The Landscape of Investment Accounts

It’s easy to become confused by the array of different investment options, such as pre-tax and post-tax accounts. Are there optimal periods to open, contribute to, and withdraw from them? Even the terms pre-tax, tax-deferred, and tax-free may not crystalize into a clear picture. While we regularly advise on and manage these strategic decisions for our clients, having a base familiarity with these investment vehicles and techniques is often helpful. 

Considering different account types can feel like selecting the right tool from a Swiss Army Knife or Leatherman. Like a multi-tool with its many implements – some of which are common and familiar while others are more obscure and rarely used – you may not be acquainted with all types of accounts. Just as a multi-tool offers a range of functions, different investment accounts have unique features tailored to diverse financial needs, goals, and timing.

The most common method to save for the future is to defer a portion of your regular paycheck and contribute to a pre-tax savings account through your employer, like a 401k or 403b. These contributions will reduce your taxable income in the current year and can grow savings for the future. Most companies in the US offer 401k and 403b plans for their employees to contribute retirement savings. Their purpose is akin to multi-tool pliers, used quite often and with varied functionality. 

A common feature in these plans is the ability for employers to match employee contributions up to a certain amount, providing a helpful boost to retirement savings and an incentive to contribute. Some 401k plans also allow for loans and penalty-free early withdrawals in certain cases, including buying your first home. Beyond this basic landscape, more advanced savings options can be explored using a Roth 401k if your employer provides that option, or Solo 401k or SEP IRA when you are self-employed. 

Flash-forward to when you need to start taking distributions from these accounts, typically during retirement, and any dollars taken out become taxable income in the year they are withdrawn. With good planning, you are able to make deductible contributions when your tax rates are higher, and then withdraw funds in retirement when tax rates are lower.  

Beyond employer sponsored retirement accounts, many people have their own Individual Retirement Accounts (IRAs) that offer similar tax protection with greater flexibility and control. These accounts allow your savings to grow on a tax-deferred basis, though eventually, the IRS does require you to take the funds out and pay taxes. These Required Minimum Distributions (RMDs) begin once you reach a specific age, which has crept higher over time and currently stands at age 73. 

One of the primary benefits of IRAs is to consolidate old employer retirement accounts, commonly referred to as a rollover. This provides a simple way to keep track of retirement savings from prior jobs. These buckets of savings need to stay invested until your retirement because most early distributions from IRAs come with a 10% penalty before age 59 ½, in addition to the income taxes you’ll pay on the withdrawal.   

Roth IRAs are similar but different. The main difference is that Roth IRAs are funded with after-tax money, and their earnings grow tax-free. Like Traditional IRAs, there are rules about when you can take funds out of a Roth, but unlike Traditional IRAs, there are no RMDs required during the account holder’s lifetime. Funding a Roth IRA creates diversification between pre-tax and post-tax assets, giving you more control and the ability to manage taxes. In addition, Roth IRAs are a great way to create legacy bequests that are tax-free for your heirs.

For investment savings that aren’t allocated to retirement, the most common option is a taxable brokerage account. Rather than being tax-sheltered until retirement in a 401k or IRA, these accounts are subject to capital gains taxes each year, but are easily accessible if you need to use the money. Taxable accounts are an important part of a well-diversified portfolio to serve you over the long-term. 

One of the most common options for these accounts, particularly in California, is a trust account. In simple terms, a trust is a legal document creating a “wrapper” on an account governing who controls the assets – both during your life and afterward. The trust outlines your wishes for how to transfer your financial assets, as well as sentimental items, to your loved ones or charitable organizations. One key reason to establish a trust is to avoid probate in California, which can be an expensive and lengthy process.

Getting into the more specialized tools in your financial Swiss Army Knife, we find account types like 529 Education Accounts and Donor Advised Funds (DAFs). These accounts may not be relevant for all households, but they can provide significant tax and financial planning benefits in the right situations. 

A new child coming into the family generates joy and often sparks planning conversations with parents and grandparents alike. A 529 account can be opened by anyone and offers a powerful way to save and invest for future education. Within these accounts, distributions and investment growth are not taxed when used for qualified expenses such as tuition and materials. Planning for College with 529s, a recent article by Sam Wood-Bednarz, offers more detail about these accounts.  

Roth IRAs, which we touched on above, can also be a great option for gifting to those in their early earning years. One way to utilize this tool is to open and fund a Roth IRA for kids who are working and earning income, but may not have enough disposable income to contribute to one themselves. Roths are also wonderful legacy assets, since passing along a Roth IRA to your heirs means they are receiving an asset that is tax-free to them. For more detail, see our article Roth IRAs: Investing In Your Future by Matthew Gatt.  

Donor Advised Funds can be a powerful way to save for future charitable gifting while benefitting from the tax deduction now. Beyond the tax benefits, these accounts can also be a great tool for sharing your family’s values with the next generation and supporting causes and organizations that are important to you. For more detail, Daniel Smyth wrote an article titled Donor Advised Funds.

When you have various types of accounts, you have flexibility. Tax law changes over time, as do our own personal needs, and the timing is not always within our control. Our team at North Berkeley explores the various options with our clients, constructing a personalized landscape of account types based on their unique situations and goals. 

The future may take unexpected turns, but like readying for a hike or camping trip, packing the right tools ahead of time allows you to successfully navigate different situations. Utilizing the appropriate financial tools can enhance your overall financial security and success.