Choosing the Right Investment Account
Finding the right fit.
Investing can be a powerful way to grow your wealth and secure your financial future, but navigating the myriad of account options available can be daunting for beginners and seasoned investors alike. From retirement accounts like IRAs and 401(k)s to taxable brokerage accounts and specialized accounts such as Health Savings Accounts (HSAs), each type of investment account comes with its own set of rules, benefits, and tax implications. Understanding the distinct features and advantages of each account type is crucial in making informed decisions that align with your financial goals. In this post, we'll explore the various types of investing accounts, helping you determine which options might best suit your needs and investment strategy.
Retirement Accounts
The most common account type that you will come across is the retirement account. There are many incentives provided for these types of accounts because policy makers want workers to save for their future so that they aren’t completely reliant on the government for income in retirement. The tradeoff is that there are restrictions on when withdrawals can be made (generally after age 59 and a half). There are two main “flavors” of retirement accounts: Employer sponsored and Individual.
Employer sponsored retirement accounts are funded through payroll deductions. Contributions to these accounts aren’t considered as income for tax purposes. Generally, employers will match your contributions up to a percentage of your income (often 3% to 6%). Throughout your career, any income within the account will not be taxed. Once you begin withdrawing from the account in retirement, withdrawals will be taxed as ordinary income. Common employer sponsored retirement accounts include:
401(k): Most common. Typically offered by large for-profit employers
457(b): Similar to a 401(k) but intended for government employees
403(b): Similar to a 401(k) but intended for employees of non-profit organizations and schools
SIMPLE IRA: Stands for “Savings Incentive Match Plan for Employees.” Similar to a 401(k) but typically offered by smaller employers.
SEP IRA: Similar to a 401(k) but intended for self-employed individuals
Individual retirement accounts or IRAs are funded directly by the saver. Contributions to these accounts are deducted from income before calculating income tax due. Similar to employer sponsored accounts, income within the IRA will not be taxed but withdrawals are taxed as ordinary income.
There is an additional provision for some retirement accounts that you’ve probably heard of: Roth. Accounts that are designated as Roth accounts have special rules when it comes to taxation. Unlike traditional retirement accounts, contributions to Roth accounts are not deducted from income. However, the major benefit is that distributions from Roth accounts are not taxed at all. This benefit is so powerful that access to Roth accounts is limited to individuals below a certain income level (however, there are some “backdoor” ways for anyone to contribute to a Roth account). Roth IRAs are the most common Roth account, but some employer sponsored plans have been set up with Roth provisions.
Education Accounts
There are several different accounts that could be appropriate for funding education expenses, but the most common is the 529. As the account grows, no taxation is incurred and distributions from a 529 plan that are used for education expenses are tax free. Another option would be to use a custodial account. Custodial accounts are accounts owned by the child, but managed by an adult until the child reaches the age of majority. Earnings within the account are taxed, but at the child’s (often lower) tax rate. Withdrawals from the account can be made “for the child’s benefit” including to pay for their education. The main drawback to this method is that the child can do anything they want to with the account when they reach the age of majority, even if they choose not to continue their education.
Pro Tip:
If you think your child may qualify for need-based financial aid, custodial accounts probably won’t be the best fit. Since these assets are owned by the child, they have an outsized impact on financial aid applications.
Healthcare Accounts
The main option for long-term savings for healthcare expenses is the HSA account. Contributions to HSAs are tax-deductible similar to a Traditional IRA. Earnings within the account grow tax free and if used for healthcare expenses can be distributed without taxes as well. The drawback to this account is that it can only be used by individuals with a High Deductible Health Insurance Plan (HDHP). Another option for healthcare savings is the FSA but these accounts must be emptied by the end of the year.
Taxable Accounts
If none of these accounts are appropriate for your saving or investing goals, there is always the taxable account. These brokerage accounts don’t offer any special tax benefits but are the least restrictive of all investing accounts. Income within the account is taxed annually but one small advantage is that gains made on the sale of assets within the account are taxed at the more favorable capital gains tax rate as opposed to the ordinary income tax rate.
So many choices.
When deciding where to put your money there can be many options, each with their own pros and cons. Foresight Financial Planning can help you invest for the future by using your goals to choose the most appropriate account type for you.
Featured Articles
