When I speak to many people who are interested in growing their wealth, they do not have any idea what the difference is between an IRA, 401K, and many other investment accounts. Today I am going to list every investment account and give you a sort summary.
Every Investment Account Type: Categories
There are about 5 major categories, these are your 401K plan, IRA plan, educational accounts, health savings accounts, and your classic brokerage accounts.
1) What is a 401K?
A 401K is a type of qualified investment plan in the United States that allows employees to put wages from their employer into an individual investment plan.
They are otherwise known as “deferred wages” because they are set aside and used later in life for retirement. There a few different types that can be used.
Traditional 401K
A traditional 401K is a tax-advantaged retirement account where employees can contribute a portion of their pre-tax income. Employers may match a percentage of contributions.
The funds grow tax-free, and taxes are paid upon withdrawal in retirement, typically starting after age 59½. Early withdrawals may incur penalties unless qualifying for exceptions. Overall, it provides long-term savings with tax advantages to build wealth.
BONUS: many employers offer what is called a 401K match to employees. This is essentially free money and not every investment account has it. So, make sure you ask your employer if this is offered.
Roth 401K
A Roth 401K is a retirement savings account where contributions are made with after-tax dollars from your employer. Unlike a traditional 401K, withdrawals in retirement, including earnings, are tax-free.
This offers tax diversification in retirement planning, allowing individuals to manage their tax liability more flexibly. It is similar to how a Roth IRA works.
403b Plan
A 403b plan is a tax-advantaged retirement savings plan available to employees of certain tax-exempt organizations, such as schools and nonprofit entities. I know several school teachers who use this as their retirement plan.
Similar to a 401K, participants contribute pre-tax income to the plan, reducing their taxable income. Employers may offer matching contributions. Contributions and earnings grow tax-deferred until withdrawal in retirement, at which point they are subject to income tax.
Early withdrawals may incur penalties, and the plan often provides a range of investment options for participants to choose from.
Solo 401K
For those who are self-employed (what the underpaids are aiming for with passive income) there is also the Solo 401K. It is a retirement plan designed for self-employed individuals or small business owners with no employees, except for a spouse.
It combines the features of a traditional 401(k), allowing pre-tax contributions, with a profit-sharing component. This means participants can contribute as both the employer and the employee, potentially allowing for higher contribution limits.
2) What is an IRA?
An Individual Retirement Account (IRA) is a tax-advantaged investment account for individuals to save for retirement.
It offers various investment options, and contributions may be tax-deductible (Traditional IRA) or made with after-tax dollars with tax-free withdrawals in retirement (Roth IRA). In addition, there are other specialized versions of the plan for small business situations.
Traditional IRA
A Traditional IRA is a tax-advantaged retirement account where individuals contribute pre-tax income. Contributions may be tax-deductible, and earnings grow tax-deferred until withdrawal in retirement.
Withdrawals are subject to income tax, typically starting after age 59½, and early withdrawals may incur penalties unless qualifying for exceptions.
Roth IRA
A Roth IRA is a tax-advantaged retirement account where individuals contribute after-tax income. Earnings grow tax-free, and qualified withdrawals in retirement are tax-free.
Unlike a Traditional IRA, there are no mandatory withdrawals, providing flexibility in retirement planning. Contributions can be withdrawn penalty-free at any time.
Simple IRA
A Simple IRA, or a Savings Incentive Match Plan for Employees, is a retirement plan designed for small businesses. Employers and employees can make tax-deductible contributions.
Employers must either match employee contributions or make a fixed contribution. It offers simplified administration and is suited for businesses with fewer than 100 employees (keep this in mind if you are a small business owner).
SEP IRA
A Simplified Employee Pension (SEP) IRA is a retirement plan for self-employed individuals and small businesses. Employers make tax-deductible contributions to each employee’s IRA, including their own.
Contributions are flexible and based on a percentage of income, up to annual limits. SEP IRAs are known for their simplicity and are easy to set up and administer.
3) Educational Investment Accounts
529 Savings Plan
A 529 Savings Plan is a tax-advantaged investment account designed for educational expenses. Contributions grow tax-free, and withdrawals for qualified education expenses are also tax-free. These plans, administered by states, offer flexibility and a range of investment options.
A 529 plan can be used for various education-related costs, including tuition, room and board, and textbooks. They are a popular choice for parents and guardians looking to save for their child’s education, providing a reliable and tax-efficient way to invest in the future.
Coverdell Education Saving Account
A Coverdell ESA is another tax-advantaged option for education savings. It allows contributions to grow tax-free, and withdrawals are tax-free when used for qualified education expenses, which include not only college but also K-12 expenses.
Coverdell ESAs offer more flexibility in investment choices compared to 529 plans, allowing individuals to invest in a variety of securities. They are especially valuable for those wanting to fund education costs at the primary and secondary levels. However, there are contribution limits, and eligibility is subject to income restrictions.
4) Health Savings Account (HSA)
An HSA is a tax-advantaged account that individuals can use to save for qualified medical expenses. Contributions are tax-deductible, and qualified withdrawals are tax-free, providing a triple tax advantage.
HSAs are linked to high-deductible health plans (HDHPs), and individuals can use the funds to cover various medical expenses, including deductibles, copayments, and certain preventive care. The account also allows for long-term savings, making it a valuable tool for managing healthcare costs in retirement.
5) Brokerage Account
A brokerage account is not like every investment account because of its flexibility. It allows individuals to buy and sell a variety of financial assets, such as stocks, bonds, and mutual funds. It serves as a platform for executing trades.
There are no penalties for withdrawal, however, the tax status of gains and losses in a brokerage account is subject to capital gains tax each year unlike a retirement account. The two types are cash as well as margin accounts.
Cash Brokerage Account
A Cash Brokerage Account is a standard investment account where individuals use their available cash to buy and sell securities. Unlike retirement accounts, there are no tax advantages, and gains and losses are subject to capital gains tax.
Cash accounts are straightforward and easy to manage, making them suitable for investors who want liquidity and accessibility to their funds. However, they lack the tax benefits associated with retirement or education-focused accounts.
Margin Brokerage Account
A Margin Brokerage Account is similar to a cash account but with the added feature of margin trading. Investors can borrow funds to amplify their buying power, potentially increasing returns but also exposing themselves to higher risks.
Margin accounts can be beneficial for experienced investors seeking leverage, but it’s crucial to manage risks carefully. If investments decline in value, investors may face margin calls and be required to deposit additional funds to cover losses.
Ultimately what fits your needs best is the investment account for you. If you found this article useful, please consider sharing and subscribing to the Underpaids Newsletter.
