By Matt Anderson, CPA

Posted Monday, December 18, 2023

You’ve decided to open that retirement plan personally or through your small business – what now? Or maybe your friends at WCG created some tax savings that you would like to put to work.

The world of investing sounds like a foreign language when listening to most financial advisors. At WCG we like to keep things simple. Let’s dive into a crash course on basic investing terminology.

Taxable Brokerage Accounts
As the name suggests, this account does not provide any tax advantages. The general population will brush this account off and move on to the tax advantaged account (which we will discuss next). As tax accountants, we would like to highlight the upsides. This investment account allows you to take advantage of “Capital Gain” tax rates, assuming you hold the investments for longer than one year before selling. Most dividends become “qualified” after holding the investment for longer than 60 days, meaning they are also taxed at “Capital Gain” tax rates. The taxable brokerage account also does not have contribution limits and money can be withdrawn anytime without penalties – woo-hoo!

Traditional Retirement Accounts
This bucket includes accounts such as IRAs, 401Ks, and SEP IRAs just to name a few. Money contributed to these accounts becomes a tax deduction, sounds amazing right? Well not so fast. This money will be taxed later down the road when withdrawals are made from the retirement account. These accounts have limitations on the amount that can be contributed and have limitations as to when money can be withdrawn.

Roth Retirement Accounts
This bucket also includes IRAs and 401Ks and has similar restrictions on contributions amounts and when the money can be withdrawn, like traditional IRAs and 401Ks. With Roth accounts, contributions do not become tax deductions, but the withdrawals are TAX FREE! One question we like to ask is “Is it easier to pay tax now or later down the road?” To ask it differently, “Is it easier to work more now or when you are older?” We will let you ponder that question.

Check out one of our past articles discussing Roth vs Traditional 401K considerations (see button below).

Phewwwwww that was a lot of work to decide which account to open. Now that you have one, how do you invest inside of the account? Generally, 401Ks through major employers have pre-selected options to choose from. As a DIY investor or small business owner, you will have the world at your fingertips (sounds scary but we have some tips). Here is some help with what you will see inside of your account.

Money Market Funds
Money market funds are where the cash you contribute to your account will sit until you purchase investments. Many people think that contributing to their 401K means investing and this is not true. While some 401Ks do automatically purchase investments for you, others may not. Which means you actively need to log in and check for yourself. Money market funds typically earn interest like a savings account at a bank.

Stocks
When you purchase a single stock, you are purchasing a piece of that company. Your returns come from dividend payments and increases in the fair market value of the stock. Ever heard someone say, “I bought a share of Apple”? This is what they are referring to. Single stocks tend to be very volatile, meaning one day the value increases a lot and then falls back down soon after. This volatility may yield higher returns over time.

Bonds
When you purchase a bond, you are essentially lending money to that company. Your returns come from interest payments and the return of principal. The value of the bond itself can rise and fall with the rise and fall of interest rates. Generally, bonds tend to be more stable than stocks. This stability yields lower returns.

Mutual Funds
A mutual fund is an easy way to own a basket of stocks without the hassle of picking them yourself. Due to someone else’s hard work, mutual funds will charge something known as an “expense ratio”. This is the fee charged for someone or something else picking the basket of stocks you will invest in. Like single stocks, you will purchase “shares” of the mutual fund which contains many different stocks. Your returns will come from dividend payments and an increase in the fair market value of the mutual fund shares.

Index Funds
A popular term being thrown around recently is “Index Funds”, and no these don’t have anything to do with index cards. Index Funds are Mutual Funds that base their holdings off established stock or bond market indices. Ever heard of the S&P 500 or the Dow Jones? Please say yes…

You can buy an S&P 500 Index Fund, which means the holdings of this mutual fund will mirror the S&P 500 Index. Weren’t we taught that being a copycat was a bad idea? When it comes to index funds, not so much. This is the reason index funds have lower expense ratios than typical mutual funds. Mutual funds with human fund managers will have expense rations between 0.5 – 1.0%. Index funds will have expense ratios between 0.04 – 0.2%.

We won’t get too nerdy here, but over a long-term investment horizon, the difference in expense ratios of 0.04% and 1.0% can have a material effect on your investment returns.

To throw in a published fact practically anywhere investing related, the average return of the S&P 500 since inception is just under 10%. This time horizon is from around 1928 to the present day. Keep in mind that entering the stock market and exiting at different times will have effects on your personal rates of return.

Now that you have your basics of investing covered, we would like to leave you with a parting thought. Ever heard of someone by the name of Warren Buffet? He is arguably the greatest investor to walk the face of the earth. At the time this article was written, he was number 5 on the list of richest people in the world worth around $120 billion. Warren Buffet has been a strong advocate of investing in an S&P 500 index fund for years. If you don’t know anything about investing, you might want to think about Warren Buffet’s advice.

Feel free to reach out to your friends at WCG CPAs & Advisors with any general investing questions you may have. As a disclaimer, we must state that this article is not investment advice, nor are we registered investment advisors.

Our content is intended to be used and must be used for informational purposes only. It is very important to do your own analysis before making any investment based on your own personal circumstances. You should take independent financial advice form a professional in connection with, or independently research and verify, any information that you find on our website and wish to rely upon, whether for the purpose of making an investment decision or otherwise.

Matt Anderson, CPA is a Tax Supervisor for WCG CPAs & Advisors, a business consultation and tax preparation CPA firm located in Colorado Springs, Colorado.