If you’re just starting your investment journey, one of the first barriers you may face is choosing the right investment account. Investment accounts are tools, but just like tackling a DIY project, you need to choose the right tool for the job. There are different types of accounts which serve different purposes. So, in this article, we’ll examine the various investment accounts to help you find the right one for you.
Brokerage Accounts
Brokerage accounts are a standard option whether you go through a brokerage firm or use a trading platform. This type of account allows you to buy a variety of investments including stocks, mutual funds, bonds and ETFs.
Brokerage accounts are taxable investment accounts, which means that they are flexible as they lack some of the restrictions imposed on tax sheltered accounts. This means that you can withdraw your funds at any time without penalties. There are no income or contribution limits, so anyone can open an account regardless of their employment status or income.
However, unlike some other types of accounts, you won’t get any tax deductible, tax deferred or employer matching benefits.
A brokerage account is a good option if you are not saving for a particular goal such as education, retirement or healthcare. You can add or withdraw your funds without any restrictions and, depending on the brokerage platform, you can trade in a variety of asset classes.
Cash Management Accounts
Cash management accounts are offered by financial institutions and they typically combine the features of a checking or savings account with a brokerage account. So, in addition to being able to invest in money market mutual funds, you can write checks, pay bills and even use a debit card. Many money market accounts also feature deposit sweeping, where your uninvested cash is moved into an FDIC insured deposit fund.
This type of account provides an all in one solution to spend, save and invest from the one account. This is a beginner friendly option as you can enjoy low fees and a competitive rate of return together with FDIC protections. However, there are no tax advantages, you may be limited on the choice of investment options and you are not likely to have access to a physical bank branch network.
If you’re completely new to investing, a money market account can provide a good starting point. You can earn decent rates on your uninvested cash and start experimenting with limited investing choices.
Traditional IRAs
An IRA is an Individual Retirement Account and this type of investing account is designed to help you to invest for retirement independent of your workplace. There are contribution limits for traditional IRAs, but once the funds are in the account, they can potentially grow until you reach retirement age and want to withdraw the money. You will need to pay taxes on your retirement withdrawals, but if you wait until you are 59 1/2 or older, the tax is deferred. This can allow you to grow your investment fund more quickly, as you won’t need to pay tax on each transaction.
In fact, if you’re within the income limits, you may be able to deduct part or all of the contributions from your federal tax return. This type of account is also very accessible, as you just need to have earned income to be eligible to contribute to your IRA. However, if you need to access the funds before retirement age, you’ll face penalties. You will need to pay not only the income tax, but a 10% penalty on the withdrawal amount.
Even if you already have a workplace pension plan, a traditional IRA is a good option to invest beyond the annual contribution limits of your 401k.
Roth IRAs
Roth IRAs have different tax advantages compared to traditional IRAs, allowing you to contribute money that you’ve already paid tax on. You may wonder about the advantage of this, since you won’t reduce your current income tax burden. However, it does mean that when you’ve reached retirement age or met any aging requirements, you can make tax free withdrawals.
There are contribution limits for Roth IRAs and you do need to be within the IRS income limits to be eligible to contribute. Additionally, you can’t deduct the Roth IRA contributions from your federal income taxes.
A Roth IRA could be a good account for you if you are interested in potential tax free growth and withdrawals. This account works well if you qualify and anticipate taxes today will be lower than in the future. Additionally, if you have concerns that you may need to access your retirement fund early in an emergency, provided you’ve met the aging requirements you can withdraw the contributions at any time.
SEP IRAs
SEP IRAs or Simplified Employee Pension Individual Retirement Accounts are plans for small business owners and the self employed. This account is designed to help provide retirement savings for small business owners and their employees, with fewer requirements and administrative fees compared to the typical workplace plan, such as a 401k.
Your SEP IRA contributions are tax deductible and the accounts are relatively simple to set up and maintain. There are also higher contribution limits and a greater degree of flexibility, which can be advantageous if you’re unsure about consistent business profits.
However, unlike some other retirement accounts, you cannot catch up on your contributions with a SEP IRA. This could potentially limit retirement savings for those aged 50 plus. Additionally, you cannot defer employee contributions.
If you’re a small business owner or a self employed entrepreneur, interested in high contribution limits, low admin fees and tax benefits, a SEP IRA could be a good choice. But, business owners do need to be aware that in order to contribute to your own SEP IRA, you will need to make contributions to your SEP IRA eligible employee accounts.
