Summary:
- Investing is a way to work toward building wealth throughout your lifetime and at various life stages
- There are various investment account types, including retirement and non-retirement accounts
- Those investment accounts can be invested in various types of funds, like mutual funds, ETFs, index funds, and more
- Diversification and rebalancing play an important role in portfolio management
- Risk tolerance and investor behavior can evolve over time, and we can help
Investments play a big part in your financial plan. Investing is a way to work toward building wealth throughout your lifetime and at various life stages, whether it be to afford your first home or save for retirement. At West Invest, we coordinate the selection of your investments with your personal goals.
When you think of investments, you might think of stocks, bonds, CDs, or maybe a mutual fund. Investments can also be made in real estate (a primary home or an investment property) or other areas of life. Let’s talk about types of investments, but first let’s talk about different investment account types.
Account Types
Let’s first look at retirement accounts. Retirement accounts were created by the federal government to incentivize workers to save for retirement when pensions were being phased out. To accomplish this, these accounts have special tax advantages that incentivize contributing and investing. They come in two main types: employer-sponsored and Individual Retirement Accounts (IRAs). We’ll deep dive into these two types of accounts, but importantly, generally both come with the regulation that if you withdraw funds before age 59 ½, you will incur a 10% tax penalty on those withdrawn funds (there are some exceptions).
Employer-Sponsored Retirement Accounts: These retirement accounts are set up by your employer, and you can contribute funds from your paycheck to the accounts. Plus, employers can make contributions as a retention benefit. Some typical employer-sponsored retirement accounts are 401(k)s, 403(b)s, or 457(b)s, and they all come with some special rules:
- There are contribution limits. For 2026, an employee can contribute up to $24,500. Employers can make contributions on top of that employee contribution limit, but the combined employee/employer contributions total cannot exceed $72,000. These limits increase to $32,500 and $80,000 if you’re age 50+. If you’re age 60-63, the limits increase to $35,750 and $83,250.
- Employers can write their own policies about plan eligibility, such as requiring an employee to be employed for 1 year before opening their retirement account.
- Employers can also write policies about how much they will contribute to the retirement account on behalf of each employee, often in the form of ‘matching’ employee contributions up to a certain percentage.
- Employers can also write their own policies about ‘vesting’, which requires an employee to maintain employment with the company for a defined time period to be entitled to any employer contributions made to the retirement account.
- These retirement accounts usually allow for ‘traditional’ contributions and ‘Roth contributions’, allowing the employee to elect what percentage of their contributions are made on a pre-tax or post-tax basis.
- There are more employer-sponsored retirement plans such as SIMPLE IRAs and SEP IRAs, and these come with their own contribution limits and rules!
Traditional and Roth IRAs: The other type of retirement accounts are Individual Retirement Accounts (IRAs), they come in both Traditional IRA and Roth IRA options. Regardless of whether you open a Traditional IRA, or a Roth IRA, or both, there some rules that apply to both:
- You can contribute $7,500 (or $8,600 if you are over 50 years old) to a Traditional or Roth IRA as long as you had that much in earned income that year. This amount typically goes up each year.
- You can contribute to both a Traditional IRA and a Roth IRA in the same year, but the contribution limit applies to the combined contributions.
Traditional IRAs have some specific rules:
- For every dollar you contribute, your taxable income for the year can possibly be reduced by that amount. This ability to tax-deduct Traditional IRA contributions from your taxable income may be reduced or eliminated if you or your spouse also have an employer-sponsored retirement account.
- The IRS needs you to pay taxes one way or another, so when you go to withdraw the funds from a Traditional IRA, the full amount you take out is taxed as ordinary income.
Roth IRAs do not have the same tax savings from contributions as Traditional IRAs.
- Unlike a Traditional IRA contribution, you cannot deduct a Roth IRA contribution from your taxable income in the year you make the contribution.
- The incentive to invest in these accounts is that the contributions can grow tax free and withdrawals are tax free!
- There is an income ‘phase-out’ that limits the amount you can contribute based on your income, starting at $153,000 for partial contribution limits, and $168,000 eliminating the ability to contribute directly to a Roth IRA.
Then there are Non-Retirement Accounts (or Non-Qualified accounts), which are types of investment accounts that don’t come with tax incentives tied to retirement. However, these accounts offer more flexibility than retirement accounts. These can be individual accounts (only one owner), joint accounts (multiple owners such as spouses), or entity accounts (owned by a trust or business).
With a non-retirement account you can contribute as much as you want and there are no early withdrawal penalties before 59 ½. In these accounts, you can still invest in the same securities as the retirement accounts such as stocks, bonds, mutual funds and ETFs.
Another thing about non-retirement accounts is you may have to pay taxes along the way, as your investments grow. These types of taxes come in the form of dividends and capital gains. We can explain those at a later time, but first let’s explain the types of funds that can be invested in any of the account types discussed.
