Pardon us for interrupting your illustrious investing career for this very important public service announcement: Any money you need in the next month, five months, or five years does not belong in the stock market.*
Go ahead and read that sentence again. It is the key to avoiding heartache, headache, and a lifetime of Pepto addiction.
Got it? If so, please continue reading. For those into footnotes, we've provided this one:
*The last place for your short-term savings is anyplace where it is at risk of being worth less when you need it most. That rules out the stock market, which is prone to roller-coaster-like ups and downs, as is evident on any chart that tracks its month-to-month performance. Now, we don't want to scare you away from stocks. Over five- and 10-year periods, that squiggly line on the chart that resembles a ride on the Great American Scream Machine morphs into a gently rising upward slope. The key is time -- giving your money time to ride through the stock market's bumps and tumbles and reap the rewards of long-term investing.
With that important bit of business out of the way, we're ready to find proper accommodations for all of your savings needs and devise a strategy for funding your long-term financial goals.
The best places for your short- and mid-term savings
There's a vast array of appropriate places to stash the money you may need to access soon, including basic checking and savings accounts, high-yield savings accounts, money market accounts and funds, certificates of deposit, Treasury bills, and all sorts of bonds. These types of accounts are safe harbors: They won't provide killer rates of return (and may not even keep up with inflation), but they do provide a guarantee that the money you deposit will all be there when you need it.
Keep in mind that one type of account may not best serve all of your short-term savings needs. For example, cash earmarked for a home down payment that you plan to make in a few years is ideal for a CD. Junior's summer camp tuition is better off in a high-yield savings account. (Elsewhere on Fool.com we go into more detail on finding the best place for your short- and medium-term savings.)
Once you've deployed your funds for near-term needs, it's time to find the right spot for the money you'll need to cover Saturday date nights ... in the year 2041.
Long-term parking for your money
Your long-term cash stash (specifically, money designated for your retirement years) belongs in accounts set up solely for that purpose -- we're talking IRAs and employer-sponsored retirement accounts (such as 401(k)s). Now, sit back while we guide you through this savings maze.
Long-Term Parking, Lot A: Your 401(k) (or other workplace plan)
What if you could invest your money in a place where at least a portion of your contribution was guaranteed to double?
Well, if you work full-time, chances are you have that opportunity through your employer-sponsored retirement account -- your 401(k), 403(b), or 457. If your company offers one of these plans -- with a company match -- for goodness sake (and your sake), don't pass up the free money! We typically recommend that you put your first long-term investment dollars into this type of account if it's available. Ask your friendly HR department how to get started.
These plans allow you to contribute pre-taxed money directly from your paycheck (within limits; see the IRS's website at IRS.gov for this year's allowable contribution amounts). That way your money grows tax-free, and (added bonus alert!) your contributions lower your taxable income for the year (which means a lower tax tab come April). You pay the piper (in this case, Uncle Sam), only after you retire and begin to withdraw the money.
Unfortunately, not all plans are created Foolishly. Some employers don't offer a match, and some plans provide horrid investment choices and charge high fees. Plus, it's not always easy to figure out if your plan is one of the lemons. Don't worry, we've got your back. "Save Your 401(k)" shows you how to assess your plan, and what to do if it's a stinker. We can even help you identify the best investment alternatives in your 401(k) plan.
Long-Term Parking, Lot B: An IRA
Once you've maxed out your workplace retirement account (or, if it's an atrocious plan, invested enough to get your employer match), divert your next retirement dollars into an IRA.
IRAs have one big advantage over workplace retirement accounts: They typically offer more investment options. However, Uncle Sam won't let you contribute as much money to these accounts each year (again, check with the IRS for this year's limits). And, depending on your income, you may not be eligible to contribute to one fully -- or at all.
IRAs come in two garden varieties -- Roth and traditional -- and they offer different tax advantages:
- Traditional IRA: Tax-wise, this account works just like a 401(k) -- the money you put into it is not taxed until you make withdrawals during retirement. Also, like a 401(k), you can deduct the money you contribute from your income, lowering your tax bill in the year you make the contribution.
- Roth IRA: This account gives Future You a tax break. The money you sock away here is never deductible. However, come retirement you get off scot-free -- you pay no taxes on the gains or the principal when you withdraw the money. A Roth IRA also allows you to withdraw your contributions tax-free at any time for certain things, such as a first-time home purchase or education expenses, whereas with a traditional IRA (and 401(k)), you'd not only pay taxes, but you'd also get hit with penalties.
Which one is right for you? We like the flexibility of the Roth -- and the fact that the earnings grow tax-free. That said, the Roth is not necessarily the best choice for everyone. Read "Roth vs. Traditional IRA" for a rundown of the choices, and then use our calculators to crunch the numbers. When you're ready to open an account, our three-step article will show you how to get one set up.
Long-Term Parking, Lot C: Taxable accounts
If, after maxing out the tax-advantaged retirement accounts above, you still have money to sock away, we have just two things to say: (1) Huzzah!, and (2) watch out for Uncle Sam!
The only real difference between retirement accounts (IRAs and 401(k)s) and regular (taxable) accounts is, you guessed it, how the investments are taxed. Follow these two basic guidelines to (legally) dodge the taxman (as much as possible):
- Fill your tax-favored retirement accounts with the most tax-inefficient investments. Those are the investments that generate the biggest tax bills -- bonds, real estate investment trusts (REITs), high-turnover stock mutual funds (if you must, though we're not fans). The payouts from these investments are taxed at ordinary income tax rates, so shelter them within your plan for as long as possible.
- Use non-retirement accounts for investments that are already tax-efficient. That includes long-term, buy-and-hold vehicles like stocks that pay little or no dividends, or tax-managed stock funds. Since you won't pay taxes on these investments until you sell, they have a built-in tax-deferred benefit -- as long as you hold for many years. When ultimately cashed in, the gains will be taxed at the long-term capital gains rate, which is lower than ordinary income tax rates.
Setting up a taxable account is as easy to do as opening an IRA. Compare fees and special deals in our Discount Broker Center, and you'll be off and investing in no time. Once you set up your accounts, just three things are left on your "to do" list: Lather. Rinse. Repeat.
Put your savings on auto-pilot
OK, now you know that saving and investing your money is good for you -- just like eating right and exercise. Fortunately, discount brokers and fund companies make it a whole lot easier than counting calories and doing your cardio -- through dollar-cost averaging. That's just another name for automatic investing. It works just like your 401(k): Money is taken out of your account before you can even think about spending it.
What are you waiting for? The sooner you get your short- and long-term savings accounts set up, the sooner you can get to the fun stuff -- investing.
Action: Take the free money! If you haven't signed up for your workplace retirement plan yet, consider this your friendly Fool nudge to go talk to HR. You may be passing up a guaranteed way to instantly double your money -- and all it requires is a few minutes to fill out a few forms. Go ahead, we'll wait.
Fantastic. Next, get ready to put your investing dollars to work outside of your employer-sponsored retirement account. You'll need a discount brokerage account for either an IRA or a taxable account, which are even easier to set up than your 401(k). Check out the brokers we like in our Discount Broker Center.
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