Last Updated on November 23, 2023 by Prakash Kolli
What kind of investment accounts do you need?
There are various investment accounts, depending on your lifecycle and financial goals. Choose investment accounts that advance your goals. Your goals may be to begin investing, saving for retirement and college, liquidity for emergencies, and tax optimization strategies. These accounts can help you build wealth.
Families may want to set up college savings or custodial accounts for young children, including a Roth IRA. Young investors may want to open a standard brokerage account, depositing some cash to get started buying index funds. Conversely, advanced investors may seek more risk and enjoy access to options like buying on margin and short selling.
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To open a brokerage account, you must be at least 18 years of age and have a social security number or tax ID. A standard brokerage account is a taxable investment account that will allow you to deposit and hold cash to buy various investments like stocks, bonds, money markets, mutual funds, index funds, or ETFs.
Taxable accounts require holders to pay taxes on any interest or dividends they earn on investments and any investment gains realized in the year made.
Typically, most brokerage accounts are cash accounts, but some investors want to open a margin account. You can build your brokerage by depositing enough cash to take advantage of a market downturn and pick up stocks at reduced valuations.
A margin account requires an investor to have cash for liquidity. When you buy securities on margin, you borrow money from your brokerage firm to purchase securities or short selling. These strategies carry high risks.
You can open an individual or joint brokerage account. An individual account means the holder retains ownership and has responsibility for paying taxes earned. A joint account includes two or more people, often spouses or partners, children, or other family members but can be a non-relative.
Investors, especially young beginners, may want a self-directed brokerage account to take control over their investments, and make choices over the type of securities, individual stocks, ETFs, and mutual funds they buy for their portfolio.
They may prefer doing their research and can save money by not paying for a financial advisor, especially when managing a relatively small account. You can learn investment strategies like dollar-cost averaging and how to harvest tax-loss selling to reduce taxes.
Longer term, investors may want access to a financial advisor. A financial advisor can help investors build an investment portfolio for their short-term and long-term financial goals and tax optimization strategies.
Many options exist from traditional brokerage firms, Robo-advisors, online trading platforms, or wealth management firms.
Saving for retirement at an early age usually begins with employer-sponsored 401K or Roth 401K retirement account plans. The traditional 401(K) is the best-known defined contribution plan for employees of private companies, offered by 67% of these firms. Most 401(k) plans provide at least three investment choices in your 401(k) plan, but some sponsor many more, like Vanguard, a popular choice.
The IRS recently raised limits on the maximum contributions of the 401 K per year to $22,500 in 2023, from $20,500 in 2022 that an employee may contribute to an employer-sponsored plan. Additionally, the 401K “catch-up” provision permits workers age 50 or older to contribute increases in 2023 to $7,500 (or $1,000 higher than in 2022) to help those getting a late start on retirement savings. These increases apply to 403 (b), most 457 plans, and the federal government’s Thrift Savings Plan.
The IRS imposes eligibility requirements based on compensation limits on retirement plans (e.g., 401K and IRA) subject to annual cost-of-living adjustments. The limits consider whether a workplace plan exists and whether a taxpayer is filing single or jointly. Check the IRS website for various limits for eligibility.
Some employers will match a portion of your contribution to a percentage of your salary, like 5%.
For example, if you earned $60,000 per year, and they match 100% of your annual contribution (or $3,000) of your 401K, your employer would contribute 5% of your salary or $3,000 more to your account.
It would be best if you prioritized contributing a large enough amount to earn your employer’s full match, as it is part of your compensation, and you don’t want to lose it.
Most retirement plans are subject to required minimum distributions (RMDs). Retirement holder owners who turn 72 must withdraw minimum amounts from their account annually starting in the year.
The RMDs apply to:
All employer-sponsored retirement plans, including:
- Profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.
- Roth 401(k) accounts.
- RMD rules do not apply to Roth IRAs while the owner is alive.
Increasingly, employers are offering Roth 401K retirement plans, with 70% of companies providing this option. Unlike the Roth 401K plans, your contributions for traditional 401K are pre-tax, and once you begin to withdraw from your account in retirement, you’ll have to pay your taxes at your current rate. Similar to the traditional 401K accounts, you are making after-tax contributions to your Roth 401K and will not have to pay taxes upon withdrawal in retirement.
In addition to 401K plans, there are:
403(b) plans are for employees of non-profit organizations (e.g., colleges, hospitals, religious and other not-for-profit organizations) and have the same contribution limits as the 401K plan.
457 plans are for state and local government employees and nonchurch-controlled tax-exempt organizations. They have the same contributions as the 401K, but no employer contributions are allowed for this plan.
SIMPLE 401K is for employers with 100 or fewer employees and is different than the other 400 plans. In the 401K plan, the employer must choose between matching contributions of up to 3% of each employee’s pay or non-elective contributions of 2% of the employee’s income.
The employee can elect to defer some compensation limits. SIMPLE 401K contributions rose to $15,500 in 2023 from $14,000 in 2022. For “catch-up” contributions for employees aged 50 and over, the additional contribution amount increased to $3,500 in 2023, up from $3,000 in 2022.
