Choosing the Ideal Investment Account: A Comprehensive Guide
Investing

Choosing the Ideal Investment Account: A Comprehensive Guide

Investing

Choosing the Ideal Investment Account: A Comprehensive Guide

When it comes to investing your hard-earned money, there are several account types to consider. You must choose the account you will use before you can buy any assets (like an index fund). The account is the gateway to purchase those assets, and each serves a different purpose and offers unique benefits. At the end of the day, it all boils down to your financial goals. I know.. that is broad guidance, so let’s explore the most common investment accounts, using simple language to help you understand them better.

In an attempt to reduce the overwhelm, I find it helpful to compare the following six features of every account:

#1 BENEFICIARY – Who is the money in the account for? Who gets to spend it upon withdrawal?

#2 RESTRICTIONS ON USAGE OF MONEY – When I invest money into a particular account, are there rules as to how I must use the money when I withdraw it?

#3 TAX SHELTERING BENEFITS – Does this account have unique features that reduce my yearly tax bill or limit the taxes I owe when I make a trade inside my account?

#4 – ACCESS / ELIGIBILITY – What requirements are there in order to be able to open and use this account?

#5 CONTRIBUTION LIMITS – Am I limited as to how much money I can put into this account in a calendar year?

#6 AGE RESTRICTIONS ON WITHDRAWALS – Do I have to reach a certain age before I can access my money in this account (without any penalty)?

By understanding and using these 6 data points to compare accounts, I can get a better understanding of which one fits my current situation and goals! While there are several accounts available for you to invest in, we are going to take a look at just 7. This is not a comprehensive list of every option, but perhaps a list of the most common accounts for the average investor.

401k

A 401(k) is an employer-sponsored retirement account. It’s like a piggy bank for your future. You put a portion of your salary into this account, and your employer might also contribute a little extra (this is called a company match & is essentially bonus money being invested on your behalf, from the pockets of your employer). The best part? You don’t pay taxes on the money you put into a 401(k) until you take it out, when you’re ready to retire. It’s a smart way to save for your golden years. 

  • BENEFICIARY – self, this account is investing money for YOUR future / retirement.
  • RESTRICTIONS ON USAGE OF MONEY – none, you have free rein to use this money on whatever you’d like once you withdraw it!
  • TAX SHELTERING BENEFITS – yes, if you choose to contribute your money Traditional (as opposed to Roth), you do not have to pay taxes on your contributions until you withdraw.. this means you lower your tax bill every year you contribute! An added bonus is that if you decide to sell a stock inside your 401k to buy a different stock, you are not on the hook to pay any taxes on the amount your initial investment may have grown.
    • (example: I buy a stock of Facebook for $20, and 2 years later it has grown to $35.. if I want to sell that stock to buy a share Tesla, I would have earned $15 in “capital gains“. In investment accounts that are not tax sheltered, when I make that transaction, I have to pay capital gains tax on my earnings ($15).
  • ACCESS / ELIGIBILITY – employer benefit, in order to have access to a 401k, it must be offered as a benefit from my employer.. I cannot go out and open a 401k on my own (unless you are self-employed). 
  • CONTRIBUTION LIMITS – yes, every year the IRS sets a limit as to how much you can contribute to a 401k. In 2023 the maximum amount you can put into your 401k is $22,500 & if you are over the age of 50 you can put in an additional $7,500 (this is called catch up contributions).
  • AGE RESTRICTIONS ON WITHDRAWS – yes, you must reach age 59 1/2 before you can withdraw money out of your 401k. If you do so before that age you will have to pay a 10% penalty on the amount withdrawn (of course there are some loopholes & special circumstances in which you can withdraw earlier without penalty).
 

IRA (Individual Retirement Account)

