Building Your Portfolio, Part 1: Accounts

Building Your Portfolio, Part 1: Accounts

I’ve decided to write a four part series of blog posts on building your investment portfolio.

Just that phrase alone, “investment portfolio,” may seem a little intimidating.  But I would like to try to demistify it and show you that anyone can, and should, begin building their own investment portfolio.

This series of posts is meant to work in tandem with my FI Step by Step series.  As you progress towards financial independence, you should be building your investment portfolio a little at a time.  

What is an Investment Portfolio and Do I Need One?

Your investment portfolio is simply the sum total of all of your various investments.  It is usually composed of multiple different accounts that hold various types of assets.  These could include cash, stocks, bonds, real estate, fine art, cryptocurrencies, commodities, precious metals, etc.  The aggregate of all your investments can give you important information about your overall diversification, exposure to risk, and expected returns.  

Do you need an investment portfolio?  You may think to yourself “I’m not a millionaire, I shouldn’t have an investment portfolio” or “I’m still in debt, I shouldn’t even be thinking about my investment portfolio.”

The reality, however, is that no matter where you are in your financial life, you should be building an investment portfolio.  The better question probably is “Should you be investing?”  And I would say the answer is an unequivocal yes.  Even if you are working on paying off debt, you should still be investing enough to at least get your employer match.

Back to the Basics

While many investors have an infinitely complex portfolio, I’m going to try and keep this as simple as possible for those that are just getting started.  Once you have the basic building blocks in place, you can start to get a little fancier.  

In today’s post I want to discuss the basic accounts you will need to get your portfolio started.  After all, you have to put your invested money somewhere.  

The second post will be about the types of investments you should consider, and in what proportion.  More specifically, we will discuss asset allocation.  

In the third post we will discuss specific investments within each asset class you should consider, such as individual stocks, bonds, mutual funds, index funds, ETFs, REITs, real estate, etc.  

In the last post we will discuss how to prioritize the order in which you should contribute to your investment accounts.  Understanding these concepts can optimize your taxes and maximize your investment returns.  

Factors to Consider in Choosing Investment Accounts

When choosing the accounts that will form the foundation of your investment portfolio, there are several important factors to consider:

Liquidity

Liquidity refers to how easily an asset can be bought or sold on the open market.  Cash is the most liquid asset, and is the measuring stick that other assets are compared to.  Cash in a high yield savings account is very liquid and easily accessible.  Equity in a rental property is much less liquid and difficult to access.  

Liquidity is very important to consider when building your investment portfolio.  You should save and invest for short term financial goals (like buying a car or going on a big vacation) in more liquid assets, while longer term financial goals (like retirement) can be in illiquid assets.  

Tax Optimization

For most Americans, taxes represent their number one expense.  If you can find a way to decrease your tax bill (legally), you should.  One of the best ways to do this is to invest your hard earned money in tax advantaged accounts.  This not only cuts down on your annual tax bill, but also increases the rate at which your portfolio grows since you are able to invest more.  As such, tax advantaged accounts should be a key part of your investment portfolio.  

Tax Diversification

Tax diversification may be a new concept for some of you, but it is nevertheless important.  You are likely familiar with the concept of diversifying your investments (don’t put all of your eggs in one basket).  Similarly, you are also able to diversify the tax treatment of your various investments.  By holding various investment accounts that have different tax rules/treatment, you can customize both your contributions and your eventual withdrawals to minimize the amount you owe in taxes.  

Another benefit of having various types of accounts with different tax treatment is you can place less tax efficient investments (REITs, bonds) in more tax efficient accounts, and more tax efficient investments (stocks, mutual funds) in taxable accounts.  

Financial Goals

Be sure to consider your overall financial goals when building your investment portfolio.  These should be part of your written financial plan.  Are these investments for a shorter term investment like buying a car, or longer term investments such as retirement?  Which accounts would be best to save for each different type of goal based on its time horizon and tax implications?

Investment Options

Every investment is not available in every account.  This is something I was unaware of when I started learning more about personal finance.  For example, most 401(k) plans only have a limited number of funds you can invest in, and some of them aren’t very good.  On the other hand, most IRAs with major brokerage firms have the full spectrum of investments available to you.  The various investment options available to you are a factor to consider when choosing which accounts you will use to build your portfolio.  

