Three Types of Investment Accounts to Consider

If you’re new to investing, sorting out how to invest probably feels a little (or a lot) overwhelming. Making sure you understand some basic investment terminology is a great first step. The next step is deciding what type of investment account you want to open.

Depending on your long-term savings goals, there are several different types of investment accounts that you can and should consider. Rules for these vary and can be somewhat complex so you’ll want to be careful to understand how contributions and withdrawals work for each, as well as any relevant tax implications.

Three types of investment accounts

There are three primary types of investment accounts, each with different advantages and disadvantages. These are retirement accounts, taxable brokerage accounts, and education savings accounts. Generally, you’ll want to decide what your investment goals are so you can choose which investment account type is best for you.

1. Retirement accounts

Since saving for retirement is so important to your future, it’s also important that you understand the benefits of investing in one or more retirement accounts. These accounts are given special tax treatment which makes them an especially great choice for just about everyone. However, because they have significant tax advantages, retirement accounts are subject to contribution limits and distribution rules, including a hefty 10% penalty on early withdrawals.

There are two basic retirement account types: employer sponsored and individual. Here’s a comprehensive (but not complete) overview of each.

Employer sponsored plan

Employer sponsored plans are excellent for growing your retirement savings. Common employer sponsored plans are a 401K, Thrift Savings Plan (TSP), and 403b. These accounts have relatively high contribution limits and are incredibly easy to get started with.

For 2022, contributions to employer sponsored plans are limited to $20,500 per year. If you’re age 50 or more, you can contribute an additional $6,500 in “catch-up” contributions for a total of $27,000 per year.

Pros:

• Investments grow tax free
• High contribution limits
• You may be eligible for employer matched contributions. Total contributions, employer and employee, cannot exceed $61,000 (or $67,500 if you’re eligible for catch up contributions).
• No income limitations
• Easy to set up elective deferrals (so your contributions come directly from your paycheck)

Cons:

• Limited investment options, based on your employer’s offerings
• May not offer a Roth option
• 10% penalty for early withdrawal, under age 59.5, in addition to ordinary income tax
• Required minimum distributions (RMDs) at age 72 (this was recently raised from 70.5 years of age due to the CARES Act of 2020)

Note: most employer sponsored plans are automatically set to reject excessive contributions. That means you generally won’t need to worry about going over the contribution limit for the year. Check with your plan administrator to be sure.

Individual Retirement Account

Individual retirement accounts, or IRAs, are a great investment option if you don’t have access to an employer sponsored plan. You can also invest in an IRA in addition to an employer plan. IRAs are entirely separate from employer sponsored plans and carry separate maximum contribution limits and rules.

For 2022, IRA contributions are limited to the lesser of 1) your earned income or 2) $6000. This limit increases to $7000 for those 50 or older, including $1000 in catch-up contributions.

IRAs are self-directed. That means you can open an account yourself at any number of financial institutions and choose exactly which investments (stocks, bonds, mutual funds, index funds, etc.) you want to fund it with.

Traditional IRA

Generally, a traditional IRA is best for someone whose income is higher now than they expect it to be in retirement. That’s because traditional IRA contributions are (usually) tax deductible on your tax return. Your investment then grows tax deferred until it is withdrawn, at which point you’ll pay taxes on your contributions and any earnings at your ordinary income tax rate.

Although anyone can open and fund a traditional IRA, it may not be deductible if you or your spouse are also covered by an employer sponsored plan. If so, then you’ll be subject to income limitations. The specifics are a little complex, especially because the numbers are indexed for inflation and change slightly from year to year. More info can be found at the IRS website but here is an overview:

• If you’re not covered by an employer sponsored retirement plan, your contributions to a traditional IRA are fully deductible, regardless of your income. You can contribute up to $6,000 to a traditional IRA each year (as of 2022).

• If you are covered by an employer retirement plan, your traditional IRA contributions are limited by your income:
  • Single: if your modified adjusted gross income (MAGI) is $68,000 or less, contributions are fully deductible; between $68,001 and $77,999 they are partially deductible; $78,000 or more and they are nondeductible.
  • Married filing jointly: if your MAGI is less than $109,000, contributions are fully deductible; between $109,001 and $128,999 they are partially deductible; $129,000 or more and they are nondeductible.

• If you’re not covered by an employer plan, but your spouse is, then limits are as follows:

Married filing jointly: if your MAGI is $204,000 or less, contributions are fully deductible; between $204,001 and $213,999, they are partially deductible; $214,000 or more and they are nondeductible.

Traditional IRA pros:

• Tax deferred growth on contributions and earnings
• Wide range of investment options, based on the bank(s) or investment firm(s) you choose
• Simple to open
• Simple to fund (e.g. automatic bank transfers)

Traditional IRA cons:

• Low contribution limits
• Subject to ordinary income tax rate at withdrawal
• 10% penalty for early withdrawal, under age 59.5
• Required minimum distributions (RMDs) at age 72
• Possibly subject to income limitations
• No elective deferral option

Roth IRA

A Roth IRA is generally best for someone whose income is projected to be higher in retirement than it is now. Roth contributions are not tax deductible, but your investment will grow tax free. You can withdraw your contributions at any time and for any reason with no tax implications and no penalty. However, your earnings can’t be withdrawn without penalty until you are 59.5 and your account has been open for at least 5 years.

