In this post we go into the different investment accounts available, the differences between them, and the tax implications of each option.
Investment Account Comparison
Personally I open all of the following accounts as I believe diversifying is key and each has its own strengths and weaknesses. I will give an explanation for each account type I have and why I use it in the following sections.
401k Account
The retirement account familiar to most people is the 401k account since it is often provided through their employers. 401k accounts tend to have limited investment options, primarily comprised of mutual funds and large index funds. After leaving your employer, these accounts can be rolled over into IRA retirement accounts with substantially more investment options available.
These 401k accounts can be of either the Traditional (pre-tax) or the Roth (post-tax) tax distinctions. Annual limits exist for individual contributions to these accounts due to their tax-advantaged status but employers can match and contribute over this limit allowing for excess contributions than what one could invest on their own.
Traditional/Roth IRA Account
The retirement account known for its increased investment options and better tax treatment are the IRA retirement accounts. These accounts have annual contribution limits less than a third of that of 401k accounts and therefore tend to hold fewer assets. In exchange for these lower contribution limits though, one receives access to a wide array of investment options including individual stocks and options.
Similar to the 401k, the IRA retirement accounts have both Traditional and Roth tax distinctions for pre-tax and post-tax contributions respectively. However, the IRA account has income restrictions for contributions to Roth IRAs and therefore high income earners will need to indirectly contribute to a Roth IRA via a Backdoor Roth Conversion.
Roth IRA Backdoor Conversions and Rollovers
Roth tax distinctions are post-tax classifications meaning you pay taxes up front on your contributions and then get to withdraw the balance later tax free for all gains you accrue in addition to the principle contributions. Traditional tax classifications however are pre-tax, meaning you contribute before tax is applied and therefore pay taxes on contributions and gains later when you withdraw.
There are a lot of online calculators, to compare post-tax and pre-tax estimates for gains in the long run, that let you play with the numbers and get an estimate of projected balance. The general consensus though is that taxes must go up to pay for an aging population and therefore paying taxes now to avoid taxes on gains as well as higher taxes on contributions is often considered an optimal strategy.
Roth IRAs are best for this since they have the most investment options for the benefits received but unfortunately they have income limits of $139,000 in order to qualify for contributions. People with income greater than this must use the traditional tax classification instead of the Roth which means that taxes will be assessed later when money is withdrawn instead of when it’s contributed.
This lowers your taxable income since that income won’t be taxed for the year so there’s some benefits for that but generally people in these situations would still prefer to pay the taxes now and avoid them in the future.
For these people they can contribute to a traditional IRA then ask their broker to roll it over into a Roth IRA with a backdoor conversion. This is free to do but you will now owe taxes again on the amount converted just like you would if you had contributed directly.
To make this update your broker may provide a form that you will supply in your tax filling for the year to designate the amount you converted so the taxes can be added back in to be paid.
Backdoor Roth Conversion Guide
Health Savings Account
The HSA retirement/savings account is a source of pretax money that can grow tax free and be used in emergency medical situations. Since many don’t plan for these types of disasters such as illness or death, and additionally no minimum withdrawals are required for the account, HSA accounts provide an effective means to safeguard oneself.
In addition to being the only account to spend pre-tax money with (and effectively avoiding taxes for said expenses), I can keep the account until I die and pass it on to my family to continue to appreciate. It is often paired with a High Deductible Health Plan and may sometimes see contributions from an employer similar to employer 401k contributions. Given the amazing tax benefits given to these accounts, it is understandable why contribution limits for HSAs are about half the limits of IRAs without rollover/conversion strategies to contribute excess funds.
Brokerage Account
Finally the brokerage investment account is last. Unlike the other accounts, brokerage accounts are not tax advantaged, nor do they have any withdrawal penalties. As a result, there are no investment limits for brokerage accounts and taxes are assessed via short/long term capital gains.
Given the fact that the other retirement/savings accounts have contribution limits unlike brokerage accounts, it emphasizes the need to protect contributions in those tax-advantaged accounts to take full advantage of the benefits of said accounts. Brokerage accounts therefore tend to become the more appropriate place for riskier trades since you are not risking a finite amount of retirement funds that cannot be replenished if lost.
Summary
We see that there are a variety of different accounts each with different contribution limits, tax treatment, and investment options. Whether it be through retirement, savings, or brokerage accounts, it’s important that you put your money to work for you to help yourself in the future. Diversifying and using each option where best suited is the key to providing a stable foundation for building your income for the future.
