U.S. investors seeking to accomplish financial goals by investing in securities generally have access to four types of investment accounts—brokerage accounts, Individual Retirement Accounts (IRAs), education accounts, and employer-sponsored retirement plans. Learn the differences, who can invest, pros and cons, and how each of these investment accounts work.
Sometimes referred to as taxable brokerage accounts because earnings inside the account are subject to taxes, traditional brokerage accounts provide access to a broad range of investments, including but not limited to:
Types of Brokerage Accounts
There are three different types of brokerage accounts that can be opened:
- Individual brokerage account: Can be opened in the name of only one account owner.
- Joint brokerage account: Can be opened in the names of two or more people, typically spouses.
- Custodial brokerage account: Can be set up for the benefit of minors under the age of 18. Depending upon the state of residents, these are typically set up as UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfers to Minors Act) accounts.
Eligibility to Open a Brokerage Account
Any U.S. citizen over the age of 18 with money to invest can open a brokerage account, and the process is straightforward. Most of the larger brokerage firms allow investors to open accounts online in under 10 minutes. Whether applying online or in person at a brokerage firm, applicants must provide some personal information, such as Social Security number, date of birth, employment information, basic financial background, and investing experience.
Contribution Limits and Tax Implications
There are no limits to how much money you can contribute to or withdraw from a traditional brokerage account. However, investors are responsible for any taxes owed, such as capital gains tax from the sale of investments, or tax on income from dividends and interest earned.
Minimum Deposit Requirements
Some brokers have minimum initial investment amounts but many have low minimums. For example, some discount online brokers allow investors to get started with as little as $5, while others may require $100 to $1,000 to begin investing.
Pros & Cons of Brokerage Accounts
An advantage of traditional brokerage accounts is that they are flexible, providing access to a broad range of investments. Investors can self-direct which investments they want to create a portfolio suitable for their objectives, risk tolerance, and investment style. With an online brokerage account, investors can track their investment transactions in real-time while monitoring the performance of their portfolios.
A disadvantage of traditional brokerage accounts is that they are self-directed, putting the onus on investors to choose suitable investments. However, any time an investor thinks they may need guidance, many brokerage firms offer the support of a financial advisor.
Should You Open a Brokerage Account?
Generally, investors who open traditional brokerage accounts do so with money they have in excess of what they are allowed to contribute to tax-deferred retirement accounts. However, some investors invest in both accounts to achieve tax diversification when they start withdrawing their money in retirement.
Withdrawals made from a traditional IRA or 401k account are taxed as ordinary income, while withdrawals made from the sale of securities in a taxable brokerage account are taxed at capital gains tax rates. Depending on a person's tax situation in retirement, it may be less taxing to withdraw capital gains from a taxable brokerage account.
Traditional brokerage accounts are held separately from tax-deferred retirement accounts, primarily because of the differing tax treatment. Investors can transfer money in and out of a traditional brokerage account at will, to a bank account, or to an IRA, which would be considered a retirement contribution. Generally, investors tend to keep their brokerage accounts segregated from other types of accounts.
Individual Retirement Accounts (Traditional, Roth & SEP IRAs)
Individual retirement accounts, such as traditional IRAs and Roth IRAs, are available to certain qualifying individuals who want to compliment or supplement an employer-sponsored retirement plan.
Types of Individual Retirement Accounts
- Traditional IRA: Contributions are made with pre-tax dollars and withdrawals are taxed as income.
- Roth IRA: Contributions are made with after-tax dollars and withdrawals made in retirement, and some other qualifying withdrawals, are tax-free.
- SEP IRA: Typically established by a small business owner who establishes a Simplified Employee Pension plan.
All three types of individual retirement accounts are managed by the account owner, and all are tax-qualified, meaning they have favorable tax treatments.
Eligibility for Opening an IRA
Traditional IRAs and Roth IRAs have income limits for contributions. For example, for traditional IRA contributions to be fully deductible, the income limit for a single person is $68,000, whereas for a married couple the income limit is 109,000 or less to get the full deduction. Income limits for Roth IRAs are $129,000 for single filers and $204,000 for married filing jointly.
Keep in mind that certain qualifying and reduced contributions may be made at income levels above these limits, at phase out levels, where reduced deductibility or contribution amounts apply.
A SEP IRA can also be established through any financial institution that offers IRAs. However, to establish a SEP IRA, individuals must be a participant in an employer-sponsored SEP plan.
Minimum Deposit & Tax Implications
Many financial institutions don't require a minimum deposit to open an IRA. All IRAs are tax-qualified plans, meaning they receive favorable tax treatment. For traditional and SEP IRAs, contributions made up to the maximum allowable limit are tax-deductible, and earnings inside the account grow tax deferred. All withdrawals are taxed as ordinary income in the year they are received.
For Roth IRA accounts, contributions are not tax-deductible; however, earnings are allowed to grow tax-free; meaning, they are never taxed, even when withdrawn.
All IRAs are subject to the same penalty of 10% on withdrawals made before age 59 ½. There are some exceptions, such as in cases of a disability or certain types of financial hardship.
