If you’re new to investing, compounding should be at the start of any investing discussion. Compounding refers to earning interest on top of the interest you’ve already accumulated from previous periods, and it’s a way to potentially magnify your savings over time just by staying invested in the market.

If you can understand compounding as a beginner, it allows you to get excited about the possibilities of investing and set expectations about how that money can grow over time.

So, what is compounding?

Simply put, compounding is the percentage of money you earn on top of your original investment (aka your principal investment) plus its earnings from previous periods. It can be calculated by banks or financial institutions on a daily, monthly, or annual basis. 

How does compound interest work?

Compounding interest is the interest on a loan or investment found by the initial principal plus the interest accrued from preceding periods. 

The principal is compounded because it’s periodically increased by a percentage (i.e., adding 10% each month). This differs from linear growth when the principal is increased by a fixed number (i.e., adding 10 each month). Let’s look at an example: 

Imagine that you deposited $100 in a savings account that accrues 10% interest annually. After one year, you’d have $110 in that savings account. After two years, though, your interest would have compounded, and you’d have $121.

That’s because you’re not just earning 10% interest on your initial deposit ($100)—you’re earning interest based on your new total earnings ($110). So after two years, you’ll earn your 10% interest based on your new total of $110. Here’s a breakdown of how those earnings could compound over time: 

Initial deposit: $100

Year 1: $100 + (100 x 10%) = $110

Year 2: $110 + (110 x 10%) = $121

Year 3: $121 + (121 x 10%) = $133

And after 10 years of compounding at a rate of 10%, your $100 deposit would grow to $259.37. That’s the power of compounding in action.

So, what does compounding have to do with you and your money? 

Compounding can either work for you or against you, depending on whether it’s for an asset or a liability. The example above shows how compounding works in your favor if it’s for a savings deposit or investment (assets). 

But it can also apply to liabilities, like money owed on a loan—when compounding interest is accrued based on your unpaid principal plus interest charged over time. In this case, the compounding interest means the amount you owe increases (compounds) over time. Compounding money when it comes to accounts with debt is something you want to avoid. 

The compound interest formula

The formula to calculate compound interest is A=P(1+r/n)nt.

• A = the total amount of money accrued on your principal plus interest, after n years 
• P = principal (the initial investment or deposit) 
• r = interest rate (in decimal form) 
• n = number of compounding periods (how often the interest is compounded per year) 
• t = time in years (how long the principal remains invested/deposited)  

Let’s put this formula into action with some concrete numbers. Say you deposit $500 into a savings account with a 5% interest rate that compounds monthly for 10 years. So: 

• P = $500 
• r = 0.05 
• n = 12
• t = 10

Now let’s plug those numbers into the compound interest formula: 

A = P (1 + [r / n]) ^ nt

• A = $500 (1 + [0.05 / 12]) ^ (12 * 10)
• A = $500 (1.00417) ^ (120)
• A = $500 (1.64767)
• A = $823.84

In 10 years, your new total is $823.84—your principal plus $323.84 in interest. 

Compound interest vs. simple interest

Simple interest is interest that’s paid only on the initial principal of a loan, and not on any interest from previous periods. That means the interest isn’t compounded. 

Going back to our $500 savings deposit example, a deposit of $500 with a 5% interest rate would mean earning $25 a year, every year. Instead of the earned interest being added back into the principal (compound interest), simple interest is calculated based on the original principal alone.  

Here’s how to calculate simple interest: 

A = P (1 + rt) 

• A = the total amount of money accrued after n years, including interest
• P = principal (the initial investment or deposit) 
• r = interest rate (in decimal form) 
• t = time in years (how long the principal remains invested/deposited)  

We can see that this formula is just a simplified version of the compound interest formula. Here’s what it looks like using our $500 example: 

A = P (1 + rt) 

• A = $500 (1 + [0.05 * 10]) 
• A = $500 (1 + 0.5) 
• A = $500 (1.5)
• A = $750

Ten years of earning 5% simple interest on your $500 deposit yields an extra $250 earned. 

Compound returns

The answer to “what is compounding” is incomplete until we also understand the element of compound returns.  The magic of compounding is revealed when it comes to compound returns on your investments in the market. 

When you keep reinvesting the dividends you earn, your returns have the chance to compound significantly over time. And if you’re a young investor who still has a ways to go until retirement, your opportunity to accumulate long-term wealth grows exponentially. 

Timing is everything when it comes to compounding. The sooner you start investing, the more time that money has to grow. Even a small amount a day can add up to sizable returns thanks to the power of compounding. Here’s a brain teaser to prove it: 

If you were offered the choice of $100,000 today, or a penny today with the amount you receive doubled every day for a month (a penny on the first day, 2 cents on the second day, 4 cents on the third day, etc.), which would you choose?

Surprisingly, it’s smarter to start with the penny, because by day 31, you’d have more than $10 million. That’s the magic of compounding. 

