In this post, we will look at the 5 reasons to diversify your accounts, but first, here is our disclosure.
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Diversifying Your Investments and Your Accounts
We all have heard that we should diversify our investments across stocks and bonds to minimize risk and maximize returns. What about diversifying the types of accounts you use to hold those investments? Diversifying where you place your money can help you with such things as liquidity and taxes and allow you many more investment options. So, without further delay, here are 5 reasons to diversify your accounts.
1. Liquidity
What is liquidity?
Liquidity is how quickly you can convert an asset or security into cash.
This would make cash in your wallet or savings account the most liquid asset. Your house would be on the other end of the spectrum. It is hard to sell a home, making it an illiquid asset. Do you know what else is not a liquid asset? Your 401K before you reach retirement age. After you retire, it becomes liquid, but not so much before that time.
Many people have their money tied up in their homes and an employer-sponsored retirement plan like a 401K. Sure, the investments in their 401K might be diversified, but they are a sitting duck regarding liquidity. They have almost all their money in illiquid assets or accounts.
A good rule of thumb is to have roughly 15% of your net worth in liquid assets. This does not mean taking 15% of your portfolio and stuffing it into a savings account. And please do not confuse liquidity to mean only having an emergency fund. The key is to have 15% of your net worth in assets that can be converted to cash in days, not weeks, months, or years.
Sure, some of that money can be your emergency fund of 3 to 6 months of expenses that you have held in a high-yield savings account. But it also means investing in marketable securities through a brokerage account instead of just a retirement account. These securities, like stocks, ETFs, or index funds, can be converted quickly to cash because they are held in a brokerage account.
The Example of Mr. Money
Mr. Money is in his late 30’s and doing pretty well for himself, having amassed a net worth of $500,000. His net worth grew quickly over the past few years as the red-hot housing market added thousands of dollars to his home’s value. But there is one big drawback to his net worth, and that is $485,000 of his net worth is in illiquid assets.
The equity in his house makes up a big chunk of his net worth, with the rest being in a 401K plan. Mr. Money only has $10,000 in an emergency fund and another $5,000 in a money market account, and he does not hold any other investments outside of his 401K. This means only 3% of his net worth is liquid.
A big Problem Just Got Bigger
One day, Mr. Money comes home from work to find that a pipe had burst in his bathroom, causing extensive damage. A contractor tells him it will cost $20,000 to repair the damage. Now Mr. Money has a big problem. How is he going to pay for this repair? He only has access to $15,000 out of his $500,000 net worth, and if he puts all of that $15,000 toward the repair, he will deplete his emergency fund and money market account.
Mr. Money is left with very few choices. He has to get the bathroom repaired but does not have the money to do so. Mr. Money decides to go to the local bank and takes out a home equity loan to cover the repair cost at an interest rate of 5%. Mr. Money, who has a net worth of $500,000, had to take on debt and pay 5% to service that debt for a $20,000 repair.
Imagine how different this scenario would have been if Mr. Money had 15% of his net worth in liquid assets. He would have had access to $75,000 of his $500,000 net worth to cover the repair. He could have pulled cash from a savings account or cashed out some stocks from his brokerage account.
Bottom Line
It is an excellent idea to minimize liquidity risk by avoiding having all your net worth wrapped up in non-liquid accounts like a 401K or an asset like your home. Ensuring you have adequate liquid assets serves you in an emergency by helping to make up for any shortfalls you may have in an emergency fund.
2. Greater Investment Choices
Employer-sponsored retirement accounts, like a 401K, are a great way to save for retirement, but you are at the mercy of your employer. They choose the plan and the selection of funds that are offered, not you. Your investment choices are limited to only those funds in the plan. You can unlock your investment options by opening an IRA or brokerage account in addition to your employer-sponsored retirement account.
By investing outside of an employer-sponsored retirement account, you now have a myriad of options to choose from. Besides your typical mutual and index funds, you can now invest in individual stocks or ETFs. Or, maybe you want to invest in companies focusing on sustainability or creating diverse and inclusive workplaces. You can also expand into debt instruments like government bonds and treasuries. And if real estate is your thing, you can invest in publicly traded REITs.
Expanding into other accounts can give you greater control and more options. However, it’s important to be cautious about investing in too many unfamiliar areas. While diversifying your accounts is a wise move, spreading your money too thin could lead to missed opportunities for returns. You also need to be mindful of fees as you broaden your investments.
It’s important to keep track of fees and expenses as you explore various accounts and investments. These costs can significantly reduce your returns over time. To minimize expenses, consider using a low-cost brokerage company like Fidelity or Vanguard when opening new investment accounts. By doing so, you’ll be able to keep a tight rein on fees and expenses.
