What types of investment accounts are there, and how do they differ?
You have several investment options in the market, and I’m not just talking about different stocks and bonds. The type of investment account you use will be one of the biggest investment decisions you’ll make.
Some investment accounts let you invest and withdraw as much as you want, whenever you want. Others come with contribution and withdrawal limitations, making up for them with tax advantages.
If you manage your portfolio properly, you’ll probably have at least two different account types and could have many more. Find out why and which ones below!
Types of Investment Accounts
Most brokerages offer a wide range of different account types. The most common types of accounts include:
1. Taxable Brokerage Accounts
- Eligibility. Anyone 18 years of age or older.
- Investment Options. Any assets offered by your broker. Most offer several investment products including stocks, bonds, exchange-traded funds (ETF), options, and futures. You can also access the forex and cryptocurrency markets with some taxable accounts.
You can contribute any amount of money you want to a taxable brokerage account and choose your own investments. But there’s no special tax treatment. The income you generate in a taxable account is taxed at your standard income tax rate when the investment is held for less than a year or at the capital gains tax rate on investments held for longer than one year.
2. Employer-Sponsored Retirement Savings Accounts
Retirement savings accounts are tax-advantaged investment accounts designed to incentivize investors to plan for their retirements. In most cases, retirement savings accounts have contribution limits and holding period requirements that may lead to penalties for early withdrawals.
About 50% of employers offer retirement benefits according to ADP. Those benefits are provided through employer-sponsored investment accounts. These are the common types of retirement accounts that fall into this category.
- Eligibility. You must work for a company that offers 401(k) plans. Some plans require participants to be age 21 or to have worked for the company for a while before becoming eligible for the employer’s plan.
- Investment Options. The company you work for is in charge of choosing the retirement plans for the company. In most cases, you either invest in the company itself or a list of diversified exchange-traded funds and mutual funds.
401(k)s are the most common type of employer-sponsored retirement account. You can contribute to your 401(k) on a pre-tax basis, meaning it’s a tax-deferred investment account. You won’t be taxed on contributions or growth in the account until you access the money in retirement. However, you will pay taxes at your current income tax rate when you withdraw funds.
A Roth 401(k) works like its traditional counterpart. Eligibility and investment options are the same. The difference between the two is how they are taxed and how you access the money in the account.
Roth 401(k)s are funded on a post-tax basis, meaning you don’t get a tax break on your contributions today. You can withdraw contributions tax-free at any time. If you withdraw non-contribution funding (your gains) from the account before you’re 59 ½, you will have to pay income tax on the non-contribution funding portion of the withdrawal plus a 10% fine imposed by the IRS.
Once you turn 59 ½, all withdrawals from the account are tax-free as long as you’ve had your account for at least five years.
- Eligibility. If your employer offers a 403(b) plan, you’re eligible for inclusion as long as you work at least 20 hours per week. 403(b) investment plans are only offered by non-profit organizations, such as churches, educational institutions, and other public service organizations.
- Investment Options. Your employer makes the investment plan decisions. In most cases, 403(b) investments are made in mutual funds and annuities.
403(b) investment plans come with contribution limits. Moreover, the IRS will impose a 10% penalty on withdrawals before you turn 59 ½. Once you turn 59 ½, you’ll pay your current income tax rate when withdrawing funds.
- Eligibility. 457 plans are usually provided by state and local government agencies to non-federal government employees. However, some nonprofit organizations also provide 457 retirement plans.
- Investment Options. 457 plans are limited to mutual funds and annuities.
457 plans work just like 401(k)s in terms of taxes and withdrawals. You can withdraw money without penalty when you turn 59 ½ years old, and you’ll pay your ordinary income tax rate when you access your money.
- Eligibility. If your employer offers a SEP IRA, you’re eligible as long as you’re 21 years of age, make at least $600 per year, and have worked for the company for three out of the past five years.
- Investment Options. Although your employer sponsors this plan, you choose your own investments. Your broker will dictate the investment products you have access to, but they generally include stocks, bonds, ETFs, mutual funds, and certificates of deposit (CDs).