Availability/Eligibility

Is the account you are interested in available to you?  Perhaps you want to make Roth contributions to a 401(k).  First, you need to make sure that this is an option in your employer sponsored retirement plan.  Maybe you want to contribute to a health savings account (HSA).  If that’s the case, you need to make sure you have a high deductible health plan that makes you eligible to contribute to an HSA.  You may want to contribute to a Roth IRA but have too high an income.  If that’s the case, you need to explore backdoor Roth IRA contributions.  Before deciding on the accounts to include in your investment portfolio, do your homework and see what options you have.  

The Accounts

As you can see, there are a lot of things to consider when constructing your portfolio.  After considering these factors, here are four accounts that I recommend people use to begin building their own investment portfolio. I am going to assume that everyone already has a basic checking and savings account.

High Yield Savings Account

The first account I recommend is a high yield savings account.  A high yield savings account has a much higher interest rate than a standard savings account.  These types of savings accounts are usually offered by online banking institutions.  Because they don’t have as many of the costs of a brick and mortar bank, they can offer these higher interest rates.  As of this writing, the best interest rates available are only 0.8 to 0.9%.  It’s important to remember that the interest rates on savings accounts are variable based on the federal reserve interest rate.  Since the fed reduced their interest rate to near 0% due to the pandemic, banks have had to drop their rates as well (at the beginning of 2020 high yield savings accounts had interest rates from 2 to 2.5%).  While 0.8% isn’t much, it is still up to 80 times higher than the 0.01 to 0.05% interest rate offered at most banks for standard savings accounts.  

There are three main reasons I recommend you have a high yield savings account.  First, it doesn’t get any more liquid than this.  If you need your money right away, like for an unexpected emergency, you have near instant access to it.  Second, a high yield savings account is extremely low risk.  Not only is it FDIC insured up to $250,000, the amount in your account doesn’t change with the ups and downs of the market.  So you don’t have to worry about losing your money before you need it.  This makes a high yield savings account perfect for shorter term financial goals or an emergency fund.  Third, while the interest rates aren’t anything to write home about, you at least get something in return, putting you closer to keeping up with inflation.  

We actually have 4 high yield savings accounts, each earmarked for a different financial goal: savings for a future vehicle purchase, college savings (in addition to 529 plans),  our emergency fund, and savings for future real estate investments.  I use Ally Bank because they have competitive rates, good customer service, and I like their online platform.  

401(k)

The second account I recommend is your employer sponsored retirement plan.  For most people, this will come in the form of a 401(k) or 403(b).  If you are self-employed, you could substitute this with a solo 401(k).

Since your 401(k) is an employer sponsored retirement plan, your employer is the one who chooses the plan sponsor, which affects the investment options offered in the plan.  Sometimes these are plans with major brokerages that have excellent investment options (like the one I have with Fidelity), and sometimes they are not.  Either way, you can still be wise in choosing your investments and take advantage of the perks these plans offer.  

The primary reason you need to have this account in your investment portfolio is the tax advantage.  Most people contribute to their 401(k) plans on a pre-tax basis.  This means that the amount you contribute is deducted from your taxable income, which means you owe less in taxes.  This allows you to invest more and grow your wealth on a tax deferred basis.  Even though you will owe taxes when the money is distributed in retirement, there are a number of strategies you can use to minimize this tax bill.  

Another important reason to have this account as part of your portfolio is your employer match.  Most employers that offer a 401(k) plan also offer some form of an employer match.  This is the highest return for your money you can possibly get, which is why many call this “free money.”  It should be one of your highest priorities when building wealth.  

Roth IRA

The third account I recommend is a Roth IRA.  IRA stands for Individual Retirement Arrangement per the IRS website, but most people just call this an Individual Retirement Account.   Since this is an individual account, both you and your spouse can have their own IRAs.  In order to contribute to an IRA, you must have earned income.  However, if you are married and only one spouse has earned income, the other spouse can still open a spousal Roth IRA.    