If you don’t have access to an employer-sponsored 401K plan, or even if you do, you can personally set up your retirement account with a traditional IRA or a Roth IRA.
Traditional IRAs, typically used for retirement savings, would normally incur taxes and a 10% penalty for withdrawals before age 59.5.
However, there is an exception. You may withdraw money in an IRA account early to pay for qualified college expenses for yourself, your spouse, your children, or your grandchildren without being penalized. Frankly, consider withdrawals from retirement accounts as a last resort, as these accounts are for your financial future,
The limit on annual contributions to an IRA increased to $6,500 in 2023, up from $6,000. The IRA catch‑up contribution limit for individuals aged 50 and over is not subject to an annual cost‑of‑living adjustment and remains $1,000.
IRA withdrawals begin at age 72 as required minimum distributions or RMD. The retirement plan account owner of IRAs, including SEP IRAs and SIMPLE IRAs, is responsible for taking out RMDs.
Other IRAs have increased limits on contributions. SEP IRA contribution limits rose to $66,000 in 2023 from $61,000 in 2022. SIMPLE IRAs rose to $15,500 in 2023 from $14,000 in 2022.
With Roth IRAs, you contribute after-tax dollars, and your money grows tax-free. Your withdrawals are tax-free after 59.5 years.
Roth IRAs have no required minimum distributions like their older IRA counterpart. You may be able to withdraw your contributions, not your earnings, before age 59.5 years without penalty if your Roth IRA has existed for five years or more.
In many ways, Roth IRA has become the preferred vehicle for personal retirement accounts and is more tax-friendly.
Investment accounts are excellent ways to save for qualified education expenses. The 529 Savings Plans and the Coverdell Education Savings Account are the most popular savings vehicles. You can do both plans for the same beneficiary if it suits your needs.
A 529 plan is a college savings plan that offers tax-deferred savings and financial aid benefits. Originally begun to save for college, families may now use the plans to save and invest for K-12 tuition at private schools, retaining their tax-deferred nature.
Every state has a 529 plan; you do not have to live in that state to set up an account in each child’s name. Each state plan may vary, so check what works for you.
There are no maximum caps on how much money you can invest annually. State tax treatment of these withdrawals differs from state to state. So check with your state’s taxing authority or state 529 plan administrator.
Parents can typically choose various investment portfolio options, including Vanguard mutual funds, ETFs, allocation fund portfolios, and age-based portfolios. Which fund you choose depends on your appetite for control and risk. You can make changes between the funds based on your children’s age or the target date portfolios, which shift from more aggressive growth rates to more conservative rates as your child ages.
The 529 plans typically do not have income or age limits. An older person can use it for school later on.
These accounts are similar to 529 plans offering tax-free investment growth and tax-free withdrawals when you use the funds on qualified education expenses. Like 529 plans, the invested amounts are not limited to college and can be used not only for K-12 tuition but also expenses, including books.
Contributions to Coverdell ESAs are limited to $2000 annually per beneficiary, similar to limits set for IRAs. A Coverdell investment option is self-directed, so you have more options. Grandparents can each set up their account for the same beneficiary, with a $2,000 limit for each account.
Coverdell ESA’s have age and income limits. A beneficiary must use the funds by age 30 unless the beneficiary is a special needs person. If your adjusted gross income is over $220,000 as a married couple or $110,000 as a single taxpayer, you cannot contribute any longer.
Although you could set up a traditional IRA for your child, the contributions to a Roth IRA benefit from the likelihood that the child’s earned income will have a relatively low tax rate when you contribute to their account. The child’s income could come from performing personal services and receiving salaries, wages, tips, and net earnings from a parent’s self-employment if they helped in the business.
Creating a Roth IRA for your children provides more flexibility before they reach adulthood, as these funds can help pay for college, make a first home purchase, or retire.
A Roth IRA is preferable to a traditional IRA with after-tax contributions, tax-free growth, and withdrawals. Once your child becomes an adult, their custodial account needs to convert to a regular Roth IRA in their name.
Parents can set up these custodial accounts for each child if they are under the age of 14 years and managed by the parent until the child turns the age of majority, typically age 18 years, unless stated otherwise.
Investments in these accounts are not limited.
For children below 18, the first $1,100 of unearned income from the investment is tax-free to the child, after which the next $1,050 is taxed at the child’s tax rate, then income above the $2,200 is taxed at the parents’ (usually higher) tax rate. When the child turns 18, they will pay taxes at their rate.
Couples filing jointly can contribute up to $30,000 annually for each child or $15,000 if an individual sets up an account. Anyone can set up a custodial account, including grandparents, aunts, and uncles.
Once the child has access to the account based on their age of majority, it becomes their asset.
Besides having savings and checking accounts at the bank, it is essential to understand the various investment accounts to fulfill your short-term and long-term financial goals to invest, save for retirement and your children’s education, tax advantages, and build your wealth.
This article by Linda Meltzer originally appeared on Savoteur, and was republished with permission.
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