Types of Investment Accounts
If you want to reach your financial goals in life, it’s time to start investing. That way, you can put your money to work for you.
Investing is one of the most important personal finance decisions that you will ever make.
The sooner you start putting money aside strategically into accounts, the sooner it will grow and start collecting compound returns — making it that much easier to achieve financial independence.
Investments vs. Deposits
First, some terms. An investment is a financial transaction that serves to increase the principal amount through appreciation. When you make a deposit into a checking account or savings account, your money is usually backed by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA) up to $250,000.
What this means is that if the financial institution goes belly up or someone breaks into the bank and steals your money, the government insures up to $250,000.
When you make an investment (e.g., in the stock market), the money is not insured by a federal institution. As such, investments are riskier than deposits and so you risk losing money due to market volatility or bad investment choices.
Why People Invest
The reason people invest instead of depositing all of their money into insured accounts is that investment accounts offer much higher growth potential.
In addition, investment accounts can come with certain tax benefits that can defer tax obligations until retirement, allowing the money to grow tax-free for decades — and in doing so, giving investors more money to play with in the market.
Why Are Investment Accounts Important?
Investment accounts are important because they can help provide portfolio diversification.
Most investors choose to leverage a mix of secure checking and savings accounts and riskier investment options. What’s more, some investments are riskier than others. There are some strategic investments that you can make that will protect you from market volatility, allowing you to capitalize on higher returns with less risk of losing all of your money during an unexpected downturn.
Now that you have a general overview of investment accounts, here is a breakdown of some of the various options that you should consider.
The first thing you’ll want to do if you’re considering investing is finding a brokerage firm.
A broker is a financial provider that makes or facilitates investments on your behalf. In other words, you place investment orders through the broker, and they go ahead and complete the transaction.
When you’re buying or selling financial products, you want to look for licensed and accredited brokers. These individuals provide market data, investing tools and support, and serve to guide you to make the right decisions.
Are brokers necessary?
Brokers aren’t required by law and some investors will choose to forego them in order to avoid paying fees, although more and more brokers are offering free trades for their customers. Investors may choose to use a transfer agent or a direct purchase plan through an employer to avoid using brokers.
This approach is usually not recommended for beginner investors. The tried-and-true method to purchase financial products like stocks, exchange-traded funds (ETFs), and mutual funds is to go through brokerage firms. Not only are such firms well-established, they also stay on the cutting edge. For example, some even allow you to purchase cryptocurrencies like Bitcoin.
Types of Brokerage Accounts
When it comes to brokerage accounts, there are two main types.
Individual Taxable Brokerage Account
As the name suggests, an individual taxable brokerage account is an account that’s opened by a person who has ownership of the account. That individual will be solely responsible for the account and paying taxes on all gains (more on taxes below).
For example, a single 25-year old investor may open an individual taxable brokerage account for themselves as a way to grow their wealth.
Joint Taxable Brokerage Account
A joint taxable brokerage account is an account that’s shared by two or more individuals (e.g., a husband and wife). A joint account essentially gives multiple account holders the ability to make deposits, withdrawals, and trades.
While these types of accounts are ideal for married couples, you don’t have to be related to someone to open a joint taxable brokerage account with them.
Why Investors Use Brokerage Accounts
Brokerage accounts are great for short- to medium-term investing because they provide the option to accumulate wealth while still enabling you to liquidate your assets if you need to. You may decide to open a brokerage account to start funding a new car or house or as a way to supplement your checking or savings accounts.
My personal favorite is Robinhood because they’re free and easy to use, but there are a ton of other great options as well.
Learn More: Read our full Robinhood Review.
What brokerage accounts aren’t ideal for, however, is planning for retirement. They can supplement retirement savings, but they won’t shield you from having to pay taxes.
For this, you will need to open a specific retirement account, like a traditional IRA or a Roth IRA.
A retirement account is a type of account that lets you invest funds and defer paying taxes throughout your prime earning years. Accounts can allow pre-tax contributions to grow tax-free until they are taken out at retirement age. On the flipside, there are certain accounts that can be funded with post-tax dollars, freeing accountholders from having to pay taxes on withdrawals.
There are many types of retirement accounts, each with specific rules governing when you are allowed to access your money.
Here are a few of the most popular options to consider.
A traditional 401k is an employer-sponsored retirement plan that lets investments grow on a tax-deferred basis. If your employer offers a 401k, you can devote a portion of your paycheck to grow tax-free while also potentially collecting contributions from the employer.
It’s important to remember that companies have various rules governing what you can do with your money as it grows. Some investment companies allow you to manage your own money actively while others do not.
The difference between a traditional 401k and a Roth 401k plan has to do with when taxes are due.
A traditional 401k will require you to make contributions using pre-tax dollars, meaning you will have to pay them at the retirement age of 59 ½. A Roth 401k will require you to make contributions using after-tax dollars, meaning you will pay taxes upfront but you can withdraw contributions and earnings tax-free at retirement age if you’ve held the account for at least five years.
A solo 401k is a retirement account for self-employed individuals or business owners that do not have full-time employees. Basically, a solo 401k allows you to make contributions as an employer and an employee, giving you the ability to maximize deductions and retirement contributions.
Not all investors today are using 401k plans exclusively, even though it may seem like it. In fact, many employers don’t offer 401k plans, forcing employees to take control of their own financial planning. And even when they do, investors might opt to fund a 401k and open an individual retirement account (IRA) alongside it to let more of their money grow.
A traditional IRA is a type of retirement account that allows individuals to make pre-tax contributions and let investments grow tax-deferred until retirement.