Solo 401k
Solo 401ks or self employed 401ks are specifically designed for the self employed or those small business owners that have no employees, other than a spouse. This type of account is similar to traditional 401ks, as you fund the account with pre-tax compensation as if you were an employee of your company. But, you can also contribute as the employer with up to 25% of your compensation, subject to some IRS limits. You can defer tax on your investment fund until retirement, when you will be subject to ordinary income tax.
Your contributions are tax deductible from your personal income, if you have an unincorporated business, or as a business expense for incorporated businesses. However, you can only take money from the account when you reach a triggering event, such as reaching the age of 59 1/2. You also need to make regular, substantial contributions for your Solo 401k to remain active.
If you’re a small business owner who has no plans to take on employees and want to aggressively save for your future, a Solo 401k could be a good account for you as you can enjoy flexible investment options, tax advantages and high contribution limits.
SIMPLE IRAs
The name “SIMPLE IRA” does not come from this product being straightforward, but rather it is an acronym for Savings Incentive Match Plan for Employees. This type of plan is designed for the self employed or small business owners with less than 100 employees. SIMPLE IRAs allow employees to defer a part of their salary into their retirement account and their employee can match the contribution. This can be up to 3% of the salary or set as a fixed percentage.
This type of account does offer the tax benefits of 401k, but employees can enjoy the convenience of having a personal IRA. The contributions are made with pre tax funds and the money can potentially grow as tax deferred until you make a withdrawal.
The main advantage of a SIMPLE IRA is that they are lower cost to set up compared to 401ks and they require less admin work to maintain. They also offer wider access to investment products including individual bonds and stocks. However, if you need to make a withdrawal before retirement age, you could face a penalty of up to 25%.
If you’re a business owner with a small to medium team and want a low cost retirement plan for your employees, SIMPLE IRAs could be a good option for you.
HSAs
HSAs or Health Savings Accounts are tax advantaged accounts that are specifically designed for saving for eligible medical expenses. To make HSA contributions, you need to have an eligible health plan that is in the category of HDHPs (high deductible health plans.) Generally most HDHPs are eligible for HSAs.
HSAs offer three tax benefits. Firstly, your contributions are tax deductible. Additionally, any withdrawals and any investment growth can both be withdrawn tax free if the funds are used for qualified medical expenses.
After you reach the age of 65, the funds in your HSA can be withdrawn for non medical expenses without any penalties, but you will need to pay income tax on these withdrawals. Your HSA remains yours even if you change health care plans or jobs, you can keep the account or transfer it into an employer sponsored HSA plan with your new job.
An HSA is a good choice if you want to save for your current and future medical expenses, particularly if you can afford higher out of pocket costs to maximize the tax savings on your future health care expenses.
529 Plans
529 Plans are tax advantaged investment accounts that are flexible and allow you to save for future education expenses. However, this is not just for college education, as you can use up to $10,000 to pay for K to 12 tuition and education.
529 Plans can only have one beneficiary, but you can change your beneficiary to an eligible family member at any time. Additionally, in some circumstances, you can transfer your 529 fund into the beneficiary’s Roth IRA.
529 Plans are built using post taxed dollars, but there is the potential for tax deferred growth. If you make withdrawals for qualified education expenses, you won’t pay federal income taxes on the investment growth. Qualified educational expenses are not limited to tuition as the funds can be used for accommodation, books and even some technology. You may even use the funds for up to $10,000 of student loan expenses. You may qualify for state tax incentives, such as a tax deduction for your 529 plan contributions. However, if you make a non qualified withdrawal, you will be subject to federal and state income tax and a 10% penalty on the funds.
If you’re planning on saving for your child or another relative’s educational expenses, a 529 plan is a good option to benefit from the tax advantages.
