Type of Accounts
If you’re going to be starting a new business, or if you just want to start investing, it’s good to get your personal finances in order. It’s also good to know what your money’s actually doing. Here are some basics about storing your money.
Checking Account
This is your basic account. This is where you keep your money for daily use. This is what your debit card and your checks are linked to. Checking accounts offer little to no interest rate, so your bank does not really reward you for storing your money this way.
Savings Account
A savings account is used for storing your money on more of a short to medium term basis. You’ll receive a higher interest rate than a checking account, but the government limits how many times you can withdraw from a savings account (6 times per month). They basically don’t want you to touch the money, they want it to sit there. The bank temporarily uses your money to offer loans to other customers, so they like knowing you won’t be needing your money any time soon.
The problem is, most savings accounts nowadays do not offer a great interest rate, so they have become rather pointless. Big banks (Bank of America, Wells Fargo, Chase) offer less than 0.05%, which is pathetic. If you had a whopping $100k in their savings account, at the end of the year they would give you $50. Pathetic. There’s no point in even having a savings account like this, all you’re doing is limiting how many times you can access your money.
Online banks (Ally, Discover, Capital One) offer much better interest rates, because they save money by not having storefronts and can pass more money onto their customers. Their interest rates are more like 1.5%. So if you had $100k sitting in that savings account, you’d receive $1500. Much better. These are often referred to as high-yield savings account.
Most people are of the mindset that your checking account and savings account need to be at the same bank. That’s a terrible philosophy. Go set up a new savings account at a better bank right now and transfer your money, takes ten minutes.
Brokerage Account
This is also known as an investment account. This is where the real investing happens. You deposit money into this account and then use that money to buy investments: stocks, bonds, index funds, etc.
Do not simply transfer money into your brokerage account and let it sit there! Depositing the money is only step one. You then have to actively choose what to buy with it (stocks, bonds, funds, etc..).
Retirement Accounts (IRA)
Individual Retirement Accounts are just special brokerage accounts and operate in the exact same way. The government wants to encourage you to plan for retirement, so they minimize the tax burden on these accounts to help you out. But they also limit how much you can invest per year and there are penalties if you withdraw your money too early in life.
So if you know you’re investing for the long game, then you would put money into an IRA over a standard brokerage account. You would invest as much as the contribution limit will allow, and anything extra you want to invest just put into your normal brokerage account.
There are two types of Individual Retirement Accounts: Traditional IRA and Roth IRA. The main difference between these two is the way taxes are applied.
With a Traditional IRA you are depositing money from your income that has not yet been taxed.
So if you make $50k a year at your day job.
And you invest $5k into a Traditional IRA that year.
You will pay income tax on $45k that year.
And when you’re old and cash out your investment, you pay income tax.
With a Roth IRA you are depositing money from your income that has already been taxed.
So if you make $50k a year at your day job.
You then pay income tax on that $50k.
You then invest $5k into a Roth IRA that year.
And when you’re old and cash out your investment, you pay no taxes.
In a vacuum, the math basically works out the same. The issue has more to do with your tax bracket when you withdraw. If you expect to be in a high tax bracket, you don’t want to use a Traditional IRA, because you’ll lose more of the your money to taxes.
There are some other key features and differences besides taxes:
The government places yearly contribution limits on how much you can invest into your IRA account. This applies to both types of IRAs. The current limit is $6k ($7k if you’re over age 50). But a Roth IRA also has an income limit, so if you make over a certain amount of money (currently $140k), you can no longer invest.
You can only invest up to how much earned income you made that year. So if you only made $5k that year, you could only invest up to $5k in your IRA, even though the limit is $6k. This is true for both types of IRAs.
You can keep contributing to an IRA until the day you die. But you are forced to start withdrawing from a Traditional IRA at the age of 72. This is known as mandatory distributions. You are required to withdraw a certain amount every year. Whereas you never have to withdraw from your Roth until you want to.
There are penalties for withdrawing from IRAs before you’re age 59 ½. Remember, the government wants you to sit on this money and plan for retirement, that’s why they’re rewarding you these tax benefits. There are no penalties on withdrawals of Roth IRA contributions, but there's a 10% penalty tax on withdrawals of earnings. This means you can take out your initial investment anytime, but if you want the profit you made along the way, you pay the penalty. With a traditional IRA, there's a 10% tax on withdrawals of both contributions and earnings. So if disaster should strike, and you need your money back, you’d want to be in a Roth.
My personal preference is a Roth IRA. It’s simpler. You don’t have to think about taxes, what you see is what you get. You’re not forced to withdraw your money. And if you have to withdraw early, the penalty is less. By the way, you can have both, but the contribution limit applies across all your accounts.
FDIC Insured
The Federal Deposit Insurance Corporation. The government insures your checking/savings accounts at a bank. This way if the dumb, greedy bank goes bankrupt, you don’t lose all your money. The government insures up to $250,000 per bank. So if you have $300,000 between your checking and savings account, and the bank goes bankrupt, the government will give you $250,000, and you’ll lose the remaining $50,000. So once you start making serious money, it is important to spread out your money over several banks, for each bank will be insured the $250,000. A separate government insurance, SIPC, covers your investment accounts up to $500,000.