Why Having Different Types of Investment Accounts Is a MUST!

Ok, you understand the basics that we have posted about previously. You have your debt under control and you have a cash reserve for emergencies.  Yahoo! You are ready to open an investment account. In this post, we will cover the types of accounts available to you for your goals. It is important for you to have a variety of account types as you invest. This is so you can avoid being taxed fully on your investments, like your paycheck. There are three types of accounts you can use: taxable, tax-deferred, and tax-free.

  • Taxable:  Taxable accounts are funded with money that has already been taxed by your paycheck (or someone else’s paycheck if you receive a gift) and as the value of the account grows the gains are taxed when you sell a security. Gains are only considered gains when you sell. If you have a loss when you sell a security you can offset other gains you may have from other taxable investments; depending on the length of time they have been held. Dividends or income will also be taxed when it is collected or earned. Taxes on gains and dividends have historically been taxed at better rates than ordinary income. Taxable accounts have an ownership that can be for an individual person or jointly held for two people (married or parent and child for example). There is no maximum for how much you can save into a taxable account.

 

  • Tax Deferred:  Tax-deferred accounts are often times the bulk of someone’s long-term savings. This would be an employer-sponsored account like a 401(k) or 403(b). These accounts are funded with your earnings from your work before they are taxed, and employers will, commonly, contribute a pretax percent of your earnings to these accounts as well. Financial advisors recommend that investors contribute to this type of savings first before anything else, at least up to the employer match, because they can save you now from taxes and you can automatically invest. This type of account only becomes available for your use after you turn age 59 1/2. Any withdrawal before then is penalized with a steep fee to the IRS, and would be taxed as ordinary income like your work income. Even after 59 1/2 the investment will be taxed as ordinary income when you make a withdrawal. There are maximums you can save into your 401(k), see the IRS website for more information (currently, you can save a max of $18,000 per year and more if your are over 50).

 

  • Tax-Free: Tax-Free accounts are designed to grow tax-free and are also tax-free at withdrawal. Roth IRAs and 529 Plans are popular examples of this type of investment account. The money you contribute to these accounts has already been taxed with your paycheck and when you withdrawal the money it is tax-free. Penalties do apply to early withdrawals. There are maximums you can save into your Roth IRA, see the IRS website for more information (currently, you can save a max of $5,500 per year and more if you are over 50). State offered 529 Plans have no maximum but money can only be used for qualified education expenses for the beneficiary, otherwise, there is a tax. Gift taxes may apply as well, so check with your tax professional.

 

If you are more graphical, the image below may help. The idea is that you should have a mix of these types of accounts as you save for your long term goals. You want to avoid having all of your savings taxed as ordinary income in retirement. Contribute up to your employer match in your employer retirement plan and then consider another investment account type for additional savings. There are IRS rules that restrict how much you can save in tax deferred and tax free accounts based on your income, so please do your research or ask a professional.

Once you know what type of account you want to open see next week’s post that will compare different custodians or the company where you can open your account. Until then keep learning, knowledge is key!

 

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