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Investing in stocks, bonds, mutual funds, and other financial instruments is an important part of building wealth. But there are many different types of investment accounts available, each with its unique advantages and disadvantages.
What is one of the major advantages you ask? Choosing when you want to pay taxes to the federal government!!
The Different Types of Investment Accounts
The IRS (Internal Revenue System) offers many different types of investments that allow people to save money for retirement, college tuition, and other goals. These include traditional IRAs (Investment Retirement Account), Roth IRAs, 401(k) plans, 403(b) plans, 457 plans, SEP-IRAs, SIMPLE IRAs, and others. Each type has its pros and cons, so it’s important to understand how each works before choosing which one is best for you.
We will define the most popular types of investment accounts and break them into three different categories Tax-deferred, Tax-Free, and Taxable. Let’s see where these accounts fall!
| Tax-Deferred | Traditional IRA 401(k) |
| Tax-Free | Roth 401(k) Roth IRA |
| Taxable | Traditional Brokerage Account |
Tax-Deferred Investment Accounts
Firstly, the term Tax-Deferred means that you won’t pay tax on the money that you contribute to the investment account. Instead, you’ll pay taxes on the contributions and the earnings of the investment when you begin taking distributions in your retirement.
Traditional IRA
A Traditional IRA is a retirement account that you can open as an individual. If you (or your spouse if filing jointly) have taxable compensation as defined by the IRS, you are welcome to contribute to this plan. As of 2022, you can contribute up to $6,000 per year ($7,000 if you’re 50 or older by the end of the year). Ultimately, the contributions you make are tax deductible on your federal tax return, and can lower the taxes you pay! Paying less to the federal government today sounds like a sweet deal to me.
Your tax deduction can be limited based on your income level. Even more, It could also limit your deduction if you (or your spouse) are participating in a retirement plan through your employer.
Generally, you can begin making withdrawals at the age of 59 1/2. In most cases, making a withdrawal from the account before this age can penalize you. An early withdrawal can hit you with a 10% tax penalty in addition to the normal taxes on the distribution. This is a hefty penalty, SHEESH!
But the IRS does allow some exceptions for you to avoid the early withdrawal penalty. Here is a list of the exceptions that Charles Schwab put together.
401(k) Plan
Overall, A 401(k) plan is similar to a Traditional IRA. An employer must offer this plan to you, and you can’t open it on your own. Employers that commonly offer this benefit are in the private sector (employers that are non-governmental entities). It allows employees to invest pre-tax dollars and encourages employers to match the contributions you make as well. Employees must enroll in the plan to receive employer match funds.
I have held jobs with several different employers and I have seen employers match percentages between 3-6% of my salary. I’d highly recommend taking advantage of this opportunity if available to you. Especially if you are in your 20s, that’s between 30 and 40 years of tax-free growth on your investments if you plan to retire at 60! These matches are essentially FREE MONEY that employers are offering to invest in you for your retirement!!
As of 2022, employees can contribute up to $20,500 per year ($27,000 if age 50 or older by the end of the year). Just like the traditional IRA, you can take distributions at the age of 59 1/2. In most cases, if you take distributions from the plan before 59 1/2 you’ll have to pay a 10% tax penalty. This is in addition to the normal taxes on the distribution.
Fortunately, the IRS does allow some exceptions for you to avoid the early withdrawal penalty. Here is a list of the exceptions that the IRS has defined.
According to the IRS, you also must take your first required minimum distribution for the year in which you turn age 72 (70 ½ if you reach 70 ½ before January 1, 2020). So if you are planning to make plenty of money in your later years, this could increase your tax liability.
Tax-Free Investment Account
Secondly, on our list of different types of investment accounts is the Tax-free account. The term Tax-Free means that you will pay taxes on the money that you contribute to the investment account. But you won’t pay taxes on the contributions and the earnings of the investment when you begin taking distributions from the account.