Types of Investment Accounts – An Overview
| Type of Account | Key Features | Tax Advantages | Eligibility |
|---|---|---|---|
| Traditional IRA | Individual retirement account. Contributions are typically tax-deductible. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Income limits apply for tax-deductible contributions if covered by an employer plan. |
| Roth IRA | Individual retirement account. Contributions are made with after-tax dollars. | Tax-free growth and withdrawals in retirement. | Income limits apply for eligibility to contribute. |
| 401(k) | Employer-sponsored retirement plan. Contributions are pre-tax, sometimes with employer matching. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through employers. Annual contribution limits apply. |
| Roth 401(k) | Employer-sponsored retirement plan. Contributions are made with after-tax dollars. | Tax-free growth and withdrawals in retirement. | Offered through employers. Annual contribution limits apply. |
| Health Savings Account (HSA) | Tax-advantaged account for medical expenses. Must be paired with a high-deductible health plan (HDHP). | Contributions are pre-tax, growth is tax-free, and withdrawals for medical expenses are tax-free. | Must have an HDHP. Contribution limits apply. |
| 529 Plan | Education savings plan. Can be used for K-12 tuition and higher education expenses. | Tax-free growth and withdrawals for qualified education expenses. | No income limits. Contribution limits vary by state. |
| SEP IRA | Simplified Employee Pension IRA for self-employed individuals or small business owners. | Tax-deferred growth. Contributions are tax-deductible. | Must be self-employed or a small business owner. Contribution limits apply. |
| SIMPLE IRA | Savings Incentive Match Plan for Employees for small businesses. | Tax-deferred growth. Contributions are tax-deductible. | Employers with fewer than 100 employees. Employee salary reduction contributions allowed. |
| 403(b) | Retirement plan for employees of public schools and tax-exempt organizations. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through eligible employers. Annual contribution limits apply. |
| 457(b) | Retirement plan for state and local government employees. | Tax-deferred growth. Pay taxes when withdrawing in retirement. | Offered through eligible employers. No early withdrawal penalty before age 59½ if separating from service. |
| Coverdell ESA | Education Savings Account. Can be used for K-12 and higher education expenses. | Tax-free growth and withdrawals for qualified education expenses. | Income and contribution limits apply. |
| Traditional Brokerage Account (with Tax-Loss Harvesting) | Standard investment account. Gains and losses can be offset during tax filing (not fully tax-advantaged). | Gains taxed at lower capital gains rates, and losses can reduce taxable income. | No income limits. No contribution limits. |
How to Choose the Right Investment Account for You
So, now you are more familiar with some of the best accounts for new investors, but how do you decide which one is best for you? Each type of account has its own unique characteristics and benefits, but there are some potential drawbacks that will influence your decision. Fortunately, there are a few questions to ask yourself which can help you to make a decision.
What is Your Purpose for Investing?
The most obvious place to start to narrow down your investment account choice is to think about your purpose for investing. If you want to save money for retirement, health or education, there are very specific accounts for these purposes. On the other hand, if you don’t want to invest for these reasons, you will need an account with greater flexibility.
Do You Meet the Qualifications?
Once you’ve narrowed down the options, you need to look at if there are any qualification criteria to be able to open or maintain an account. Some accounts are only available if you meet certain criteria, such as needing to have an appropriate health plan to open an HSA or you need to have a certain number of employees to manage the various types of retirement plans for your small business.
Will You Need to Access the Funds?
While you may have the intention of investing for the medium to long term, if there is a possibility that you may need to access the funds early, you will need to assess the potential penalties. For example, some retirement accounts have a 10% or higher penalty if you need to withdraw funds before you reach retirement age. You can also run into penalty issues if you need to withdraw funds for a non qualified expense from a HSA or education plan.
If there is a strong possibility that you will need the money for any purpose, you may prefer to sacrifice the potential tax benefits for the additional flexibility of a taxable account.
Do You Understand the Tax Benefits?
If you are looking at tax advantaged accounts, you need to understand the tax benefits. You will need to appreciate the difference between investing pre and after tax dollars. There are immediate benefits to using pre tax dollars, as you will lower your current tax burden. However, when you make withdrawals you will pay income tax on the funds. This effectively means that you are deferring paying tax on your investment contributions. On the other hand, if you use after tax dollars, you won’t get the immediate tax benefit, but your investment fund can potentially grow tax free.
So, you will need to assess your current situation and anticipate your future circumstances. If you are currently in a high tax bracket, using pre tax dollars and getting a tax deduction now could be beneficial. However, if you anticipate being in a higher tax bracket in the future, it may be a good idea to choose a plan that uses after tax contributions.
Is the Account Easy to Manage?
As a beginner, you are likely to feel a little overwhelmed learning about investment strategies and transactions, so you will need to choose an account that you find easy to manage. Remember that you can often have more than one type of investment account. In fact, it is usually a good idea to have at least one taxable investment account and one tax advantaged account. So, you can always start with an easy to use taxable account while you get to grips with learning about investing and open up another account later.
Have You Assessed the Fees?
Finally, be sure to check the fees associated with the account. If you have minimal funds to invest initially, you want to maximize your returns with minimal fees.
Opening the right investment account can be a little daunting, as there are so many types of accounts and plans to choose from. Since there are so many potential benefits, it is well worth taking the time to assess a short list of accounts to find the one best suited to your circumstances, preferences and requirements. You can then focus on developing your investment skill set and confidence to reach your financial goals.
