Where Should I Put My Savings? Different Types of Investment Accounts
Copyright 2006 Emma Snow
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.
Retirement Accounts
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.
Other Accounts
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.
About the author:
Emma Snow is a writer who specializes in financial planning. She
has worked in the financial industry for over eight years.
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