Roth IRA
A Roth IRA is an after-tax account. If you (or your spouse if filing jointly) have taxable compensation as defined by the IRS, you are welcome to contribute to this plan. Contributions are made with post-tax dollars. Also, Earnings are never taxed. But early withdrawals are subject to income taxes. As of 2022, you can contribute up to $6,000 per year ($7,000 if you’re 50 or older by the end of the year). It should be noted, that the amount you are allowed to contribute can be limited based on your income level.
This is a powerful account to have even alongside a 401(k), as it would allow you to withdraw money in retirement tax-free! Just like the traditional IRA, you can begin taking distributions at the age of 59 1/2.
A special component of this account is that you can withdraw contributions without any penalties at any age. But you will not be able to withdraw the earnings that you have made until you are 59 1/2 and your Roth IRA has to have been open for at least five years. If you do withdraw early you will face the wrath of the IRS with a 10% tax penalty.
As always there are exceptions to the 10% tax penalty. These exceptions are for first-time home purchases, college expenses, and birth or adoption expenses.
Roth 401(k)
Simple and easy this is very similar to the 401(k) in the sense of employee contributions. The twist here is that the contributions you make are post-tax. This means that not only are you benefiting from the employer contributions, but you can withdraw your contributions as well!
The best part of this account is all of the sweet earnings you make in it will not be taxed in retirement. This would be a win-win for me if your employer offers it!
Taxable Investment Account
Last but not least on our list of different types of investment accounts! A taxable investment account is a traditional brokerage account with no tax-free or tax-deferred benefits.
The best (and potentially worse) is that the account owner can withdraw their money from this account at whatever age they would like. I say ‘potentially worse’ for those of us that lack self-control. Because you are in total control of when you withdraw your investments.
If you see an attractive real estate investment or even if an entrepreneurial venture comes up you have access to that money. There would be nothing holding you back in that regard.
If “IT’S YOUR MONEY AND YOU WANT IT NOW!” was an investment account. This would be it.
Taxes on Investment in Taxable Accounts
With this account, you will be taxed on dividends, interest, and capital gains. The amount of taxes that you’ll pay would depend on your income level.
For dividends, you can be taxed 0%, 15%, or 20%, depending on your taxable income and filing status. These tax tables created by Investopedia compile the tax rates from the IRS.
As for capital gains, there are two different ways you can be taxed. There are two types of gains you will encounter when selling your investments. These gains will be either short-term gains or long-term gains.
Short-term gains can vary greatly depending on your income level. Be sure to research what your potential tax liability could be if you plan to hold investments for less than a year.
Conversely, long-term gains tax are much more clean-cut to figure out. In 2022, if you are single and have an income between $41,675-$459,750 your tax rate is 15%. If it is less than $41,675 the tax rate is 0% and if greater than $459,751 it’s 20%. Furthermore, If you are married and your income is between $83,350-$517,200 then you will be taxed at 15%. If you are married and below or above that range you will be taxed at 0% or 20%, respectively.
Tax Avoidance In Wealth Building
Deciding when you want to pay taxes and finding ways to avoid them altogether (legally of course) is how many individuals became wealthy. Tax avoidance is also how the wealthiest individuals remain wealthy. According to the White House, the wealthiest 400 billionaires paid an average 8.2% tax rate on their income between 2010-18. This is far less than the 13.3% tax rate that the average American paid, as reported by the Tax Foundation!
In terms of dollars, this is HUGE! ProPublica is an independent nonprofit newsroom that produces investigative journalism with moral force. According to this article, the newsroom obtained 15+ years of tax return data from the Internal Revenue Service. They conducted research on the Top 25 wealthiest individuals from 2014 to 2018 and discovered that while their wealth grew by 401 billion dollars collectively they only paid $13.6 billion in federal taxes! THAT IS A TRUE TAX RATE OF 3.4%!?!?!
Although many of us Americans can’t take advantage of the tax benefits available to Elon Musk, Bill gates, Warren Buffet, or those alike, there are options available to us.
The type of investment account that you choose to hold your investments can aid you in lowering your tax bill and increasing your wealth as well!
