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Lesson 8 - The Different Types of Investment Accounts

Lesson 8 - The Different Types of Investment Accounts

There are lots of different types of investment accounts. For the sake of simplicity, I am going to group similar ones together. 

Retirement Accounts

One way to separate out retirement accounts is by referring to them as either qualified having tax-deferred growth (meaning the money is not taxed when you contribute but is taxed when you withdraw in retirement) or nonqualified having tax-free growth (money is taxed before being added but you don't pay any taxes when pulling it out). With this in mind, here are a number of different retirement accounts and a couple details around them. For specific details on each of these accounts, visit the IRS site here

401(k) or Roth 401(k) - Money can be either qualified (Traditional 401(k) or nonqualified (Roth 401(k)). Company sponsored plan that allows employees to contribute a portion of their wages to retirement. Employer can decide to match part or all of their contribution. There are yearly limits on how much an employee can contribute (check with the IRS site to see latest figure) and these go up once you hit 50 years old. You cannot pull money out before 59 1/2 years old without a penalty (10%) unless certain criteria are met. You will also be required to pull out a certain percentage of their investments due to Required Minimum Distributions (RMDs) once you reach a certain age (does not pertain to Roth 401(k)). You can find out more about RMDs here.

403(b) - similar to a 401(k) but are specifically offered to employees at public schools, universities, churches and other unique organizations. Contributions are qualified and made through contributing a portion of your pay. There is a contribution limit for employees, check the IRS site to see the most up to date number. It is possible to take a loan from your holdings if certain terms are met. You will be penalized for withdrawing before 59 1/2 years old except for certain circumstances.

457 - offered to state or local government employees and some nonprofit organizations. Contributions are tax deferred and done through salary deferral. Can be amended to be Roth (nonqualified). There is a contribution limit, check with the IRS site to see the most up to date number. One big difference is that these plans allow for early withdrawals (before 59 1/2) with no penalty in some circumstances. One downside is 457 accounts are less likely to have an employer match. 

IRA (Individual Retirement Account) - there are several different types of IRAs including traditional, Roth, Simplified Employee Pension (SEP), and Savings Incentive Match Plan for Employees (SIMPLE). These accounts can be opened up by individuals or be a part of a small business' retirement plan. They are tax advantaged and do not allow withdrawals before 59 1/2 (unless under certain circumstances) except for Roth IRAs which allow for you take withdraw any contribution amounts (but not any growth) at any time with no penalty so long as the account has been opened for 5 years. 

Education Accounts

Anyone with children has thought through the possibility of saving for their kid's education. There are multiple options on how to do so that have tax advantages. 

529 Account - this is an account that can be opened by a relative or not for a beneficiary's education. In some cases, the contributions can be tax deductible at the state level and distributions are tax free so long as they are used for educational expenses for the beneficiary. Any withdrawals not used for educational expenses are taxed and can be subject to a 10% penalty. There is no annual limit on how much you can contribute but large contributions can be subject to a gift tax. 

*Note: As of 2023, the SECURE Act 2.0 now allows for unused funds from a 529 account to be rolled over to a Roth IRA in the beneficiary's name so long as the account has been open at least 15 years. 

Coverdell Education Savings Account - similar to a 529 plan (offers tax-free investment growth and tax-free withdrawals as long as they are used for educational expenses). Total maximum contribution per year of $2,000. Must be used by age 30 or else money is distributed to beneficary and taxed at their tax rate. Restricted to investors under an income limit. Can be used for tuition and other school expenses. 

Other Notable Accounts

A standard brokerage account is what people typically think of when thinking of investing in a non-retirement account. It is a financial account investors use to buy and sell assets. Assets can mean stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), and all sorts of other more complicated things.

There are no conribution limits or early withdrawl penalities. You can open up an account and start investing right away. You can connect your bank account to one after you open it, transfer money in, and off you go playing the game of investing.

The key part to note here is the tax treatment. Any gains you earn (meaning if you sold an asset for higher than you bought it for) are taxable. If you sell an investment after holding it for less than a year then it is subject to ordinary income tax. If you sell it after a year, it is subject to long term capital gains tax. This tax can be 0%, 15%, or 20% depending on your filing status and income. 

UGMA/UTMA - stands for Uniform Gifts To Minors Act/Uniform Transfers To Minors Act. These are custodial accounts (means you have control of the account but the person who the account is intended for is someone else) that allow you to invest in financial assets to a minor without establishing a trust. The account is in the a minor's name but controlled by a parent or relative. 

These are similar to 529 accounts in that they are intended for minors but are controlled by adults. Key differences are the tax benefits are slightly different for UGMA/UTMA accounts. Contributions are made with after-tax dollars and the first $1,150 in income per year is tax free. The next $1,150 is taxed at the minor's tax rate. Anything above this is taxed at the adult's tax rate. 

These accounts provide more flexibility on spending as they can be used for anything, not just educational expenses. While the child is still a minor, funds can be used for educational related expenses. 

The last key difference is that when the child reaches the age of majority (age in which the child reaches adult status as chosen by the state),all funds are transferred to the child. Let me repeat that. The child can do whatever they want when they reach this age, which for most states is 18. Do you remember what you were like at 18? Just keep this in mind if you decide to move forward with this account.