With a Roth IRA, account owners can withdraw an amount equal to their contributions at any time tax- and penalty-free. To withdraw earnings from a Roth IRA without owing taxes or penalties, the account owner must be at least 59½ years old and have held the account for at least five tax years.
Pros & Cons of Individual Retirement Accounts
Benefits of an IRA
- Favorable tax treatment that enables investors to accumulate retirement capital more quickly.
- Wide range of investment options with IRAs established with a brokerage firm or financial institutions with brokerage services, from stocks and bonds to mutual funds and ETFs.
- Roth IRAs allow for contributions to be withdrawn at any time, although gains on contributions may be taxed if withdrawn before retirement.
Disadvantages of IRAs
- Restrictions on withdrawing money, including a penalty for withdrawals from a traditional IRA, or gains on contributions from a Roth IRA, before age 59 ½.
- IRA account holders must start taking required minimum distributions (RMDs) from their accounts when they reach age 72. That can be a disadvantage if the withdrawals force a retiree's income into a higher tax bracket.
Should You Contribute to an IRA?
IRAs are excellent vehicles for retirement savings. A traditional IRA may be more appropriate for high-earning investors who can take advantage currently of tax-deductible contributions but expect to be in a lower tax bracket in retirement. Conversely, the tax-free withdrawals from a Roth IRA may be more attractive for investors who expect to be in a higher tax bracket in retirement.
Generally, IRAs are held as separate accounts because their funds shouldn't be commingled with the funds of taxable accounts. This is also true of IRA rollover accounts, which should be held separately from other IRAs for tax purposes.
Key Takeaway: IRAs provide individuals with access to tax-favored retirement savings and the flexibility to choose from a wide range of investment options.
Employer Retirement Plans (401k, 403b)
Most full-time employers in the U.S. offer retirement plans to their employees as an employee benefit and as a way to help their employees save for retirement. Employees benefit by participating in employer-sponsored plans because they can have a percentage of their earnings automatically deposited in their accounts without paying taxes on them.
Tax savings and the potential employer matching contributions allow more of their money to go to work for them, and because their earnings inside the account grow tax-deferred, they have the opportunity to grow their investments more quickly.
Types of Employer-Sponsored Retirement Accounts
Depending on the employer, its size, how it is organized, the number of employees, and the owners' financial circumstances, employers may offer one of several different types of retirement plans.
- 401(k) plan: Typically offered by private-sector employers with more than 100 employees.
- Roth 401(k) plan: Many employers offer Roth contributions, which like a Roth IRA, are made on an after-tax basis and qualifying withdrawals are tax-free at retirement.
- 403(b) plan: Similar to a 401(k) but offered by a non-profit organization.
- 457 plan: Offered by a state or local government employer, or a thrift plan for federal or military employers.
- 401(a) plan: A type of money purchase plan, the employer is required to make contributions for employers, while employee contributions are voluntary, if allowed by the plan.
- SIMPLE Plan: Typically offered by smaller employers with fewer employees. However, a SEP IRA is generally easier and less expensive for employers to manage.
Eligibility & Signing Up
Generally, employers must offer a retirement plan option to all employees who meet the employer's eligibility rules, which, at a minimum, require that any employee who works at least 20 hours a week be offered access to the plan.
For employees, gaining access to the plan is very easy, typically by checking a box on an enrollment form opting into it. They then indicate what percentage or dollar amount of their earnings they want to be deposited into the plan from their paychecks and make their investment choices from a menu.
Employer retirement plans are tax-qualified, meaning contributions by either the employer or plan participants to the plan are made with pre-tax dollars. Also, earnings inside the plan accumulate on a tax-deferred basis, meaning they will be taxed when they are eventually withdrawn from the plan.
The only exception to these rules is with a Roth IRA, in which contributions are made after-tax, and the earnings grow free of taxes, currently and upon withdrawal.
For all types of employer-sponsored retirement plans, the same general withdrawal rules apply. No withdrawals can be made before age 59 ½ without penalty, which is 10% of the withdrawal amount on top of taxes owed. Traditional contributions are taxed in retirement as income, while qualifying Roth contributions can be withdrawn tax-free.
There are some exceptions on withdrawal rules, for instance, if the account owner becomes disabled or meets the requirements for the plan's hardship withdrawal rules.
Pros & Cons of Employer Retirement Plans
- Positive tax treatment, which can allow participants to contribute pre-tax dollars and grow their money tax-deferred (after-tax contributions and tax-free growth with a Roth IRA plan).
- Most plans allow high maximum contributions, which can result in significant current tax savings.
- Many plans offer employer matching contributions for plan participants who meet certain contribution requirements. A typical matching contribution by employers is 50% of the first 6% contribution made by employees. That's like free money going to work tax-deferred.
- Once your contributions are in your account, the money can't be taken away, even after you leave that employer. Employer contributions and matches are generally yours immediately as well, though some employer contributions may be subject to a vesting schedule that requires you to remain an employee for a period of time until that contribution becomes fully yours.