Examples of compounding

As we mentioned earlier, compound interest can work for you or against you, depending on whether you’re investing money or owing money. Here are some  examples of compounding in different types of accounts: 

• Savings and checking accounts: Making deposits into an interest-bearing account like a savings account means that interest will be added to your balance, allowing your money to grow over time. 
• Tax-advantaged retirement accounts (401(k)s and Roth IRAs): Investments in accounts like a 401(k) or a Roth IRA also compound over time, and you can grow your balance faster if dividends are reinvested regularly. 
• Student loans, mortgages, and other personal loans: Compound interest works against you when you’re borrowing money. Compounding on loans means any unpaid interest for a given period is added to your loan balance, from which future interest charges are accrued. 

Best practices for approaching compound interest

Any new investor should apply the power of compounding if their goal is to accumulate long-term wealth. Use these tips to reap the full benefits of compound interest and allow your money to work for you: 

• Start early: The sooner you start investing, the longer your money has to grow. Every day you wait is a missed opportunity to benefit from the power of compounding. 
• Pay off debt: Since compounding works against you when you’re borrowing money, prioritize paying down any debts to avoid paying more over time. 
• Focus on the long term: Time is on your side when it comes to compound interest. Instead of going after short-term gains or cashing out when the market is high, learn to ride the waves of the market and give your money time to grow. 

• Look at APY, not APR: Focus on annual percentage yield (APY) rather than APR when comparing accounts. The APY provides a more accurate view of expected interest earnings, whereas APR accounts only for the simple interest rate. 
• Choose accounts that compound interest daily: Compounding frequency is the interval at which your interest is paid out. The more often interest is paid, the greater returns you’ll see from compound interest—look for accounts that compound daily rather than quarterly or annually. 

The concept of compounding reveals why investing can be a smarter path to building wealth than simply saving. Not to mention, one of the keys to maximizing your financial potential is to save or invest money early and often.

If you’re looking for extra support, consider turning to a platform like Stash—users can automate the investing process with the help of Auto-Invest, which can save or invest money for you automatically.

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Compounding FAQs

Have more questions along the lines of “what is compounding?” We have answers.

What is the rule of 72?

The Rule of 72 is a calculation that estimates how long it would take for an investment to double in value as a result of compound interest. Here’s the formula:

Years to double = 72 / rate of return on investment (the interest rate) 

In other words, you can find the number of years it would take to double an investment by dividing 72 by the interest rate. 

How can investors receive compounding returns? 

Investors can receive compound returns through dividend payments. If you’re investing in stocks and the value of a stock grows over time, you can earn compound interest by reinvesting your profits. 

If payouts are made in cash, they will need to be manually reinvested in order to potentially earn additional compounding returns. Mutual funds, on the other hand, often offer automatic dividend reinvestments in order to earn compound returns.  

What type of average is best suited for compounding?

For investments that have compounding, the time-weighted rate of return (TWR)—also known as the geometric average—is best suited for calculating average returns. It’s able to provide a more accurate estimate of returns by isolating returns that were affected by cash flow changes, balancing out the distortion of these growth rates. 

The post What Is Compounding? An Explanation of Compound Interest appeared first on Stash Learn.

When you invest in an ETF by buying shares, you are essentially buying a stake in the entire pool of securities held by the fund. This is different from investing in individual stocks or bonds of specific companies. Instead, you’re getting a piece of the whole pie. By owning shares of an ETF, you gain exposure to a diversified portfolio of multiple investments, which helps to add diversity to your overall investment portfolio. 

ETFs operate much like traditional mutual funds, but unlike mutual funds, you actually can buy or sell ETFs on a stock exchange, just like you would with regular stocks.

In this article, we’ll cover:

• How ETFs work
• Advantages of ETFs
• Disadvantages of ETFs
• Types of ETFs
• Choosing an ETF
• Exchange-traded fund FAQs

How do ETFs work?

ETFs can give you relatively easy investment access to a broad range of asset classes; instead of buying shares of multiple different securities, you get exposure to all the securities held by the fund.

Just like stocks, you can purchase shares in an ETF through a brokerage and trade them anytime during the stock market’s operating hours. The share price may change throughout the trading day as they are bought and sold on the market. Investors make money when assets within the ETF grow in value or generate profits in the form of dividends or interest.

ETF fees

All funds have management costs, and the fund’s strategy can affect how much you pay. As a general rule, passive funds are less expensive than active funds. Here’s the difference:

• Passive funds aim to match a market index, like the Dow Jones Industrial Average or the S&P 500, and most ETFs fall into this category. Fund managers make investments that mirror the index, which minimizes the need for frequent trading. Thus, fees tend to be lower.
• Active funds seek to outperform an index or achieve some other goal. For example, a fund might attempt to track a market sector, like technology or healthcare. That typically requires more oversight from management, including trading, and which can translate into higher fees.

In addition to management fees, ETFs may come with other costs, such as commissions or bid/ask spreads. 

Benefits of ETFs

If you’re new to investing, ETFs can be a great way to get started. ETFs allow you to invest in several assets at once without the pressure or risk of going all in on an individual commodity. Compared to mutual funds, ETF fees are generally lower, and most funds disclose their holdings on a daily basis, making it easier to track performance. These funds may be an efficient way to dip your toe into the world of investing, and they have long-term payoff potential as well.

