounts. However, there is still substantial space for optimization when it comes to one’s savings plan, particularly when it comes to taxes. There are also plenty of other account types not discussed in today’s post that could be a better fit for you depending on your goals and circumstances. Helping clients prioritize which accounts they should be saving into is one of the most impactful things that I do. Be sure to reach out with any questions!
