Keep Investing Simple: Taxable vs Tax-Advantaged Investing

Investing can be complicated if you let it be. There’s a million different concepts, strategies, and funds to think about. And that’s okay for some, but not for most. Most people are turned off by investing and never really get into it because of the multitude of choices. With that in mind, I’m providing some simple information to help you frame your approach to investing.

The way I see it, there are two types of investing you can do:

1. Tax-Advantaged – This is where you should focus your attention. There’s more than enough options in this area to have you set for retirement and have your kid’s college paid for, all while reducing your taxes. Keep things simple and focus on investing here.
2. Taxable – This is the area of investing that should take a back seat for most people. Only go here if you’ve exhausted all options above. If you do invest in this area, please don’t use money that could be securing your retirement or your kid’s college.

Again, that’s just my take on things. I’m sure there are people who could argue against it. To me it’s just the simple way to approach things. Here’s more…

Tax-Advantaged Investing Specifics

Whether they know it or not, most people are already doing tax-advantaged investing through their 401k. This is great! However, even more tax-advantaged investing can be done through a Roth IRA (which uses after-tax dollars, and earnings are tax free if withdrawn after 59 and 1/2).

This is the investing sequence most should use:

1. 401k to Get the Employer Match
2. Roth IRA to the Max
3. Back to the 401k to the Max

See the 2009 Retirement Contribution Limits to find out how to get to the max.

This approach will help you avoid taxes now and in the future. The government, via the IRS, is trying to encourage you to save for your retirement so you won’t simply rely on Social Security. That’s why we have these types of accounts. And that’s why most of these accounts come with stipulations about leaving the money where it is, for it’s intended purpose.

A Roth IRA can be opened at a bank or at an investment firm. I recommend Vanguard. They don’t have minimums on their accounts and their funds are some of the cheapest in terms of fees. If you don’t have one of these, please go open one today. Just do it and get started. It’s really simple.

There’s even more tax-advantaged investing you can do. I won’t get into it here, but I’ll just refer you to this article on 529 Plans and other tax-advantaged education savings accounts.

Taxable Investing Specifics

Taxable investing is taking your after-tax dollars and investing it without a tax-advantaged account. Simple, right? The key thing to remember here is to only invest money here after you’ve exhausted your options in the tax-advantaged areas. These investments will be taxed before you put the money in and the earnings on the investments will be taxed.

Taxable accounts can be opened up at the same places as tax-advantaged accounts, at banks and investment firms. But the best places are the one’s who’ll let you trade cheaply, since you’ll theoretically be doing that more often (because of no limitations by the IRS). These are places like eTrade, Scott Trade, Zecco, Sharebuilder, etc.

More Information

There’s obviously more to investing: what to invest in, proper asset allocation, etc. But the above should hopefully give you an initial framework when trying to decide which direction to go with your investing. Maybe next week I’ll tackle the subject of different funds and asset allocation.

So what’s your take? Is there ever a reason to go with a taxable account first?

photo by thelastminute

1. Investing in Single Stocks – Why I Don’t Do It?
2. How to Find the Best Roth IRA Rates
3. Roth and Traditional IRA Contribution Limits for 2010
4. Opening a Roth IRA for the First Time
5. Roth IRA Rules

Tagged as: 401K, investments, IRA, IRS, Retirement, roth-ira, stocks, target-date-funds, tax-advantaged, taxable, taxes, zecco