Episode Transcript
Brenton: [00:00:00] A savings account and a 401k will not be enough for many investors to reach the goals they want to achieve financially.
In this episode, we talk about an underutilized account that can make sure those funds that don't hit your 401k are working for you when you are not working.
Let's get started.
Welcome, welcome. My name is Brenton Harrison of New Money, new Problems, and your host for the New Money New Problems podcast.
If you've joined us over the last several episodes, we've been on a journey from establishing one month's expenses saved, to three months expenses saved, to the end goal of your final destination, at which point you will not put any more funds in cash savings. And in that process we talked about the importance of establishing some financial priorities that can make sure you can allocate those extra dollars to places that will help you achieve those financial goals.
As a part of that process, we mentioned the importance of getting a return on your investment and also [00:01:00] determining the type of investor you would like to be. Are you the type of person who wants to contribute to a 401K until you become wealthy? Are you the type of person that wants to pursue entrepreneurship or side hustles?
And regardless of the type of investor you choose to become, it is beneficial to have money working for you when you are not working.
That's why we asked you to determine the amount upon which you're not going to save in cash. It's why we talked about the potential return on an investment that comes with contributing to a retirement account where your employer is matching some of those contributions. It is also why when first telling you to stop your retirement contributions until you had one month's expenses saved, we mentioned the term qualified investments.
As a refresher, a 401k is a type of qualified investment account. These accounts have a number of different features that they offer to participants, mainly being the tax deferral of growing assets. And tax deferral simply means that as your money [00:02:00] grows, you get to defer taxes on that growth until a later date and time.
If you have a 401K that started out at a thousand dollars and it grows to a million dollars, you do not pay taxes on any of that growth. They are deferred.
Tax deferral is a tremendous benefit that could pay huge dividends to those who stick with these type of accounts over an extended period, and it's nothing to sneeze at .
But with tax deferral comes other restrictions. One of those restrictions being the amount of money that you can contribute to these tools on an annual basis. You can't just up and decide to put $200,000 into a 401k in any given year.
You're going to be capped as to what you contribute, and the IRS determines those contribution limits on an annual basis. Another restriction when it comes to tax deferred accounts is when you can access the funds. In most cases, when you have a tax deferred account like a 401K or a 403b, save for certain [00:03:00] exceptions, you cannot access those funds until at least age 59 and a half.
Depending on the type of tax deferred account, it could have other implications. As an example, if you have a traditional IRA or a 401k, once you reach age 72 and a half, whether you need those funds or not, the IRS can start forcing you to take what's called required minimum distributions from these accounts.
The purpose being that the IRS wants to make sure that they get a crack at the egg. They wanna make sure that they can tax all of the funds that can be taxed. And in some of these pre-tax traditional qualified accounts, you have not paid taxes until you take the money out.
So they start forcing you to do. If you take too much out of these accounts, it can lead to other implications like the taxation of social security benefits or even increased premiums for things like Medicare.
To be clear, these accounts are wonderful accounts. They are simply accounts that [00:04:00] have their restrictions in terms of how much you can contribute and how you can access them. And when establishing and pursuing financial wealth, it is helpful to have money in qualified accounts. It's helpful to have money in cash, and it's also valuable to have a type of investment called a non-qualified account. And today we're going to talk about something called a non-qualified brokerage account.
A non-qualified account as a refresher, it's a type of account that doesn't offer things like tax deferral, but in exchange for that deficiency, it has more flexibility as to how much you can contribute and when you can access the funds. With a non-qualified investment account, there are no contribution limits for most of these vehicles. Just like the brokerage account we're gonna discuss. There also are no limitations on when you can access the funds in terms of your age.
So by establishing a savings account, you're establishing cash reserves that will be there in case of an emergency.
[00:05:00] By putting money in a qualified account, you're able to access tools like tax deferral that allow your money to grow more freely, and in some cases eclipse the growth of what you might find in a comparable non-qualified account that is taxable. But by establishing non-qualified investments, you are establishing money that is working for you when you're not working, but you also have access to when needed.
For clarification, you can have a non-qualified brokerage account, but you can also have a qualified brokerage account. For today's purposes, we're talking about the non-qualified option.
A non-qualified brokerage account is an account that you open for the purpose of investing.
It's not a savings account. The money that goes inside of it is designed to be put to use.
Now once funds have been deposited into said non-qualified brokerage account, it's up to you to determine where those funds are put to use. You can use a brokerage account to [00:06:00] invest in things like individual stocks, like exchange traded funds, like mutual funds, like real estate investment trusts.
It is up to the owner of the account to decide in which to invest, but once the funds are there, the purpose is to then put them to use in those other.
