Understanding Investment Accounts: 401(k), IRA, HSA, and Taxable
I’ve talked before about what I invest in (index funds) and how to evaluate what investment is best for you. Today is about the accounts you use for buying these investments. There are mainly two types: tax-advantaged and taxable. There are a lot of nuances to this so I left out a lot; if you’re interested in learning more I’ve included some further resources at the bottom. In the meantime, let’s make understanding this stuff more transparent in one tidy blog article!
(Note: all of the following assumes you are a younger adult who is not self-employed. The rules are different for people who don’t fall under that umbrella, which I don’t discuss as that would make this much longer than it already is.)
Tax-Advantaged Investment Accounts
The difference between a taxable brokerage account and tax-advantaged accounts comes down to whether or not they help you owe less to the government in taxes. Tax-advantaged investment accounts let you invest money from your pay without getting taxed on it. That’s good to know in theory, with those tax savings boosting your net worth by thousands. Let’s make it simple and say you have a $10,000 paycheck for easy math. At a 25% tax rate, you’re getting $7,500 of that as your take-home pay. But if you have access to a 401(k) and an HSA like I do (both tax-advantaged accounts) then you’re ultimately keeping more money.
Here’s how:
Let’s say you put $1,000 of that pay into a tax-advantaged account, one that specifically lets you make pre-tax contributions. That means the tax rate only applies to $9,000 of your pay instead of the full $10,000. It leaves you with $250 extra! That only goes up if you’re like me and have a high-paying job; I can multiply these figures by 9 and see this can mean thousands on my end. It’s even better when you either increase your contributions or invest in more than one tax-advantaged account.
There are limits, however, to how much you can put into each account; not adding limits means people earning outrageous amounts suddenly don’t have to pay income tax on what they earn, so it’s a necessary rule. These limits are also subject to change depending on if the government decides to increase the limits. For example, the limit to contribute to an IRA has increased by $500 since I first opened one. It’s good to check in around the end of the year to see if you can contribute more, if your income allows.
Anyway, there are three types of tax-advantaged account I have here. I’ve personally got money growing in all three so I’ll walk through what each one is, how it benefits you, and how you can start investing with one.
401(k)
401(k) investment accounts are the best known, but are only accessible if your employer offers one. This amount of money goes tax-free into an investment account, where you then choose what to invest that money in (mine is in a fund that tracks the S&P 500). This account is meant to be used for retirement in your old age; unless you find a loophole, you’re not able to touch this money without penalty until you’re 59.5 years old. That’s not a typo, either – you have to be at least fifty-nine years and six months old to start withdrawing from this account. The limit is currently at $19,500. You don’t have to actually hit that $19,500 figure to use it; contribute however much you can to maximize your earnings.
How it works
Talk with your company’s HR or finance department about opening a 401(k) account. They will have a brokerage already for you to invest through and will provide all the paperwork you need to set one up. You’ll in all likelihood have to do your own research regarding what to invest your money in, as they do not automatically invest it for you. Don’t let your 401(k) contributions just sit there; INVEST! My current company sent me a packet explaining the 401(k) when I started working for them, amongst all the other paperwork I’d need. All I had to do was set things up in our online portal and boom, I could contribute with my very first paycheck.
A big hidden perk to this type of account is when your employer offers a 401(k) match! This means that, if you put in (let’s say) $1,000 into your account, the company will match that and put in another $1,000. That means an automatic 100% return on your investment and that is HUGE. Each company has different match rules so it’s worth it to see what those rules are. For example, some will offer a full match on one amount and then a partial match on a higher amount. There aren’t many who will match the full $19,500, if you manage to do that. But regardless of the amount you put in, remember two words with the match:
Free.
Money.
Don’t miss out and go get your extra dollars. 401(k) are the way to go!
IRA
This stands for “Individual Retirement Account” and, unlike a 401(k), any working adult is eligible for one. There’s only two requirements: you have to have taxable income, and you have to be younger than age 70.5 (again with the fractions, I see). Basically: as long as you’re a working stiff and not born in 1950, you’re in!! IRAs are, as it says on the tin, also meant for funding your old-age retirement. It’s another account where you can’t access the spoils until age 59-and-a-half.
Now here’s the curveball: there are TWO kinds of IRAs you can get. Which one is right for you depends on your income level, your tax situation, and where you expect to be in the future. Sounds complicated, but I promise it’s not in layman’s terms! The traditional IRA is best for people with high incomes or think they won’t be making as much money in the future. The Roth IRA is for those with lower incomes and/or think they’ll be making more money in the future. The future stuff is important because that future income might be different enough to put you in a different tax bracket. The two IRAs provide different tax advantages, and you should consider if you’d rather one or the other.
You won’t go wrong with either, but one is likely better for you.
The traditional lets you invest it pre-tax like a 401(k), but on the condition that you have to pay taxes when you start taking money (withdrawing) from it. You’re basically deciding to enjoy the tax advantages now instead of later. A Roth is the opposite: you have to use post-tax (ie paycheck) dollars to invest it, but then you can take money from it in the future tax-free. Better yet, your Roth investments also grow tax-free, giving you a double-advantage!
There are both contribution and income limits on these IRA options. You can only contribute (currently) $6,000 per year to either one or the other, and no more. Income-wise, you can only contribute to a Roth if your taxable income (as a single person) is less than $124,000. If you earn more than that (which I can only aspire to) a traditional IRA is your better bet.
