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If you’re new to investing, one of the first decisions that you must make is determining which type of investment account to open and fund.
To help you get started, this post will provide a basic outline of the various investment accounts that are available to you, including individual retirement accounts, employer sponsored retirement accounts, and taxable brokerage accounts. Each type of investment account varies with regard to ownership requirements, tax treatment, contribution limits, and unique advantages.
Individual Retirement Accounts (IRAs)
Individual retirement accounts, often called IRAs, are extremely popular among investors. An IRA must be owned by one individual, and there are specific guidelines provided by the Internal Revenue Service (IRS) that must be followed when establishing an IRA.
For 2017, the maximum amount of money that you can contribute is $5,500 across all IRA accounts, or $6,500 if you’re age 50 or older. You can split your contributions between both types of IRA accounts, but you cannot exceed the maximum contribution limit.
Contributions must be made by the tax filing deadline in April each year. For example, you can make a 2017 IRA contribution any time before April 17th, 2018 (the 2017 tax filing deadline).
There are two different IRA account options that you can select.
With the Traditional IRA, contributions are usually tax deductible (see below) and future withdrawals are taxed as ordinary income.
You must have earned income (salary, wages, commissions, self-employment income, alimony, or combat pay) and be younger than 70½ years of age to fund a Traditional IRA.
Not all Traditional IRA contributions are tax deductible.
- If you (and your spouse) are not covered by an employer sponsored retirement plan (such as a 401k), Traditional IRA contributions are always tax deductible.
- If you (or your spouse) participate in a qualified, employer sponsored retirement plan, contributions are tax deductible only if your income remains below the IRS threshold.
You cannot withdraw money from your Traditional IRA until age 59½. If initiated before then, any withdrawal is subject to a 10% penalty in addition to the tax liability. When you reach age 70½, you must begin taking required minimum distributions from each Traditional IRA that you own. When the money is withdrawn, the entire withdrawal is taxed as ordinary income. The tax rate depends on your taxable income at the time of withdrawal.
When you reach age 70½, you must begin taking required minimum distributions from each Traditional IRA that you own. When the money is withdrawn, the entire withdrawal is taxed as ordinary income. The tax rate depends on your taxable income at the time of withdrawal.
Roth IRA accounts are funded with after-tax dollars. There are no tax breaks for contributions made to a Roth account.
However, all earnings inside of a Roth account grow completely tax-free, and qualified withdrawals are completely tax-free.
Like the Traditional IRA, you must have earned income to fund a Roth IRA. However, there are no age restrictions when making contributions.
While Traditional IRA contributions are limited by the availability of employer sponsored retirement plans, Roth IRA contributions are limited by your modified adjusted gross income (MAGI).
- Roth IRA contributions are not allowed if your MAGI exceeds the IRS threshold.
- Roth IRA contributions never depend on your participation in a qualified, employer sponsored retirement plan.
Like the Traditional IRA, Roth IRAs are subject to the same 10% penalty for withdrawals made before age 59½ years old. However, there is an exception to this rule. All of your initial contributions can be withdrawn from a Roth IRA at any time.
For example, let’s assume that you contribute $5,000 this year to a Roth IRA and the account balance grows to $8,000 over the next five years. You can withdraw any portion of the initial $5,000 contribution, at any time, without penalty. But you cannot withdraw any portion of the $3,000 earnings growth. A withdrawal of any earnings before the age of 59½ will be subject to the 10% penalty.
There is another important rule that you must understand. The Roth IRA requires that your first contribution be made at least five years before you withdraw any earnings, regardless of your age when the account is opened. For example, if you open a Roth IRA and make your first contribution at age 58, you must wait until age 63 to withdraw any earnings from the account. If you violate this rule, the IRS deems the withdrawal a “nonqualified distribution,” where all earnings are subject to taxation and the 10% penalty.
As an added benefit, Roth IRAs are not subject to required minimum distributions at age 70½.
Which IRA Should You Choose?
You are allowed to contribute to either IRA account type each year, and you can split your annual contribution between both accounts.
Under the IRS rules, the Traditional IRA provides additional tax savings for individuals in a higher tax bracket, while the Roth IRA provides the largest benefit for individuals in a low tax bracket.
There are other important considerations that distinguish the two account types, so consider reading my detailed explanation comparing both accounts.
Employer Sponsored Retirement Plans
Many employers offer retirement accounts to their employees, such as the 401(k) and 403(b). These plans offer tax benefits that are similar to the IRAs, making them a great investment choice if you are looking to invest more than the IRA limit. For 2017, The maximum employee contribution is $18,000, or $24,000 for those age 50+. Employer contributions do not count toward this limit.
One downside is that employers often impose a waiting period before an employee becomes eligible to participate in the plan. These waiting periods range from a few months to over a year. These restrictions are put in place to incentivize employees to stay with the firm.