Speaking of fees, let’s move on to the next reason to diversify your accounts: Cost control.
3. Cost Control
You cannot always control the fees and expenses of investing and saving. If you take advantage of an employer-sponsored retirement account at work, you may be paying more in fees and investment costs than you want. You are at the mercy of who your employer chooses to administer the program and the funds they make available for you to invest in.
None of this is to say you should stop investing in your employer-sponsored retirement account. Instead, do not let your 401K prevent you from taking advantage of other investments and savings options.
You can expand on your investment options and lower fees by opening investment accounts outside of your 401K or other employer-sponsored retirement accounts. The key, once again, is to open these additional accounts at a low-cost brokerage company. For example, I like Fidelity. There are no minimums or fees to open a brokerage or IRA account. Fidelity charges nothing to buy and sell stocks and offers many funds and ETFs with very low expense ratios and no minimums required to invest.
You can also lower your fees on checking and savings accounts by using online banks. They tend to offer greater yields with minimum fees. They will also offer competitive rates on certificates of deposits (CDs). Just make sure the bank is FDIC insured.
The reason why you need to be so mindful of fees and expenses is because of the power of compounding. Even small percentages can accumulate into significant amounts of money over time. The difference between a fund with an expense ratio of 0.015% and one at 1% can end up costing you thousands if not hundreds of thousands of dollars over 40 years.
4. Taxes
If you’re anything like me, the mere mention of taxes can send shivers down your spine. Unfortunately, taxes are an unavoidable part of life that we all have to deal with. However, by diversifying your accounts, you can have more control over how and when you’re taxed, leading to a more effective tax strategy.
When you contribute to a retirement account offered by your employer, the funds are deducted from your pre-tax income and accumulate tax-free until you withdraw them. This approach helps you reduce your taxable income while you are working and defer the tax payment until you retire. However, if you choose a Roth IRA, the opposite is true.
When you choose to invest in a Roth IRA, you use after-tax dollars. The biggest advantage of this account is that your money is able to grow tax-free, and your withdrawals during retirement won’t be taxed either. However, you won’t receive the same upfront tax benefits that come with a 401K or other employer-sponsored retirement accounts. When combined, these accounts can create a powerful financial strategy. What about other accounts that are not tied to retirement?
Investing in a brokerage account can be a tax-efficient way to grow your wealth until you decide to sell. When you invest in a company’s stock or funds, you won’t face taxes on any profits until you sell those securities. However, be cautious when selecting investments for your brokerage account. Opting for actively managed mutual funds may lead to higher capital gains taxes, so it might be wiser to invest in passive index funds and ETFs in a taxable account.
5. Accessing Money
Utilizing various account types is a smart money move leading to greater control over when and how you access your funds. This approach allows you to manage liquidity based on your preferences and needs. Having greater control over liquidity is super important as you approach the golden years of your retirement.
For example, funds in a 401K account can only be withdrawn without facing penalties from the age of 59 1/2 onwards. Attempting to withdraw the money before then will result in strict penalties and regulations. Additionally, when you reach the age of 72, you must withdraw the required minimum distributions, regardless of whether you need the funds or not. On the other hand, a Roth IRA takes a different approach allowing for increased flexibility.
Unlike a 401K, with a Roth IRA, there are no required minimum distributions. You can also withdraw money sooner than age 59 1/2 penalty-free if you are a first-time homebuyer or for higher education. However, it’s important to note that the regulations surrounding Roth IRA withdrawals can be complex. To learn more, I recommend checking out Investopedia’s article on Roth IRA Withdrawal Rules
Savings and money market accounts allow you to withdraw money at any time. You can do the same with a brokerage account but must deal with the tax implications. Other accounts fall between the strict rules of retirement accounts and the freedom of savings accounts.
Conclusion
We all know the importance of diversifying your investment portfolio to avoid holding all your eggs in one basket. This helps to minimize the risk associated with investing. The same is true regarding the types of accounts you hold. When it comes to financial planning, diversifying your accounts is a smart move that can yield numerous benefits.
Firstly, it enables you to access a broader array of investment options, which can help you achieve your financial goals. Moreover, diversification can help mitigate liquidity risk as you want to be able to access your funds when you need them most. Additionally, diversification can aid in tax planning, potentially reducing your tax liabilities and increasing your bottom line. Finally, diversification can also help lower investment costs, allowing you to retain more of your hard-earned money. Overall, diversifying your accounts is a prudent financial strategy that can pay dividends in the long run.
Key Takeaway: It is not a good strategy to keep all your investments in a single account, just like how you wouldn’t put all your eggs in one basket. Diversification is key for a well-rounded investment portfolio.
