Do you hear that Christmas jingle in the air? Maybe it’s all that spare change falling out of your pockets!
The end of the year is a flush time for many in the Western world — Companies tend to pay out bonuses and profit sharing rewards to employees at the end of the year. It’s the most cash-rich time of the year for many … at exactly the same time when society turns on the most pressure to spend.
Any other time of year, and the bonus money might get put into a savings account, pay down some debt, or possibly even get invested. But the holidays are built around spending. It’s hard to resist. No one wants to be a Scrooge afterall.
Give The Gift Of Wealth
Last year, (in one of my earliest posts) I talked about my favorite ways to avoid Capitalist Christmas. All those ideas still hold true.
If you have a family obsessed with gifts and holiday cheer, I suggest you go read that post first. Spending money is not required to have yourself a holly-jolly happy holiday! (Say that 3 times fast!)
But this year I’m going to recommend a different kind of gift: Giving yourself the gift of wealth!
It’s a gift that will change your life!
What could be better than buying yourself (and your spouse) the gift of an ever growing income stream? It’s a gift that doesn’t just “give once”, but it gives every single year you own it!
Obviously saving wealth for financial independence takes time, but you can get there by following a few key principals. That, and having the right financial tools at your disposal.
So what is the magic “gift” you’ll give to yourself (and your spouse) — The best two financial tools in the world, a Taxable Brokerage Account, and a Roth IRA.
Instead of spending your holiday bonus, invest that money into the two accounts and realize a lifetime of wealth.
Let me explain…
Taxable Brokerage Accounts
Taxable accounts may not get a lot of respect in the Personal Finance Blogging world, but they are a HUGE part of “The Gift of Wealth”. If you (or your significant other) don’t already have one…go get one!
Don’t get me wrong, I LOVE tax advantaged accounts. When I had jobs with employer sponsored 401k’s, I used ’em!
But tax advantaged accounts have limits. In the case of a U.S 401(k), contributions are limited to $18,000 (this year). That’s not nearly enough for financial independence at a young age! What’s worse, you can’t withdraw funds from a 401(k) without penalties until age 59.5!
So instead, we utilize both tax advantaged and taxable accounts to our advantage!
In my case, I maximized the use of my tax advantaged accounts. and then everything else was saved into a taxable account!
Taxable accounts often get a bad reputation. You may have heard horror stories about people with brokerage accounts before:
- Day-traders who buy and sell investments continuously and rack up tons of losses and trading fees.
- Gamblers who think they’ll strike it rich by betting on the next big technology stock! Then they lose it all!
- Speculators who buy a stock with leverage only to have a margin call when the stock price drops. They lose tons!
- People with more money than brains that follow the advice of a broker … and end up losing it all.
Each of these horror stories has some truth to them, but they also miss a key point — Taxable accounts can hold exactly the same assets as any 401k or retirement account!
That’s right! There’s absolutely no need to day-trade, use leverage, or gamble on tech stocks. You can invest in the same slow and steady index funds that you’re used to with pre-tax accounts!
That said, taxable brokerage accounts are the single most flexible accounts at your disposal. It’s entirely possible to do incredibly stupid things. Don’t.
A taxable brokerage account is a tool just like a car. They can be sensible efficient grocery-getters, or they can be a flaming death machines for your portfolio!
The Roth IRA
For individuals looking to retire early, the Roth IRA is an invaluable tool. Hell, you even don’t have to be interested in early retirement and it’s still a incredible tool!
Instead of pre-tax contributions, Roth IRA contributions are “post-tax” contributions. This is money contributed from your taxable accounts. But the beauty is that after initial taxes have been paid, distributions made later in life are tax free!
Confused? Think about it this way:
IRA / 401(s) — Don’t pay taxes now, pay later!
Roth IRA — Pay taxes now, but don’t pay taxes later!
If you’re relatively young, the advantage of a Roth IRA is decades of tax-free growth! That’s right, any money you contribute now can grow substantially and you’ll won’t need to pay taxes on that growth at age 59.5!
But what if you want to retire earlier than 59.5? Can you withdraw Roth IRA contributions without penalty?
Yes, you can! But only the standard contributions, not the dividends, interest, or capital appreciation, AND your rollover contributions must be seasoned for 5 years before withdrawal.
(After age 59.5, all money is fair game of course)
Normally Roth IRA’s have contribution limits of $5,500 or $6,500 (depending on your age), and that’s not a lot. But there is a MASSIVE HACK in the tax system that allows for larger contributions called rollovers.
