Types of Investment Accounts

When you start investing, the alphabet soup of types of investment accounts can feel daunting. Understanding the different types of investment accounts and how they operate can provide you with insights into how to grow your wealth over time.

Vault’s Viewpoint on Investment Accounts

• Different investment accounts have various characteristics, including tax treatment and purposes.
• Taxable accounts require you to pay taxes on earnings when you sell assets, while tax-advantaged accounts might delay taxes or even help you avoid taxes on earnings.
• Make sure you understand the requirements for different types of investment accounts so you aren’t subject to penalties.

Types of Investment Accounts: Taxable vs. Tax-Advantaged

When deciding where to put your money, understanding the difference between taxable and tax-advantaged accounts is the first step to make the best investments.

Taxable Investment Accounts

Taxable accounts are usually offered by online and traditional brokerages. You can move money in and out of the account without penalty. But you must pay taxes on any earnings resulting from selling your investments. As you sell some assets and buy others, the sale triggers a taxable event. You’ll have to determine whether you owe long-term or short-termcapital gains taxes in the year you sell investments.

Tax-Advantaged Accounts

Tax-advantaged accounts offer some type of tax advantage. You typically choose whether to get a tax deduction for contributions to the account.

• If you contribute pre-tax dollars, your investments will grow tax-deferred, meaning you won’t have to pay taxes until you withdraw from the account.
• If you contribute after-tax dollars to a tax-advantaged account, your earnings are usually tax-free, and you don’t have to pay taxes when you withdraw from the account.

You can usually sell investments and buy other assets within the tax-advantaged investment account without triggering a taxable event. But there are usually requirements associated with tax-advantaged accounts, including restrictions on when and how you can withdraw your investment earnings.

Different Types of Taxable Investment Accounts

Anyone over the age of 18, or the age of majority in their state, can open a taxable investment account and learn how to invest. It’s also possible to open a custodial account for someone under 18 and manage their portfolio until they come of age.

Here are some of the different types of taxable investment accounts you’ll find when opening an investment account with a broker.

Cash Accounts

With a cash account, you deposit money with the brokerage and then use that money to purchase investments. Many brokers offer access to assets like:

• Stocks
• Bonds
• Exchange-traded funds (ETFs)
• Index funds
• Mutual funds

In general, the number of securities you can buy is limited by the money you have in the account. Many brokers allow you to set up automatic investment plans, where they withdraw a set amount of money from your bank account each week or month and then use that cash to buy the assets you designate.

Margin Accounts

A margin account allows you to borrow money to invest. Margin is basically debt you use to leverage your investment purchases. There are two main types of investment you can participate in with a margin account:

• Margin trading: The securities in your portfolio act as collateral for the loan. You pay interest on the loan, but it is usually a smaller interest rate than you might pay with other types of debt. You have the potential to magnify gains when you use margin trading. The flip side, though, is that you could also magnify losses.
• Short selling: With this strategy you borrow investments and then sell them, expecting their value to decline. Later, you hope to purchase those same assets at a lower price.

Margin accounts generally come with higher risk when you employ these strategies. Review your risk tolerance and investment strategy before using debt to leverage your portfolio.

Other Assets

Depending on the brokerage, you might have access to different assets, such as:

• Cryptocurrencies
• Foreign currencies (forex)
• Commodities
• Futures
• Fractional shares in artwork, real estate, collectibles and wine

In some cases, you might need to meet minimum investments and have to lock up your investment for a certain number of years. Sometimes, you might need to establish a special account, or show that you’re an accredited investor. An accredited investor has at least a $1 million net worth (excluding their residence) or an income of more than $200,000 (or $300,000 as a married person) in each of the prior two years and expects the same.

Carefully evaluate the risks and restrictions associated with alternative investments, and make sure you understand how they work before adding them to your portfolio.

“While alternative assets can offer the potential for big returns, they can also result in an emotional roller coaster. I enjoy experimenting with cryptocurrencies and dabbling in collectibles, but I try to limit alternatives to 8% to 10% of my portfolio.”

— Miranda Marquit

Different Types of Tax-Advantaged Investment Accounts

Tax-advantaged retirement accounts provide you with some type of tax advantage. They usually have more restrictions on contributions and withdrawals.

Employer-Sponsored Retirement Accounts

Employers typically offer retirement accounts as a benefit for working with them. Most tax-advantaged retirement accounts force you to wait until age 59 ½ to withdraw money without paying a penalty, although certain exceptions exist.