• Built-in diversification: ETFs contain a basket of diverse investments, which could cushion your portfolio if a single commodity loses value.
• Many options: With over 1,700 ETFs traded on US markets, there’s an ETF available to match a wide range of investing goals interests, and you can gain investment exposure to an entire sector through a single ETF.
• Potential for lower fees: While the mutual fund might involve higher management fees due to its active management approach, the ETF’s fees tend to be lower. With ETFs, you can potentially keep more of your investment returns in your pocket, allowing your wealth to grow over time.
• Intraday trading allowed: ETFs can be traded throughout the day, just like individual stocks. This means you can seize those favorable moments, making adjustments to your portfolio when it matters most.
• Tax efficient: Often, ETFs distribute smaller and fewer capital gains, which can lower the amount of tax you have to pay.

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Downsides of ETFs

ETFs have many possible benefits, any type of investment presents risk, and ETFs are no exception. While investment advisors often praise the built-in portfolio diversification, it’s not necessarily a given. Additionally, some may come with higher fees or other costs.

• Diversity isn’t guaranteed: While ETFs contain multiple securities, they can be concentrated in one market segment or asset class, offering more limited diversification. 
• Fees can be higher: Passively managed ETFs are often celebrated for their lower fees compared to mutual funds. However, some ETFs are actively managed by professional managers who make investment decisions. These active ETFs may come with higher costs to cover the expenses associated with active management.
• ETFs can be risky: Although many see ETFs as lower risk than individual stocks, every fund has a different level of risk; inverse ETFs and leveraged ETFs are usually considered high-risk and unsuitable for inexperienced investors.

Types of ETFs you can invest in

When it comes to investing in ETFs, there are several types to choose from. These funds usually have a particular focus or objective, like matching the performance of an index, investing in specific sectors, or implementing a particular investing strategy. You can select an ETF that best supports your investment goals, risk tolerance, and personal interests.

• Market ETFs
• Passive ETFs
• Active ETFs
• Sector ETFs
• Thematic ETFs
• Bond ETFs
• Commodity ETFs
• Foreign market ETFs
• Currency ETFs
• Inverse ETFs
• Leveraged ETFs

Market ETFs

Market ETFs, also known as equity funds, are designed to track specific market indexes, such as the S&P 500 or Dow Jones Industrial Average. These indexes represent a basket of securities from various companies that collectively represent the overall market. When you invest in a market ETF, your goal is to closely replicate the performance of the underlying index. This means that as the index goes up, your ETF should follow suit. And when the index experiences a dip, your ETF’s value may fluctuate accordingly.

A market ETF’s success depends on how closely the ETF tracks the underlying index. Factors such as the ETF’s management strategy, transaction costs, and tracking error can impact how well the ETF mirrors the index’s performance. Make sure to do your research and find an ETF that has a track record of closely aligning with the index you want to follow.

Passive ETFs

Passive ETFs generally follow a buy-and-hold indexing strategy designed to mirror the performance of a specific benchmark or index. These benchmarks can range from widely recognized market indices like the S&P 500 or the Dow Jones Industrial Average to sector-specific or asset-class-focused indices. By tracking a benchmark, passive ETFs aim to provide investors with broad market exposure. Passive ETFs are also considered budget-friendly. These funds tend to have lower costs because they don’t play the trading game as actively managed funds do.

When exploring passive ETFs, take a peek at the benchmark’s characteristics. How was the team chosen? What is their methodology? What is their track record? These factors can help you align your goals, tolerance for risk, and desire for diversification

Active ETFs

In contrast to passive ETFs that follow a set benchmark, active ETFs have a manager or team of experts who make strategic decisions about portfolio allocation. They bring their experience and knowledge to the table, allowing them to deviate from the index when they see opportunities. Because the active management approach requires far more effort, an actively managed ETF generally has higher management fees compared to a passive ETF.

The fund manager’s goal is to generate attractive returns by actively selecting investments they believe will outperform the broader market or achieve a specific investment objective. But while active ETFs offer potential rewards, it’s important to be aware of the risks. Market volatility can impact the performance of active ETFs, as their success relies on the ability of the managers to make accurate investment decisions. The market can be unpredictable, and even the most seasoned managers face challenges in timing the market effectively.

When considering active ETFs, it’s crucial to assess the track record and investment strategy of the fund’s manager or team. Look for a proven history of successful portfolio management, a consistent investment approach, and alignment with your investment goals. 

Sector ETFs

Similar to a market ETF, these funds aim to match the overall performance of an index, but focus on a specific sector or industry, such as technology. These funds may offer diversification within a given sector, but if the entire sector’s performance falls, the value of the fund’s shares may also drop.

Thematic ETFs

Even more narrowly focused than sector ETFs, these funds target a subset of a sector; for instance, the fund may invest in stocks related to esports or video games rather than technology overall. The narrow focus of these funds may tend to offer less diversification.

Bond ETFs

Also called fixed-income ETFs, these funds invest exclusively in bonds. Because bonds tend to be less volatile than stocks, they’re often considered lower risk. Bond ETFs can be an excellent addition to your investment portfolio, offering stability and balance in comparison to the potentially higher volatility of stocks.

It’s important to remember that while bond ETFs offer lower risk, they are not without risks. Factors such as interest rate changes, the credit quality of the underlying bonds, and macroeconomic conditions can impact bond prices and returns.