An IRA is like a 401(k), but you set it up yourself. Think of it as a personal retirement savings account. You choose which company (aka Brokerage) you want to open your account with, and then you start contributing money and choosing your investments (like an index fund). This type of account is a bit more accessible to individuals, and therefore is commonly the first place many individuals will start investing! 
  • BENEFICIARY – self, this account is investing money for YOUR future / retirement.
  • RESTRICTIONS ON USAGE OF MONEY – none, you have free rein to use this money on whatever you’d like once you withdraw it!
  • TAX SHELTERING BENEFITS – yes, if you choose to contribute your money in a Traditional IRA (as opposed to Roth), you do not have to pay taxes on your contributions until you withdraw.. this means you lower your tax bill every year you contribute! If you choose to invest your money in a Roth IRA you wont lower your tax bill in the current year, but you will get to withdraw all of your money tax free!
    • Like the 401k, if you decide to sell a stock inside your IRA (regardless if it’s a Traditional or Roth account) to buy a different stock, you are not on the hook to pay any taxes on the amount your initial investment may have grown.
  • ACCESS / ELIGIBILITY – 18yrs of age + earning income / paying taxes, in order to contribute to an IRA you must be an adult that is earning income & paying taxes on that income.
    • now is a good time to note that there is an income limit for those contributing to a Roth IRA, if you exceed this income you are not allowed to directly contribute to a Roth IRA & will be penalized come tax time, learn more here.
  • CONTRIBUTION LIMITS – yes, every year the IRS sets a limit as to how much you can contribute. In 2023 the maximum amount you can put into your IRA is $6,500 & if you are over the age of 50 you can put in an additional $1,000 (this is called catch up contributions).
    • if your taxable income is less than these limits, your taxable income becomes your maximum contribution allowed. 
  • AGE RESTRICTIONS ON WITHDRAWS – yes, you must reach age 59 1/2 before you can withdraw money out of your IRA. If you do so before that age you will have to pay a 10% penalty on the amount withdrawn.

 

Custodial Roth IRA (Individual Retirement Account)

Remember how we just discussed you must be 18yrs of age to open an IRA? Here’s an account you can use for a child / minor before age 18! You contribute money on their behalf, and the earnings grow tax-free. When they reach a certain age, they take control of the account and enjoy tax-free withdrawals in retirement (age 59 1/2). It’s important to take special note of the Access / Eligibility rules for a Custodial Roth. 

  • BENEFICIARY – child / minor, this account is investing money on behalf of a child / minor (under the age of 18).. you are the “custodian” of the account, managing it until they are of age.
  • RESTRICTIONS OF USAGE OF MONEY – none, you have free rein to use this money on whatever you’d like once you withdraw it!
  • TAX SHELTERING BENEFITS – yes, when you invest money in a Roth IRA it wont lower your tax bill in the current year, BUT you will get to withdraw all of your money tax free!
    • Like the 401k & IRA, if you decide to sell a stock inside your IRA to buy a different stock, you are not on the hook to pay any taxes on the amount your initial investment may have grown.
  • ACCESS / ELIGIBILITY – child must be earning income & paying taxes on it, it doesn’t matter if they’re working for an employer or providing services like babysitting, as long as the child is making money and paying taxes on it, they (or you, on their behalf) can contribute to a Custodial Roth IRA. 
  • CONTRIBUTION LIMITS – yes, every year the IRS sets a limit as to how much you can contribute to a Custodial Roth IRA. In 2023 the maximum amount you can put into a Custodial Roth IRA is $6,500 or the total amount of money that your child made during the year, whichever is less.
  • AGE RESTRICTIONS ON WITHDRAWS – yes, you must reach age 59 1/2 before you can withdraw money out of your IRA. If you do so before that age you will have to pay a 10% penalty on the amount withdrawn.

 

HSA (Health Savings Account)

A HSA is like a health piggy bank. It’s used to save for medical expenses, and it comes with a nice tax benefit. When you put money into a HSA, you don’t pay taxes on it, and you can use it tax-free for qualified medical costs. Plus, any money left over can be invested and grow over time.

  • BENEFICIARY – self and family, as long as you meet the eligibility requirements you can use HSA funds for yourself, spouse and dependents on your tax return
  • RESTRICTIONS ON USAGE OF MONEY – qualified healthcare expenses, you must use HSA funds to pay for healthcare expenses that are qualified by the IRS, otherwise you will face a 20% penalty & owe taxes on the amount withdrawn.
  • TAX SHELTERING BENEFITS – yes, a HSA is one of the MOST tax efficient accounts. You do not have to pay taxes on the money you contribute (lowering your yearly tax bill) AND you don’t have to pay taxes when you withdraw, as long as it’s used for qualified healthcare expenses!
  • ACCESS / ELIGIBILITY – HDHP (high deductible healthcare plan), in order to contribute to a HSA you must currently be covered by a High Deductible Healthcare Plan
    • You must also not be enrolled in Medicare, nor claimed as a dependent on another person’s current year tax return
  • CONTRIBUTION LIMITS – yes, every year the IRS sets a limit as to how much you can contribute to a HSA. In 2023 the maximum amount you can put into your HSA is $3,850 for self-only coverage and $7,750 for family coverage. Those 55 and older can contribute an additional $1,000 as a catch-up contribution.
  • AGE RESTRICTIONS ON WITHDRAWS – no, you can withdraw your HSA dollars at any time you’d like!

