Types of Investment Accounts and How to Choose One

If you’re thinking about opening an investment account, it can be overwhelming to understand the differences between the types of accounts and which one or ones you should open. Investment accounts come in a variety of types, including retirement accounts, employer sponsored accounts and taxable accounts. Each of these accounts offers different benefits, and individuals should understand why and when to use each type of account.

Individual Retirement Accounts (IRAs)

Individual retirement accounts, or IRAs, are a great way for individuals to begin saving for retirement as they provide tax benefits. However, because of the tax benefits, there are specific rules for how much an individual can invest in a specific year and when an individual can take money out of an IRA (along with their exceptions).

Traditional IRA

A traditional IRA lets individuals save for retirement and experience tax-deferred growth on their investments. This means that an individual can put money into an IRA and he won’t pay taxes until he withdraws the money. Each year that an individual contributes to an IRA, he may be able to deduct his contributions on his taxes. Because of the tax benefits, there are a few rules for opening, funding and withdrawing from an IRA. 

Only individuals who received taxable compensation and are younger than 70½ years old can contribute to an IRA in a given year. The Internal Revenue Service (IRS) defines compensation to include salary, wages, commissions, self-employment income, alimony and combat pay. There are also limits to how much an individual can contribute in a year.

For 2016, individuals can contribute up to $5,500 per year across all IRA accounts they own, unless the individual is at least 50 years old, in which case s/he can contribute up to $6,500. Any broker or trustee fees incurred when investing in an IRA are not considered part of an individual’s contribution. When an individual contributes to an IRA, he or she must also contribute by the deadline. For contributions in 2015, an individual needed to contribute to his IRA by April 18 2016, which was also the deadline for filing taxes.

Individuals cannot withdraw money without penalties or fines from an IRA unless they are at least 59½ years old. If an individual withdraws money before then, there is a 10% additional tax on the withdrawal. Once an individual is at least 70½ years old, there are required minimum distributions that an individual must withdraw every year from his or her IRA. Several exceptions apply to these penalties.

Roth IRA

Roth IRAs are similar to traditional IRAs, but with one key difference. Roth IRAs allow an individual to invest money they’ve already paid taxes on and then withdraw the money later tax-free. Because of this, individuals cannot deduct contributions to a Roth IRA on their taxes, and there are additional income requirements for a Roth IRA.

The absolute maximum amount an individual can contribute across all Roth IRAs s/he owns is the same as a traditional IRA ($5,500, or $6,500 if at least 50 years old), but there are some income restrictions that can reduce this amount or make the individual ineligible to contribute to a Roth IRA. As we can see in the table below, individuals making at least $132,000 or married couples making at least $194,000 per year are not eligible to contribute to Roth IRAs. 

Tax Filing StatusIncomeContribution Limit
Married filing jointly or widow(er) Less than $184,000 $5,500 (or $6,500 if at least 50 years old)
Between $184,000 and $194,000 A reduced amount determined by income
$194,000 or more Not eligible
Single, head of household or married filing separately and you did not live with your spouse at any time during the year Less than $117,000 $5,500 (or $6,500 if at least 50 years old)
Between $117,00 and $132,000 A reduced amount determined by income
$132,000 or more Not eligible
Married filing separately and you lived with your spouse at any time during year Less than $10,000 A reduced amount determined by income
$10,000 or more Not eligible

Like traditional IRAs, Roth IRAs also have a 10% additional tax penalty for withdrawing money before you are 59½ years old. Roth IRAs also require that the first contribution is made at least five years before you can withdraw money -- so if you open and fund a Roth IRA when you are 58 years old, you could not begin withdrawing until you were 63 years old. Certain exemptions apply. Unlike traditional IRAs, Roth IRAs do not have required minimum distributions. 

Benefits of an IRA

IRAs, whether traditional or Roth, provide great tax benefits. Contributions to a traditional IRA are tax deductible when you put them in and contributions to a Roth IRA are after tax, allowing your contributions to grow without taxes eating up any of the gains. Roth IRAs are also great for investors that expect their income tax to increase over time as an investor can contribute money at their current lower tax rate and withdraw the money later tax-free. Even though the contribution limits mean that an IRA is unlikely to completely provide for you in retirement, the tax benefits make an IRA a great additional investment account in your portfolio.

