In future weeks, we will be going through different types of investment accounts and the different types of investments that can be held within them. For example, we will explore the difference between a Roth IRA and a Traditional IRA, the difference between stocks and mutual funds, and more. Before we begin to explore these things, it is important to understand the difference between an account and the investments held within it.
From my experience, the difference between the account type and the investments owned within the account seems to be a common source of confusion. For example, I’ve heard people say some version of, “I want to invest in a Roth IRA.” What they really mean is, “I want to open a Roth IRA and put money into it, and then invest that cash in mutual funds, stock, bonds, etc.” Making the distinction clear between the account type and the types of investments held within the account is important and will lay the foundation for future discussions.
This post is mostly addressing a typical investment account setup – an account opened at a custodian and/or broker-dealer. With certain other types of investments, such as insurance products (annuities and whole life insurance), the distinction between the account and investments is not as straightforward.
Different account types
There are many different types of investment accounts. The simplest and most straightforward is just a taxable investment account – anyone can open a taxable investment account and there are minimal rules and restrictions, but all income (dividends, interest, capital gains) is taxable.
There are other types of accounts that have special tax treatment and other rules that are meant to incentivize certain behavior – saving for retirement, education, and health care expenses. Some of these accounts can be opened by individuals, such as: a Roth IRA, traditional IRA, 529, health savings account (HSA). Others are set up through businesses, such as: a SEP IRA, Individual 401k, SIMPLE IRA, 401k, 403b.
An account is not an “investment” in and of itself, it is simply a vehicle with certain rules (tax and otherwise) that can be used to house investments. The rules associated with an account will impact who can contribute, when they can contribute, how much they can contribute, what tax breaks they get for contributing, when withdrawals can be taken, tax treatment of withdrawals, and more. However, the investments themselves will determine the returns of the account and its volatility (amount and severity of ups and downs).
As we explore the different account types in future weeks, it will be important to understand at least the basics of income taxes, because a lot of the accounts receive special tax treatment. If you haven’t read last week’s post, Basics of Federal Income Taxes, it lays a good foundation that will be helpful for these future discussions.
Different investment holding types
As mentioned above, within an investment account are different individual investment holdings. These holdings, which can also be called “securities,” can include: stocks, bonds, mutual funds, and exchange traded funds (ETFs). Different types of holdings have different characteristics. For example, stocks are fractional ownership of a company and allow the investor to participate in the company’s growth. Bonds, on the other hand, are loans made to companies or governments, and entitle the owner to receive interest payments and a return of the original amount that was lent. The investment holdings, not the account type, will determine the returns of the portfolio and its volatility (amount and severity of ups and downs).
Examples of different account types with different investment holdings
Below are some visual examples of different types of investment accounts with different investment holdings within them. Remember, the account has its own rules and tax treatment and the investments are held within the account.
The examples show:
Shares of stock within a taxable investment account
Mutual funds within a 401k
Exchange traded funds (ETFs) within a Roth IRA
A combination of different securities within a traditional IRA
Investing strategically with asset location
Because the investment holdings are separate from the type of account, there can be opportunities to strategically put certain assets in certain types of accounts, so that the entire portfolio is more tax efficient, while being appropriately invested. This may be a topic for a future post, as it can get nuanced and there are competing factors that can impact asset location decisions. Regardless, a quick example of strategically placing assets would be: buying bonds in a tax-deferred retirement account because bond interest is otherwise fully taxable and buying stocks in a taxable investment account because capital gains and qualified dividends get special, reduced tax treatment.
Investing with asset location in mind is an interesting example of one of the strategies that is possible when we clearly understand the differences between account types, investment types, and their respective tax treatments.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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