Commodity ETFs

Commodities are raw materials such as oil, gold, and agricultural goods. Some commodity ETFs actually purchase the commodities, though this is limited to precious metals. Other funds invest in companies that produce or handle commodities; this can give investors exposure to commodities without the costs associated with the physical possession of goods. 

Foreign market ETFs

Like market EFTs, these funds attempt to mirror an index. The difference is that these target a non-U.S. index, like the Nikkei Index, an index of the Tokyo Stock Exchange. Foreign market ETFs could bring more geographic diversity to your portfolio.

Currency ETFs

Currency ETFs, also called foreign currency ETFs, track the relative value of one or more currencies. These funds can give investors exposure to trading currencies without the complexity and burden of trading on the foreign exchange market.

Inverse ETFs

Unlike most other funds, these ETFs are designed to increase in price when a given market index declines in price. Inverse ETFs require active management, which may increase fees, and they tend to represent a significant risk.

Leveraged ETFs

Leveraging, an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements, can lead to significant gain and equally significant loss. Since leveraged ETFs follow this strategy, using financial derivatives and debt to boost the returns of an underlying index, they can be just as risky.

> Explore ETFs to learn more about the different types offered.

How to pick an ETF

With so many types of ETFs, it may feel overwhelming to choose the right fund to invest in. Let’s dive in with an approach that keeps it real, while focusing on the bigger picture.

1. Know your investment objective

Start by asking yourself what you hope to achieve with your investment. Are you looking for long-term growth, stable income, or specific sector exposure? Understanding your objective will help you narrow down the options and focus on the ETFs that can help you reach your goals.

2. Assess costs and operating expense ratios

Expense ratios are like the price tags on ETFs, representing the annual costs you’ll incur as an investor. These ratios cover the fund’s management fees, administrative expenses, and other operational costs. It’s important to pay attention to expense ratios because they directly impact your investment returns. 

Lower expense ratios generally mean more money in your pocket for growth. They can have a significant long-term impact on your investment growth, especially when compounded over time.

3. Understand the impact of expense ratios on returns

It’s important to see the bigger picture when it comes to expense ratios. These seemingly small numbers can have a significant long-term impact on your investment growth.

4. Evaluate the ETF’s index and tracking record

Another critical factor in choosing an ETF is the index it tracks. Does the index align with your investment objectives? Is it broad-based or specific to a sector or asset class? Understanding the index composition will give you insights into the underlying assets and the potential risks and rewards associated with the ETF.

Additionally, take a look at the ETF’s tracking record. Has it closely followed its underlying index over time? Consistent tracking performance is an indicator of a well-managed ETF and can increase your confidence in its ability to deliver the desired investment exposure.

5. Consider market position and competition

The ETF market is constantly evolving, and competition among fund providers is fierce. It’s worth considering a fund’s market position and the presence of similar offerings. The first ETF issuer for a particular sector often has an advantage, as they have the opportunity to gather assets before competitors enter the market.

Protect your portfolio with a diverse and defensive strategy

Whichever assets you choose, it’s usually wise to protect your portfolio with a diverse and defensive investment strategy. A single investment in an ETF can provide diversification and the flexibility you need to stay defensive as your portfolio grows. Stash can help you start investing in ETFs; with over 90 options, you can find the fund that matches your investing goals. 

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ETF FAQ

1. Are ETFs good investments for beginners?

They can be. ETFs offer some diversification in a single purchase, they are often less expensive than mutual funds, and there’s one for virtually any investment strategy. 

That said, not all ETFs are created equal. Some are quite risky, and not all add meaningful diversity to a portfolio. As with any investment, it’s important to fully understand an ETF before buying shares.

2. Are ETFs safer to invest in than stocks?

It depends. For example, a market or index ETF is likely less risky than any given individual stock, because it relies on the performance of many companies, rather than just one. If one company’s value falls, others may rise, shielding you from the struggling company’s price dip. On the other hand, a leveraged ETF is probably riskier than buying shares of a long-established company with many decades of stable performance. 

As a general rule, a basket of stocks tends to be less risky than an individual stock, but it’s important to research any investment before buying.

The post What Is an ETF? Definition and Guide appeared first on Stash Learn.

In this article, we’ll cover:

• Roth IRAs and their features
• 401(k)s and their features
• Roth IRA vs. 401(k)
• Factors for choosing between a Roth IRA and a 401(k)

What is a Roth IRA?

A Roth Individual Retirement Account (IRA) is a tax-advantaged retirement account in which contributions are made with after-tax income; you put money into the account after you have paid income tax on it. Roth IRAs are subject to income eligibility rules and contribution limits set by the IRS, which are similar to those for traditional IRAs and may change from year to year. The key benefit of a Roth IRA is that qualified withdrawals in retirement are tax-free, for both the contributions you make and the money you earn on those contributions while they are invested in the account.

Eligibility requirements

To contribute to a Roth IRA, you have to meet certain requirements when it comes to your earned income and Modified Adjusted Gross Income (MAGI). To qualify, you must earn income, such as wages, salaries, or self-employment income, and your MAGI must fall within specific limits, which depend on your tax filing status. If your income exceeds the upper limit for your filing status, you may be unable to contribute, or limited to a lower amount.