Employer Sponsored Plans

Many employers offer retirement investment accounts to their employees, such as 401(k)s or SIMPLE IRAs, and matching contributions to those plans for employees who contribute a minimum amount per year. These plans also offer the same types of tax benefits associated with IRAs, making them a great investment choice for most employees.

Traditional and Roth 401(k)

One of the most common employer sponsored plans is the 401(k) plan. In a 401(k) plan, an employee can contribute a portion of his or her wages into an investment account run by the employer. The employer will pick the types of investments to sponsor in the plan (frequently mutual funds), but the employee decides how to invest his money.

Employers may also offer a matching contribution to employees that contribute a minimum amount per year. For example, an employer may offer to contribute 3% of an employee’s salary if he contributes at least 6% of his salary to his 401(k) per year. For employers that do offer matching, there is usually a vesting period for these matches. This means that you must work at the company for a certain period of time before you gain access to the matching contributions. If you leave the company before the vesting period is up, you will lose some or all of your employer’s contributions.

Employers may also impose a waiting period before an employee can begin investing in his 401(k). These waiting periods may range from a few months to over one year. These restrictions are put in place so that employers can incentivize employees to stay with the firm longer or protect themselves against employees that leave after only a few years.

Like IRAs, there are rules and restrictions for funding and withdrawing from a 401(k) account (although certain exceptions apply). The maximum amount that an employee can contribute, excluding employer contributions, in 2016 is $18,000, or $24,000 if the employee is at least 50 years old. An individual may begin withdrawing money from a 401(k) penalty free once she is at least 59½ years old.

401(k)s may be traditional or Roth with the same tax benefits as a traditional or Roth IRA respectively. For traditional 401(k)s, there are required minimum distributions once you reach 70½ years old. Roth 401(k)s provide the same tax benefits as Roth IRAs, but with a couple of key differences: required minimum distributions starting at age 70½ and no income limitations. It’s also important to note that Roth 401(k)s can only be offered if the employer also offers a traditional 401(k). Some employers that offer both traditional and Roth 401(k)s allow employees to contribute to both types.

SIMPLE IRA

A SIMPLE IRA (Savings Incentive Match Plan for Employees) allows employees to contribute to a traditional IRA set up by their employer. SIMPLE IRAs have no operating or administrative costs and are ideal for small employers that cannot offer a 401(k) plan due to costs associated with running such a plan.

SIMPLE IRAs are different from both 401(k) plans and normal traditional IRAs. First, the employer is required to contribute to the plan: either a matching contribution of up to 3% of the employee’s salary for participating employees or a default contribution of 2% of the employee’s salary for all eligible employees, regardless of whether they contribute to the SIMPLE IRA or not. Employees are also 100% vested in the SIMPLE IRA, meaning that they have access to all of the money, including employer contributions, in it from the time it was created.

Employees are eligible for SIMPLE IRAs if they received at least $5,000 in compensation in the prior two years and if they expect to receive at least $5,000 in compensation during the current year. The maximum amount that an employee can contribute, excluding employer contributions, to a SIMPLE IRA is $12,500 in 2016. Like traditional IRAs, employees can begin making penalty-free withdrawals at age 59½ and are required to make minimum withdrawals upon reaching 70½ years old. Certain exemptions may apply.

SEP IRA

A SEP IRA (Simplified Employee Pension) IRA allows employers to contribute to a traditional IRA on behalf of employees. SEP IRAs can be used by businesses of any size, even self-employed individuals. Like SIMPLE IRAs, there are no costs to starting and operating them, making them ideal for small businesses.

Unlike 401(k)s and SIMPLE IRAs, employees cannot contribute to a SEP IRA. Only employers can set up and contribute to SEP IRAs, but they may contribute up to 25% of an employee’s salary. Despite employees not being able to contribute, employees are 100% vested in the SEP IRA from the date it was created.

Employers must also set up SEP IRAs for all eligible employees. Employees are only eligible to participate in SEP IRAs if they are at least 21 years old, have worked for the employer in at least three of the last five years and have received at least $600 in compensation during the current year. The maximum that an employer can contribute to an employee’s SEP IRA in 2016 is either up to 25% of the employee’s compensation or $53,000, whichever is less. Like traditional IRAs, penalty-free withdrawals begin at age 59½ and required minimum distributions begin at age 70½. Certain exceptions apply.

