If you’re ready to buy stocks, bonds, or ETFs, you may be wondering where these types of investments are held.
There are a few different types of accounts in which you can hold investments. But they can’t live in your standard bank account. Here are your options.
Saving for retirement is most people’s biggest long-term goal. With the average person retiring at 62, either by choice or due to layoffs and health issues, most Americans face 20 years or more of retirement in which they need assets to support themselves.
To help you prepare for this massive goal, the government offers tax incentives. However, if you invest in these accounts, your access to your funds is limited until 59 ½. In some cases, there are penalties for withdrawing your money earlier.
Here are the type of accounts that offer tax savings.
Employer-sponsored retirement accounts such as 401(K)s, 403(B)s, 457s, and more, allow employees to save for retirement directly from their paycheck. Some employers offer contribution matches as a perk to double-down on your retirement preparation.
Typically, you put “pre-tax” money into these accounts, which means you don’t pay income tax on those dollars. Any money invested grows without tax until you ultimately withdraw it for living expenses in retirement. As you withdraw funds, you will pay income tax on the withdrawals. However, most people are in a lower tax bracket in retirement so pay lower rates.
As of 2020, you can contribute up to $19,500 in a given year to one of these accounts, not including any employer contribution. If you are 50 years or older, you can contribute up to $26,000 a year.
Traditional vs. Roth IRA
If you don’t have access to an employer-sponsored retirement account or have already maxed out your contribution, you can also open an Individual Retirement Account (IRA) to invest.
There are two types of IRAs: Traditional and Roth.
A Traditional IRA works the same way as employer-sponsored plans when it comes to taxes. Any money contributed will be treated as “pre-tax” and reduce your taxable income for that year.
A Roth IRA, on the other hand, is funded with post-tax dollars. This means you’ve already paid your income tax, so when you withdraw it in retirement, you don’t pay income or capital gains tax. The money is all yours. Roth IRAs offer excellent tax benefits but are only available to certain income levels. If you make more than $135,000 a year as a single filer or over $199,000 as a married filer, you aren’t eligible for a Roth IRA.
As of 2020, you can contribute up to $6,000 per year to an IRA. If you are 50 years or older, you can contribute up to $7,000 a year.
529 college savings plans
These accounts, offered by each state, provide tax benefits for parents saving for college. Operating like a Roth IRA, contributions are made post-tax, but all withdrawals are tax-free as long as the funds are used for higher-education expenses.
Your state may offer tax benefits or contribution matches for investing in your local 529 plan, but you can utilize any state’s 529. Since each state has different fees and investment options, be sure to find the best 529 for your money.
Brokerage accounts offer no tax benefits for investing but operate more like a standard bank account to hold your investments. There are no limits on annual contributions to these accounts, and you can access your money at any time.
Cash or cash equivalents
Since investing should only be undertaken for the long-term, you may need to hold onto cash while saving for shorter-term goals. In that case, a traditional bank account might not do the trick. Checking and savings accounts offer incredibly low interest rates, if any at all, which means you are entirely at the mercy of inflation.
Luckily, there are cash accounts that pay higher interest:
A CD, or Certificate of Deposit, is a savings account that restricts access to your cash for a specified period (6 months, 12 months, 24 months, etc.). There is a small penalty if you want to withdraw your money before the term is up, but these accounts typically offer a higher interest rate in exchange for the lack of access.
High-yield online savings accounts are the middle ground between CDs and traditional savings accounts. They pay higher interest than a conventional savings account but still allow a few transactions a month so you can access your cash if you need it. Many online high yield savings accounts have no deposit minimums or fees.
Money market accounts are very similar to high yield savings accounts, but with slightly higher interest rates and higher deposit requirements. For instance, CIT Bank’s money market account offers a 1.85% interest rate but requires a $100 minimum deposit.
In any of these accounts, your cash deposited is not at risk. FDIC insurance guarantees you your money back, even if the bank that holds your account goes bankrupt.