You are eligible to contribute to a Roth IRA based on the following income limitations (2022):

• Single: with a MAGI below $129,000 you are fully eligible to contribute; between $129,000 and $143,999, contributions are limited; above $144,000 and you are ineligible to contribute.
• Married filing jointly: with a MAGI below $204,000 you are fully eligible to contribute; between $204,001 and $213,999 contributions are limited; above $214,000 and you are ineligible to contribute.

Roth IRA pros:

• Contributions can be withdrawn at any time without any tax or penalty
• Earnings and contributions grow tax free
• Contributions and earnings are tax free upon withdrawal
• Wide range of investment options, based on the bank(s) or investment firm(s) you choose
• No required minimum distributions (RMDs)

Roth IRA cons:

• Low contribution limits
• Not tax deductible
• Subject to income limitations
• 10% penalty for early withdrawal of earnings, under age 59.5
• No elective deferral option

Spousal IRA

If you’re married, one spouse may work while the other stays home. Generally, to contribute to a retirement plan you must have earned income – i.e. wages, salary, tips, etc. However, this is where the spousal IRA comes into play. Essentially, a spouse who does not have earned income can still contribute to an IRA as long as the working spouse earns enough to cover the non-working spouse’s contributions. The couple must also file a joint tax return.

For example: if the working spouse earns $50K per year, both spouses are eligible to contribute the maximum $6000 (for 2022) to their IRAs. That’s because $6000 + $6000 < $50,0000. The working spouse’s income more than covers both contributions.

However, if the working spouse only earns $10K per year, then he or she can contribute $6000 to their own account but the non-working spouse can only contribute $4000 to theirs. That’s because the contributions allowed are the lesser amount of the IRA maximum or the earned income. In this case, the earned income is less than the maximum contribution allowance for both spouses.

A spousal IRA can be either traditional or Roth and is subject to all the same contribution, withdrawal and income limitation rules as described above.

Special note: It’s important to point out that “spousal IRA” is an IRS term. In reality, a spousal IRA is just a regular IRA that belongs to a non-working spouse. They can contribute under spousal IRA rules or under ordinary IRA rules, depending on whether or not they have their own earned income in any given year.

Good news! If you’re self-employed, you have additional retirement account options. For more information, see this post.

2. Brokerage accounts

A taxable brokerage account is one of the most basic types of investment accounts. A brokerage account can be individually or jointly owned. It can be entirely self-managed or managed by a (paid) investment broker. While these accounts don’t offer any of the tax benefits that retirement accounts do, they also don’t have any of the same restrictions. You can contribute as much or as little as you like and withdraw funds whenever you want. This can be appealing to investors who want to retain more control over their investments. It’s also ideal for anyone who is already contributing fully to their retirement accounts and has more to invest.

Brokerage accounts offer a broad range of investments, including mutual funds, index funds, stocks, bonds, and exchange-traded funds. Any interest or dividends you earn, as well as gains on investments you sell, are (usually) taxable. How much tax you’ll owe, if any, depends on your tax bracket and how long you held the investment for.

Some of the more popular discount brokerages include Vanguard, Fidelity, and Charles Schwab.

Pros:

• Contributions and earnings can be withdrawn at any time
• No contribution or withdrawal limits
• No income limitations
• Easy to open
• Wide range of investment options, based on the bank(s) or investment firm(s) you choose
• No required minimum distributions (RMDs)

Cons:

• No tax advantages
• Will (usually) owe tax on any dividends or capital gains

3. Education accounts

Different types of investment accounts serve different purposes. Some investment accounts are specifically for education savings. The most popular options are a 529 College Savings Plan account and a Coverdell Education Savings account (ESA). Both plans are similar to retirement accounts in that you invest funds that must be used for a specific purpose. Both types of accounts provide tax-deferred growth. Additionally, as long as the money is used for qualified education expenses it can be withdrawn tax-free.

529 accounts are more flexible than ESAs, but ESAs offers a distinct benefit. Namely, its funds can be used for elementary, secondary or higher education. In contrast, 529s are for post-secondary education only. Here are additional advantages and disadvantages of the two different types of investment accounts for education.

529 College Savings Plan

Pros:

• Very high contribution limits (vary by state)
• Earnings and contributions grow tax free
• Contributions and earnings are tax free upon withdrawal
• No age limit for the beneficiary
• Contributions may be deductible on state taxes
• Anyone can open and contribute to a 529 plan

Cons:

• Qualified expenses are limited to tuition, room, board, and books
• Withdrawals can only be used for post-secondary schools – i.e. college
• Investment options are limited by the plan you choose

Coverdell Education Savings Account (ESA)

Pros:

• Invested funds grow tax-free
• Investment options are not limited (self-directed)
• Qualified expenses are more broadly defined (tuition, room and board, books, computers, internet access, etc.)
• Funds can be used for K-12 or higher education
• Withdrawals are tax-free if used for qualified educational expenses

Cons:

• Income limitations apply
• Contributions are limited to $2,000 per year
• Not tax-deductible
• Beneficiary must be under the age of 30
• Balances must be spent (or transferred) before the beneficiary is 30 or taxes may apply

Summing Things Up

Opening an investment account is a fairly straightforward process, once you know which account best suits your needs. Investing itself takes planning and research to ensure your portfolio matches your risk tolerance level, but can also be easier than you think. If you’re still unsure about where to begin, a fee-only fiduciary can provide answers to any questions you have.