Financial institutions are in the business of making profits, leading to a constant stream of new products and offers made to consumers. With so many types of accounts and products out there, where do you begin? As with many things in investing, when you filter out the noise of marketing and promotions, most banks and brokerage firms offer many of the same foundational types of investment accounts under all the bells and whistles. Let's look at some of the most important and popular types of investment accounts available to you today.
It’s first important to understand the difference between a taxable and a tax-advantaged investment account. Taxable accounts (e.g. checking and savings accounts, brokerage accounts, etc.) are accounts in which the money you earn from your investments can be taxed. Other accounts are tax-advantaged, meaning the earnings are eligible for tax incentives or are tax-deferred. Examples of these accounts are Individual Retirement Accounts (IRA’s), 401(k)’s, 403(b)’s, and Health Savings Accounts (HSA’s), to name a few. It is important to consider the impact of taxes on your investments, as taxes can impact your long-term earnings and income. Always consider consulting a tax or financial professional when making important decisions regarding your investments in either taxable or tax-advantaged accounts.
Brokerage accounts are taxable accounts (i.e. the earnings are taxable) that allow for direct trading of stocks, bonds, and other financial instruments. Day traders and short-term investors often use brokerage accounts to make trades and capitalize on the day-to-day movement of the stock market. Brokerage accounts can also be used for long-term investing, but generally are not used for building long-term wealth in the same way as tax-advantaged retirement accounts.
401(k)’s are one of the most common types of tax-advantaged retirement accounts. “401(k)” and “403(b)” refer to the sections and paragraphs of the Internal Revenue Service (IRS) tax code that governs how these accounts are handled from a tax perspective. 401(k)’s are set up by an employer, and allow for employees to make contributions from their wages. Many employers also match their employees’ contributions up to a certain percentage of their gross income. The savings in most retirement accounts are not allowed to be accessed until a worker turns 59.5 years old, which provides some security that the worker will have a source of income upon retirement. There are many exceptions for early withdrawals to be made from these types of accounts, depending on a person’s circumstances.
A major advantage of 401(k)’s is their tax-advantaged status, providing the means for a worker to either defer their taxes until retirement (a traditional 401(k)) or pay the taxes up front so that withdrawals are tax-free in retirement (a Roth 401(k)). Two general rules of thumb when investing in 401(k)’s are to (1) contribute 15% of your gross income to the 401(k) each pay period, and (2) at the bare minimum contribute up to your employer’s match. If you do not contribute up to your employer’s match, you are essentially throwing away free money!
A 403(b) is nearly identical to a 401(k), but is only offered by non-profit organizations.
IRA’s are another popular type of retirement accounts. Similar to a traditional or Roth 401(k), IRA’s can either be tax-deferred or pre-tax (i.e. taxes are paid up front). IRA’s provide a means of retirement investing for a worker whose employer does not provide a 401(k). It is important to remember that there are annual limitations the IRS sets on how much an individual can contribute to an IRA ($6,000 is the limit in 2020). Additional contributions above the annual limit may be made by workers over the age of 50 called “catch-up contributions.”
Checking accounts are cash accounts offered by financial institutions that allow consumers to spend money via a debit card or make cash withdrawals. These accounts rarely offer much, if anything, in terms of interest rates on the cash invested. The Federal Deposit Insurance Corporation (FDIC) insures cash deposits in most banks up to $250,000 per account, so banks (online and traditional brick-and-mortar) are generally one of the safest places to park your cash.
Savings accounts are very similar to checking accounts, but usually offer an interest rate on cash invested. High-yield savings accounts have become much more popular in recent years due to their competitive interest rates. For example, Ally Bank offers an 0.8% interest rate right now in its high-yield savings account (more details here). However, based on economic conditions and interest rates set by the Federal Reserve System, these rates can be quite low compared to inflation and other investment accounts. Money market accounts are similar to high-yield savings accounts, except that they offer interest rates based on current money market rates as opposed to interest rates set by the financial institution. Despite current low interest rates, a high-yield savings or money market account still offers higher returns than a traditional savings account and either is a good option for setting up an emergency fund.
Certificates of Deposit (CD’s) are another type of cash-savings account that offer slightly higher returns for cash invested over a fixed period of time, provided the investor does not withdraw the cash during the given period. Common terms for a CD are 6 months or 1 year.
Don't forget: just because you deposit money in one of the accounts we discussed does not mean the money is invested! With the exception of cash accounts like savings accounts and CD's, you still need to purchase investments within your accounts to start earning returns. Otherwise, your cash will remain cash sitting in your account, slowly losing value over time to inflation. Next time, we will look at the actual types of investments available to you within these investment accounts.
Disclaimer: The opinions and views expressed by the author do not constitute investment advice or recommendation, and are provided solely for informational purposes, and are not an offer to buy or sell any securities. Always conduct your own research and due diligence before making any investment decisions.