SEP IRAs are a popular choice for small business owners who want to provide retirement benefits to their employees. They’re also a common way for self-employed people to save for their own retirement through their business.
Employees don’t make contributions to SEP IRAs at all. All contributions are made by the employer, which makes no difference if you’re self-employed.
SEP IRAs follow traditional tax-deferred investment tax rules. Contributions are made on a pretax basis, giving you a tax break today, and you’ll pay your ordinary income tax rate if you withdraw funds after you turn 59 ½. If you withdraw funds early, the IRS imposes a 10% fee on top of the associated tax burden.
- Eligibility. Small businesses that don’t offer other investment programs sometimes offer these plans. The eligibility requirements for these plans are set by your employer.
- Investment Options. Mutual funds and annuities.
SIMPLE IRAs are tax-deferred investments, meaning you make pretax contributions into the account. You can access your money penalty-free at age 59 ½, but you will pay a 10% penalty to the IRS if you withdraw funds early. You’ll pay your ordinary income tax rate when you withdraw your money.
3. Individual Retirement Accounts (IRAs)
Individual retirement accounts, or IRAs, are available with most brokers. The biggest difference between these accounts and employer-sponsored plans is that your employer usually isn’t involved in your IRA holdings. IRA accounts are created and maintained by individuals who own the account in every way.
IRAs are often the most practical option if you’re self-employed or not eligible for an employer-sponsored retirement plan through your work
- Eligibility. Anyone over 18 can set up an IRA.
- Investment Options. Stocks, ETFs, mutual funds, and annuities.
Traditional IRAs work like most traditional retirement investments. Contributions to your IRA are tax deductible now, but you will be charged your standard income tax rate when you access the funds in the future. The IRS will impose a 10% penalty if you access the funds before you turn 59 ½.
You can set up an IRA for yourself through most brokerages. Some discount brokers offer no-fee IRAs, letting you hold onto more of your gains.
- Eligibility. Anyone over 18 can set up a Roth IRA. However, the IRS sets maximum annual income caps above which you lose the ability to contribute to a Roth IRA ($144,000 for individual filers or $214,000 for joint filers in 2022).
- Investment Options. Stocks, ETFs, mutual funds, and annuities.
Roth IRAs are similar to traditional IRAs in terms of setup and investment options. The primary differences between the two are related to how you’re taxed and when you can access your money.
When you invest in a Roth IRA, you make contributions on a post-tax basis, meaning contributions aren’t tax-deductible. You can withdraw your contributions tax-free at any time without penalty. However, if you withdraw the investment gains in your account before you’re 59 ½, you’ll pay your ordinary tax rate in addition to a 10% IRS penalty.
Once you’re 59 ½, withdrawals are completely tax-free. Moreover, your heirs won’t pay taxes on Roth IRA inheritances.
4. Education Savings Accounts
Education can be expensive. However, there are two types of education savings accounts you can open to help relieve the financial burden.
529 Savings Plans
- Eligibility. 529 savings plans can be opened by anyone 18 years old or older for themselves or their children.
- Investment Options. Available options depend on your provider. Some offer access to stocks, ETFs, and mutual funds, while others only offer a diversified blend of mutual funds.
Most 529 savings plans are investments in a portfolio of mutual funds, stocks, and ETFs. However, some are provided by educational institutions and act as prepaid college tuition plans. Parents who sign up for these plans pay today’s prices for their children’s education years from now.
Contributions to 529s are not tax-deductible, but in most cases, you won’t pay taxes on contributions or gains when you withdraw them to pay for college and related educational expenses.
However, contributions made by donors are considered gifts for federal tax purposes. As of 2022, the first $16,000 contributed from each donor to a beneficiary is exempt from federal gift taxes annually. All other donations to your 529 savings plan will be taxed at between 18% and 40% depending on how far your cumulative gifts add up above gift tax limits. These taxes are usually paid by the party giving the gift.
Coverdell Education Savings Plan
- Eligibility. Your taxable annual income must be below $110,000 if you file as an individual or $220,000 if you’re a joint filer.
- Investment Options. Some providers have limitations, but most offer stocks, bonds, ETFs, and mutual funds.
