Investing Part 3: What Type of Account Should I Use?

Note: All limits in this post reflect the IRS guidelines as of 2020. They will likely change in the future.

Now that we’ve covered the basics of what defines an investment and how to begin investing passively and successfully, the final step is to open an account. But what kind?

There exists a variety of accounts that allow people to invest in the stock market, each with its own benefits and characteristics. Some differences between types of accounts include how they’re taxed, annual contribution limits, and guidelines regarding withdrawals, to name a few.

Before we cover a few of the common account types, let’s go over some terminology that will help explain the benefits of these accounts.

And now, some account overviews.

401k#

Description

A 401k is an employer-sponsored retirement account for employees in the private sector. It can offer both traditional and Roth contributions options¹. Both types of contributions usually come right out of a person’s paycheck. The investment options, employer match, and other details are subject to the employer’s 401k plan and therefore vary by employer.

(A 403b and a 457 are similar accounts for public school employees and government employees, respectively)

Contribution Limit

$19,500 total between traditional and Roth contributions per year if you are under 50 years of age.

$26,000 if you are 50 years of age or older, thanks to the ability to make a $6500 catch-up contribution.

Note: This does not include your employer match! For example, if you are under 50 and your employer contributes $4000 per year to your 401k, the total contributions between you and your employer can total $19,500 + $4000 = $23,500. For people 50 and older, it could total to $19,500 + $4000 + $6500 = $30,000.

Pros

• Employers often contribute a match to the account.
• Tax advantages.

Cons

• There’s a contribution limit.
• You pay a 10% penalty plus taxes on any withdrawal made before you are 59.5 years old.
• RMDs at age 70.5 (traditional 401ks only).
• Available investment funds through 401k plans are usually very limited.
• The plan is tied to your employer. If you change jobs/retire, you keep the account but can no longer contribute to it unless you convert it to an IRA or roll it into your new job’s 401k.

IRA#

Description

An Individual Retirement Account. This is a retirement account that offers similar benefits to a 401k but exists separately from your employer. Therefore the investment options aren’t limited by a 401k plan but can instead be used to invest in all publicly traded equities in the stock market.

Unlike a traditional 401k which is funded with pre-tax money right from a person’s paycheck, a traditional IRA is technically funded with post-tax money which is then deducted from the person’s total earned income when they file their taxes, so the end result is essentially the same.

Here I’ll cover just traditional and Roth IRAs, but there are other less common variants.

Contribution Limit

$6000 total between traditional and Roth contributions per year if you are under 50 years of age.

$7000 if you are 50 years of age or older.

Income Limit

The ability to claim a deduction on contributions to a traditional IRA decreases and eventually reaches $0 for a single person who has access to a retirement plan at work (such as a 401k) and whose MAGI exceeds $65,000. For couples where at least one of them has access to a retirement plan at work, the MAGI limit begins at $104,000.

The contribution limit to a Roth IRA decreases and eventually reaches $0 for single people whose MAGI exceeds $124,000 and for couples that exceed $196,000.

Pros

• Tax advantages.
• Independent of employer.
• Access to all publicly traded equities.
• Can withdraw contributions at any time without paying taxes or penalties (from a Roth IRA only).

Cons

• There’s a contribution limit.
• You pay a penalty plus taxes on any withdrawals made before age 59.5 (from a traditional IRA only).
• RMDs at age 70.5 (traditional IRAs only).

Brokerage Account#

A basic account that allows access to trading and investing in all assets in the stock market. It has very few limits but also none of the benefits of the previously discussed retirement accounts.

Pros

• There are no contribution limits.
• There is no maximum income limit.
• Not tied to an employer.

Cons

• No tax advantages; contributions are made with money that has been taxed, and all future capital gains and dividends will be taxed at the appropriate rates.

Conclusion#

Despite the restrictions on contributions and withdrawals, taking advantage of accounts with preferential tax treatment is a great way to maximize the efficiency of your hard-earned money. In general, the best approach is to fund these as aggressively as possible until the contribution limits prevent you from depositing more, at which point, all excess contributions can flow into a brokerage account.