- Automated savings, by way of automatic payroll reduction, makes it easy to aside money for the future and to increase contribution levels as earnings increase.
- Withdrawals are not allowed (with a few exceptions) without incurring a 10% penalty.
- Investment choices are often limited. Though most plans offer a mix of investment options, such as mutual funds, to allow for proper asset allocation, they don't provide a full range of investment securities typically available through a brokerage IRA.
- Required minimum distributions (RMDs), with exception of Roth contributions, must begin at age 72, regardless of whether they need the income. That could have the effect of pushing a retiree's income level to a higher tax bracket.
Should You Contribute to an Employer-Sponsored Retirement Plan?
It's generally recommended that all employees participate in their employer retirement plan, at least to the extent they can receive an employer matching contribution. For younger employees, it's often their first opportunity to start saving and learn about investing.
Employees maintain their employer retirement accounts separately from taxable accounts. While they may have multiple employer retirement accounts because of changing employers, they are held separately unless the employee wants to roll over 401(k) account funds from one plan to another. They can also roll old retirement plan accounts into an IRA rollover account (which should be maintained separately from other IRAs).
Key Takeaway: Employer retirement plans allow employees to access automated retirement savings accounts, often including matching employer contributions.
Education Savings Accounts (529 Plans & ESAs)
While parents or adult guardians may set up a custodial brokerage account, such as an UGMA or UTMA, or use certain qualifying amounts from a IRA, the main types of investment accounts established for college savings are 529 plans and Coverdell Education Savings Accounts, or ESAs.
Types of Education Savings Accounts
The main types of education savings accounts are:
- 529 plan: A state-sponsored investment vehicle that can either be prepaid tuition plans that are usually associated with specific state schools, or education savings plans that can be used within or even outside of the owner's state of residency.
- Coverdell Education Savings Account, or ESA: Formerly called "Education IRAs," the ESA is an investment and savings vehicle that can be applied to qualified education expenses that range from elementary school up through college and extend beyond tuition to expenses such as transportation and equipment as well.
Anyone can contribute to a 529 plan and contributions are not limited, though if greater than $16,000 in a given year, they can be subject to the gift tax. To be eligible to open a Coverdell Education Account, a parent or donor cannot have a modified adjusted gross income (MAGI) greater than $110,000, and contributions are limited to $2,000 per student per year.
Minimum Deposit and Tax Implications
Most brokers and state sponsors of education investment accounts have no minimum deposit if automatic deposit is set up. Some states with a state income tax may allow state income tax deduction for 529 plans. Contributions for both 529 plans and ESAs grow tax-deferred.
Withdrawals from education investment accounts are generally tax free if they are made for qualifying education expenses.
Pros & Cons of Education Accounts
- Tax deferral: All taxes on income and gains in the account are deferred.
- Tax-free withdrawal: No tax is levied on withdrawals if used for qualified education expenses.
- Transferrable: Plans can be transferred to another child in the family.
- Qualified education expenses: Plans can cover expenses for secondary education as well as college. Funds can also be used to pay for tuition, fees, room & board, books & supplies, computer equipment, and even to pay down student loans.
- Contributors: No income restrictions on contributors.
- Taxes and penalties: Funds used for non-qualified education expenses are subject to taxes on income and gains plus a 10% penalty.
- Investment limitations on 529s: Must choose from limited available investment options within state 529 plan offerings.
- Specific state requirements on 529s: Some details may vary from state to state and will also be different for prepaid tuition plans.
- Low contribution limits on ESAs: Contribution limits are lower than for other types of custodial accounts and education savings plans.
- Income limitations on ESAs: Contributions are not permitted from individuals with incomes over the stated limit.
Should You Contribute to an Education Investment Account?
The tax benefits, expense options, and transferability of 529 plans vs. Coverdell ESAs are similar. For those looking for greater investment flexibility, a Coverdell offers that advantage. But if you are a higher-income donor or wish to make contributions above $2,000 per year, you would have to use a 529 plan. Something to keep in mind is that you can have both types and you can even have multiple 529s in different states.
Key Takeaway: The two main types of education investment accounts are state-sponsored 529 plans and Coverdell Education Savings Accounts. Both investment accounts grow tax-deferred and offer tax-free withdrawals if used for qualifying education expenses. 529 plans have higher contribution limits, whereas ESAs have greater investment type flexibility.
Comparing the Types of Investment Accounts
There are four main types of investment accounts, including brokerage accounts, IRAs, employer-sponsored retirement accounts, and education investment accounts. Each account type has its own rules, taxation, benefits, and limitations. Therefore, it's important for investors to understand how these account types work before opening an account.
|Brokerage Account|| |
|Retirement: IRA|| |
|Employer-Sponsored: 401k|| |
|Education: 529 or ESA|| |
Most investors have access to multiple types of investment accounts. Four of the more common types are traditional brokerage accounts, IRAs, employer retirement plans, and education accounts. Each has its advantages and disadvantages, but they serve different purposes as part of an overall investment strategy that combines taxable and tax-favored investing.
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