 

529 Plan 

A 529 Plan is a dedicated college savings account. It’s a bit like a special piggy bank for your kid’s education. When you put money into a 529 Plan, it grows tax-free, and when you use it for qualified educational expenses, you won’t have to pay taxes on any investment growth. It’s an excellent way to help your loved ones pursue higher education. Each state sponsors its own 529 plan, so the details below often vary by state. 

  • BENEFICIARY – self or child, you can use this investment account to save and invest for your own future education OR for a child’s future education. 
  • RESTRICTIONS OF USAGE OF MONEY – qualified education expenses, you must use 529 Plan funds to pay for specific education expenses that are qualified by the IRS, otherwise you will face a 10% penalty & owe taxes on the amount withdrawn.
  • TAX SHELTERING BENEFITS – yes, while contributions to a 529 plan will not lower your yearly tax bill, all withdrawals from this plan are tax free when used for qualified education expenses.
    • certain sates allow for a portion of contributions to be tax deductible.
  • ACCESS / ELIGIBILITY – none, you can open an account for a child, grandchild, friend, or even yourself. The only rule is that the beneficiary must be a U.S. citizen or resident alien with a valid Social Security number or other taxpayer identification number
  • CONTRIBUTION LIMITS – some, contribution limits for 529 Plans vary by state
  • AGE RESTRICTIONS ON WITHDRAWS – no, you can withdraw your 529 Plan dollars at any time you’d like! 

 

Brokerage Account

A brokerage account is like a wallet for buying and selling investments. You can use it to invest in stocks, bonds, and other assets. Unlike retirement accounts (401k & IRA), there are no tax advantages here. Any gains you make might be subject to taxes, depending on how long you hold onto your investments. On the plus side there are little to no rules on how much you can contribute and at which age you can withdraw. 

  • BENEFICIARY – self, this account is investing money for YOUR future / goals.
  • RESTRICTIONS OF USAGE OF MONEY – none, you have free rein to use this money on whatever you’d like once you withdraw it!
  • TAX SHELTERING BENEFITS – none, unlike 401k and IRA your money contributed never lowers your tax bill, and when you make a trade inside your account, or sell your investments to withdraw your money, you will once again owe taxes
    • to be a tax efficient investor inside a brokerage account aim to hold your investments for 1yr before selling, so that you fall in the long term capital gains bucket (which results in a lower tax bill than short term capital gains, when you sell within the 1yr window)
  • ACCESS / ELIGIBILITY – none, as long as you are 18 you can open a Brokerage account 
  • CONTRIBUTION LIMITS – none, since you have already paid taxes on the money you will invest, the government doesn’t care how much you put in this account in a given year
  • AGE RESTRICTIONS ON WITHDRAWS – none, you can withdraw out of this account at any time. 

 

UGMA / UTMA (Uniform Gift/ Transfer to Minors)

UGMA and UTMA accounts are investment accounts that parents or guardians can set up for their children. They act like a trust fund for minors. You invest money on their behalf, and when they become adults (usually at a specified age), they gain full control over the account. Be aware that these accounts don’t have the same tax benefits as 529 Plans or Custodial Roth IRAs & the money in this account may have an impact on college financial aid.

  • BENEFICIARY – child, this account is investing on behalf of a child.
  • RESTRICTIONS OF USAGE OF MONEY – none, you have free rein to use this money on whatever you’d like once you withdraw it!
  • TAX SHELTERING BENEFITS – none, unlike a 529 Plan or Custodial IRA the money contributed never lowers your tax bill, and when you make a trade inside your account, or sell your investments to withdraw your money, you will once again owe taxes
    • to be a tax efficient investor inside a UGMA / UTMA account aim to hold your investments for 1yr before selling to fall in the long term capital gains bucket (which results in a lower tax bill than short term capital gains, when you sell within the 1yr window)
  • ACCESS / ELIGIBILITY – none, as long as you are 18 you can open a UGMA/UTMA account & become the custodian for a child or family member. 
  • CONTRIBUTION LIMITS – none, since you have already paid taxes on the money you will invest, the government doesn’t care how much you put in this account in a given year
  • AGE RESTRICTIONS ON WITHDRAWS – none, you can withdraw out of this account at any time. 

 

There you have it, 7 of the most common investment accounts compared. As always, be sure to do your own research or seek advice from a professional if you are still unsure. At the end of the day – it’s better to get started, and learn from your mistakes along the way.. as opposed to not starting at all!

For more education on investing, feel free to check out my self paced investing course, Confused to Confident.