An investment account is not the same as a checking or a savings bank account. What’s more, it is not used in the same way either.
If you consider opening one, we invite you to discover more closely what it is, how it is used, and how many types of investment accounts there are for you to choose according to your goals or needs.
With an investment account, you can invest money through trading instruments. That is –unlike other types of accounts including money market accounts with higher interest rates– the client deposits money in order to invest in shares or stocks, derivatives, bonds, funds, and even real estate and retirement plans.
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If you want to know more about investment accounts, what types there are, and how they work, just keep reading!
5 Investment Account Types
One of the several types of investment accounts is the Individual Retirement Account (IRA). According to Investopedia, with an IRA “you can invest in all sorts of traditional financial assets such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds.”
They are a simple way to save for retirement as they offer many tax advantages and the opportunity to earn income during those long-awaited days.
The IRA allows you to move toward achieving your goals and secure income for your family.
Perhaps the first and most obvious advantage of an IRA is that it offers you the possibility to secure income for retirement. This might sound very self-explanatory but many people keep postponing this and suddenly they see themselves and their loved ones in trouble.
According to the Bureau of Labor Statistics, barely 60% of Americans had access to an employer-sponsored retirement plan in 2020.
In detail, an IRA brings you tax benefits because all the earnings you generate with those savings will not pay a single dollar in taxes.
For example, if you managed to have $1,000 in a non-IRA investment account, you must subtract the tax money. With the tax benefits of an IRA –no matter if it is Roth or traditional– your money will grow faster and in greater amounts.
Further, the IRA is an account that will stay with you forever, regardless of your changes at work, and that is the third advantage.
Since employers pay a 401k account for your retirement –we’ll get to that later– you don’t have control over that money. If you quit your job, you will no longer be able to contribute to the 401k and years and years can go by as your money stagnates.
So, with an IRA, it is very easy to transfer money from your 401k so you can have control over your money, savings, and returns.
One drawback of IRA accounts is that they have strict contribution limitations. So, if you are 50 or older, you can contribute up to $7,000 as established for 2020 and 2021.
However, if your Modified Adjusted Gross Income (MAGI) goes beyond a certain limit, you could not be able to contribute to a Roth IRA.
Further, you might be penalized for withdrawing your money in advance as the account is intended for when you reach retirement age. If you’re contributing to a traditional IRA, the penalty could account for 10% on top of the taxes owed for any withdrawals before age 59 and a half.
Still, “with the Roth IRA, you can withdraw a sum equal to your contributions penalty and tax-free at any time,” according to Investopedia.
Another disadvantage is that IRAs require withdrawals under specific conditions. The Required Minimum Distributions start at age 72 and the amount is based on your life expectancy.
The amount will also be added to that year’s taxable income, and if you fail to take the RMD, you can face a 50% penalty plus taxes you might owe.
According to the IRS, a 401k is a feature of a qualified profit-sharing plan “that allows employees to contribute a portion of their wages to individual accounts.”
It could also be defined as an agreement that allows an employee to choose between receiving cash compensation or deferring a percentage of it to the 401k account.
With a 401k, workers can make automatic contributions to their accounts through payroll withholdings, freeing themselves from the task of contributing to the plan on a monthly basis.
Additionally, employers have the option of matching some or all of the contributions made by the worker, causing the account balance to progressively increase.
Further, earnings from 401k investments are not taxed until the employee withdraws the money, which generally occurs after retirement.
There are also some other advantages. Let’s say you have an outstanding debt and you lose your job. Your creditor could try to obtain the payment forcibly through a lawsuit, but they will not be able to go for your 401k plan –with some exceptions.
And there is more. If you are over 50 in 2021, you can contribute more than $19,600 to your 401k retirement plan –from $26,000.
Compared to other types of investment accounts, 401k accounts typically don’t offer such a diverse range of investment assets. You may only be able to access basic investments with minimal risk, and this will generally result in lower returns.
Another disadvantage of the 401k plan is that you will have to pay a 10% penalty if you make an early withdrawal –that is, before reaching the age of 59 and a half years.
In addition, it should be added that this withdrawal is also subject to taxes –each contribution is made tax-free, that is, tax-deferred.
529 College Savings Account
According to the Securities and Exchange Commission (SEC), “A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs.”
“529 plans, legally known as ‘qualified tuition plans,’ are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.”
Although contributions are not deductible, 529 plan earnings grow free of federal tax and will not be taxed as long as the money is withdrawn to pay for college expenses.
As of 2018, tax-free withdrawals may include –but are not limited to– tuition expenses of up to $10,000 for private, public, religious, elementary, or secondary schools –per year, and per beneficiary.
In 2019, student loan payments and apprenticeship costs were added as qualified education expenses.
In addition to federal tax savings, more than 30 states currently offer partial deductions, full deductions, and credits for contributions to 529 plans.
Each year you will be able to claim your tax benefits to contribute to your 529 savings plan, so it would be an excellent idea to make constant deposits until you have paid the last bill for your tuition.
With some exceptions, the legal beneficiary does not have legal rights to the funds in a 529 plan account, by virtue of ensuring the proper use of the money stored therein.
Withdrawals from a 529 plan that are not used for the beneficiary’s qualified education expenses are subject to the payment of taxes and penalties –the account earnings are subject to a 10% federal penalty.
Also, investment options for a college savings plan are limited to the pre-established investment portfolio offered by the plan –prepaid tuition plans offer no opportunity to choose your investments.
College savings plans do not guarantee a return and are subject to risk, so you may lose some or all of the money you have contributed.
Further, college savings plans do not have a legal requirement to allow you to change the investment option on your existing contributions once per calendar year, or allow you to choose a new investment option for future contributions.
Individual Brokerage Account
According to Forbes, “A brokerage account allows you to buy and sell stocks, bonds, exchange traded funds (ETFs), and mutual funds.”
“A brokerage account is also called a taxable investment account –to differentiate it from a tax-advantaged retirement account like IRA and 401k.”
You deposit your money and invest it in different ways –as in a taxable account– as the broker is in charge of executing said investments. The broker is paid a minimum commission fee for their execution.
An individual brokerage account offers many different types of investment assets including stocks, bonds, funds, and much more.
Although they offer fewer tax perks than a retirement account, there are also fewer restrictions on when a trader can contribute or withdraw money.
Further, a brokerage account offers the opportunity to withdraw at any time with no penalties and you can spend proceeds on anything you want.
Also, some will allow you to hold member stakes in a limited liability company or in limited partnership units in a limited partnership –usually tied to investing in a hedge fund.
According to Zacks, with an individual brokerage account “you’ll have to keep an eye on your investments yourself, and you also won’t have the safeguards of investing in certain less risky investments, like insured bank products and government bonds.”
Also, you are taxed on the gains of your brokerage account, possibly at lower long-term capital gains rates.
Real Estate Crowdfunding
Among the types of investment accounts, real estate crowdfunding is the method by which any user can access an online platform and make investments for a project. This means that the user will finance a small part of a complete project in the real estate sector.
Investors are the key in real estate crowdfunding, as they represent the force behind this type of business.
Real estate crowdfunding is seen as the democratization of investments as they open the door to those with a small investing capacity. It also offers a wide choice of projects to invest in, and investors can minimize risk by investing in different opportunities that may differ depending on the type.
Also, you don’t have to be real estate savvy, and investors can trust the experts on the real estate crowdfunding realm.
Like any other, real estate investments are not risk-free. However, it is possible to minimize them by diversifying into different opportunities and get results in the short term. The waiting time is shorter compared to traditional investments, since investments can be made online.
Further, real estate crowdfunding platforms are subject to careful supervision and inspection by regulators in order to offer investor protection and avoid fraud.
In these types of investment accounts, it is essential to bear in mind that the real estate market is constantly changing, and sale and rental prices can fluctuate.
Also, some platforms claim that financial knowledge is not necessary because they take care of everything, but that is not entirely the reality. The user must be aware of a minimum amount of information for their safety.
Further, it is very important to have clear and transparent information on how and where the money is being invested, and the consequences. There is great risk in investing money and not having control over it.
On the other hand, crowdfunding amounts are currently limited, but the Securities and Exchange Commission will increase the maximum amount that can be raised through a campaign from $1.07 million to $5 million in any twelve-month period, as reported by Republic.
Types of IRAs
Basically, there are two types of individual retirement accounts: the Roth IRA and the traditional IRA.
Roth IRAs are an exceptionally flexible savings option that offers the potential for tax-deferred earnings and tax-free withdrawals. You can pay taxes when you contribute and, in return, you can make withdrawals –qualified with tax exemption– of potential earnings from your contributions.
According to Investopedia, a Roth IRA differs from a traditional IRA as the former is funded with after-tax dollars –the contributions are not tax-deductible. Still, once you start withdrawing funds, the money is tax-free.
“Conversely, traditional IRA deposits are generally made with pretax dollars; you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement.”
A traditional IRA account is a very good option to build retirement savings since it allows you to make contributions of up to $ 5,500 a year –or $ 6,500 a year if you are over 50 years old– with the possibility of deducting them from taxes.
According to US Bank, “Traditional IRAs offer the key advantage of tax-deferred growth, meaning you won’t pay taxes on your untaxed earning or contributions until you’re required to start taking distributions at age 72.”
