Today’s post is just a quick educational post about some of the different types of investment accounts that are available and why we might choose to use them.

When you or I go to open an investment account, what most of us think of is probably a standard individual investment account. This is an account with a brokerage that allows us to deposit money  into the account at whatever frequency we like and then use that money to make investments. This standard account is contributed to with net money – we put money in this account after we have paid taxes on it already. In most cases this means that we get our paycheck and then put a portion of the net amount into the investment account to use for investments. When you open this type of investment account, you have access to your money at any time, for any reason, without any sort of penalty.

The second main type of investment account is a probably the most widely-known type of retirement account: the 401(k) or IRA. A 401(k) or IRA account operate very similarly from a tax perspective. Both of these accounts allow you to make investments with post-tax money. The main difference between the accounts is that a 401(k) plan is administered and managed by your employer, while an IRA account allows you to manage the investments. IRA stands for Individual Retirement Account. The main advantage to using an IRA is that outside of transaction costs for investments, you are able to manage your retirement account at whatever level of detail you deem necessary without paying the often exorbitant management fees associated with institutionally managed accounts. The main advantage of utilizing a 401(k) account is that most 401(k) accounts are funded via payroll deduction, which means that the contributions happen automatically, before you can even realize that the money has been deposited. Automated, automatic investing is always awesome. On top of that, many companies offer some sort of matching program for 401(k) contributions, which is something that you have to take advantage of if it is offered. It’s free money. Who doesn’t like that?

The 401(k) and IRA accounts are also available in a Roth option. A Roth 401(k) or Roth IRA account allow you to deposit money pre-tax and then pay tax on that money whenever it is distributed back to you at some point in the future.

Here’s how I think about these accounts:

I use my standard investment account for my everyday investing. This is money that I have earmarked for investing but not necessarily for retirement. I’ve already paid my income tax on this money and plan on holding the investments long term. That means that after income taxes, I’ll pay only long-term capital gains tax on the money.

I also take advantage of my employer’s 401(k) plan. The investment options in the plan are not totally fantastic, but they are fine. The main reason I use it is to receive the company match on my money. I want that free money.

Additionally, I have a Roth IRA account into which I make regular deposits. This is retirement money that I want to directly control.

From a tax perspective, I try to use these accounts to hedge against future uncertainty in tax rates. Here’s my logic: my company-sponsored 401(k) plan is funded with pre-tax money. I’ll pay taxes on this money when I take distributions from the account. I make just enough contributions to this account to receive the company match and no more than that. In my opinion, taxes in the future will only go up from our current historically low rates and so I want my future tax exposure to be as low as possible. I believe that I’ll be in a slightly higher tax bracket when I retire that I am in currently, so it makes sense to not have the bulk of my money in this account.

My regular investment account is money that has already been taxed once via income taxes. Future taxes I pay on this will fall into the capital gains category, which I believe is 15% right now. That will likely increase in the future but capital gains tax rates will probably always be lower than income tax rates. I’m happy to keep contributing to this account and pay my capital gains taxes later. After all, if I’m paying capital gains taxes, that means I’ve got some capital gains. That’s a good thing.

I fund my Roth 401(k) via regular direct deposits as well as intermittent transfers from my checking account whenever I have cash to put into it. This account has already been taxed and allows me to contribute post-tax money without worrying about paying a higher rate when I start taking distributions. At the moment, I keep this account value at about 33% of my regular investment account. I think that I’ll probably start increasing this number in the near future.

When it comes to taxes and investing accounts and retirement, there is an awful lot to consider and I’m sure that I don’t have a perfect strategy. I think they key is to try and think things through and come up with a plan that makes sense for you. There is no one-size-fits-all solution and anyone that tells you otherwise is probably trying to make money off of you.

Do you have a tax strategy when it comes to investment accounts? Care to share?

Share: