Explained — The alphabet soup of Investment Accounts in US!

With so many types of Investment accounts (401K, IRA, Roth-IRA, 529 Account, Taxable Brokerage Account) and the choices around what to buy inside these accounts, it can get complicated pretty fast! Let’s tackle it one by one by understanding these account types, then connecting the dots to understand the bigger picture of an ideal investment setup.

Investments vs the Account itself (Allocation vs Location!): Some people tend to confuse the investment account (ie. Location) with the investments held within that account (what some refer to as the allocation within the account). All accounts mentioned above can hold cash and various investments (mutual funds, ETFs, stocks, bonds etc) within them but the Account itself may be different along with its tax treatment. For example, a 401K account (with pre-tax dollars) may be invested partly in government bonds and partly in several mutual funds.

401K

Let’s start with the 401K account since this will likely be your first encounter with investment accounts via your employer. These are employer specific accounts that allow employees to contribute pre-tax money towards retirement. These are called “tax-deferred” accounts also since taxes are paid on withdrawals “later” after retirement age. These accounts have a pre-specified list of mutual funds that employee can choose from as investments. These investments grow tax free until the withdrawals are made in retirement and are considered ordinary income. Since contributions to these accounts are not taxed, these reduce your taxable income. IRS sets a limit on how much can be contributed pre-tax into these accounts each year. ($19,500 for 2021)

Since most employers want to encourage their employees to save for retirement, they have a match program wherein if the employee contributes to his/her 401K, the employer also matches these contributions as per a pre-defined criterion. (For example, Employer A may match 50% of employee contributions up to USD 5000. So, if the employee contributes 10000, employer will contribute 5000 in this case!)

401K vesting: Many employers have a “vesting” schedule for the money the “employer” contributes towards an employee 401K. What this means is that although the money was contributed by the employer, it will not belong to the employee unless the vesting terms are met. Many times, the vesting is simply a minimum time period served, for example 2 or 3 years and once employee completes this period with the firm, he owns the employer contributed funds. But at others there may be more complex vesting schedules (like rolling, graded etc). One must read the 401K plan details of his/her employer to understand the vesting details.

401K Roth: Some employers offer the “Roth” option as well in 401K accounts. This is “post tax” contributions that you can put in now instead of pre-tax that will then grow tax free. If you expect to be making large income in your retirement years, thereby having a higher expected tax bracket Roth option may be suitable for you. One can also split the contribution to both Tax-deferred and Roth buckets.

401K Post tax: Few employers also allow employees to make Post-tax contributions to 401K account. Please note that this is not the same as Roth option, since in this bucket the contribution in not taxable but any growth will be taxable income. But an IRS conversion provision (google - Roth mega-backdoor!) allows people to convert this after-tax contribution into Roth accounts that can then grow tax-free! (paying taxes on any growth) Total 401k contributions for a year (including pre-tax, post-tax and employer contributions) are limited by IRS to a pre-defined limit. (For 2021, it is $58,000)

Traditional IRA:

This is a tax-deferred retirement account to which people can contribute outside of employer plans. (max $6000 for 2021) But to be able to contribute and deduct this amount from taxable income, one must have income (AGI) within IRS defined limits. In 2021, for married filing jointly the limit is 105,000 after which you cannot deduct the whole amount and beyond 125,000 you cannot deduct anything. For single filers the same limits are 66,000/76,000. If your adjusted gross income (it is actually Modified Adjusted Gross Income — that is different from your gross income, falls within these amounts, you can take benefit of these deductions and contribute to traditional IRA accounts. Please note that withdrawals from these accounts are subject to restrictions like a 401K account and there will be penalty for withdrawals before retirement age). Like 401K accounts, the money and the earnings on it are taxed when making withdrawals in retirement.

Since these income limits are pretty low, contributions to traditional IRA may not be sensible for a lot of us. (except for the Roth conversion contributions that I will talk about while discussing Roth accounts)

Roth-IRA:

Roth-IRA accounts are for making after-tax contributions that will then go tax-free forever. These accounts also offer more flexibility since they allow withdrawing the contributed principal anytime. Any growth can be withdrawn after turning 59.5 or for some qualified exemptions.

I believe that Roth IRAs are the best investment vehicles available in US given the enormous benefit of contributed money growing tax free indefinitely! These are also flexible in that they do not have Required minimum distributions in retirement. (in case you are still earning and don’t need to withdraw)

There are income (MAGI) limits for being able to contribute into these accounts as well. In 2021, for married filing jointly the limit is 198,000 after which you cannot contribute the whole amount and beyond 207,000 you cannot contribute anything. For single filers the same limits are 124,000/139,000. (Please check latest limits on IRS website.)

Maximum contribution is 6000 for 2021. Please note that this limit is the combined limit for both traditional and Roth IRAs. This limit is per person in that both you and your spouse can contribute 6000 separately.

If the combined MAGI for you and your spouse is more than 198,000 and you cannot contribute full amount to Roth-IRA, there is still an IRS provision that allows people to contribute maximum to Roth IRA. This is known as Roth conversion, wherein you first make a non-deductible contribution to a traditional IRA and then convert it to a Roth IRA. (google — Roth backdoor) But there are special tax implications if you do this and you should read about it in detail before doing such a conversion. US Congress may also eliminate this option in the future, but as of now (Dec, 2021) it is available.

529 Accounts:

These accounts are only relevant for people with kids or if you or your spouse want to study in future. Essentially these allow post-tax money to be deposited into these accounts like Roth-IRAs and then allows this money to grow tax-free indefinitely. The only catch is that the money can only be used to pay for qualified education expenses. Since the cost of college education is US is very steep and is expected to continue increasing, funding future college expenses for your kids is not a trivial matter. 529 accounts (if given enough time for money to grow) can greatly help in this matter.

These plans are administered by states, but you are not restricted to the plan of the state you live in. Depending upon whether your state’s 529 plan offers any deduction in your state income taxes and the quality of funds available/fees associated with it, one can choose these plans.

Health Savings Account:

An HSA allows you to save money pre-tax to pay for qualified medical expenses. This money does not expire year to year like FSAs. This account is truly exempt from all taxes (EEE!) if the funds are used towards qualified medical expenses. Contribution is tax exempt and any growth (capital gain and dividends/interest) is also tax exempt. One should of course invest these funds and not let them sit as cash in the account. Most providers offer a brokerage account that can live within your health savings account and allow you to invest.

Taxable Brokerage Account:

This is the normal taxable brokerage account where all money that you cannot place in other tax advantaged vehicles will land up (if you want to invest it). Here all realized gains (short/long term), dividends and interest earned is added to your income for taxation every year.

Well now you understand more than most folks do about the types of investment accounts available in US! You may now ask, how do I actually create an Investment Portfolio using this information for an ideal tax efficient setup? Well that would require some more investment of your time and if you are interested, you can go through this story here where I have discussed the process in some detail. (Please be warned — this is a long story! But it will likely answer most questions about putting into action a long term investment portfolio.)

Another simple but powerful tool for building wealth is to start tracking your net-worth. See why here!