“With traditional IRAs, you’re investing more upfront than you would with a typical brokerage account.”
Other Corporate Sponsored Accounts
Smart Asset defines a pension plan as a type of retirement plan in which employers commit themselves to pay a defined benefit to employees for life after they retire.
“It’s different from a defined contribution plan, like a 401k, where employees put their own money in an employer-sponsored investment program.”
An employee’s pension income is often paid out as a percentage of the salary during working years, depending on the terms agreed with the employer and based on the time worked for the employer.
“A worker with decades of tenure with a company or government may get 85% of their salary in retirement. One with less time under their belt, or at a less generous employer, may only receive 50%.”
The 403b retirement plan is a retirement account designed for specific employees of public schools and tax-exempt organizations. Common beneficiaries of this retirement account include teachers, school administrators, professors, librarians, nurses, doctors, and government employees.
The 403b retirement account is similar to the 401k but it serves employees of public schools and tax-exempt organizations more than private sector workers.
The advantages of a 403b over a 401k may include faster delivery of your funds and the ability to make additional contributions to catch up. However, investment options may be more limited with a 403b and some accounts offer less creditor protection than a 401k.
According to the IRS, a SIMPLE IRA plan (Savings Incentive Match PLan for Employees) “allows employees and employers to contribute to traditional IRAs set up for employees.”
“It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.”
Small businesses can opt for SIMPLE accounts since they are a less expensive and a less complicated alternative to a 401k plan.
According to Investopedia, 457 plans are “non-qualified, tax-advantaged, deferred compensation retirement plans offered by state governments, local governments, and some nonprofit employers.”
Those eligible participants can make salary deferral contributions, depositing pre-tax money that is allowed to compound without being taxed until it’s withdrawn.
457s are similar to 401k plans, but instead of being offered to employees at for-profit companies, they are designed for state public workers, “together with highly paid executives at certain nonprofit organizations, such as charities.”
A SEP IRA is a Simplified Employee Pension IRA. It’s a type of traditional IRA with which self-employed and small business owners can save up to $57,000 for retirement.
However, the contribution rules mean that these plans tend to be better for companies with few or no employees.The “simplified” side of a A SEP IRA points to the fact that it’s a basic retirement account, much like a traditional IRA.
“Contributions to the SEP IRA are tax deductible and investments grow tax-deferred until retirement, when distributions are taxed as income,” according to Gasking Consulting.
The Solo 401k –a one-participant 401k according to the IRS– is an individual 401k especially catering to business owners with no employees.
Actually, according to the IRS, if you employ people full-time, you can’t contribute to a solo 401k but you can still cover yourself and your partner in the same plan.
A Solo 401k allows you to contribute up to $57,000 last year, with an update to $58,000 in 2021. If you are 50 or older, you can make a catch-up contribution of an extra $6,500.
Diversifying Your Investment Account Types
As you can see, there are several types of investment accounts that you can use for whatever goals or needs you might have –investing in assets, investing for retirement, etc.
However, investment accounts like IRA or 401k are the safest bet to start off because they are not complicated and are the most common.
Once you grow confident and your contribution to these investment accounts have levelled-off, you might feel like turning to other options to start diversifying your investments.
Such diversification will allow you to juggle with several investment accounts and discover how you can always have an ace up your sleeve –whether it be to save money for retirement or to keep money flowing in.
Having several investment accounts can grant you various tax benefits like those inherent to IRA accounts, your 401k, or even 529 college savings accounts.
A taxable brokerage account will compensate for the penalty fees for withdrawing from your 401k, as with the former you can withdraw money at any time.
If you see investment accounts as sheer investments, you will always have resources and back-ups, as applying the principle of diversification in investment accounts is a prime.
How many investment accounts should I have?
There is no specific number but you are advised to have as many as you can handle. Diversification is key, so having several products will reduce risk and give you peace of mind.
According to expert Stuart Michelson, “With more than one brokerage account, an investor has many more diversified investment possibilities, using both funds and exchange-traded funds.”
Further, he says, multiple accounts with a different person as a joint owner –a joint taxable brokerage account– allow investors to manage their brokerage assets completely independent of a will or any other estate planning.
“For example, an investor may name their sister as a joint owner on one account and their child as a joint owner on a different account, simplifying the distribution of assets upon their death.”
What type of investment account should I open?
It all depends on your life plan and goals. It is advisable, however, to start investing in IRAs or 401ks before jumping to a taxable brokerage account or similar.
For instance, if you want to save money for education, a 529 college savings account should be your first option.
Every account type works differently and it is essential that you grasp the basics correctly, before deciding which ones are best for you.
You should also keep in mind the purpose of your investment account –investing, education, or retirement– and whether they offer the tax advantages or the freedom and flexibility you’re looking for.