And in most cases, you are not limited to how many investments you can have in those brokerage accounts.
As an example, let's say that I put $15,000 in a brokerage account. And I decide that I wanna keep $5,000 in cash so I can take advantage of future investment opportunities if prices decrease. But then I put $5,000 in an exchange traded fund that meets my long term investing goals. And maybe I put $5,000 in a bond or $5,000 in a real estate investment trust, or $5,000 in an index fund of my choosing.
I still have $15,000 in total, but that $15,000 is spread out across three different places, but they are all housed inside of [00:07:00] my brokerage account. And that's another way to think of it. It's like a house that holds all of your investments inside. Each one has its own proverbial room, but the whole house keeps the entirety of your investment portfolio.
This account in our, this account, in our example, is a non-qualified brokerage account. Meaning, unlike qualified accounts, it is not tax deferred. And when you have investments inside of a brokerage account that are kicking off gains that are taxable from year to year, or you're making transactions with those investments that are taxable from year to year, you have to pay taxes on those transactions. At the end of each calendar year, you'll get a tax form that you would submit, just like you would submit a 1099 or a w2. And based on those investment activities, it will factor in to that taxable burden that you have come April 15th or later in the fall, depending on when you file.
And I made the illustration of a house where each room holds a different investment, [00:08:00] for the purposes of you understanding that the house itself is not an investment. A brokerage account is not an investment in and of itself.
It's simply the place that holds the investments that you choose. Once funds hit the account, if you put money into a brokerage account and you don't make the decision on how they're gonna be invested, it sits in cash.
That illustration also hopefully drives home the point that the house itself is not as important as the investments inside of them. There are hundreds of different brokerage companies out there.
And after the break we'll tell you how you can go about finding the brokerage account that's right for you.
Welcome back. Before the break, we introduce you to the concept of a brokerage account. We talked about the pros and cons of a non-qualified brokerage account as compared to a qualified investment. Now it's time to talk about the different things that could influence the type of brokerage account you choose.
One of those things is fees. I would say that we're in a pretty competitive landscape where one company's [00:09:00] fees should not be too far off from their competitors, but each brokerage account does have its own respective fees. Not just fees for things like general account maintenance, but also for investment activities that you do inside of the account. As an example, you might have one brokerage firm that charges more for you to make a trade into an investment or out of an investment than another of their competitors.
You might have another brokerage company that has lower fees for higher frequency traders and they seek to attract that type of customer, where another brokerage company, as long as you stay within 20 trades a month or 10 trades a month, could offer lower fees and seek to attract investors who are more long-term oriented and are not doing a lot of transactions from month to month.
Another simple consideration is ease of use. Do you like this brokerage company's platform? Do they have research available where you can read reports and understand how to make your own trades and make your own investments, and do [00:10:00] analyses that make sense to you as a novice investor?
If you have found that platform, it might speak to you in terms of its aesthetics and the research that they have available for you to learn on your own time.
You might also be the type of person that utilizes the services of what's called a third party money manager. We're gonna talk about this in detail in future episodes, but the premise of a third party money manager is they are companies, in some cases, they are a team of professionals that you can hire for a fee to come into your brokerage account and make decisions on how the funds in that account are managed.
Well, you could have a brokerage account that you open at E-Trade or at Fidelity or at Charles Schwab, and for a fee you could hire those third party managers to come into your account and make investment decisions on those funds.
This is important because some third party managers have specific relationships with certain brokerage companies. So you might prefer to [00:11:00] have your money managed by this third party manager, and they may say, to do so, you have to have your accounts custodied at Charles Schwab or at Fidelity, which means that's the place that you have to open the brokerage account because that's where they have their relationship.
These elements are a part of the decision in where you open your brokerage account, but regardless of the options in front of you, you should have plenty of brokerage accounts at your disposal. We've talked about places like E-Trade, Scott Trade, Merrill Lynch, fidelity, Charles Schwab.
All of these are arms that have multiple elements of their business. They may offer their own investment management services or third party money management services, but they also may offer brokerage accounts, and you can decide and evaluate amongst those options of which is right for you.
So today's episode is not about you deciding the investments that will go in each room of the house. It's just making you aware that the house exists. And when we talk about making your money [00:12:00] work for you when you're not working, you can't do that when your money is in cash, because I assure you, whatever the rate of inflation is, your bank is gonna offer just that much less.
So in terms of the purchasing power of these funds, you would actually be losing money by keeping your money by keeping your money in cash that you are not gonna be able to use to purchase as much next year as you were this year. A retirement account is great. An emergency fund is great. It's also important that we establish that middle layer of funds to which you have access, and in future conversations, we'll talk about once you've established the house, how to decide the investments that will go in each room.