The main reason to have a Roth IRA is it’s unique tax advantage.  A Roth IRA gives you a place to invest post-tax dollars that can then grow tax free AND be withdrawn tax free.  It’s a pretty great feeling to know that any money you have in a Roth IRA will never be taxed again.  I recommend a Roth IRA rather than a traditional IRA because it gives you tax diversification when paired with your pre-tax 401(k) account.  Everyone should have an account that allows them to make tax free withdrawals in their investment portfolio.

It is important to know that there are income limits on direct Roth IRA contributions.  In 2020, if you make more than $139,000 as a single individual or $206,000 as a married couple, you cannot contribute directly to a Roth IRA.  However, you can make an indirect contribution through a mechanism known as a backdoor Roth IRA conversion.

Another reason to have a Roth IRA in your investment portfolio is that it can give you access to the full spectrum of investment options.  As opposed to the limited investment options in many 401(k) plans, you can invest in nearly any stock, mutual fund, or ETF you want in your IRA.  It is very easy to open a Roth IRA with any of the major brokerages, such as Vanguard, Fidelity, Charles Schwab, TD Ameritrade, etc.

My wife and I both have Roth IRAs with TD Ameritrade.  We make backdoor contributions to them each year.  It is one of my favorite accounts because I know the money there will never be taxed again.

Taxable Brokerage Account

The final account I recommend is a taxable brokerage account.  If you fill up your tax advantaged spaces in your 401(k) and your Roth IRA, meaning you contribute the maximum amount to each account in a given year, and you still have more money to invest (way to go by the way!), the next best option is a taxable brokerage account.  

A taxable brokerage account is funded with post-tax dollars.  It is called a taxable account because as the money grows, you will owe taxes on any dividends or interest received.  Furthermore, you will owe taxes on any capital gains when you sell an investment.  However, despite these taxes owed, a taxable brokerage account has some great features and should be a part of the foundation of any investment portfolio.

One advantage of a taxable brokerage account is that it is very liquid.  As opposed to your 401(k) and Roth IRA where you would have to pay a penalty to access your money before age 59 1/2 (with the exception of Roth contributions), you can pull money out of your taxable brokerage account at any time penalty free.  

Another advantage of a taxable brokerage account is that it gives you access to the full spectrum of investment choices.

Finally, there are no annual contribution limits to a taxable brokerage account.  So you can keep investing in it as much as your income and savings rate will allow.  

Conclusion

Today we’ve discussed the building blocks of a basic investment portfolio.  I have recommended four basic accounts to begin building your portfolio: a high yield savings account, your 401(k), a Roth IRA, and a taxable brokerage account.  If you have these four accounts, you check all of the boxes we mentioned above in factors to consider:

• You have liquidity without penalty in both your high yield savings account and taxable brokerage account
• You achieve tax optimization by contributing to tax advantaged accounts
• You have tax diversification with both a tax advantaged pre-tax account (401(k)) and a post-tax account (Roth IRA)
• You can save for both short term and long term financial goals with these investment vehicles
• These four accounts cover a broad spectrum of investment options
• Each of these accounts, or a similar variation, is available to nearly everyone

After you build this foundation for your investment portfolio, you can start to look at other accounts and options such as an HSA, 529 plans, a donor advised fund, and real estate investments.  But first, start with the basics and begin building your investment portfolio today.  Here are some take home points to consider and some action items.  Don’t just read what I write about, decide to take action and begin building your investment portfolio today.

• Everyone should begin building an investment portfolio, regardless of their overall financial situation.  Even if you are in debt, there are still some investments you should be taking advantage of, such as your employer 401(k) match.

• Open up a high yield savings account today.  They are easy to open and give you a place for your emergency fund and short term financial goals.

• Make sure you are signed up for your employer sponsored retirement plan, most likely a 401(k) or 403(b).  If you already are, make sure you are contributing enough to get your employer match.

• If you don’t already have a Roth IRA, sign up for one today.  They are easy to open with any major brokerage.

• Open up a taxable brokerage account.  Again, they are easy to open with any major brokerage and should be part of our investment portfolio.

Thanks for reading.  In the next post in this series we will discuss how to determine what asset allocation is right for you in your investment portfolio.

I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keep working towards Freedom Through FI!

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