IRAs have contribution limits that change from time to time. For 2020 and 2021, investors can add up to $6,000 per year to grow tax-free.
One of the top benefits of using a traditional IRA is that your contributions are tax-deductible. For example, if you earn $50,000 per year and contribute $6,000 to a traditional IRA, your taxable income will only be $44,000 — meaning you’ll pay less to Uncle Sam when tax season rolls around.
In addition to an IRA, you can also choose to open a Roth IRA. Much like a Roth 401k, a Roth IRA will tax you up front but you won’t have to pay taxes in retirement. As such, you won’t have to pay taxes on your investment earnings.
One of the downsides to using regular IRAs is that they limit the types of investments that you are allowed to own. If you want to own alternative investments, like real estate, you will need to open a self-directed IRA (SDIRA), which is a different type of IRA that gives you more freedom to determine which types of investments you want to make. It’s worth noting that not all firms offer SDIRA services. So if this option sounds appealing to you, research brokers to ensure they offer it.
A SIMPLE IRA is a type of retirement account that allows business owners and employees to set aside a percentage of pay for retirement. It works a bit like a 401k, but it’s designed specifically for small businesses with 100 employees or less. SIMPLE IRAS are 100 percent vested, while 401k plans tend to have different vesting rules.
A simplified employee pension (SEP IRA) is another type of IRA that allows an employer or self-employed individual to make contributions for tax-free growth. These kinds of accounts have substantially higher contribution limits than traditional IRAs.
If you have children or are planning to have them, then you may want to consider looking into specific investment options to prepare for the costs of funding their education.
This is especially true when considering that the average cost of tuition and fees for the 2020-21 school year is a whopping $41,411 for private schools, $11,171 for state residents in public colleges, and $28,809 for out-of-state students in state schools.
Education is expensive, and it’s getting worse every year, so it’s best to plan ahead.
The 529 Savings Plan
If you’re interested in saving for your child’s education, one option to consider is a 529 savings plan, which serves as a tax-advantaged account to pay for qualified education costs in K-12, college, and even apprenticeship.
What’s more, 529 savings plans can offer income tax breaks for investors. However, the funds will be fully visible to colleges when applying for financial aid. So, your child may receive less aid if you have a 529 savings plan set up. This also holds true for education savings accounts, trust funds, and brokerage accounts.
Certain types of investments can allow you to set money aside while increasing your chances of maximizing financial aid when it’s time to apply.
Here are some of the most frequently asked questions about types of investment accounts.
What are compound returns?
Compound returns are the term for what happens when your returns generate returns of their own, on top of the initial investment. Think of it this way: if you invest $1,000 and it returns 10% in a year, your pile of money grows to $1,100 and all of it, including your $100 in new money, makes money going forward.
Over the course of 20 to 30 years, compound returns can significantly increase in value, to the point where the accumulated returns potentially dwarf the initial investment. Through compound returns, you can become a millionaire by investing small amounts and letting time and the market do the work.
It’s the same idea as making deposits and enjoying the benefits of compound interest.
What is a rollover?
A rollover occurs when an investor decides to transfer the holdings of one investment account into another one.
Rollovers are also commonly seen with certificate of deposit (CD) transactions when investors use ladders to transfer funds when accounts reach maturity.
In a retirement plan, a rollover can also be used to describe an account transfer that occurs without creating a taxable event (e.g., a 401k to an IRA).
What are annuities?
An annuity is a type of investment that requires an insurance company to make periodic payments to the customer.
When you buy an annuity, you can either make a single lump-sum payment or a series of payments. In exchange, you will receive payments at an agreed-upon date.
Is a savings account an investment?
A savings account is not typically considered an investment if it’s protected by a federal agency. Some savings accounts can offer attractive interest rates, but they are generally much more secure than investments.
Do I need a financial advisor to invest?
You don’t need a financial advisor to invest, but it won’t hurt you either — unless you wind up paying too much in fees or use someone who gives bad advice.
Some investors are also choosing to leverage robo-advisors from services like Betterment and SoFi instead of working with humans. These services can be helpful for investors who want to take a hands-off approach or for people who are just dipping their toes into the markets.
What is the capital gains tax?
The capital gains tax is a tax that’s placed on any financial appreciation incurred on an investment when you trigger a taxable event (e.g., selling shares of a stock for a gain).
Can you have a 401k and an IRA?
In the U.S., investors are allowed to have more than one retirement account. So, you could legally open a Roth IRA while also contributing to your employer’s retirement plan. Many investors choose to take this option to maximize long-term, tax-free growth.
Can an employer choose to contribute to an IRA?
Employers can choose to contribute to IRAs and Roth IRAs. There are specific plans that allow employers to contribute to non-401k plans, like SIMPLE IRAs.
The SECURE Act of 2019 also provides tax incentives to encourage small business owners to contribute to certain retirement accounts. So, it’s worth talking to your employer to see if they can set up a plan that will help you maximize your retirement plan.
What is a Safe Harbor Match?
Safe Harbor Match is a type of mandatory employer contribution. There are three types of mandatory contributions:
- Non-Elective Safe Harbor Match, providing an annual employer contribution amounting to 3% of an employee’s salary.
- Basic Safe Harbor Match, where the employer matches 100% of the first 3% of each employee’s contribution and 50% of the next 2%.
- Enhanced Safe Harbor Match, where an employer agrees to match 100% of the first 4% of each employee’s contribution.
The Bottom Line
It’s great that you’re looking into different types of investment accounts. The more you invest, the closer you will get to reaching your financial goals — in the short-term and in the long-term.
Know your options, make smart decisions and let time do the trick. Follow this advice, and you are bound to set yourself up for success. Good luck!