Fund Types
Mutual Funds are a pooled investment vehicle which allows you to own many different companies, bonds, or other investments in a much simpler way than owning them individually. For instance, if you purchase a mutual fund modeled to track the S&P 500, you have interest in over 500 companies while only owning one security. These are also helpful so you don’t have to keep track of each stock separately. Mutual Funds differ from individual stocks or ETFs in that they are not traded throughout the stock market trading hours. They only trade at the end of the day. This means if you were to place a buy or sell order for a Mutual Fund at 8am, 10 am, or 12:30pm, none of the orders would be executed until the end of trading hours at 4pm ET.
Exchange Traded Funds (ETFs) are similar to Mutual Funds in that they are pooled investment vehicles and in fact many investment companies have ETFs and mutual funds that hold the same or very similar securities. The way ETFs differ is they can trade throughout the day. Just like a stock, the prices of ETFs change throughout trading hours, and they can be traded at any time while the stock market is open for trading. ETFs can also have lower internal fees and be more tax efficient than mutual funds as they are a newer investment vehicle and have different rules. The tax efficiency is especially important when investing in a non-retirement account.
Active Funds can be Mutual Funds or ETFs which are managed by a person or team of people. These people are referred to as money managers. The money managers are hired to research, buy, and sell the securities within the Mutual Fund or ETF. The purpose of hiring money managers is so that an individual investor or financial planner does not need to time the market or individually research and decide which stocks to buy or sell. Active Funds can be especially helpful when an investor wants to invest in small companies or in international markets. In the case of international markets, money managers can have offices in or near the markets you are investing in. For instance, some money managers may have an office in China to make it easier to research the companies in the area. That’s pretty hard for your financial planner to do!
Unlike an active fund, an index fund's goal is to match the return of an index as closely as possible. Index funds use a passive investment strategy. The way investments within these funds are chosen is by a set of rules rather than solely by the choice of the money manager. This means passive funds can be more cost effective than active funds.
Here are a few indexes which index funds may try to follow:
- S&P 500; the S&P 500 is comprised of and tracks about 500 of the largest companies in the United States
- Russell 2000; the Russell 2000 tracks about 2000 of the largest companies in the United States
- Wilshire 5000; the Wilshire 5000 tracks all publicly traded stocks in the United States (at its highest point, this index had over 7,500 stocks. Now it is comprised of roughly 3,500)
Target Date Funds are the funds you may be familiar with from an employer-sponsored retirement plan. These (typically mutual funds) are usually the default investment in those plans and have a date in their name such as 2030, 2045, or 2060. The investor picks the Target Date Fund with the date closest to their own retirement, and the money managers adjust the portfolio in a way that they believe will benefit the investor as they near retirement. These are not always the best options for investors as everyone has their own goals and different risk tolerances.
We prefer to create an investment portfolio for each individual client that suits their specific needs and goals.
Diversification and Rebalancing
If you have been investing long enough, you’ve probably heard the term “diversification”. But what does it mean anyway? A simple way to put it is, don’t put all your eggs in one basket. Diversification is the act of spreading your risk over many assets.
Diversification can be done through owning a number of different stocks in different sectors or purchasing different Funds which target different areas of the market (maybe a combination of Large Cap Growth, Large Cap Value, Mid Cap, Small Cap, and international Funds). Diversification can also be done by not just investing in your 401(k) but also having an emergency fund at the bank or investment properties that you rent out.
Rebalancing is something we do in a diversified portfolio. If for instance you have an investment account with 4 funds and you would like the split to be 25% each, over time a couple funds may outperform the others. When this happens, the portfolio may look something like this: (Fund A: 30%, Fund B: 35%, Fund C: 20%, Fund D: 15%). We would rebalance the account to bring all the funds back to 25%.
Rebalancing is not an attempt to time the market. The date of the rebalance is set well in advance (usually the same date each year) and once or twice a year is frequent enough.
Risk Tolerance and Investor Behavior
When we are choosing investments for clients, it is important that we first gauge their risk tolerance. One way to look at risk tolerance is it tells us at what point an investor will no longer feel comfortable being in their investment of choice. Risk tolerance is different for everyone, a younger person who is saving for retirement over the next 30 or 40 years may have a much different risk tolerance when investing in their IRA or 401(k) than a person who is thinking of retiring in the next few months.
Risk tolerance can also differ between the accounts a person has. That same young person with 30 or 40 years to retirement might have a different risk tolerance in their non-retirement account which they are using to build up funds for a home down payment in only a year.
Investor behavior goes hand in hand with risk tolerance. If someone reaches the limit of their risk tolerance, they may feel compelled to sell a stock at a poor time or wait too long to get back into the market.
As we are planning with clients, we try to adjust risk tolerance by using different tools. In the case of the person thinking of retiring, it may be wise for them to have a larger emergency fund built up so they can tap into that in the case the market goes down as they enter into retirement.
Conclusion
These are the basics to understanding investment vehicles and the types of investments that can exist within them. You may have multiple types of accounts, with various types of investments, all at the same time. How you utilize the various account types and available investments is dependent on your financial situation and your goals, and we can help strategize.