Contribution limits and deadlines

For the 2023 tax year, total contributions for Roth IRA accounts are capped at $6,500, and you must make contributions by April 15, 2024. If you’re 50 or older, you can make an additional catch-up contribution of $1,000, bringing your total contributions to $7,500.

This limit differs depending on your income and tax filing status. For instance, Roth IRA contribution limits are lower for single filers making more than $138,000 and people who are married, filing jointly who make over $218,000. And if your income is lower than the contribution limit, you cannot contribute more than your MAGI for the year. 

Tax implications

Tax advantages are a primary appeal of a Roth IRA, and it’s important to understand how they work to ensure you benefit from them. 

• Contributions: Contributions are made to a Roth IRA with after-tax income. Because you have already paid taxes on this money before depositing it into the account, you can withdraw it at any time with no penalties, and you will owe no taxes. 
• Earnings: Money generated by the investments in your Roth IRA is tax-exempt as long as you follow the withdrawal rules.
• Withdrawals: Withdrawals of your earnings are tax-free once you reach the age of 59½, as long as the account is at least five years old.
  

If you withdraw your earnings before you’re 59½, you’ll have to pay income tax on the money, plus an additional 10% early-distribution tax. There are a few exceptions to the early-distribution tax, like withdrawing money for education expenses or buying your first home. But even in these cases, you’ll owe income tax on earnings if you withdraw them early.

Investment options and flexibility

With a Roth IRA, you can invest in a wide range of assets. In addition to the typical options like stocks, bonds, mutual funds, index funds, and exchange-traded funds (ETFs), a self-directed Roth IRA allows you to expand your investment into assets like real estate, private equity, precious metals, and more. With more flexibility and control over your choice of assets, you can diversify and potentially capitalize on different investment strategies. 

Advantages and benefits

A Roth IRA offers several advantages that can enhance your retirement strategy. This type of account offers more flexibility in managing your investments and provides a level of accessibility to your funds in case of emergency financial needs.

• Tax-free withdrawals in retirement: Qualified withdrawals after the age of 59½ from a Roth IRA are tax-free, including both contributions and investment earnings. That means you pay no tax at all on your earnings if you follow the withdrawal rules.
  
• No required minimum distributions (RMDs): Unlike traditional IRAs, Roth IRAs do not have required minimum distributions, or mandatory withdrawals, during the account holder’s lifetime. That allows you to keep your money growing in the account for as long as you like, and even pass it on to your heirs.
  
• Penalty-free withdrawal of contributions: Roth IRA accounts allow you to withdraw your contributions at any time without incurring penalties or paying additional taxes. Note that this applies only to the after-tax money you have directly contributed, not to earnings on your investments.

Disadvantages and limitations

Before you open a Roth IRA for your retirement plan, it’s important to acknowledge its potential disadvantages, specifically when it comes to your tax bracket and filing method. Depending on your income, marital status, and how you choose to file your taxes, you may be ineligible or your maximum contributions may be limited.

• Income limitations on eligibility: In 2023, individuals making $153,000 or more per year cannot contribute, and those making more than $138,000 per year are subject to a lower contribution limit. Married couples filing jointly and making more than $218,000 per year are ineligible, and those making between $218,000 and $228,000  are also limited to a lower contribution amount.
  
• Contributions are not tax-deductible: Unlike 401(k)s and traditional IRAs, contributions to a Roth IRA are made with after-tax income, so you cannot deduct them from your taxable income for the year.

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What is a 401(k)?

A 401(k) is a retirement saving plan offered by employers in which you can put a portion of your pre-tax income into an investment account. Because you’re contributing money before it’s taxed, putting funds into a 401(k) reduces your taxable income, which may reduce the amount you pay in taxes during the years you contribute. Your employer might also match a portion of your contributions, adding money to your 401(k) account on your behalf. And you can roll the account over if you change jobs.

Eligibility requirements

To contribute to a 401(k), individuals must meet certain eligibility requirements set by their employers. These requirements may include factors such as being at least 21 years old, completing a specified period of service with the company, or being classified as a full-time employee. Employers have the discretion to set additional eligibility criteria for their 401(k) plans, so it’s important to consult the plan’s documentation or your HR department to understand your specific requirements.

Contribution limits and deadlines

The annual cap on 401(k) contributions is significantly higher than the limit for Roth IRA accounts. For 2023, the contribution limit for 401(k) plans is $22,500. Additionally, employees over the age of 50 can contribute another $7,500 as part of a catch-up contribution. Unlike Roth IRAs, which have a 2023 tax year deadline of April 15, 2024, all contributions to a 401(k) must be made by December 31, 2023. 

Tax implications

The tax advantages differ between a Roth IRA vs. a 401(k), with the primary distinction being when taxes are assessed and how taxes are applied to contributions and earnings.

1. Contributions: Contributions to a 401(k) are made with pre-tax income, meaning they are deducted from your paycheck before taxes are applied. 
2. Earnings: Contributions and any investment earnings in a 401(k) are taxed when withdrawn in retirement.
3. Withdrawals: Withdrawals from a traditional 401(k) are subject to ordinary income tax rates at the time of withdrawal.