How it works
It’s up to you to set up an IRA. The same brokerages that offer taxable accounts overwhelmingly offer IRA options as well. Check some of them out to see what’s right for you; out of the three brokerages I first looked at (Vanguard, Fidelity, and Charles Schwab) I chose Fidelity because I had heard they had the most user-friendly investment platform. Any of those three are good options; do your own research to see if there’s another brokerage out there you’d rather invest with or if you’re happy with one of these three. Then, go to their website or contact them to set up your IRA and start investing.
HSA
It’s funny because a health savings account (HSA) is a tax-advantaged investing account NOT for retirement. It’s meant for your future healthcare needs instead, with politicians choosing to give the high earners a lifeline instead of everyone. Ah, the joys of lobbying. /s
These HSAs come with THREE big tax advantages (which you might hear referred to as “triple tax advantage”).
- You are NOT taxed on the money you put in. It’s like a 401(k) in that you can make pre-tax contributions.
- You are NOT taxed on the growth of your investments.
- As long as it’s for medical-related expenses, you are NOT taxed on the money you take out of it
You can use your HSA at any point for the rest of your life; you don’t have to wait until you’re old to start using this, and you can take money out in the same year you contribute if you want to. The big thing is you can only do it if it’s for something medical. Paying for doctor’s appointments or prescriptions are fine. Paying for your trip to Malibu isn’t. If you want to use these expenses for something non-health-related, you either have to wait until you’re 65 and pay taxes on the withdrawal, or take it out and pay taxes on top of a 20% penalty.
So, y’know, there’s the rub.
HSAs might be the one available to the least amount of people, as you’re only eligible for one if you’re under a high deductible health insurance plan (HDHP). It’s also got the lowest limit, capping the amount you can put in per year at $3,550. But hey, if you max it out for three years you’ll have over $10,000 invested. And, if you’ve got then in index funds that historically grow at 10%, you’re making an extra thousand dollars each year without lifting a finger. That thousand is absolutely free of the tax code to boot. LET’S GO!!
How it works
If you’re getting your health insurance through work then your employer/HR department can help you get set up. In my experience, I had to jump through a few more hoops to open up an HSA. The investment options were a little stricter and the bank I had to use has some weird rules. Your mileage may vary.
Here’s some neat news: you can have all three types of investment accounts if you want! No need to only stick with one – as long as you’re eligible, they’re all open for you!
Taxable Accounts
Woohoo, looks like the government is encouraging investments by withholding investment taxes, right? Not so for a taxable account. This is an account you put your post-tax dollars into – i.e. taking out of that $7,500 instead of the $10,000. You’ll also get taxed on the investment growth; I have to fill out some extra forms every year now that my investments are more valuable than before.
It doesn’t help you avoid the tax goons, but it’s got its own advantages regardless in terms of flexibility. Because I’ve already paid the taxes for the money I’ve invested, I can take money from it without any penalties. If you become a high earner and want to invest a lot, taxable accounts are what you turn to after filling the tax-advantaged ones; your 401(k), IRA, and HSA have those pesky limits to how much you can put in. Bye-bye to not having to worry so much about taxes; the good news though is that investment taxes are kinder to your wallet than your run-of-the-mill income tax is.
In fact, the tax rates on a taxable account are very favorable when you’re using one to pay your expenses. As long as you’ve had money in there for more than a year you only need to pay a small rate.
That would be the long-term capital gains tax rate.
A wordy name, yes, but don’t let it scare you. It has different tiers depending on how much money you take from it; if you take over $144,000 from it, for example, you need to pay a 20% tax rate on that. Which is a better tax rate than anyone earning income over $40,000.
But it gets better: if you’re like me and live on less than $40,000 a year, the amount you take out is taxed at 0%. If I withdraw $30,000 for the rest of my life, I pay no taxes whatsoever on that amount. That is an absolute win if I ever need to rely on my investment to fund my lifestyle.
There aren’t different types of taxable investment accounts because they don’t have different rules. The only thing that makes a difference is what brokerage firm you decide to open your account with. Think of it like choosing which bank to open a savings account with: one bank might give you different account options than another, but they’re pretty much offering the same thing.
How it works
Like an IRA, you set up this account yourself. I’m going to recommend Vanguard and Fidelity again here as I’ve personally used both for investing and can vouch for having good experiences. Do your research before opening one and setting up how much you’re contributing and then investing.
More Investment Accounts Resources
If you want to learn more about any of these investment accounts, definitely do so. This is meant as a summary of these accounts to give you a basic idea and is by no means the be-all, end-all. There are some other excellent sites out there that explain in-depth; my favorites include:
- Investopedia – I’ve linked to their tax-advantaged accounts page here, but they are a goldmine of investing and other financial information
- MadFIentist – he’s best known in financial circles for his writeups on all kinds of tax optimizations. You’ll want to look at specifically his “Investing” and “Tax Avoidance” categories for information on investment accounts, but you can’t go wrong with the rest of his stuff.
- Nerdwallet – These guys are great at offering more overview of what’s available and out there. I end up on their site all the time and I learn something during each visit.
- JL Collins – I’m linking to his Stock Series here, which went viral thanks to how easy he makes it to understand investing. This is a need-to-know so you won’t just take my word for how to invest.
- Millennial Revolution – This link goes to their Investment Workshop. It’s more geared towards Canadians, but the information is invaluable even for Americans as they discuss what’s open to us south of the border too.
And there you have it! These are the four types of investment accounts I have and currently contribute to. You can start contributing to a taxable and an IRA right away if you so wish; check with your employer if you can add a 401(k) or an HSA to your portfolio as well. Remember to invest the money you put into your investment accounts instead of leaving it to sit there; you already know where I recommend you invest it. Happy savings!
Cover image: Ibrahim Boran via Unsplash