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The Various Types of Investment Accounts

Even experienced investors can become nauseous when reviewing the dizzying array of investment account options in existence.  Quite honestly, there are too many.  This should come as no surprise, because much like craft beers, vape shops, and obnoxious catchphrases, we have a track record of excess in this country.

The problem is that you need to invest, but are likely having a hard time understanding what the different account types mean and whether or not you should be considering them.  This is a common frustration for a lot of investors.  In an effort to provide some clarity, let's do a quick review of the primary account structures, how they operate, and who they serve.

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To begin, please reference the cheat sheet listed here.  This is a quick guide that highlights the primary account structures in existence.  Of these, most investors only need to know a select few.  Here is an overview of the accounts you need to better understand, and some features that make them unique.

Account quick reference

Account quick reference

Retirement accounts

401(k), 403(b), 457, and TSP:  All are various forms of work retirement plans established to encourage employees to save for their future retirement.  These plans are usually combined with a contribution match made by the employer (which all should take advantage of, as this is free money!).  Employee contributions are limited to $18,500/year for 2018 and $19,000/year for 2019 ($24.5k/year for 2018 and $25k/year for 2019 if 50 or older).  These contributions are treated as a tax deduction which reduces your tax burden today.  Earnings are not taxed as the account grows, but withdrawals at retirement are then treated as ordinary income.

Also of note, there is a useful version of the 401(k) for self-employed individuals called the Solo 401(k). It carries added contribution flexibility, allowing for contributions up to $55k/year for 2018 ($56k/year for 2019).

IRA (Traditional and Rollover):  It's best to think of Traditional and Rollover IRAs as one in the same.  Rollover IRAs are just a way of separating those funds you once had in a work retirement plan that you might roll back in to a future plan.  Contributions to either are limited to $5,500/year for 2018 and $6,000/year for 2019 ($6.5k/year for 2018 and $7k/year for 2019 if 50 or older).  These contributions are treated as a tax deduction (subject to income restrictions if also covered by a work retirement plan) which reduces your tax burden today.  Much the same as a work retirement plan, earnings are not taxed as the account grows, but withdrawals at retirement are then treated as ordinary income.

SEP IRA:  For self-employed individuals or small business owners, the Simplified Employee Pension (SEP) IRA can be a sleek and lucrative retirement savings option.  Being very easy to establish, the employer (or self-employed individual) makes contributions for themselves and their employees (if any) which is prorated based on salary.  These contributions can be the lessor of 25% of compensation or $55k/year for 2018 and $56k/year for 2019, per employee.  These rules really boost the potential contribution total, which gets treated as a deductible business expense.  Like the IRA, earnings here are also not taxed as the account grows, but withdrawals at retirement are treated as ordinary income.  Here is some additional light reading from the IRS is you would like further detail on the SEP IRA.

Roth 401(k) and Roth IRA:  The Roth 401(k) and Roth IRA follow the same contribution limit rules as their counterparts (the 401(k) and the IRA).  The main difference here lies in the tax treatment.  Contributions to Roth accounts do not get a tax deduction upon deposit.  Instead, earnings grow tax-free and withdrawals at retirement are also tax-free.  This is the equivalent of paying your taxes in advance (today) so that you don't have to pay anything later.  I really like Roth accounts for a number of different reasons.  Due to the nature of their taxation, Roth accounts work great for anyone who might be in a lower tax bracket today than they will likely be in future years (think young professionals or those in an anomaly year of lower income).

BONUS NOTE:  Anytime an investment account has tax advantages associated with it, there will also be withdrawal rules/requirements attached.  Most retirement account will not let you access your money before age 59 1/2 without incurring a penalty for doing so.  It should come as no surprise that the government does not give away tax savings for free!  This liquidity issue is a trade-off that you have to weigh as an investor.

College savings accounts

529 Plan:  The 529 plan is the only account we will touch upon in the college savings arena, simply because it has more potential monetary benefits than it's competition.  Let's review.  Upon contribution, most states offer a state tax deduction.  Contributions then grow tax-deferred, and withdrawals are tax-free when used for qualified K-12 and college education expenses.  This is a triple crown of savings that you are going to be hard pressed to find anywhere else.  Be aware that contributions to 529 plans are considered gifts and follow the same tax rules as any other gifts.  There is an annual gift exclusion of $15k/year per donor that will keep you out of that gift tax territory.  The Coverdell ESA works very similar to the 529 plan but only permits $2k/year in contributions.

Taxable investment accounts

Individual and Joint Account:  Whether structured in a single name or jointly, the primary characteristic to note with taxable investment accounts (think a standard brokerage or personal account) is that all earnings are taxed as they are realized.  This means that taxes are owed as interest is incurred, dividends are paid, and as any capital gains are captured when securities are sold.  There are no tax deductions or deferrals to take advantage of, but for this trade off there are also no restrictions on account contributions or withdrawals.  You always have access to this money, which can be a major advantage if you are planning to use your funds before a traditional retirement age (I'm talking to you, early financial independence enthusiasts!).

Trust Account:  While not digging into the various types of trust accounts, know that trusts are primarily used for asset protection (as they are considered a separate legal entity).  As is the case with any investment vehicle, there is a trade-off for this benefit.  Trusts receive very inefficient tax treatment, moving into the highest tax bracket (37%) at the very low income threshold of $12,500.  Considering a married couple filing jointly doesn't cross into this threshold until income surpasses $500k for 2018 ($510,300 for 2019), the monetary/tax concession for asset protection can be very steep.

BONUS NOTE:  For a complete breakdown of the tax brackets for 2018 and the underlying tax treatment of various investments/accounts, the folks at Nationwide have created a quick reference guide that does a good job at condensing the tax planning picture.

Before kicking off on any portfolio investing journey, make sure to understand the account options that are available to you, investing only in the vehicle(s) that will best get you to your financial goals.  Start with an appropriate account, then with a solid investment strategy; all the while holding the power of diversification and your investing lessons learned close to the vest.  In doing so (and by staying patient and disciplined), you will provide your journey towards portfolio investing success a powerful boost.