You may have heard somewhere that investing is the best way to build wealth and save for your biggest financial goals, including retirement. But how do you actually get started?
That’s where investment accounts come in. An investment account allows you to buy and sell securities to add to your investment portfolio. Over time, the value of your assets may grow, helping you to make a return on your investment.
When you’re ready to start investing, there are four types of accounts you can use. Each type of account has its own characteristics and rules, and each is designed to help you save for a particular goal. And some of the four categories are broken down into even more specific types of accounts.
Wondering which type of investment account is right for you? Keep reading to learn more about the different types of accounts and how you can use each one to reach your financial goals.
Taxable Brokerage Accounts
A taxable brokerage account is the simplest type of investment account. It allows investors to buy and sell securities of all kinds, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), options, and more.
A distinct feature of taxable brokerage accounts is that any transaction in the account may be subject to either income taxes or capital gains taxes, thus the name taxable brokerage account.
Certain types of income in your taxable brokerage account, including interest income, gains on securities you’ve held less than a year (known as short-term capital gains), and certain dividends are subject to ordinary income taxes.
Meanwhile, other dividends and gains on securities you’ve held for more than one year are subject to long-term capital gains taxes, which have a more favorable rate than your ordinary income tax rate. Long-term capital gains are taxed at either 0%, 15%, or 20%, depending on your income.
Taxable brokerage accounts have plenty of advantages. First, there are no limits on the type of securities you can buy, while other types of investment accounts may be more limited. You can also contribute as much as you want to your account and withdraw it whenever you want.
Additionally, like a bank account, a taxable brokerage account can be either an individual or joint account, meaning you can share one with your partner.
Retirement accounts are the type of investment accounts that many people make their first investments in. There are several types of retirement accounts depending on the type of employer you have and whether you’re investing through your employer or on your own.
A 401(k) plan is the most common type of workplace retirement plan and is offered by many for-profit companies. Using a 401(k) plan, employees can defer up to $20,500 of their income each year and an additional $6,500 if they are 50 and older. Employers can also contribute on behalf of their employees for a total combined contribution of $61,000.
There are two primary types of 401(k) plans: traditional and Roth. Using a traditional 401(k), workers contribute pre-tax money, meaning they save on taxes in the current year. The money grows tax-deferred in their account, and they’ll pay income taxes on their withdrawals during retirement.
With a Roth 401(k), workers contribute with after-tax money, meaning there are no immediate tax savings. However, the money grows tax-free in the account, and distributions during retirement are tax-free as well.
Once you’ve contributed money to your employer’s 401(k) plan, you can invest it in anything on the employer’s menu of investment options. Then, because the account is intended for retirement savings, you can start taking withdrawals once you reach age 59½.
Note: The IRS also allows one-participant 401(k) plans — known as solo 401(k) plans — for self-employed individuals with no employees. Under this plan, someone can contribute $20,500 as an employee, and another $40,500 as an employer, for a total of $61,000.
A 403(b) plan, known as a tax-sheltered annuity, is an employer-sponsored retirement plan offered by some public schools, non-profit organizations, and churches. These plans have many of the same characteristics of a 401(k) plan, including their contribution limit, withdrawal age, and traditional vs. Roth options.
The major difference between a 403(b) and a 401(k) is what they can be invested in. 401(k) plans can offer an investment menu that includes options like stocks, bonds, and mutual funds. But a 403(b) plan must be invested in an annuity contract through an insurance company or a custodial account invested in mutual funds.
An individual retirement account (IRA) is a type of retirement account workers can open separate from their employer. Using this type of account, you can contribute up to $6,000 per year (or $7,000 if you’re 50 or older). Because the account is held directly with a brokerage account rather than an employer, you have a wider range of investment options.
To contribute to an IRA, you must have earned income. And the amount you can contribute to your account is capped at the lower of the IRS contribution limit or your annual income.
Like a 401(k) plan, an IRA can be either traditional or Roth. However, eligibility may be limited. First, like a 401(k) plan, contributions to a traditional IRA can be tax-deductible. But deductions may be limited for workers who also have a retirement plan through their employers.
There are also limits on who can contribute to a Roth IRA. As of 2022, you can’t contribute to a Roth IRA if you have an annual income of $214,000 for a married filer or $144,000 for a single filer.
Finally, there are a couple of IRAs specifically available for self-employed individuals:
- SEP IRA: This type of IRA is available for self-employed individuals, allowing them to contribute up to $61,000 or 25% of their income per year. If a self-employed individual has others working for them, they must also contribute to their employees’ SEP IRA accounts at the same percentage as their own.
- SIMPLE IRA: This type of retirement account is available to employers with 100 or fewer employees who earned $5,000 or more in the preceding year. Employees can contribute up to $14,000 to their own accounts. Meanwhile, employers must make either a matching contribution up to 3% or a non-elective contribution of 2%.
A 457 plan(b) plan is a non-qualified deferred compensation plan available to state and local governments and non-governmental tax-exempt entities. Using this type of plan, employees can make salary deferral contributions of up to $20,500 per year.