The following chart from the IRS details all the possibilities, but most pre-tax retirement accounts allow rollovers into Roth IRAs. Here’s the kicker: There are no limits on rollover contributions!
For early retirees, this is fantastic news! We can have our cake, and eat it tax-free 5 years later!!
The IRS rule on rollover contributions means you can roll-over pre-tax 401(k) dollars into a post-tax Roth IRA after paying the low income taxes of a early retiree!
Do this every year and you’ll build a steady stream of tax-free income called a Roth IRA Conversion Ladder. Justin over at Root Of Good has the best writeup on the internet about how to build one of these conversion ladders.
Even if you’re not early retired, I suggest setting up a Roth IRA this holiday season. Contribute the maximum $5,500 from your Christmas bonus into that IRA as soon as possible. Your spouse should do the same.
Then, when you finally say goodbye to 50 hour work weeks, you’ll have years of contributions already seasoned! At that point you can begin rollover contributions, and live off the already seasoned contributions along with money invested in taxable brokerage accounts.
Can the Roth IRA story get even better? Yes it can! A traditional IRA has a terrible rule called the required minimum distribution when you reach age 70.5. It means you have to start withdrawing money…even if you don’t want to pay those taxes.
The Roth IRA does not require minimum distributions! You can continue to grow wealth tax-free even after you turn 70!
Where To Open Accounts
OK, if you’re still reading this there might just be hope for you! Are you ready to give yourself this fantastic holiday gift?
You can create these awesome wealth building accounts right away, but first you need to decide where.
There are literally hundreds of different fund companies and banks vying for your investing dollar that offer both traditional brokerage accounts and Roth IRA’s. A quick google search will provide hundreds of comparison sites … no need to redo that here.
That said, I have my favorites: Vanguard and Fidelity.
Most brokerages will charge fees for investing in stocks, ETF’s and Mutual funds. Typically this is less than $8 for stock/ETF transactions, and Mutual fund fees will vary based on what you’re buying.
For example: At large mutual fund houses like Vanguard or Fidelity, investing in home-grown funds is typically free. But if you invest in a Vanguard mutual fund from a Fidelity account, they normally charge a $49.95 fee.
In that case, there are several options:
- It could make sense to pay the $7.95 fee to buy the Vanguard ETF version of that same index fund rather than pay the $49.95 fee Fidelity charges…depending on how frequently you’ll be buying.
- Or, better yet, just open a Vanguard account and skip all the fees.
- If we’re talking index funds, another option is to find a Fidelity version of the same index fund. Usually they’re quite comparable.
As you can see, there’s numerous possibilities to avoid or reduce fees. Do your homework!
Here’s the fee breakdown for these two popular fund companies:
|Broker||Stock/ETF fee||“House” Mutual Fund Fee||Outside Mutual Fund Fee|
Both Vanguard and Fidelity have taxable accounts and Roth IRA’s available to customers. They share many similar features. Both are great companies with a stable financial situation.
Mrs. Tako and I have historically kept our funds at Fidelity, but that’s mainly because our employer sponsored 401(k)’s were located there.
Fees can change over time, so watch them closely. Today, Vanguard seems to be the most fee efficient option of two. In the future Mrs. Tako and I may end-up moving some of our funds there if this pricing situation continues.
The holiday’s are here and that means year-end tax planning!
Mrs. Tako and I will be making our maximum Roth IRA contributions in the next few days before the end of the year. The rest of our excess income and dividends are contributed into our taxable accounts.
For now, we’re not performing 401(k) rollovers while Mrs. Tako is still working. We’ll avoid large rollovers because of our ‘high’ income tax bracket. Once Mrs. Tako quits working though, we’ll start that process. Ideally this will be done at a lower tax rate.
If you’re interested in building wealth, I suggest considering a similar strategy for your own accounts.
Rather than spending your holiday bonus on material gifts that only bring temporary happiness, I hope you’ll consider a different kind of gift this year (and every year hereafter).
While it may take a number of years to get the ball rolling, these accounts are an incredible advantage for building wealth.
Talk about it with your spouse. Read the IRS rules. Take that holiday bonus and open a taxable brokerage account and Roth IRA at your favorite brokerage.
There’s still time too — 3 weeks left in 2016 for you to make your Roth IRA contributions. It’ll only take a few minutes, but you’ll continue to reap the rewards year after year after year…and maybe pass on that income to your heirs tax free.
You’ll thank me for it later.
Update: A reader corrected me that rollovers from pre-tax retirement accounts are not taxed at capital gains rates (like I originally stated), but at income rates. The post was corrected to reflect this.