Depending on your long-term goals, saving money in the bank may not be enough. Many people turn to investing to help grow their money. If you are new to investing, getting started can feel intimidating.
You may be asking:
- How does investing work?
- How do you choose investments?
- What risks should you consider?
This guide answers these questions. Below, you will find common types of investments, along with key terms, tax considerations, and potential risks to help you shape an approach that aligns with your goals.
What Is Investing?
Investing means putting your money to work. You place cash into an asset with the goal that it will grow over time. A key part of investing is understanding risk.
There is always a chance you could lose money or that your investments will not grow.
The Power of Compound Interest
How does investing grow your money? One key factor is compound interest. Compound interest is interest earned on both the original amount and the interest that builds over time.
For example, say you invest $1,000 and earn 10%. In the first year, you earn $100 and have $1,100 total. If you continue earning 10%, the next year you earn $110.
At first, gains may seem small. Over time, earnings can grow beyond what you originally invested. However, past performance does not guarantee future results. A strong year is not always followed by another.
Different Types of Investments
Stocks
When you buy stock, you purchase a small ownership share in a company. If the company performs well, you may benefit.
If the company’s outlook improves after you invest, the stock price may rise. You could sell your shares to another investor for more than you paid. When a company has strong earnings, it may pay shareholders cash payments called dividends.
Stocks offer the potential for higher returns, but they can be more volatile than other investments. You could lose money if prices fall and you sell your shares.
Bonds
Bonds are similar to making a loan to a company or the government. You provide money, and in return they agree to pay a set interest rate during the bond term and repay the original amount by a specific date.
Bonds are often considered less volatile than stocks because they promise scheduled interest payments. However, they are not risk-free. If the issuer runs into financial trouble, it may not make interest payments. In extreme cases, the issuer could declare bankruptcy and you could lose your investment.
Mutual Funds & ETFs
If you want support managing investments, you can buy shares in a mutual fund or exchange-traded fund (ETF). These funds create a portfolio that may include:
- Stocks
- Bonds
- Other assets
When you invest in a fund, you own a small portion of a larger portfolio. This allows you to invest in many assets without selecting each one individually.
A professional investment manager oversees the fund and adjusts the holdings as needed. In return, the fund may charge management fees.
Alternative Investments
In addition to traditional assets, there are alternative investments. These may include:
- Real estate
- Gold and other precious metals
- Hedge funds
- Venture capital
- Commodities such as oil and timber
Alternative investments may offer higher return potential, but they can also be more complex and carry greater risk.
Types of Investment Accounts
Brokerage Accounts
A brokerage account lets you buy stocks, bonds, mutual funds, and other investments. You open the account through a registered broker-dealer. Depending on the account type, you may owe taxes each year on investment gains.
Retirement Accounts
Retirement accounts are designed to help you save for the future. The IRS limits how much you can contribute each year to certain accounts. Most withdrawals are subject to income tax. If you take money out before age 59½, you may also owe an additional 10% tax.1 Additional taxes or penalties may apply based on the account type and the reason for the withdrawal.
Common retirement accounts include:
- Traditional Individual Retirement Account (IRA): This account lets you contribute pre-tax dollars, which may lower your taxable income today. You pay income tax on withdrawals in retirement. Unlike a 401(k) or pension, it is not employer-sponsored, so you can open one on your own.
- Roth Individual Retirement Account (IRA): With this account, you contribute after-tax dollars. If you are age 59½ and have held the account for at least five years, qualified withdrawals may be tax-free, including earnings. Investment gains are not guaranteed, and you could lose money.
- 401(k): This is an employer-sponsored retirement plan available through your workplace. Plans may offer traditional or Roth contributions, depending on how they are set up. Some employers allow you to split contributions between both types.
Education Accounts
There are also accounts designed to save for education expenses. Some allow earnings to grow tax-deferred, and qualified withdrawals may be tax-free.
529 Plan
According to the IRS, there are no income limits to open a 529 plans.2 Although typically used for college expenses, up to $10,000 per year can be used for tuition at a private elementary or high school.
Coverdell Education Savings Account (ESA)
A Coverdell ESA gives you allows funds to be used for certain K–12 expenses, such as uniforms and room and board at eligible schools. Annual contributions are limited to $2,000 per beneficiary.
Choose an investment account that aligns with your goals. Invest In My Future
Taxes on Investments
Capital Gains
When you sell an asset for more than you paid, your original investment is not taxed because it is a return of your own money. The profit is taxed as a capital gain.3
For example, if you buy a stock for $100 and sell it for $200, you receive $100 tax-free and owe tax on the $100 gain.
Tax treatment depends on how long you held the investment:
- If held for one year or less, the gain is short-term and taxed at your ordinary income tax rate.
- If held for more than one year, the gain is long-term and may be taxed at a lower rate, generally ranging from 0% to 20%, with some exceptions.
Dividends
Stocks and mutual funds may pay dividends during the year. Dividend income is taxable in the year received, even if reinvested. Tax treatment depends on the type of dividend and how long you held the investment.4 In many cases, qualified dividends are taxed at long-term capital gains rates.
Retirement Plans
With traditional retirement accounts such as a 401(k) or IRA, taxes on investment gains are deferred until withdrawal. During retirement, distributions are taxed as ordinary income.
With a Roth IRA or Roth 401(k), qualified withdrawals may be tax-free because contributions were made with after-tax dollars. Withdrawals before age 59½ or before meeting the five-year rule may result in a 10% penalty, unless an exception applies.
What Are the Risks of Investing?
The Securities and Exchange Commission (SEC) identifies several risks investors should understand.5
Business Risk
Business risk is the possibility that a company fails and you lose your investment. Diversifying across multiple companies may reduce exposure, but it does not eliminate risk.
Volatility
Market prices can change frequently. If you watch the market day-to-day, prices go up and down constantly. Volatility refers to how much and how quickly prices move. Regularly reviewing your goals and risk tolerance can help guide decisions about buying or selling investments.
Interest Rate Risk
Some investments, such as bonds, pay fixed interest rates. If market rates rise after you invest, newer bonds may offer higher returns. This can make existing bonds less attractive.
Liquidity Risk
Liquidity refers to how easily an investment can be converted to cash. Some investments can be sold quickly, while others may involve delays, price reductions, or penalties for early withdrawal.
Inflation Risk
Over time, inflation raises the cost of goods and services. If money remains in cash, its purchasing power may decline.
The Bottom Line
As you begin investing, use this guide as a starting point and continue building your understanding over time. The more you learn about different investment options, risks, and tax considerations, the more confident you may feel in your decisions. Speaking with a qualified financial professional can also provide guidance tailored to your goals and timeline.
Start investing to help your money potentially grow over time. Invest In My Future
Sources
- Retirement Topics - Exceptions to Tax on Early Distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.
- 529 Plans: Questions and Answers. https://www.irs.gov/newsroom/529-plans-questions-and-answers.
- Topic No. 409, Capital Gains and Losses. https://www.irs.gov/taxtopics/tc409.
- Topic No. 404, Dividends. https://www.irs.gov/taxtopics/tc404.
- What is Risk? https://www.investor.gov/introduction-investing/investing-basics/what-risk.
