How Choosing the Best Investment Account Can Earn You Hundreds of Thousands of Extra Dollars
In addition to investing, the wealthy take advantage of tax breaks. And guess what? There are a crazy amount of tax breaks available to the average person too! Using the best investment account can help you earn hundreds of thousands of extra dollars over your lifetime. Usually, tax breaks have good intentions (i.e. to encourage a positive behavior). When loopholes are abused, it’s definitely an issue (and an article for another time). In this case, we’re going to use the tax breaks as they are intended – to encourage saving for retirement, education, or healthcare – and reap the benefits!
How Much Can the Best Investment Account Save Me?
We’ll take a look at benefits and considerations for account below, but first, let’s see how powerful they can be.
Michael and LeBron both work for the same company, which offers one of those “mysterious” 401k plans matching 50% of an employee’s contribution up to 6% of their pay. Michael and LeBron are the same age (23), earn the same salary (50k), have the same 22% tax rate, and invest the same $500/month (pre-tax) portion of their paycheck ($6,000/year) in the same stocks. The only difference between them is the account they use to invest.*
LeBron just invested his money in a regular investment account. When he gets paid, the $6,000 per year portion he was planning to invest gets taxed at 22%, leaving $4,680 to be invested. While his money grows, it will produce some dividends, which will also be taxed at 15%, before being reinvested.
Michael took advantage of his company’s 401k plan. As a result, all $6,000 per year is invested, since contributions are not taxed. His company also matches 50% of contributions, giving him an extra $3,000 per year to invest! That $9,000/year invested will also produce tax free dividends that can be fully reinvested.
Let’s see how they each do:
- By age 65, LeBron (red line on chart) will have contributed $258,000 (pre-tax) to investments, but ends up with $2,190,137. He still crushed it, thanks to the power of compound interest.
- By 65, Michael (blue line on chart) will have also contributed $258,000 to investments. However, thanks to the additional contributions from his employer and tax breaks that allow him to invest the full amount and let dividends grow tax free, he will ends up with a whopping $4,665,087! That’s over twice as much, despite doing everything else exactly the same, thanks to the power of compound interest and choosing the best account type.
What if your employer doesn’t offer a 401k plan? An IRA account offers similar tax benefits (minus the employer contribution piece). That’s the account Steph (green line on chart) used. All else being equal to Michael and LeBron, Steph still ended up with a nifty $3,110,058 when he turned 65.
Want to play around with your own numbers? Open this Google Sheet (Go to File > Make a Copy to have your own editable version) and update a few values (yellow cells) to see what happens.
What is An Investment Account?
An investment account is what you use to buy, sell, and hold your investments (i.e. stocks, index funds, mutual funds, etc.). There are a few different types of accounts (see below). You can open an investment account through an investment brokerage firm (i.e. TD Ameritrade, Fidelity, Charles Schwab, RobinHood, etc.). Most now offer no account fees, no minimums, and commission free trades. It’s very similar to how checking and savings accounts are used to hold cash and make deposits/withdrawals. You can have different types of accounts with one bank, or even multiple accounts with different banks. The accounts themselves each come with different considerations and benefits, but it’s what you put inside the account (i.e. cash, investments) that adds value.
Types of Investment Accounts
Click on each type, below, to expand and learn the most important things about the most common investment account types.
401kThis plan is offered through your employer. They will usually pair up with an investment brokerage firm and allow you to make automatic contributions from your paycheck each month.
- Benefits
- Many employers offer matching contributions like “50% up to 6% of your salary.” For example, if your salary is $50,000, they will provide a 50% match on whatever you contribute each year, up to $3,000 (6% of $50,000). This is basically free money!
- Your contributions come out of your paycheck before taxes do – meaning you don’t pay income taxes on whatever you contribute. Dividends you earn are also not taxed, boosting your return rate.
- You set your contribution amount and investment funds once, and everything else happens automatically, until you change it. This is a big psychological benefit – set it and forget it.
- Considerations
- A 401k is run through your employer, but not all companies offer them. Many large companies do for full-time positions.
- You can “only” contribute up to $19,500/year ($26,000/year if you’re over 50)
- You may be limited to a smaller list of stocks/mutual funds/index funds to choose from. Some funds or plans may also come with management fees.
- You usually need to work at the company a certain number of years to keep the portion your company matches. The amount you contribute (and gains from these contributions) are yours no matter how long you work there.
- If you withdraw your money before age 59.5, you may need to pay a 10% penalty (in addition to taxes). Although there are some notable exceptions.
- When you do withdraw money, it will be taxed as regular income.
- Once you hit age 72, you may be required to withdraw a minimum amount each year
Anyone who earned income from a job can contribute to an IRA account. Even if you didn’t earn money from a traditional job, you may still be able to contribute to one.
- Benefits
- Any amount you contribute can be deducted from your taxable income. This essentially means that, like 401k plans, you don’t pay taxes on whatever you contribute. Dividends you earn are also not taxed, boosting your return rate.
- Considerations
- If you withdraw your money before age 59.5, you may need to pay a 10% penalty, (in addition to taxes). Although, there are some notable exceptions.
