These first few weeks of the year are when those who’ve made New Year’s resolutions are trying to establish new habits and get them to stick. Exercising more and eating healthier is usually at the top of most people’s resolution lists, but surveys show that saving more money always follows close behind.
Hopefully saving more money includes investing more as well. So as you’re looking to increase your contributions for 2022, I figured now is as good a time as any to have a refresher on investment account basics. The more conversations I have about investing, the more I realize how few people have a good understanding of the basics.
When investing, the myriad of different accounts to choose from and use can be confusing. However, while each account will have its own set of rules, they all fall under three broad categories based on how they’re taxed. Today, I wanted to take a quick look at the three types of investment accounts.
Before we start, I often hear people mistake an investment account for an investment and vice versa. A 401(k) or an IRA are not investments, they are accounts that hold investments. Investments such as stocks, bonds, and mutual funds are not tied to a certain type of account or custodian. For example, you can also own Apple stock inside an IRA or a brokerage account. You can also buy Vanguard index funds with an account held at Fidelity or Robinhood.
Ok, onto the three types of accounts you can invest in.
Pre-Tax Accounts
A 401(k), Traditional IRA, 403(b), 457(b), SIMPLE IRA, SEP IRA, HSA, etc. are all accounts that fall under the pre-tax umbrella. They are typically only accessible through your employer or can be opened if you’re self-employed. A Traditional IRA is the exception and can be opened by anyone. With pre-tax accounts:
- You get a tax deduction on the amount you contribute,
- The investments inside the account grow tax-free, and
- When you take out money from the account in the future, every dollar is subject to ordinary income taxes just as your salary is now.
For example, let’s say you contribute $1,000 to a 401(k) which lowers taxable income by $1,000 that year. Over the next 30 years that $1,000 grows to $5,000. In retirement, when you withdraw the $5,000 it’s then subject to ordinary income taxes. If you’re in a 20% tax bracket, you’d end up with $4,000.
Putting money into a pre-tax account is a great way to lower your tax burden now while also investing for your future. A big reason you’d want to avoid taxes now and pay them later is that the overwhelming majority of people will be in a higher income tax bracket when they’re working compared to when they’re retired. Around 80% of people have an effective tax rate of 0% in retirement.
After-Tax Accounts
A Roth IRA and Roth 401(k) are after-tax accounts. Roth IRAs are available to everyone, although if you make above a certain amount of income you’ll have to do what’s called a backdoor conversion to be able to contribute. With after-tax accounts:
- You don’t get a tax deduction when you make a contribution,
- The investments inside the account grow tax-free, and
- When you take out money from the account in the future, you don’t have to pay any taxes on those fund
For example, let’s say you contribute $1,000 to a Roth IRA. You don’t get any immediate tax benefit, but when the account grows to $5,000 over the next 30 years you can withdraw the entire amount without having to pay any taxes.
If you have a long time horizon, hopefully the growth in an after-tax account will be significantly larger than your contributions. This is why you’d want to pay taxes on your contributions now, even if it’s at a decently high rate, rather than on the total ending balance after decades of compounded growth.
Taxable Accounts
A taxable account is a standard investment account, often called a brokerage account, with no special tax advantages. However, they’re available to everyone, have no contribution limits, and have no early withdrawal penalties. They’re the most flexible investment account. With taxable accounts:
- You don’t get a tax deduction when you make a contribution,
- Any income generated from the investments inside the account is subject to capital gains tax that year, and
- When you sell any investments within the account, you owe capital gains taxes on the amount of gain.
For example, let’s say you contribute $1,000 to a brokerage account. Over the next 30 years that $1,000 grows to $5,000. In retirement, when you sell the investments and withdraw the $5,000, the $4,000 of gain will be subject to capital gains tax.
Your capital gains rate depends on your income and how long you held an investment. The dividing line is one year. If you bought and sold the stock within a year, you’ll have a short-term gain. If you bought and held for longer than a year, you’ll have a long-term gain.
The U.S. tax code penalizes day trading by taxing short-term gains at a higher rate than long-term gains. Long-term gains are taxed at favorable rates of 0%, 15%, and 20% while short-term gains are taxed at regular income rates of 10% to 37%.
So, which type of account should you be investing in?
Well, it depends on your financial goals, work situation, income level, tax rate, age, time horizon, just to name a few of the contributing factors.
You also don’t have to exclusively invest in only one type of account. They each offer unique benefits which can help you diversify your retirement savings. Depending on your situation, you can, and probably should, take advantage of all of them.
Thanks for reading!