Building an investment portfolio is something that can help you to create wealth and work toward your most important long-term financial goals. There are several types of investment accounts you may want to consider to diversify your portfolio and achieve the growth you want.
At Addition Financial, we often give investment advice and talk to our valued members about their goals. Since we’ve been getting a lot of questions about various types of investments and their benefits, we decided to put together this guide to help you learn about the types of investments you can use to build a diversified investment portfolio. Here are four types of investment accounts you should know about to meet your investment objectives.
#1: Brokerage Accounts
The account that many of us think of when we consider investing is a brokerage account. Brokerage accounts may be opened by anybody over the age of 18 and there is no limit on the amount of money you can contribute or withdraw from your account. However, you should be aware that any gains you make on your investment strategy, including dividend stocks, are taxable.
The benefit of brokerage accounts is that you can use them to buy into a wide variety of investments, something that is essential if you want to mitigate investment risk by diversifying your portfolio. Some of the instruments you can buy with a traditional brokerage account include the following:
- Stocks, including common stock, preferred stock and all levels of market capitalization
- Bonds or bond funds
- Exchange traded funds (ETFs)
- Real Estate Investment Trusts (REITs)
- Mutual funds
If you opt for a brokerage account, you have the option of an individual taxable brokerage account or a joint taxable brokerage account. It might surprise you to learn that you may open a joint brokerage account with anybody. There is no limitation and that means non-married partners or even friends can open a joint account if they choose.
There are two basic types of brokerage accounts that you should know about:
A cash account is what most investors choose. As the name suggests, it operates on a cash investment basis. You contribute cash to the account and you and/or your broker decide which investments are best for your financial needs. You will then use the cash to buy the stocks or bonds you decide on.
Margin accounts differ from cash accounts in that they allow investors to borrow money from their brokers to make growth investments. These are riskier than cash investments because you're betting on the margin and the potential of losing money is higher than with regular purchases.
Whichever type of account you choose, you should regularly review your risk tolerance and adjust your investments as needed. It’s never a good investment decision to have more than 10% of your money in any one stock.
#2: Retirement Accounts
Retirement accounts may also be brokerage accounts but they come with an array of rules and restrictions that keep your money tied up – or attach penalties if you need to withdraw funds early. Let’s review some of the most common types of retirement accounts.
Your employer may offer a 401(k) account as part of your benefit package. If they do, then contributing to it as soon as possible is a must in our opinion. Many employers offer matching funds, so it makes sense to max out your contributions to take advantage of them.
As of 2021, the maximum contribution you may make to a 401(k) plan is $19,500. However, people over the age of 50 may make “catch up” contributions of an additional $6,500. Any withdrawal from a 401(k) before you reach the age of 59 ½ will require you to pay a 10% penalty when you file your taxes.
Most employer-sponsored 401(k) accounts are offered through brokerage firms. You can choose your asset allocation and change it as needed. If you do not have an employer-sponsored 401(k), you may want to consider opening a solo 401(k) account.
Individual Retirement Accounts, also known as IRAs, are popular for a reason. There are several different types and they can help you put pre-tax or post-tax dollars into an investment account to save for retirement. There are several types of IRAs you should know about:
The traditional IRA allows investors to contribute money on a tax-deferred basis. In other words, your contributions will not be taxed. That can allow you to reduce your taxable income now and potentially pay taxes in a lower tax bracket when you withdraw funds.
You should know that the annual total contribution limit for IRAs is $6,000 per individual or $7,000 if you are over the age 50. If you contribute more than the annual limit, you will pay a 6% penalty. While you may withdraw funds at any time, withdrawals before you reach 59 ½ years of age come with the same 10% penalty as 401(k) accounts. You should also know that if you buy a traditional IRA, you must begin taking withdrawals at age 72.
Unlike the 401(k) and the traditional IRA, contributions made to a Roth IRA are not tax deferred. You make post-tax contributions up to a limit of $6,000 (or $7,000 if you’re over the age of 50) and your investments grow tax free and withdrawals are tax free, as well. That means you can grow your money without worrying about taxation in the future.
Another thing that sets Roth IRAs apart from their traditional counterparts is the issue of withdrawals. There are no mandatory withdrawals from a Roth IRA. If you want to view a Roth as an investment vehicle to help you pass money on to your heirs, it may be the best investment option for you.
SEP and SIMPLE IRAs
A SEP IRA is a Simplified Employee Pension. Unlike other IRAs, contributions are made only by the employer. However, as the employee and owner of the investment account, you have control over your investments, asset allocation and withdrawals.
A SIMPLE IRA is a Savings Incentive Match Plan for Employees. Like a SEP IRA, the SIMPLE IRA mandates employer contributions. You may choose to contribute or not. If you do contribute, your employer is required to make a 3% matching contribution. If you do not contribute, your employer is still mandated to contribute 2% of your compensation each year.
If your employer offers a SIMPLE IRA, we suggest contributing unless you have already maxed out contributions to a traditional or Roth IRA, or you are already over your total contribution limit for the year for all investment accounts.
#3: Education Accounts
If you have children, you may opt for an education investment account to put away money for college. There are two basic types:
529 Savings Plan
529 plans come in two types but only one is an investment plan. (The other type is a 529 prepaid tuition plan that allows parents to buy credits at state colleges at the current price for students to redeem later.) Like Roth IRAs, contributions to 529 savings plans are post-tax and withdrawals are tax free if the money is used for its intended purpose.
Some states offer tax advantages for 529 contributions. For example, you may be able to deduct your contributions from your taxable income to reduce your state tax liability. You should know that the investments made with 529 funds are dictated by state law.
You may contribute up to the gift limitation each year. That’s $15,000 per individual and $30,000 per married couple.
Coverdell Education Savings Account
The Coverdell ESA differs from the 529 plan in significant ways. The first difference is that contributions are limited to $2,000 per year and and the second is that you may not contribute if your income is over $110,000 or $220,000 if married and filing taxes jointly.
That said, a Coverdell account offers you complete freedom to invest your contributions as you wish. There are no limitations or restrictions. The only other key restriction you should be aware of is that your child must withdraw funds by the age of 30 to avoid penalties.
#4: Investment Accounts for Kids
If you want to start investing on behalf of your child, but want the freedom to use the money for things other than college, you have two options:
Custodial Brokerage Account
A custodial brokerage account works just like a traditional brokerage account except that you will own the account until your child reaches the age of majority. In most states, that means 18, but there are exceptions.
There are two different types of custodial brokerage accounts. Uniform Gift to Minors Act (UGMA) accounts allow for the purchase of stocks, bonds, mutual funds and cash. Uniform Transfers to Minors Act (UTMA) accounts allow you to add real estate investments to the mix.
Laws governing UGMA and UTMA accounts differ from state to state. Keep in mind that any money in a custodial brokerage account will be considered your child’s property for the purposes of financial aid, so you should report their holdings and be prepared to use them for college expenses.
If your child has earned income, as many teenagers do, they are eligible to make contributions to either a traditional IRA or a Roth IRA. You will need to set up the account on their behalf and maintain it until they reach the age of majority in your state.
The same IRA contribution limits that apply to adult accounts apply here. Keep in mind that any income used to fund IRA contributions must be reported to the IRS, even if it is from a non-traditional job such as babysitting.
Opening an investment account is one of the best ways to allow your money to grow. The earlier you start investing, the more likely it is that you will have the money you need to fund your child’s education or enjoy a comfortable retirement.
Are you ready to open an investment account? Click here to read about Addition Financial’s IRA plans and open an account today!