Tax-Advantaged vs Taxable Accounts
Investing in the stock market may seem complicated, but all you really need are clear investment goals and the right mix of investment accounts to get started.
Let’s talk about the two main types of investment accounts: tax-advantaged accounts and taxable accounts.
Tax-Advantaged Accounts
Examples include:
401(k)
403(b)
Traditional/Roth IRAs
529 Plans
When you contribute to these accounts, you contribute pre-tax (with the exception of Roth IRAs, which are post-tax). This means you can subtract what you contribute from your total taxable income. You also don’t pay any taxes on the interest and earnings (Roth IRAs included). The downside? You’re not supposed to withdraw these funds until you turn 59.5. There are a few exceptions to this withdrawal timeline including using the money to purchase your first home and funding your child’s education.
If you have a 401k through work then you already have a tax-advantaged account. If you work for a small biz or company and don’t receive a 401k, don’t worry – you can still open up an individual retirement account, called an IRA, on your own, with similar tax-advantages.
Taxable Accounts
Examples include:
Brokerage accounts
Taxable accounts, or more often simply called brokerage accounts, are what most investors use to buy and sell securities like stocks, bonds, and mutual funds. Brokerage accounts don’t have the same restrictions on when/why/how you can access your money as tax-advantaged accounts do, meaning your money is accessible at any time without penalty.
Brokerage accounts are always funded with after-tax money and will get taxed at capital gains rates when there is a dividend distribution, you sell an investment, or make a withdrawal.
Now that you’re familiar with both tax-advantaged and taxable investment accounts (all of which are technically brokerage accounts), the question isn’t which one should you use, but how should you use each type to meet your near, mid, and long-term goals?
Near-term goals are everything you want to achieve in the next 3 years. Money for these goals should (typically) be kept in cash, a high-yield saving account so that it is easily accessible when you need it.
Mid-term goals are everything you want to accomplish in 3-7 years. Most of this money should be invested to take advantage of the power of compounding interest. This is where taxable brokerage accounts come in.
Long-term goals are everything you want to accomplish in 7+ years. All of this money absolutely needs to be invested, and this is where tax-advantaged accounts fit into your investing plan.
To summarize…
Ready to invest?
The first step to opening an investment account is deciding which brokerage firm you want to hold your account. Brokerage firms act as the middle-man between you and your investments. These are financial institutions like big banks, discount brokers, and robo advisors.
Once you’ve landed on a brokerage firm, setting up your account online should take just a few minutes. Our final tip? Set up monthly automations (no matter how big or small) and watch your investment grow.
Still feel like there is a lot you need to learn about investing in the stock market?
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