Investment options and flexibility

The investment options within a 401(k) are typically limited to a selection of funds chosen by the employer or plan administrator. These funds often include a range of mutual funds, such as stock funds, bond funds, and target-date funds. However, compared to other retirement plan options like IRAs, 401(k) accounts generally have fewer investment choices.

Advantages and benefits

Investing in a 401(k) offers several advantages, including the ability to contribute more through matching contributions from your employer, higher limits to your contributions, and the potential to lower your annual taxable income. 

• Employer matching contributions: Many employers offer a matching contribution to employees’ 401(k) accounts as a benefit of employment. This matching contribution can significantly boost your retirement savings over time.
  
• Higher contribution limits: Compared to IRAs, 401(k) plans allow for higher annual contribution limits, allowing you to put away more toward retirement.
  
• Pre-tax contributions reduce taxable income: Contributions to a traditional 401(k) are made with pre-tax income, reducing your taxable income for the year. Additionally, both contributions and investment earnings grow tax-deferred until withdrawal in retirement.

Disadvantages and limitations

Investing in a 401(k) account also comes with certain potential challenges. Consider the following factors:

• Limited investment options: Compared to Roth IRAs, 401(k) plans typically offer a limited menu of investment choices, which are often pre-selected by your employer. This leaves you with less control and flexibility when it comes to how you invest your money. 

• Required minimum distributions starting at age 72: Once you reach age 72, you’re generally required to start taking minimum distributions, or mandatory withdrawals, from your 401(k) account. These are subject to taxes at the rate of the time of withdrawal which may impact your cash flow in retirement.

Roth IRA vs. 401(k): how do they compare?

Both Roth IRAs and 401(k)s offer valuable tax advantages and opportunities for achieving your financial goals over the long term, but they have distinct features that can significantly impact the money you’re able to save for retirement. While a Roth IRA allows for tax-free withdrawals in retirement and greater control over investment choices, a 401(k) offers the potential for employer-matching contributions and higher contribution limits. 

Factors to consider when choosing between a Roth IRA and 401(k)

When weighing a Roth IRA vs. a 401(k) for your retirement planning, take into account all aspects of your financial picture, including your earnings, tax bracket, and short- and long-term goals. 

• Current and projected income: Contributions to a 401(k) are made before taxes, which can lower your current tax burden. And if you expect to be in a lower tax bracket after you retire, it may benefit you to pay taxes on your contributions at that time. By deferring tax payments, you can potentially enjoy tax benefits while saving for retirement.
  
• Tax bracket and expected future tax rates: If you expect to be in a higher tax bracket at age 59½  than you are now, a Roth IRA allows you to pay income tax on your contributions at your current rate, then enjoy tax-free withdrawals later.

• Employer contributions and matching: If your employer offers a matching contribution, taking full advantage of this benefit can help you put away even more money for retirement. That money is part of your total compensation package, but you only get it if you contribute to your 401(k).
  
• Investment options and preferences: A Roth IRA typically offers a broader range of investment choices compared to the limited options offered with a 401(k). If you prefer more control over your investment strategy, a Roth IRA may interest you.
  
• Long-term retirement goals and financial plans: Consider the role your account will play in your overall financial plan. Evaluate factors such as your desired lifestyle in retirement, your liquidity needs, and other sources of income. If you hope to retire early, for instance, you may appreciate the ability to withdraw your contributions from a Roth IRA without penalty. 
  
• Risk tolerance and investment strategy: A Roth IRA offers more control over investment choices, allowing you to tailor your portfolio to your risk tolerance and investment preferences. A 401(k) may have limited investment options, but it can still be suitable if the available choices align with your investment strategy.

Roth IRA vs. 401(k): which is right for you? 

Both Roth IRAs and 401(k)s feature unique benefits, limitations, tax advantages, and investment options to evaluate as you choose the right retirement plan for you. And it’s simple to open either type of account and start making contributions.

And you don’t have to decide between a Roth IRA vs. 401(k); you’re allowed to have both types of accounts. If you’re already contributing to your employer’s 401(k), opening a Roth IRA can be an opportunity to save more for retirement. Depending on your overall financial goals, you may even wish to explore more types of investment accounts for building long-term wealth.

Whichever path you choose, the earlier you start saving for retirement, the more time your investment will have to grow. 

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Roth IRA and 401K FAQ

Can you invest in both a 401(k) and a Roth IRA?

You can have both. Even if your employer offers a 401(k), you can open a Roth IRA and contribute up to the maximum allowed for each account. If saving for retirement is a high priority for you, this can be a good way to maximize the amount you can invest.

If your employer offers matching contributions, you may want to contribute enough to get the full match, and then invest in a Roth IRA. If you’re able to fully fund the Roth IRA, you can put any additional deposits into the 401(k), up to the annual limit.

When should you not invest in a Roth IRA?

With any tax-advantaged retirement account, you’re trading tax benefits for keeping money in the account until retirement. So if you expect to need your money before you reach retirement age, a Roth IRA may not be the right choice for you. Also, if you expect to be in a lower tax bracket when you retire than you are now, you might save money by paying taxes when you withdraw money, rather than when you contribute it. Finally, if reducing your tax burden now by investing pre-tax dollars is important, a Roth IRA won’t give you that advantage.