- Each year, you can contribute up to $6,000 ($7,000 if you’re over 50) to either an IRA or Roth IRA.
- If you make more than a certain amount, you may be limited from contributing to an IRA. You may still qualify for a Roth IRA, which has higher limits. Also, keep in mind that it’s based on taxable income, not salary, so if you have tax deductions (like contributing to a 401k plan), you may still qualify.
- When you do withdraw money, it will be taxed as regular income.
- Once you hit age 72, you may be required to withdraw a minimum amount each year.
Like traditional IRAs, anyone who earned income from a job can contribute to an IRA account. Even if you didn’t earn money from a traditional job, you may still be able to contribute to one. The key difference is that you do still pay regular income taxes on any contributions, but when you withdraw the money in retirement, your withdrawals are not taxed. If you do a good job saving and investing, you’ll likely end up in a higher tax bracket when you retire, and investing with a Roth IRA will be more beneficial. They also offer a little more flexibility. Contributions can be withdrawn without penalty at any time, and there are no required minimum distributions (unless you pass it on as an inheritance).
- Benefits
- You avoid paying any taxes on any money you withdraw after age 59.5
- Contributions can be withdrawn at any point, tax free.
- Considerations
- If you withdraw investment gains before age 59.5, you may need to pay a penalty, in addition to taxes. Although, there are some notable exceptions.
- Each year, you can contribute up to $6,000 ($7,000 if you’re over 50) to either an IRA or Roth IRA.
- If you make more than a certain amount, you may be limited from contributing to an IRA. However, the income limits for contributing to a Roth IRA are higher than they are for a traditional IRA. Also, keep in mind that it’s based on taxable income, not salary, so if you have tax deductions, you may still qualify. If you haven’t maxed out your 401k plan yet, doing so (which reduces taxable income) may also help you qualify to make Roth IRA contributions!
With these plans, any earnings from investments are exempt from state and federal taxes, as long as they are used for education costs (college, K-12, or apprenticeship programs). Dividends earned are also not taxed, boosting your return rate. In some states contributions may also be deducted from state (but not federal) taxes. If the individual the plan’s name is in doesn’t use all the funds, they can transfer them to another beneficiary to use for education, with some limits (basically family members). More info can be found here.
HSAs exist to incentivize people to save for healthcare expenses. In order to be eligible, you need to be enrolled in a high deductible insurance plan. With HSAs, contributions, dividends, and withdrawals are tax free, as long as they are used for medical expenses. If you withdraw money for other reasons, you will pay taxes plus a 20% penalty. However, once you turn 65, the account functions like an IRA in that you can withdraw any amount you like without penalty. You will still need to pay taxes on earnings you withdraw, but in this case, like an IRA, your contributions are tax-free. Here’s a good article if you want to learn more.
Anyone can open and contribute to a regular investment account. There are no limits on what you can put into it and no limits on what you can take out. However, contributions are made from after tax income, dividends are taxed (even if reinvested), and you will also pay capital gains tax on any earned money when you sell your investments. As you can see in LeBron’s case (red line on chart above), investing in a regular account, despite these taxes, is usually still a good thing. But you may want to take advantage of the tax benefits from other accounts first.
Which Account Should I Use for My Investments?
Here’s another way to look at the different types of investment accounts. Pretend you’re at a store (investment brokerage firm) shopping for goods (investments). They give you 3 different types of bags (accounts) to purchase your goods. For the blue bag (401k account), any store brand items (pre-selected funds) that you can fit in the bag, you don’t have to pay sales tax and they will give you a gift card worth 50% of the value of the items in it (up to a limit). For the green bag (IRA), whatever you can fit in it (with a few exceptions) is tax free. Anything else you want to buy, of course, you can still put in your red bag (regular investment account), but pay full price. How would you allocate your goods/investments?
Before you even invest, I would first take care of high interest debt (except for mortgages and student loans). Then, I would put as much as I could in the 401k, at least to max out the employer match. You may be limited to what funds you can invest in, but hey – free money. After that, I would either keep filling up the 401k or a traditional/Roth IRA (more investment options and usually lower fees) to get the tax benefits. I generally prefer Roth IRAs since they offer more flexibility and if you do a good job investing, you’ll likely be in a higher tax bracket in retirement than when your working, so it makes more sense to pay taxes now and be able to withdraw tax free in the future.
If you have children and are saving for their education, I’d use a 529 plan for more tax savings. If you have a high deductible health plan and can invest with a Health Savings Account (HSA), that could offer tax savings too. And if you’re still looking to invest more after these, then I’d use a regular investment account.
Start Today
These accounts may sound intimidating, but really aren’t that difficult to set up. For a 401k, talk to your employer. For the rest, most investment brokerage companies offer the option to open accounts online and have customer service that will gladly guide you through the simple steps if you need assistance. Be sure to ask about reinvesting dividends and making contributions automatic. And as you can see, less than a couple hours of this administrative work now will pay off big time.
*Of course there’s a difference between them in real life – one is definitely a better basketball player than the other.
**Keep in mind, these values are not adjusted for inflation, so your spending power will likely be less, meaning you may want to contribute more to reach future spending goals. Based on recent rates, spending power halves about every 30 years.
