In my previous article I have provided a list of books and resources to help you learn more about personal finance. This article will primarily focus on creating and managing banking and investment accounts and provide a summary of investment account options available and how we would want to prioritize them to get the most bang for our buck!
Note that, there is no perfect answer for this topic and the accounts that you may want to create and what's available to you can vary widely from one individual to another. You should assess your financial needs and check what makes the most sense to you.
If you want to strive to achieve financial independence early in your life you should develop the habit of paying yourself first! As soon as you receive your paycheck every month, make sure you save and invest before you decide to make other purchases. Many articles and literature suggest saving at least 15% to 20% of your gross income for retirement. If you save more and invest your hard earned dollars early, you will be much better off in the long run. Check out my article on the power of compounding and ways to save on monthly expenses.
As you pay yourself first, try to get rid of your non-mortgage debt and at least pay off high interest rate credit cards. Save enough so that you are not stuck in reverse gear because of high interest rate debt. Pay your credit cards in full each month or at least pay the statement balance every month. Staying debt free will enable and empower you to save and invest more. Now let's discuss the various accounts that you may want to open and contribute to to achieve financial independence.
Personal Finance Ladder
Emergency Fund - as you master the art of managing and eliminating your debt, the very first thing you should focus on, is to save enough for the rainy day. Save at least 3 to 6 months of your monthly expenses. You can save more given your needs. It is good to have these funds liquid and saved in a high-yield savings account (HYSA) so that you can access it easily. Lot of online banks provide higher interest rates compared to brick-n-mortar banks. If your monthly expense is $5,000, you should save at least $15,000 to $30,000 in your emergency fund.
Employer sponsored 401(k), 403(b), 457, Thrift Savings Plans - these are retirement accounts offered by employers where an eligible employee can make contribution on pre-tax basis. The amount contribution amount is deducted from paychecks. Most employers also match employee contribution up to a certain percentage. For e.g., employers will match up to 3% dollar for dollar. Let's say your base salary is $65,000/year. This will result in bi-weekly payments of $2,500. So, if you contribute $75 (3% of 2,500) biweekly, your employer will match that amount and also contribute $75 to your 401(k) account bi-weekly. That is $1,950 just from the employer on annual basis. Make sure you at least contribute so that you get the fill employer match. That's free money! The amount that you and your employer contributes is invested in a curated list of mutual funds that are part of the 401(k) plans. The money grows tax deferred and withdrawals are subject to income taxes since you did not pay any taxes on your contributions. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS' website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.
Roth 401(k) - Some employer sponsored retirement plans may also offer a Roth option in addition to pre-tax 401(k). The amount is contributed after tax to a Roth 401(k). However, earnings grow tax deferred and withdrawals are tax free. So if you expect that you will be in a higher tax bracket later in life, a Roth option can be more appealing to you. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS' website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.
After you have your emergency fund set up, prioritize contributing enough to a 401(k) and/or Roth 401(k) so that you are at least getting the full employer match.
Health Savings Account (HSA) - this is a triple tax-advantaged account where your contributions are done on pre-tax basis, the money grows tax-deferred and the withdrawals are tax free for qualified medical expenses. Note, you need to be eligible to be able to contribute to a HSA. Refer to IRS's website to learn more about the eligibility and annual contribution limit. Some employers offer HSA accounts where the contributions are deducted from your paycheck. However, if your employer does not offer an HSA and you are eligible, you can open a HSA account by yourself.
If you are contributing enough to your employer sponsored retirement plans to get full employer match, the next account you may want to consider is a HSA.
Individual Retirement Arrangements/Accounts (IRA) - these are retirement accounts that provide tax advantages that you can open yourself with any brokerage firm of your choosing. Unlike employer sponsored retirement plans, an IRA has more investing options and you select stocks/mutual funds that you want to invest in. Generally, there are two widely known IRAs. Refer to IRS's website to learn more about contribution, income, age limits and required minimum distribution and also a comparison between different IRAs.
- Traditional IRA - you can contribute to a traditional IRA if you have taxable compensation. Contributions you make to a traditional IRA may be fully or partially deductible as determined by your tax filing status. The amount in this account grows tax deferred and generally the money is not taxed until you take a distribution. If you think your tax rate is high now and you will be in a lower income tax bracket in your retirement, then contributing to a traditional IRA can be appealing to you.
- Roth IRA - This is different from Roth 401(k)! You can contribute to a Roth IRA if you have taxable compensation. Contributions you make to a Roth IRA are not deductible. The amount in this account grows tax deferred and qualified distributions are tax free. If you think your tax rate will be higher later in life, then contributing to a traditional IRA can be appealing to you. Unlike 401(k) plans and traditional IRA, you are not required to start withdrawing from your Roth IRA once your reach a certain age. So, the amount in your Roth IRA account can grow tax-deferred forever and you enjoy tax free qualified distributions.