Generally, you can choose between Traditional or Roth versions of many accounts:

• Traditional accounts are funded with pre-tax dollars. This essentially results in a tax benefit today, as your contributions reduce your taxable income. The money you invest through a traditional retirement account grows tax-deferred. You won’t have to pay taxes until you withdraw money from your account during retirement.
• Roth accounts allow you to make contributions with after-tax dollars. You’ll pay taxes first, but you won’t be taxed on any earnings that come from the investments in your account. When you withdraw money during retirement, you won’t have to worry about paying taxes or required minimum distributions.

Often, you’ll be limited in how much you can contribute each year. Additionally, your investment choices might be restricted. Many plans allow you to choose from different mutual funds, annuities or company stock.

401(k)

A 401(k) is offered by your employer. They can choose to offer a Roth version which doesn’t come with an income limitation. Plus an employer can choose whether to match a portion of your contribution, helping you grow your account faster.

For 2024, the 401(k) contribution limit is $23,000, an increase from $22,500 in 2023. If you’re at least age 50, you also have the choice to contribute an extra $7,500.

There’s also a solo 401(k)—with a Roth version—available to self-employed business owners. Generally, you can only access a 401(k) through an employer, and a solo 401(k) if you’re self-employed with no other employers. The contribution limit is generally higher with a solo 401(k), since you can contribute both the employer and employee side.

403(b)

These types of investment accounts are usually offered if you work for non-profits. You typically see them for churches and public schools (including universities). They have similar contribution limits and rules to 401(k)s, and also offer Roth versions.

457(b)

Generally, these types of investment accounts can be offered to state and local government employees (including public school teachers) and employees of certain tax-exempt organizations. The contribution limits are similar to 401(k) plans, and the employer can choose to offer a Roth version.

Individual Retirement Accounts (IRAs)

There are several different types of IRAs, and some of them might also be offered by small businesses to their employees. As with other tax-advantaged retirement accounts, you’ll pay a penalty if you withdraw money from the accounts prior to age 59 ½, unless you meet certain conditions.

Generally, you have access to a wider variety of investments in an IRA, including individual stocks, certificates of deposit (CDs) and bonds, as well as ETFs and mutual funds. Depending on the custodian, you might be able to hold other assets in an IRA, like real estate and gold. There are special rules for these assets, though.

Traditional and Roth IRAs

You can open a Traditional or Roth IRA if you meet the age requirements and have earned income. The IRA contribution limit for all your combined Traditional or Roth IRAs is $7,000 in 2024, up from $6,500 in 2023. The catch-up contribution for those 50 and over is $1,000.

The Roth IRA comes with an additional income restriction. In 2024, you can’t make contributions to a Roth IRA if you make more than $161,000 a year as a single person or head of household, or $240,000 if married filing jointly.

SIMPLE and SEP IRAs

These are different IRA plans aimed at small business owners. They each have slightly different rules.

• SIMPLE plans. Employers must make a matching contribution of up to 3% for employees or they must contribute 2% of an employee’s income to the plan.
• SEP plans. These have only employer contributions, and they can contribute up to 25% of an employee’s compensation.

If you’re self-employed and want to use one of these plans for the potentially higher contribution limit, carefully understand the limitations and requirements related to your employees.

Health Savings Accounts (HSAs)

A health savings account (HSA) lets you make tax-deductible contributions to a special account for healthcare costs. As long as you use the money in the account for qualified medical expenses, you don’t have to pay taxes on earnings from the account. To be eligible you must:

• Have a qualifying high-deductible health insurance plan
• Not be a dependent on someone else’s health plan
• Not be enrolled in Medicare

Depending on where you hold your HSA, you might be able to invest a portion of your balance or all of it in various assets. If you use the money for non-qualified expenses, you pay a 20% penalty. But if you meet certain disability requirements or are at least 65, you can use the money from an HSA for other purposes without the additional penalty, although you still have to pay taxes on the distribution.

For 2024, individuals can contribute up to $4,150, and those with family coverage can contribute up to $8,300.

529 and Coverdell Plans

Finally, there are tax-advantaged savings accounts for educational purposes. Coverdell and 529 plans come without federal tax deductions on contributions, but invested money grows tax-free as long as withdrawals are used for qualified educational expenses under the chosen plan. Some states offer their own deductions for plan contributions.

• 529 plans have higher contribution limits and no income requirements. You can also transfer beneficiaries.
• Coverdell plans have lower contribution limits and income limitations. You’re not allowed to transfer the beneficiary.

Before deciding which plan to use for your child’s education, carefully consider the advantages and limitations of each.