The post Roth IRA vs. 401(k): Which Is the Better Choice for You? appeared first on Stash Learn.

If you’re wondering how to prepare for a recession, there are a few places to put your money that have proven successful even amid a volatile market, including:

• Strong-performing sectors
• Stocks in healthy companies 
• Dividend stocks and fixed-income investments 
• Mutual funds and index funds

Keep reading to learn what to invest in during a recession. 

Strong-performing sectors

The stock market includes shares from thousands of different companies, which are broken into different sectors. A sector is a group of companies with similar business products, services, or characteristics. 

Of the 11 sectors total, these have historically performed the strongest during a recession: 

1. Consumer staples
2. Energy
3. Health care
4. Utilities

These sectors, such as health care and consumer staples, are considered essential—recession or not, people still need things like medical care, food, and power. The same can’t be said about cyclical stocks in the consumer discretionary sector—these companies cater to nonessential wants versus needs. 

Essential sectors typically maintain their income streams and overall stability even when the market is volatile. This makes their stocks, known as defensive stocks, a favorable investment option leading up to and during a recession. 

To invest in these sectors during a period of market downturn, assess the different companies in sectors like health care, consumer staples, energy, and utilities. The healthcare sector, for example, is made up of pharmaceutical and biotech companies. The consumer staples sector includes household and personal care products—think food and beverage (grocery stores), toilet paper, or cleaning products. 

Stocks in healthy companies

Stocks from the sectors outlined above are a great place to put your investments during a recession, but purchasing a stock just because it’s in a defensive sector isn’t a good strategy. 

You should also pay attention to the quality of those stocks—which means purchasing stocks from the healthiest companies. Researching the specific companies you’ll invest in is imperative to successfully investing during a recession. 

Remember that whatever stock you choose, the company should still have healthy margins. 

How to find recession-proof companies

So far we’ve outlined where to focus when choosing recession investments, but how do you actually identify and vet those companies? One helpful way is by using a free stock screener like Yahoo! Finance. 

A stock screener can give you a list of suggested stocks to consider based on some information you provide. 

Consider the following to include in your stock screen: 

• Market cap: choose “large cap” or larger to filter by the largest companies in the U.S. that are typically more stable during recessions and have a low risk of going out of business. 
• Price: choose a price that’s higher than the performance of a broad index like the S&P 500. 
• Sector: choose a sector like energy, consumer staples, or health care. 

Even if you don’t use a stock screening tool, researching a company’s financial performance is a must. An alternative is to use the SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) tool to pull companies’ annual financial reports. Then, you can evaluate things like: 

• Profit and loss statements
• Cash flow statements
• Operating cost
• Revenue and expenses
• Increases or decreases in net profit 
• Outstanding debt

All of these specifications are meant to provide you with stocks from companies with healthy financials overall, regardless of market performance. This is a good indication that they can endure times of recession, too. 

Dividend stocks and fixed-income investments 

Dividend-paying stocks or fixed-income investments like bonds are highly sought after during recessions because they provide a steady, predictable source of income. 

Dividend stocks are shares of a company that allocates a portion of its profit to shareholders (depending on how many shares they own). Fixed-income investments like bonds offer regular payments in the amount of interest earned over time. Regardless of which you choose, they both offer a stable cash flow even if there’s a recession. 

High-quality dividend stocks are found in companies with a reputable history of paying strong dividends to shareholders. Aside from being a great diversification tool, the beauty of dividend-paying stocks is that you can reinvest those dividends and let your money compound over time. 

While bonds also offer regular payments, they’re structured differently than stocks. A bond is a form of debt—it’s essentially an IOU from a corporation or government entity that offers regular interest payments plus the principal amount you invested at the end of a certain period of time. 

Aside from reliable streams of income, dividend-paying stocks and fixed-income investments are popular recession investments because they allow for diversification. Diversification can reduce overall risk in your portfolio, and bond values tend to perform inversely to the rise and fall of stock prices. If you’re invested in both, you can lower the volatility of fallen stock values during a recession. This allows for more stability and balance in your portfolio when the market is down.

Mutual funds and index funds

Mutual funds like exchange-traded funds (ETFs) and low-cost index funds offer a less risky alternative than investing in individual stocks—something that’s top of mind during a recession. 

These types of funds expose you to an entire basket of securities rather than just a single stock, so if the performance of one company goes down, the stronger performance of the others in your “basket” can balance things out. This is the essence of diversification.

You can buy a mutual fund, index fund or ETF that tracks a specific sector. So, if you’re looking to invest in a defensive sector like consumer staples or energy, you can look for funds in that category. The fund you choose will include a collection of stock shares from a variety of companies within that sector. 

Plus: tips for how to invest during a recession

There’s no denying the fear you might be feeling amid a volatile and uncertain market. That said, it’s important to keep your long-term investing vision in mind and realize that market fluctuations are simply par for the course. 

