I’m ready to invest but don’t know which account to use.

If you’re just beginning your investment journey and have built up your cash reserve, you may be overwhelmed or confused about which account you should use to invest. There are a few different options and usually, when we work with clients, we align the accounts they’re investing in with their goals and time horizons.

Here are some common accounts you may have heard of; 401(k)s, 403(b)s, Traditional IRAs, Roth IRAs, and brokerage accounts. While I can’t tell you exactly where you should be saving as that can vary depending on your goals, I can give you an overview of each account.

401(k)s and 403(b)s

These accounts are very similar. For the purposes of this piece, we will view them as the same. 403(b)s are offered by government and non-profit organizations. 401(k)s are offered by for-profit companies.

In either case, these are tax-advantaged retirement savings plans. If you have just entered the workforce, you may encounter your first experience with a workplace retirement plan.

These retirement plans can allow for a maximum of $23,000 to be contributed for 2024. If you are just beginning your career, this might be a big swing, but you are not obligated to contribute this much to the account.

You can contribute a set dollar amount per paycheck or defer a percentage of your compensation to the account. This is one of the easiest ways to begin your investment journey as it is turnkey. It is the definition of “set it and forget it.”

Most 401(k)s and 403(b)s will allow for pre-tax or Roth contributions. Pre-tax contributions give you a tax break upfront and are taxed as income upon distribution in retirement. Roth contributions are taxed today but distributed tax-free after the age of 59.5.

It is common to see a match with these retirement plans. This is done to incentivize employees to save for their retirement. If you are making $100,000 and your employer offers a 4% match, by contributing $4,000 for the year, your employer will match that contribution! This is as close to a free lunch as you can get.

The employer match can be subject to vesting requirements. This is a bit more nuanced, but it can range from immediate vestiture to a 6-year graded vesting schedule. That essentially means that you’ll vest 20% each year after the first year.

Traditional IRAs

From my experience, I have seen younger professionals stray from investments in Traditional IRAs. This is because their income is usually lower than they expect it to be in the future, so they prefer Roth IRAs (we’ll get to that in a second).

Traditional IRAs allow you to contribute up to $7,000 and deduct that from your income. Similar to pre-tax dollars going to your 401(k) or 403(b), we are getting the tax break up front. Money grows tax-free and is taxed as income when distributed after reaching age 59.5.

Traditional IRAs are subject to multiple income limitations. Anyone can contribute to a Traditional IRA, as long as they have earned income to the extent they are contributing, but their ability to deduct their contribution varies.

It is pretty in-depth, but the deductibility will ultimately come down to your Modified Adjusted Gross Income and whether you are covered by an employer-sponsored retirement plan (401(k) or 403(b)).

To make things more fun, there is a phaseout range. If your MAGI is in between the phaseout range, you can partially deduct a contribution.

Who knew there was so much nuance to a little old Traditional IRA? Fun times.

Roth IRA

In my experience, the younger generation finds this account to be the GOAT. Older generations as well but the young people really seem to love Roth IRAs.

Roth IRAs allow you to contribute money that has already been taxed. There is no upfront tax benefit for contributing to a Roth IRA. However, funds in the Roth IRA grow tax-deferred and are distributed tax-free after age 59.5.

Younger people appear to be attracted to this as they are not in their peak earning years. Thus, they are willing to take the tax hit now in return for tax-free withdrawals during their retirement.

One huge plus for Roth IRAs - you can access your principal at any time. While I don’t think anyone would recommend it given Roth dollars are incredibly valuable, you can always pull out your direct contributions free of penalty. (Underlining direct because when Roth conversions get into the mix the rules are different). They really don’t make anything easy.

Roth IRAs are also subject to MAGI phaseouts. (There is a way around the income limitations known as the Backdoor Roth or Roth conversion. I will explain this in a future piece).

Brokerage Account

Ultimate flexibility. This type of account is one of the most slept-on in all of personal finance and it is actually the simplest account.

There are different advantages to this account, but it will not offer tax-deferred growth or tax-free withdrawals.

The brokerage account is really just your run-of-the-mill investment account. However, here are some things that I absolutely LOVE about them:

1. No contribution limits. You can contribute a zillion dollars per year if you have that kind of money.

2. There are no age-based limitations. You do not need to wait until you are 59.5 to take money out of the account. This is HUGE for anyone who wants to retire early without tapping into those retirement account assets.

3. Your gains can become eligible for long-term capital gains treatment. If you hold a stock for over 1-year, the profits can be taxed at a much lower rate than your tax bracket. This ranges from 0% to 20%. (23.8% for any financial professional who thought they were going to “gotcha” me on Net Investment Income Tax).

    

I am 25. While of course, I want to save for retirement, I also know that there are a bunch of other things I want to save for throughout my life. Some things will have a 10 and 20-year time horizon. Unfortunately, retirement accounts won’t be the best option to tap into when I am 45. The flexibility of a brokerage account is taken for granted in the world of financial accounts.

All these different investment account options can be overwhelming. When it comes to choosing one, it is important to consider your time horizon and goals. This will give you a lot more clarity about where to save.

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Have a more specific question or want to get your finances in order? Feel free to reach out to [email protected] for a free consultation!