Rookie investing strategy

Here is my recommendation for a basic strategy for anyone. And this strategy can be applied, no matter your income level.

0. Save! This is such a simple concept and it is remarkably easy.  The most basic form of investing in your financial health is to save money.  Just like physical health is a combination of working out and eating right, financial health is a combination of finding smart ways of increasing income (note, not salary, I said income which includes non-traditional ways) and more importantly, SAVING.

1. Emergency fund - you should have atleast 3-4 months of living expenses in a savings account in cash. 

2. Fixed Income - CDs

2. 401k - get that sweet employer match! If your employer offers a matching contribution and you don't take advantage, you are leaving free money on the table. Try and maximize your 401(k). I know, I know not everyone has $20k to spare, but start with something small $100 and let that grow over time. 

3. Roth IRA - 

Everything 401(k)

History

The idea behind 401(k) is for employers to offer a mechanism for their employees to save money for retirement in special tax advantaged accounts. 

The name comes from subsection 401(k) of the U.S. Internal Revenue Code.

Basics

The biggest advantage of 401(k) accounts is the employer match. This means the company will contribute to the employee's account (3-6% employer match is pretty standard, capped off at some amount)

For example, say you contribute $500 per pay-check, then the employer will contribute $30 (6%) per pay check capped off at a maximum of $6000

This article will focus on traditional employer offered 401(k) accounts. Note there are other types of 401(k) for self-employed individuals called Solo 401(k) or Self-Employed 401(k)

Types of 401(k)

There are 3 broad types of employer sponsored 401(k) accounts. The first two are very popularly offered by employers whereas the third type (after-tax) is a somewhat uncommon offering

• Regular/Pre-tax 401(k): This is what most people refer to when they say 401(k). This type of account has tax advantages because it is a tax deferred account

What this means is that your contribution is taken out from your paycheck pre-tax and you don't get taxed until you withdraw from the account

• Roth 401(k): This is a  type of account where you contribute money after taxes have been deducted. The big advantage with this is that both your contribution as well as earnings grow tax-free. Yes, you don't need to pay any taxes when you withdraw from this account as long as you satisfy 2 IRS rules :
• You are of age 59.5 years and above
• You have to satisfy the "5 year rule": This rule simply requires that there must be at least five years from your first deposit before you can make a penalty-free withdrawal. So, if you start your Roth 401(k) at 56, you have to wait until you are 61 to withdraw without penalty.

If you don't satisfy either of these rules then you will be subject to a 10% penalty on the amount you withdraw pre-maturely.

• After-Tax 401(k): This is a type of account where you contribute money after taxes have been deducted, however where this differs from a Roth 401(k) is that the earnings are taxed at ordinary income tax rates. 

An advanced strategy with after-tax 401(k) accounts is to roll it over into a Roth IRA or do an in-plan Roth conversion.  This is covered in more details in this advanced strategies post

Which one is best?

This is a tough question because the answer really depends on your overall financial situation and is still hard to answer. The reason being it is hard to predict what your income and tax bracket will be when you retire 15-20-30 years from now. So there is a bit of an educated guess you will need to take. 

My personal opinion is it to have both 

Tax Treatment of various investment assets

 

Type of account	Tax treatment		Additional notes
Pre-tax (regular) 401k	Deferred
Regular IRA
After-Tax / Roth IRA	After-tax money

Investing Basics

Retirement Accounts

401(k): These are retirement accounts that are attached to an employer. The most common types of 401(k) accounts:

Pre-Tax 401(k): This is generally what people refer to when they say 401(k) account. They have tax-preferential treatment since you don't pay any taxes on them when you contribute into them. The tax payer does eventually come calling because you will get taxed on your contributions (as well as any gains) when you withdraw from this account

Roth 401(k): With this type of 401(k) account, you make contributions with after-tax money so the contributions do not get any tax-preferential treatment. However, when you withdraw from them, both the contributions and the gains do not get taxed as long as you satisfy 2 rules: a) you are 59.5 or older and b) you have had the Roth account for atleast 5 years 

• Individual Retirement Account (IRA): this is linked to an individual as opposed to an employer
• Traditional IRA: 
• Contribution limit : $7,000 for those under age 50, and $8,000 for age 50 or older
• Income Limit: None
• Roth IRA
• Contribution Limit (for 2024)
  
  

  Type of filing	Modified adjusted gross income (MAGI)	Contribution Limit
  Single	<$146,000	$7,000
  	≥ $146,000 but <$161,000	Partial
  	≥ $161,000	Cannot contribute*
  Married filing jointly	< $230,000	$7,000
  	≥ $230,000 but <$240,000	Partial
  	≥ $240,000	Cannot contribute*

*There is an advanced strategy that allows high income earners to contribute to Roth IRA. For details on how to do this, please refer to this article

Non-Retirement Accounts

• Brokerage account : this type of account does not get preferential tax treatment. Examples of companies where you can have a brokerage account are Fidelity, Vanguard, E*TRADE

Fixed Income Accounts

• Certificate of Deposit (CD)
• Regular : This has a fixed term and a fixed interest rate also known as APY. There is typically a penalty for pre-maturely withdrawing your money
• No Penalty : This type of CD does not have a penalty for withdrawing before the maturity date. The tradeoff is that generally it offers a slightly lower interest rate or APY than a regular CD
• Brokerage CDs: Unlike regular CDs which are offered by traditional banks, these are special type of CDs that are offered by brokerage companies like Fidelity, Schwab etc
• Bonds
• Treasury Bonds
• Corporate Bonds
• T-bills
• Municipal Bonds

For information on how these various types of accounts are treated from a tax perspective, check out this post