When it comes to knowing what to do in a recession, keep these tips in mind:

• Keep calm: keep a level head at all times—making rash decisions based on fearful emotions can cause more harm than good. 
• Don’t try to time the market: no one can predict what the market will do today, tomorrow, or next year. Position yourself for success by continuing to regularly invest over time, regardless of market performance.  
• Avoid panic-selling: tempting as it may be to sell a low-performing stock, panic-selling only guarantees your loss. 
• Stay the course: a long-term investment strategy means riding the ups and downs of the market. This will always be a more certain path to building wealth than any short-term strategy. 

Young investors with a long time horizon can take heart knowing that a long-term strategy provides inherent protection from the market over time. Things might look bad now, but the market almost always rebounds—and so will your investments in the long run. Now that you know what to invest in during a recession, you can go forward confidently and continue building your portfolio. Your future self will thank you! 

FAQs about what to invest in during a recession

For any lingering questions about what happens during a recession, we’ve got you covered. 

What is the safest investment during a recession?

Many investors see bonds as a safer place to invest during a recession. That’s because during times of market volatility, fixed-income investments generally maintain or increase their value. 

What should you not invest in during a recession?

Recession or not—but especially during a recession—avoid investing in companies that don’t have a record of strong financial performance. Poor cash flows, high operating costs, high amounts of debt, and tight margins are all indicators of what not to invest in during a recession. 

Why can recessions create good investment opportunities? 

Sharply declining stock prices during a recession offers the chance to buy shares at bargain prices. Since the stock market has historically recovered following a decline, you can expect to reap the rewards of future returns on those investments once the market stabilizes. 

The post What To Invest in During a Recession: An Overview of the Best Investments During a Recession appeared first on Stash Learn.

Risk profiles: the tl:dr

Risk profile vocabulary

Let’s start with some definitions:

• Investment risk is the degree of uncertainty of your investment’s future returns
• Risk tolerance is how much risk you’re willing to tolerate, and it’s usually grouped into three levels: conservative, moderate, and aggressive

Risk tolerance factors

So, what determines whether your risk tolerance is conservative, moderate, or aggressive? There can be a lot of factors; here are a few common ones:

• Your age
• Your income
•  Your saving goals

For example, if you’re young, you may be thinking about your financial future over the long term. That might mean you may have more tolerance for the risk of losing money in the short term if you think long-term gains are possible. On the other hand, if you’re approaching retirement, more short-term risk could be outside your comfort zone.

If your budget is tight, or you don’t have much income left over after your expenses, you might feel more comfortable avoiding investments that have a higher degree of uncertainty regarding their future returns—or you might prefer to invest a small amount of money in an investment that you believe will pay off in the long run. On the flip side, if you feel like you have plenty of money over and above your living expenses, you may feel like you can tolerate a higher risk investment.

Your savings goals might also affect your risk tolerance. Depending on how much money you want to save up and how long you plan to work toward that goal, you might optimize your portfolio for short-term returns, long-term gains, or another outcome you hope to achieve.

It’s likely that you won’t determine your risk profile by looking at any one factor in isolation. Ultimately, risk tolerance is usually determined by an investor’s assessment of their financial big picture, including individual characteristics and financial goals. By looking at multiple factors and reflecting on the level of risk you feel you can tolerate, you can get a sense of your own individual risk profile—and that can help you decide on the investing strategy that feels right to you.

Risk profiles: conservative, moderate, and aggressive

If your risk profile is conservative, you probably prefer stability, even if it means smaller gains—but you want to see some growth potential too. Here’s a typical conservative risk portfolio:

• About 40% stocks
• About 60% bonds

If your risk profile is moderate, you’re likely looking for long-term growth potential (which may include slightly more risk of losses in the short term), but you still want some amount of stability. A moderate risk portfolio commonly contains:

• About 60% stocks
• About 40% bonds

If your risk profile is aggressive, chances are you want to maximize your portfolio growth in the long run, even if it means sacrificing stability in the near term. Your aggressive portfolio might look like this:

• About 80% stocks
• About 20% bonds

Investment mix and risk profile

You can see that the more aggressive the risk profile, the higher the percentage of stocks in our example portfolios. Conversely, the percentage of bonds increases when a risk profile grows more conservative. But why?

Over the long term, stocks may offer relatively higher returns. Since 1926, stocks for major corporations have had average return rates of 10% annually. However, that’s just an average over time; stock prices can rise—and fall—very quickly. As result, they are perceived as more volatile (that is, more likely to change) in the short term. Hence, a higher proportion of stocks can make sense for an aggressive risk profile. 

Bonds, on the other hand, tend to be less volatile. Unless the bond issuer defaults, investors receive a fixed return on their investment. That said, the long-term returns may be lower for bonds than for stocks. Government bonds, for example, have returned 5-6% annually since 1926. So more bonds in the portfolio could offer more stability, which might be what those with a more conservative risk profile are seeking.  This article offers a more comprehensive discussion of the types of investments listed in the risk profiles above. You can also learn how stock and bond prices relate to one another in this article.

What’s your risk profile?

Thinking about your situation and your financial goals may help you build a portfolio that more accurately reflects your risk tolerance—which could ease some of the worry about investing. When you reflect on your own tolerance for risk and your personal financial circumstances, you can get a sense of your risk profile. While there’s no way to eliminate risk in investing, it is possible to learn about how much risk a given investment may carry—and use that knowledge, combined with your risk profile, to make more confident and empowered investment decisions.

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