On the upside, employers often include a matching contribution for employees who contribute to the retirement plan. For example, your company might offer a 3% match on your 401(k) contributions. If you contribute 3% of your paycheck, the employer contributes an additional 3% on your behalf. That means you can double your retirement contribution using “free” money from your employer.
Employers that offer to match retirement contributions often impose a vesting schedule, which means that you must work at the company for a certain period of time before the matching contributions are legally yours. In most situations, if you leave the company before the vesting period is up, you will lose some or all of your employer’s contributions. You are always entitled to your own contributions by law. You should check with your employer about the specific vesting schedule in your plan.
Much like the IRA, many employers offer a choice between Traditional and Roth accounts.
Traditional 401(k) and 403(b)
The most common employer sponsored plans include the 401(k) and 403(b) plans. Both plans operate similarly, where an employee can contribute a portion of earned income into the plan, up to $18,000 in 2017, ($24,000 for those age 50+). Your employer chooses the available investment options in the plan (frequently mutual funds), and you decide how to invest your contributions.
When compared to the Traditional IRA, these retirement plans have a major advantage. The funding limits are much higher ($18,000 vs $5,500) and there are no income limitations preventing participation. Regardless of your income, you can participate if your employer sponsors a plan.
Traditional employer sponsored plans have the same tax implications as the Traditional IRA. Contributions are generally made through payroll deferrals (you choose how much to contribute as a percentage of your overall income). Contributions reduce your taxable income for the year and all investment earnings grow tax-deferred.
Future withdrawals are fully taxed as ordinary income. You may begin withdrawing money at age 59½, and early withdrawals are subject to the same 10% penalty described in the IRA section. There are required minimum distributions once you reach age 70½.
Roth 401(k) and 403(b)
Roth employer sponsored plans operate similarly to the Roth IRA. Contributions are not tax deductible, but all earnings grow completely tax-free, and qualified withdrawals are completely tax-free.
Compared to the Roth IRA, the benefits include a much higher funding limit ($18,000 vs $5,500) and no income limitations preventing participation. The major disadvantage is that Roth 401(k) and 403(b) accounts are subject to required minimum distributions once you reach age 70½.
Much like the decision between Traditional and Roth IRA, you must decide how to split your contributions between these different accounts. The maximum you can defer between both Traditional and Roth is $18,000 ($24,000 for those age 50+) in 2017.
The most important consideration is your employer’s matching program. Make sure to contribute to whichever account will receive a match, then decide how to handle the remaining contributions after that using my guide.
(Note – the same considerations apply when choosing between Roth and Traditional, whether you are funding an IRA or an employer sponsored plan)
Taxable Brokerage Accounts
A taxable brokerage account is an investment account funded with after-tax dollars. These accounts operate like a regular savings account but allow you to own and trade financial assets including stocks, bonds, and diversified funds.
A brokerage account can be opened individually, or jointly with another individual. These accounts are free of the restrictions and rules that govern IRAs and employer sponsored plans. Anyone of legal age (usually 18) can open and fund a brokerage account, and there no contribution limits and no restrictions on when you can make withdrawals.
Unlike IRAs or employer sponsored plans, these accounts offer no tax benefits. Any interest or dividends that you earn in a taxable account are subject to taxation in the year received. Additionally, there are tax consequences when you trade an investment. When you sell an investment for more than the purchase price, you realize a capital gain, and when you sell at a loss, you realize a capital loss.
The tax treatment depends on the holding period. If you sell an investment after holding it for 365 days or less, you have a short-term capital gain (or loss). If you sell the investment after holding it for 366 days or longer, that is considered a long-term gain (or loss).
Short-term capital gains are treated as ordinary income, while long-term capital gains are taxed a preferential tax rate. For this reason, it’s better to hold investments for longer than one year. If you sell any investments at a loss, you can use the capital loss to reduce any capital gains, offsetting some of the taxes.
How to Choose an Investment Account
I’ve covered several different types of investment accounts in this article. If you need a primer to help you decide between the accounts, consider these tips:
1) Always Take the Employer Match
Your first consideration is your employer’s matching program. If you are eligible to participate in an employer sponsored plan, and your employer offers to match your contributions, make sure to contribute enough to receive the maximum possible match. That is free money, and you can’t beat free.
2) Consider the IRA
After contributing enough to receive your employer’s match, consider opening an IRA if you are eligible.
IRAs allow you to establish the account at a provider of your choosing, which means you have complete control over the investments held in the account. With employer sponsored plans, you are limited by the investment options provided by your employer.
3) Back to the Employer Sponsored Plan
If you are ineligible to contribute to an IRA, or if you have funded the maximum amount allowed by the IRS, your employer sponsored plan is the only remaining tax shelter.
You can contribute up to the IRS defined limit each year, splitting your contributions between Traditional and Roth (depending on your tax preferences and plan availability).
4) Open a Taxable Brokerage Account
Once you have exhausted any available tax sheltered accounts, you can continue investing through a brokerage account.