Vanguard 101 – Account Setup

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Welcome to Vanguard 101: Account Setup. Here I detail the three main types of Vanguard investment accounts and highlight their advantages and disadvantages.

There are three main types of Vanguard investment accounts: Roth IRAs, Traditional IRAs, and Individual Brokerage Accounts.  After gaining a general understanding of these account types, you can decide which account suits you best!

Quick Definitions:

Pre-Tax Dollars:

  • These are your earnings before you pay taxes. Traditional IRAs are funded with pre-tax dollars.
    • Example: Anita earns $50,000. She pays $10,000 in taxes. Anita has $50,000 in pre-tax dollars.

After-Tax Dollars:

  • This is the money left over after you pay taxes. Roth IRAs and Individual Brokerage Accounts are funded with after-tax dollars.
    • Example: Bill earns $50,000. He pays $10,000 in taxes. Bill has $40,000 in after-tax dollars.

 

Roth IRAs

A Roth IRA is a type of retirement account. Roth IRAs are funded with after-tax dollars. [Tax example: Carlos earns $50,000 before tax. He contributes $5,500 to his Roth IRA. Carlos pays income taxes on his entire $50,000 earnings].

Special Rules:
  • In order to avoid early withdrawal penalties on investment gains, the account holder must be at least age 59.5 and have established his/her account at least 5 years before withdrawal.
  • Contributions = Money that you actually invested into your Roth IRA account
  • Earnings/Investment Gains = Additional funds gained from your investment
    • Ex: I put $10,000 in a Roth IRA account. Ten years pass and my account is worth $20,000. Of this $20,000 in my Roth IRA, $10,000 are contributions and $10,000 are earnings/investment gains.
Advantages:
  • Contributions can be withdrawn AT ANY TIME penalty-free and tax-free.
    • Carlos invests $10,000 in a mutual fund. His investment value increases to $15,000. Okay so here’s where some people get confused. The initial $10,000 that Carlos invested is his “contribution”. The extra $5,000 in his account is called his “earnings”. Only the $10,000 can be withdrawn from the Roth IRA at any time without paying early withdrawal fees or income taxes. If Carlos wants to access that additional $5,000 in earnings, he must pay an early withdrawal fee IF he is younger than 59.5 or established his account less than 5 years ago. He must also pay income taxes on his investment gains upon withdrawal, regardless of age or account status.
  • No taxes on investment gains for qualified accounts
    • Carlos invests $10,000 in a mutual fund. His investment value increases to $15,000. As long as Carlos is at least age 59.5 AND established his account at least 5 years before withdrawal, he will pay no taxes or fees when he withdraws money from his account.
  • No required minimum distributions
    • Carlos could keep his money in his Roth IRA until he died. He does not have to withdraw this money.
Disadvantages:
  • There is an annual contribution limit of $5,500 ($6,500 if age 50 or older).
    • Carlos has $40,000 in after-tax dollars to invest, but he can only put $5,500 into his IRA! He’ll have to figure out where to invest the rest of his money.
  • Earnings (not contributions) withdrawn before age 59.5 or from an account established less than 5 years ago will incur early withdrawal penalties.
    • There are some exceptions to this rule, but generally, the funds are quite difficult to access without penalty.
When to use this type of account:

A Roth IRA is perfect for someone who is in a lower tax bracket NOW than at the time of withdrawal. Why? A Roth IRA is funded with post-tax dollars. Carlos would much rather pay taxes on his contributions now while he’s in the 22% marginal tax bracket, rather than pay at age 59.5 when he’s potentially in a higher marginal tax bracket!

The best part about a Roth IRA is that contributions can be withdrawn at any time with no early withdrawal or tax penalty.

 

Traditional IRAs

A Traditional IRA is a type of retirement account. Traditional IRAs are funded with pre-tax dollars. [Tax example: Monique earns $100,000 before tax. She contributes $5,500 to her Traditional IRA. Since the $5,500 she contributed to her IRA is pre-tax, she can subtract that from her taxable income. Monique now only pays income taxes on $94,500 of her earnings ($100,000 – $5,500)].

 Special Rules:
  • In order to avoid early withdrawal penalties, the account holder must be at least age 59.5 when he/she withdraws any funds from the Traditional IRA.
Advantages:
  • Decrease taxable income
    • In the example, Monique decreased her taxable income from $100,000 to $94,500 by contributing $5,500 to her Traditional IRA.
  • Defer taxation
    • Instead of paying taxes on your invested money now, you can contribute to a Traditional IRA and kick the can down the road. You will eventually have to pay income tax on the contributions when you reach age 70.5 and take required minimum distributions.
Disadvantages:
  • There is an annual contribution limit of $5,500 ($6,500 if age 50 or older).
    • Monique has $100,000 in pre-tax dollars to invest, but she can only put $5,500 into her IRA! She’ll have to figure out where to invest the rest of her money.
  • Difficult to access money before age 59.5 without paying early withdrawal penalties and income taxes.
    • There are some exceptions to this rule, but generally, the funds are quite difficult to access without penalty.
  • Required Minimum Distributions
    • When the account holder turns age 70.5, he/she must start making withdrawals from his/her account or face serious tax penalties. A required minimum distribution is classified as income and the account holder must pay income tax upon withdrawal.
 When to use this type of account:

A Traditional IRA is ideal for someone who is in a higher tax bracket NOW than at the time of withdrawal. Why? A Traditional IRA is funded with pre-tax dollars. Monique will not pay income tax on her contributions until she withdraws the money from her account. If Monique thinks she will be in a lower marginal tax bracket when she’s ready to withdraw, a Traditional IRA could be a smart investment.