Like a 401(k) plan, contributions and earnings are both tax-deferred, meaning no taxes must be paid until retirement. These plans can also accept Roth contributions.
Children’s Investment Accounts
Up until this point, the investment accounts we’ve talked about are only available to those 18 and older. However, there are other types of accounts specifically designed to help families invest on behalf of their children.
Custodial Brokerage Account
A custodial brokerage account is a type of taxable investment account that an adult can open on behalf of a minor. The adult who opens the account is the custodian. They can contribute to the account and manage the investments until the child reaches adulthood.
An important feature of custodial accounts is the money invested legally belongs to the child. It’s considered an irrevocable gift, meaning once it’s been contributed to the account, the custodian can’t simply withdraw it later. The custodian has a fiduciary duty to the child, meaning they must make investment decisions that are in the child’s best interest.
There are two types of custodial brokerage accounts: Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. The two are nearly identical but differ in the types of assets they can hold.
An UGMA account can hold only financial assets like stocks, bonds, funds, cash, and insurance policies. Meanwhile, an UTMA account can hold physical assets as well, including real estate and collectibles.
Custodial brokerage accounts have certain tax advantages. The first $1,100 of unearned income in a custodial account is tax-free. The next $1,100 is taxed at the child’s tax rate, which will usually be the lowest tax rate. It’s only income above and beyond $2,200 that’s taxed at the parent’s tax rate.
Once a minor reaches the age of 18 or 21 (depending on the state), they take full control of the account and can use the funds for anything they want.
A custodial IRA is a retirement account that an adult can open on behalf of a minor. This type of account has many of the same features and rules as any other IRA. But instead of a worker opening the account on their own behalf, an adult is opening the account on behalf of a child.
An important rule regarding custodial IRAs is that, regardless of who opens the account, the child the account has been opened for must have earned income. Contributions are still capped at the lower of $6,000 or the beneficiary’s earned income.
Once the child reaches the age of majority (either 18 or 21, depending on the state), the custodial IRA will be converted to a regular IRA in their name.
Educational Investment Accounts
The final category of investment accounts is educational investment accounts. These accounts are specifically designed to help families save for their children’s higher education.
A 529 plan is a tax-advantaged investment account that helps families save for college. There are two types of 529 plans: prepaid tuition plans and college savings plans.
- Prepaid tuition plans allow families to prepay for some or all of their child’s education at an in-state school. With this type of plan, families are paying today’s tuition prices for their future education, which helps reduce the cost of college.
- College savings plans are investment accounts that allow families to invest their contributions for tax-free growth to use for future college expenses. The rest of our discussion of 529 plans will be about college savings plans.
Unlike some other tax-advantaged investment accounts, contributions to 529 plans aren’t tax-deductible for federal tax purposes. However, some states allow families to deduct their contributions. The money grows tax-free in the account, and withdrawals are tax-free as long as they’re used to pay for qualified education expenses.
There’s no annual contribution limit for 529 plans as there is for other tax-advantaged accounts. However, some accounts have lifetime limits (though these usually amount to hundreds of thousands of dollars). Once the money is in the account, it’s usually invested in mutual funds or ETFs.
The major downside of these plans is the money can only be spent on education expenses. If you withdraw money for any other purpose, you’ll pay taxes on your withdrawals, along with an additional 10% penalty. The good news is these accounts are transferable. If your child decides not to attend college, you can use the money for another family member’s education. The money can also be used for education other than college, including trade school and private K-12 schooling.
Each state has its own 529 plan with slightly different features and benefits. You don’t necessarily have to open an account with your state’s plan if you feel the benefits of another state’s are better.
Coverdell Education Savings Account
A Coverdell Education Savings Account (ESA) is a tax-advantaged education account similar to a 529 plan. With this type of plan, contributions are limited to $2,000 per year. These accounts also aren’t available to everyone.
Your family’s modified adjusted gross income must fall below the limits set for the current tax year. In 2022, the income limit is $190,000 for joint filers. At that point, allowed contributions will be reduced until a joint income of $220,000, at which point contributions are disallowed altogether.
A benefit of ESA is that there are far more investment options than a 529 plan. With a 529 plan, you can only choose from the investments offered by your state’s plan, and it’s usually limited to a small number of mutual funds. But with an ESA, investments are self-directed.
Like a 529 plan, withdrawals from an ESA must be spent on qualified education expenses. Any withdrawals that don’t meet the requirements will be subject to income taxes and an additional 10% tax penalty.
When you’re ready to start investing, you’ll have plenty of accounts to choose from. While it can feel overwhelming to choose between your many options, it’s easy to narrow down your choices when you consider your financial goal and what tool can best help you reach it.
An investment account isn’t the only tool that can help you reach your financial goals. The Personal Capital financial dashboard includes free tools to help you get your finances under control and meet your goals, including the savings planner, investment checkup tool, cash flow planner, and more. Sign up for free today.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. Compensation not to exceed $500. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.