In the big world of investing, it seems we hear a lot about what securities to invest in, but not as much about what types of accounts to invest in. There are so many different types of investment accounts, each covering a different purpose, and new types of accounts seem to be created weekly. What are some of the basic types of investment accounts and what can they do for you? This article covers some of the accounts that are available currently and why you would use each one.
IRA stands for Individual Retirement Account. An IRA is meant for those who do not have access to employer sponsored retirement plans such as 401(k) plans or those who would like to contribute more than the maximum allowed by their employer plans. Why choose an IRA? Tax-deferred growth is the answer. With a standard savings account, you have to pay taxes on the interest or earnings that the account makes each year. An IRA, on the other hand, doesn’t require you to pay taxes until the money is taken out in retirement, thus leaving more money in the account to grow each year. In many instances you can also deduct your IRA contributions on your taxes, giving you further tax savings. It seems like a small thing especially when the account balance is still small, but over time it makes a big difference. Investing $10,000 for 30 years in a regular savings account with a 28% tax bracket and a 6% average growth rate will give you $35,565 whereas that same amount put into a tax-deferred account will give you $57,435. Eventually, however, you do have to pay taxes on the earnings in your IRA, but you are still left with $44,153 after taxes are paid. Your net gain for tax-deferred growth is just over $8500.
Another individual plan is a Roth IRA. It is somewhat similar to a traditional IRA but the difference is that you cannot deduct the contributions and the earnings grow tax-free instead of tax-deferred. This type of plan is good for someone with a longer timeframe to invest or those whose tax bracket in retirement will be close to or higher than their current tax rate. Tax-free growth means that you don’t have to pay taxes on any of the earnings in the account. If we start with $10,000 and invest it for 30 years at 6% growth like our example above, you would be left with $57,435. None of that money has to have taxes paid on it since the initial $10,000 already had taxes taken out and the earnings grew tax-free. Before you wonder why anyone would not automatically use a Roth IRA, consider the fact that the initial $10,000 investment wasn’t tax deductible like it was for the traditional IRA above. With a 28% tax bracket, the Roth paid $2,800 on its initial $10,000 investment. If we look at the growth potential of $2,800 for 30 years in a tax-deferred account, it grows to $16,082. So, in this person’s situation where their tax bracket is the same in retirement as it is while working with a 6% rate of growth, a Roth wouldn’t be the best option. The Roth would only grow to $57,435 – $16,082 = $41,353 when all taxes are taken into consideration while the traditional IRA would grow to $44,153. There are several online calculators that can estimate which type of IRA would be to your advantage. Search under Roth vs. Traditional IRA for more information and calculators to determine the best account for you.
In addition to individual plans there are also employer-sponsored plans. SEP IRA, SIMPLE IRA and Keogh plans are in between Traditional Individual Retirement Accounts and the standard employer sponsored plans such as 401(k)’s. SEP’s, SIMPLE’s and Keogh’s are for self employed individuals or small companies that need to put aside more money than a standard IRA allows but aren’t large enough to warrant the expense of a 401(k) plan. Each plan allows both employee and employer contributions. Each has set maximums between $6,000 and $30,000, depending on the plan and the contributor, and each has tax incentives for both the employer and the employee. These plans are great for small businesses to be able to set aside money for themselves and their employees and not have to go through the time and expense of larger employer sponsored plans.
The last type of retirement plans are employer sponsored plans. When it comes to retirement, it seems everyone knows the term 401(k). This is because a 401(k) is the retirement plan of choice for medium and large companies. In 2006, the maximum contribution to a 401(k) is $15,000. If you are over fifty and your employer offers the 401(k) “catch-up” contribution, you can contribute up to $5,000 more, so $20,000 total. Your employer may also contribute to your 401(k) plan which generally doesn’t decrease your contribution allowance. Originally, 401(k) plans were only offered to for-profit companies. Those who worked for non-profit companies such as charities, schools, universities and hospitals weren’t able to contribute to 401(k) plans but were able to open 403(b) plans which allowed most of the same contribution limits as a 401(k). Government or public employees often used 457(b) plans for their contributions and for highly compensated employees there are 457(f) plans. This eventually changed to where 401(k) plans are now available to non-profit companies so more and more of the non-profit sector are opening 401(k) plans for their employees. Taxes on these types of plan can vary from one plan to another, so it is best to consult your plan director or talk with the investment company that manages your employers plan.
Education Savings Plans
Education plans have become available in the past decade allowing parents to better save for their children’s education. Instead of trying to set money aside in taxable savings accounts, parents can now setup an education savings account that has various tax advantages depending upon the type of account used. Choosing an education savings account depends upon what your long-term goals are for the money. There are three basic types of education savings accounts, IRC section 529 plans, the Coverdell Education Savings Account (CESA) and the Uniform Gift to Minors Account (UGMA). Each plan is tailored a little differently when it comes to its tax advantages and who gets the money from each plan, but each has the same general purpose, to save for your children or grandchildren’s future.
Medical Savings Accounts
There are three different types of accounts to help you save for healthcare costs, Flexible Spending Accounts (FSA), Health Reimbursement Arrangements (HRA) and Health Savings Accounts (HSA). The first of these, Flexible Spending Accounts are also called section 125 plans or “cafeteria plans.” This plan allows participants to put pre-tax money into the account each year to cover health insurance deductibles, co-payments, dental care and other medical expenses. Cafeteria plan money cannot accumulate from year to year, however, so it needs to be used up in one year or it will be gone. The second type of medical savings account is a Health Reimbursement Arrangement. It is similar to an FSA but the employer contributes to the account instead of the employee.
The employer can make contributions contingent on an employee participating in designated health and wellness programs. In June 2002 it was updated to allow funds to rollover from year to year, but it cannot be rolled over from employer to employer so if you change employers, you loose the accrued benefit. The last and most recently created plan is a Health Savings Account. This plan enables employees with high-deductible health insurance plans to set aside and invest money to use to pay the deductibles or other healthcare costs in the future.
These plans are designed to put healthcare decisions more into the hands of the employees. These plans are also portable so they move with you when you change employers and they can be rolled over from year to year.
For those who are just looking to invest, a brokerage account is the medium to use. Brokerage accounts are setup through investment companies to allow you to purchase securities such as stocks, bonds, mutual funds, money markets, options, etc. Generally the money sits in a “core” account such as a money market until you are ready to invest it in other securities. There are fees for purchasing many securities which vary depending on the company that the account is setup with. Brokerage accounts can also offer check writing, debit and ATM cards for easier access to money in the account. Since there are no tax-advantages of a brokerage account, money can be withdrawn at any time from the core account. These accounts are perfect for additional savings that you want to invest in the stock market.
The standard savings account is probably what everyone is most familiar with. Offered by any bank, a savings account allows you to set money aside and receive a variable or fixed interest rate depending upon the account. Savings accounts are very liquid and can be withdrawn at any time, but they don’t allow check writing capabilities. Most savings accounts now days do offer ATM cards. Certificates of Deposit or CD’s are types of savings accounts that require money to be left in for a certain period of time in exchange for a slightly higher interest rate, these accounts are less liquid and there is generally a fee to take the money out before the predetermined period of time.
Whatever the reason or account used to set aside money, it is always a good thing. Savings in any form creates a more secure financial future and allows for problems or emergencies to be taken care of without having to obtain loans or dip into less liquid savings such as a home or other physical assets. Opening up any of the above types of accounts gets you started on the right track towards savings.