This type of account has very little flexibility for early withdrawals, which might be worrisome in the case of an emergency. However, if you are in a very high marginal tax bracket, using a pre-tax account such as a Traditional IRA could be advantageous.

 

Individual Brokerage Accounts

An Individual Brokerage Account is also known as a taxable account. This means that after-tax dollars are contributed. [Tax example: John earns $50,000 before tax. He contributes $20,000 to his Individual Brokerage Account. John pays income taxes on his entire $50,000 earnings].

Advantages:
  • No contribution limits
    • In theory, John could invest all of his after-tax dollars into his individual brokerage account.
  • No early withdrawal penalties
    • John can access this money at ANY time. He will have to pay capital gains taxes on any investment gains though.
  • No required minimum distributions
    • John could keep his money in his individual brokerage account until he died. He does not have to withdraw this money.
Disadvantages:
  • Pay capital gains taxes when you sell a stock, ETF (exchange-traded fund), or mutual fund that has increased in value
    • Example: John invests $10,000 in a mutual fund. His investment value increases to $15,000. If John sells his investment, he must pay taxes on the $5,000 earnings ($10,000 + $5,000 = $15,000).
 When to use this type of account:

An Individual Brokerage Account is great for investing any money you have leftover after maxing out your IRA contributions ($5,500 annual limit between all Roth and Traditional IRAs). It’s important to utilize the tax advantages of an IRA, but the $5,500 contribution limit is restricting if you have more money to invest.

Summary

Hopefully, after reading this you have a general understanding of these three accounts. I just barely scratched the surface in terms of detail, but my aim was to give you a simple, broad overview.

If you’re interested in learning more about the differences between Roth and Traditional IRAs, check out these articles:

Vanguard – Roth vs. Traditional

Roth vs. Traditional IRAs

For those highly interested in financial independence, check out the Mad Fientist’s post on the best account for an early retiree.

Mad Fientist – Traditional IRA vs. Roth IRA

Taking Action

Now that you have a general understanding of the three main types of Vanguard investment accounts, let’s take action. Remember, every investor is different, so choose the account type that best suits you!

Step 1:

Go to https://investor.vanguard.com/home/

Click “Open an Account”.

Step 2:

This page details all the possible account types, although we will only focus on the Roth IRA, Traditional IRA, and Individual Account (Individual Brokerage Account). Select “Open a new account”.

Step 3

Next, Vanguard will ask how you will fund the account. In the example above I have “Check or transfer from my bank or another Vanguard account” selected. This is the option you will select if you do not have an investment account.

If you choose either of the other two options “Rollover from an employer plan” or “Transfer from a financial institution” there are a few more steps to take, but the process is fairly straightforward.

Step 4:

After making your selection on the previous page, click “Continue”. I selected “Check or transfer from my bank or another Vanguard Account”.

Since you presumably don’t have a Vanguard account yet, select “No”. You will establish your account during this process.

Step 5:

Then you will advance to Vanguard’s “checklist” page. This page basically just highlights the information you will need to open your account and details the new account process. After reading click “Continue”.

Step 6:

Great. So let’s open our account. Remember those three options I talked about earlier… Roth IRA, Traditional IRA, and Individual Brokerage Account? This is where you decide which account type to open. In the picture above I have “Retirement” selected and the two account types listed are “Roth IRA” and “Traditional IRA”. If you are planning on opening an IRA, choose one and click “Continue”.

This is the same page as above, but instead, I have “General Savings” selected. The Individual Brokerage Account we talked about earlier in this article is the “Individual (one owner)” option. For the purposes of this lesson, we will only focus on an Individual Brokerage Account. If you want to open a Vanguard Individual Brokerage Account, select “Individual (one owner)” and click “Continue”.

You will then have to input all your personal information in the “Tell us about you” section in order to move on to “Establish funding”.

Step 7:

Eventually, you will arrive at this page. Provide all your banking information and input an “Investment amount”. If you plan to fund the new IRA immediately, the minimum investment is $1.00! There’s no excuse to not get started today.

However, you can select the “Add money later” option and fund the account after it has been created if you prefer.

If you choose to fund the account immediately, Vanguard will make two small deposits into your bank account and you will verify these deposits in order to finalize your account. To verify your bank account you will just have to prove that you received the two deposits by typing their $ value into Vanguard. This process can take between 1-2 business days.

Step 8:

If you elected to open an IRA, you will see this page. If you are opening an Individual Brokerage Account, skip to Step 9.

Remember those IRA contribution limits I told you about? Vanguard asks how much money you want to contribute for each tax year ($5,500 annual limit, $6,500 if age 50 or older). You can contribute to your IRA up until April 17th of the following year! That’s a full 15 months!

For example, this screenshot was taken on April 10th, 2018, so Vanguard gives me the option to contribute for 2017 AND 2018. If I were to access this same page on April 19th, the only year available would be 2018.

Decide how much you want to contribute and enter your numbers. After inputting your contributions, click “Continue”.

Step 9:

When you arrive at this page, select the “Reinvest” option. Click “Continue”.

Step 10:

Now you’ve entered all your personal information, your bank information, and investment preferences. Double check to make sure all the information is correct. When you are ready, click the “Submit” button and you are done!

Congratulations! Once you verify the deposits made by Vanguard, your account is ready to invest. Now you’re ready for the Vanguard 101: How to Invest tutorial!

Keep Track!

Keeping track of your investments is important. Personal Capital is a FREE website that aggregates all of your financial information to help you track your net worth. I highly recommend using Personal Capital. Their website is easy to use, there is a mobile app, and it’s completely free! If you’d like to sign up, please use THIS LINK (You’ll get $20, FREE!).


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