Coverdell Education Savings Plans can be used to cover the cost of private elementary, middle, and high school as well as college expenses.
The Coverdell Education Savings Plan works just like the 529 savings plan in terms of taxes. The biggest difference is that Coverdell plans usually come with more investment options and provide more freedom when it comes to tax-free uses of the invested money.
There is one major drawback to choosing a Coverdell plan over a 529 plan: 529 plans can be transferred to other family members, whereas Coverdell plans can’t.
5. Health Savings Account (HSA)
- Eligibility. Your health insurance plan must be categorized as a high deductible health plan (HDHP). You qualify if your deductible on your health insurance plan is over $1,400 for individual plans or $2,800 for family plans.
- Investment Options. Mutual funds are the only available asset in most cases. Some HSAs allow investments in stocks, bonds, and ETFs.
Health Savings Accounts (HSAs) allow you to save for medical expenses and retirement at the same time. All balances in your HSA roll over from year to year.
HSAs are known as triple advantaged accounts because contributions, growth, and withdrawals are all tax-free as long as the money is used to cover medical expenses.
If you use the money in your HSA for any other purpose before you’re 65 years old, you’ll pay a 20% penalty.
When you turn 65, the 20% penalty goes away and you gain penalty- and tax-free access to all the money you saved for any purpose you deem necessary.
How to Choose the Right Investment Account for You
In most cases, you should have more than one investment account. At a bare minimum, you should have at least one taxable account and one retirement account. Here’s why:
- Taxable Accounts. Taxable accounts give you access to market gains in the here and now. They’re a great way to save for big goals like buying a new car or putting a down payment on a house.
- Retirement Accounts. Investors should also have at least one kind of retirement account. These accounts penalize early access to retirement funds, meaning you’ll try every other option before tapping into your retirement savings. This may be a pain in the heat of the moment, but it’s a great way to ensure your golden years glimmer.
As outlined above, there are multiple styles of investment accounts to choose from. Follow these steps to determine which is your best option:
- Ask Your Employer About Retirement Benefits. Take advantage of any retirement plan offered by your employer. If your employer matches contributions, contribute as much as you can afford to until you hit the match cap for an immediate return on your investment.
- Consider the Trade-Off. Most traditional investment accounts are tax-deferred. This means you pay taxes when you cash out but contributions are pretax and are deducted from your taxable income. Roth accounts don’t offer tax write-offs today, but you won’t pay taxes when you cash out in most cases. If you don’t need the tax break today, a Roth account is the better option. On the other hand, if you need as many deductions as you can get, traditional accounts are the way to go.
- Decide Whether an IRA is Best. If your employer doesn’t offer a retirement plan with matching contributions, or you’d like to contribute more than your employer will match, you may want to consider an IRA. IRAs are a great option if you’re not a fan of your employer’s chosen investment plan or your employer doesn’t offer a retirement benefit.
If you’re a parent or plan to go to college yourself, you should strongly consider an education savings account. This will allow you to take a slow and steady approach to paying for higher education.
Parents should also consider a custodial investment account because they provide a great way to teach your children about building wealth by investing.
Finally, if you’ve reached your goals in your retirement accounts and want to solidify higher levels of residual income through your golden years, you might consider an annuity. These investments provide fixed income over a predetermined period of time, and like other retirement-style investments, they can also be tax-deferred, reducing your current tax burden if necessary.
See the chart below for a simplified view of the types of accounts you should have.
|Account Type||Who Should Have One?|
|Retirement Savings Account||Everyone|
|Educational Savings Account||Anyone with plans to pay for higher education|
|Health Savings Account||Anyone with a high deductible health plan|
|Annuities||Anyone who has maxed out traditional retirement account contributions|
When you get started in the stock market, you’ll likely start with a standard taxable investment account. Over time, you’ll realize that in order to efficiently achieve different financial goals, different types of investment accounts will come into play.
In many cases, people manage four or five different accounts, each designed to achieve different objectives over different periods of time. You’re the most important factor when it comes to deciding which investment account types to open. Consider your financial, educational, medical, and tax needs when determining which account types you should have in your portfolio.