Benefits of an Employer Sponsored Plan

One of the best reasons to use an employer sponsored plan is the potential to receive a matching contribution from an employer -- this is essentially free money. If an employer offers matching contributions, you should strongly consider enrolling in the plan and contributing at least the minimum to qualify for these matches. Employer sponsored plans also offer tax benefits similar to IRAs, allowing you to avoid taxes on gains you may realize on your investments.

Taxable Brokerage Accounts

One of the most basic types of investment accounts is a taxable brokerage account. These types of accounts can be opened individually or jointly. Unlike IRAs or employer sponsored plans, they offer no tax benefits, but they are free of the restrictions and rules that affect IRAs and employer sponsored plans.

Individual Taxable Brokerage Account

This is an investment account for one person to open, and it can hold a variety of financial assets, including stocks, funds, bonds and derivatives. Any interest or dividends that you earn in a taxable account are subject to taxes in the year you receive them. Additionally, you may also be subject to taxes if you sell an investment. When you sell an investment for more than you bought it for, this is referred to as a capital gain, and when you sell at a loss, this is called a capital loss. If you sell an investment after holding it a year or less, your capital gain or loss is considered short-term; otherwise, it’s considered long-term.

Based on whether you sold an asset for a short-term or long-term capital gain, you will be subject to different taxes. Typically, it’s better to hold investments for more than a year, because the tax on capital gains will be much lower. If you sold any investments at a loss, you can also use your capital loss to reduce your total capital gain, offsetting some of the taxes. Unlike IRAs and employer sponsored plans, there are few to no eligibility requirements to open a taxable account (besides being at least 18 years old), no limits to how much an individual contribute to a taxable account and no restrictions on when an individual can withdraw money.

Joint Taxable Brokerage Account

Joint taxable brokerage accounts are similar to individual taxable accounts, except that a joint account is shared by two or more people. Most joint accounts are opened by spouses. However, if a joint account is opened by non-spouses, such as relatives or even friends, then there may be different tax implications, such as gift tax. If you’re considering opening a joint account, make sure to clearly understand how taxes will be divided and paid and if there are any other taxes beyond capital gains, dividend or interest taxes that you might incur.

Benefits of a Taxable Brokerage Account

If you are contributing the maximum to your tax-benefited accounts, such as an employer’s 401(k) or an IRA, and still have more to invest, then opening a taxable account is one way to continue investing. There are no limits on how much you can contribute to a taxable account. Unlike tax-benefited accounts, you can withdraw money at any time without penalty (though you may be subject to taxes) and there are no required withdrawals when you reach a certain age. Taxable accounts also offer more flexibility in the types of investments; employer sponsored plans may have limited investment choices and certain types of investments may be off limits in an IRA.

How to Choose an Investment Account

A good rule of thumb for picking an investment account is to start with accounts that offer matching contributions and/or tax benefits, if possible. If your employer offers a 401(k) or other plan, this is a great place to start, especially if you are new to investing. Employer sponsored plans typically offer fewer investment options, but this makes it easier for beginners to choose investments.

Many even offer target date funds, which are an all-in-one investment consisting of a mix of stocks, bonds and other assets that is managed by the firm that runs the fund and require little to no management on your part. Matching contributions from employers also make investing in employer sponsored plans a no-brainer.

If your employer doesn’t offer a retirement plan, then consider opening an IRA account, whether traditional or Roth, to receive tax benefits on your investments. IRAs are great tools to begin saving for retirement and normally have more flexibility in the types of investments than employer sponsored plans.

Roth IRAs are particularly good for investors who believe that their tax rate at retirement will be higher than it is currently. This is because a Roth IRA lets investors deposit money at their current lower tax rate and then withdraw the money later tax-free. Also, investors who are active or short-term traders would benefit from trading in a retirement account or employer sponsored plan to avoid large capital gains taxes.

If you find that you are reaching the maximum contribution limits for your employer sponsored plan and/or IRA and still have money to invest, then you should consider opening a taxable brokerage account. Investors should also consider opening a taxable account if they will be making withdrawals before age 59½. For instance, if you need to save money for a down payment on a house or you plan on retiring early, then a taxable account may be a good alternative to a standard savings account.

Because of the flexibility of taxable accounts, investors may use them to invest in assets that are not found or allowed in retirement or employer sponsored accounts, including collectibles or life insurance. Investors who want to invest in riskier, more speculative assets, such as options or penny stocks, may also choose to use a taxable account instead.

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