Explaining the Many Types of Investment Accounts
There are many types of accounts that hold cash and investments. For instance, you may have a taxable brokerage account, a retirement account through your employer such as a 401(k) and an individual retirement account (IRA). Each type of account varies in terms of ownership, tax treatment, the advantages it may offer and how much you can contribute to it annually.
Employer retirement accounts are “owned” by the retirement plan, and IRAs must be owned solely by one person. Taxable brokerage accounts can be owned individually, jointly, by a trust, a partnership or a corporation.
There are no limits on what you can deposit and invest in a regular brokerage account. However, the contributions you make to a 401(k) are limited. For 2017, you can defer $18,000 if you are under age 50 and $24,000 if you are 50 or over. The maximum amount that you can contribute to an IRA (traditional or Roth) in 2017 is $5,500 if you are under age 50 and $6,500 if you are 50 or over.
You do not receive a tax deduction for contributions to a taxable brokerage account, and the interest, dividends and capital gains generated from the investments it holds will be reported on your tax return each year.
Contributions to a 401(k) are generally made through payroll deferrals. Contributions to a traditional 401(k) account reduce your taxable wages for the year and investment earnings grow tax-deferred, meaning you do not report the investment income each year on your tax return. Future withdrawals are fully taxed as ordinary income. Generally, you must wait until age 59½ before you make withdrawals or a tax penalty is assessed.
If you contribute to a Roth 401(k), your contributions are fully taxed for the year. However, future withdrawals are tax-free and investment earnings also grow tax-free.
Traditional IRA contributions may or may not earn you a tax deduction, depending on your income. Contributions to a Roth IRA are not deductible and the account grows tax-free as long as you don’t make withdrawals for five years. Not everyone can put money into a Roth IRA because the ability to contribute to this type of account also depends on your income.
All these rules may seem convoluted (they have evolved out of changes to our tax law), but the underlying intent is to encourage you to save and invest for your retirement. At the same time, Congress wants to be sure you pay taxes now and in the future.
To decide which type of account makes the most sense for you, start with your company retirement plan. Contribute the maximum amount your budget allows up to the limit. If your employer matches contributions, be sure to contribute at least that much because this is free money. Choose the traditional or Roth account based on your desire to pay taxes now or in the future. You can also put some savings in both types of 401k(s) each year.
Next, consider a traditional or Roth IRA based on your income and the tax deduction that may be allowed. Finally, contribute to a regular, taxable brokerage account. In the end, all of these accounts help you save and invest for your future retirement. And the sooner you start to save and invest the better off you will be when you do retire.
Given the many and complex options (there are many other types of investment accounts not included in this column), I think investors would welcome a world with just one type of retirement account that has a high annual contribution limit, such as $250,000. Contributions could be flexible annually based on your cash flow. The choice of a traditional or Roth account type would depend on if you want to be taxed now or in the future. Employers could be allowed to make deductible contributions to your account also. Simplicity would be greatly appreciated.
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
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