After you get your first full-time job, you get hit with a benefits package, and you look through them and wonder what is a four-oh-wunk? After learning what that finally is, then you get hit with the ROTH? What is an IRA? Was this something we should’ve learned in college?
We certainly did not know what these are until the end of our college careers when we were applying for jobs.
After being “adults” for some time, here is our breakdown of different investment accounts that you can contribute toward with your pre-tax AND post-tax income (not financial advice!)
Quick note about pre-tax and post-tax income
Pre-tax income refers to income that has not been taxed yet on your paycheck. For example, if you make $3,000 per month, this would be your pre-tax money.
On the other hand, post-tax means the opposite; it refers to money that has already been taxed. For example, your $3,000 in reality is actually lower because some of it already went into paying for taxes, and the leftover is your post-tax money (or net income).
Taxable Account
This is the simplest and most flexible investment account that you can open. You can buy/sell stocks, ETFs, bonds, etc. once you open this account with little to no restrictions. Both the GF and I have taxable accounts! I usually contribute to this account heavily after maxing out my Roth IRA. If you’re wondering *WTF* is a Roth IRA, then keep reading 🙂
Because of how simple it is, most people would have at least 1 taxable account in combination with their retirement accounts. If you’re wondering what’s better about this account compared to others, don’t worry because we have a summary table at the end of this post!
Retirement Accounts
Retirement accounts are special investment accounts that provide you with tax benefits, mainly in the form of tax deferment (contribute to your account with pre-tax money) or of tax-free investment growth (your investment gains will not be taxed when you withdraw).
I have both a traditional 401k and a Roth IRA account, although I’ve recently decided to not contribute to my 401k anymore (the reason will be given in another post) and only focus on my Roth IRA and my taxable account.
Traditional 401k
Traditional 401k is provided by your company. In other words, you would probably don’t have access to a 401k plan unless your company offers it. This is a well-known investment account due to its tax break benefit and its sweet matching program (depends on the company).
What usually happens is that you’d have a portion of your paycheck automatically deducted and invested, pretty much a set-and-forget approach.
Roth 401k
Another type of 401k account is a Roth 401k account. This is similar to a traditional in many ways, but the main difference is that you have to use post-tax income to contribute to the account, meaning you can’t deduct it from your taxable income. However, your investment will be able to grow tax-free!
Traditional IRA
Similar to traditional 401k in many ways, a traditional IRA is a retirement account with a tax break benefit. Unlike 401k, you can open IRA accounts without going through your company! Another difference is that the contribution limit is $6,000, which is much lower than the $20,500 limit of a 401k.
Roth IRA
A Roth IRA differs from the traditional IRA in the sense that even though you have to use post-tax money to contribute to your account, your investment can grow tax-free!
Another plus for this account is that you can actually withdraw your contribution, not your gains, at any time you like without fear of penalty or being taxed, and you don’t have to wait until you’re 59.5! This, to me, is what makes the Roth IRA so much more flexible and powerful than other retirement accounts, especially if I want to stop working in my 30s 🙂
Imagine your dividends are at a high enough level for you to stop working, but you can’t because you’re not old enough, yet. Similar to you acquiring legendary gear in a game but your level is too low to equip the gear…
| Type | Pros | Cons |
|---|---|---|
| Taxable Account | -Wide range of investments to choose from -No contribution limit! -Withdraw your money at any time! | -Investment gains will be taxed! -Your contribution is not tax-deductible, meaning you’d have to use post-tax money to contribute |
| Traditional 401k | -Contribution is made with pre-tax money, meaning you can deduct your contribution on your taxable income -Company matching, where your employer will also contribute to your account to match your contribution (up to a certain amount, of course) | -Limited investments to choose from (depends on the broker your company uses) -Annual contribution limit of $20,500 for 2022 -Can’t withdraw before you’re 59.5 (unless you wanna get hit with penalties, taxes, and a side dose of crappy feeling) -You are required to start withdrawing at age 72 Your withdrawal will be taxed |
| Roth 401k | -Your withdrawal will not get taxed if you withdraw after age 59.5 -Company matching might be available | -Contribution is made with post-tax money -Limited investments to choose from -Annual contribution limit of $20,500 for 2022 -Can’t withdraw before you’re 59.5 -You are required to start withdrawing at age 72 |
| Traditional IRA | -Contribution is made with pre-tax money | -Annual contribution limit of $6,000 for 2022 -Can’t withdraw before you’re 59.5 -You are required to start withdrawing at age 72 -Your withdrawal will be taxed |
| Roth IRA | -Your withdrawal will not get taxed if you withdraw after age 59.5 -No mandatory withdrawal! -You can withdraw your contribution, not your gains, at any time without penalty or tax | -Contribution is made with post-tax money -Annual contribution limit of $6,000 for 2022 -Can’t withdraw your gains before you’re 59.5 -There are income restrictions: if you’re single and make $129,000 – $144,000, you can contribute a limited amount; for married couples, it would be $204,000 – $214,000. Anything above this limit, you won’t be able to contribute at all |
| Type | Contribution Limit | Requirements |
|---|---|---|
| Taxable Account | No limit! | -Age 18 and up -Have some forms of identification (e.g. Social Security Number) |
| Traditional 401k | -Annual limit of $20,500 for 2022 -People over 50 years old can make an additional catch-up contribution of $6,500 | -Your company offers a retirement plan that includes 401k -Age 18 and up -Have some forms of identification (e.g. Social Security Number) |
| Roth 401k | -Annual limit of $20,500 for 2022 -People over 50 years old can make an additional catch-up contribution of $6,500 | -Your company offers a retirement plan that includes 401k -Age 18 and up -Have some forms of identification (e.g. Social Security Number) |
| Traditional IRA | -Annual limit of $6,000 for 2022 -People over 50 years old can make an additional catch-up contribution of $1,000 | -Age 18 and up -Have some forms of identification (e.g. Social Security Number) |
| Roth IRA | -Annual limit of $6,000 for 2022 -People over 50 years old can make an additional catch-up contribution of $1,000 | -Age 18 and up -Have some forms of identification (e.g. Social Security Number) |
Others
There are also other types of accounts that you can choose from. For example, you can open a 529 College Saving Account. It works similar to a Roth IRA account, in which you contribute your after-tax money. Your withdrawal is tax-free if used for qualified higher education expenses.
Another type of account is a Health Saving Account (HSA). You’ll typically have access to this if you have a high-deductible health insurance plan. The nice thing about HSA is that 1) your contribution is tax-deductible 2) your investment can grow tax-free and 3) your withdrawal is tax-free as well if used for qualified medical expenses.
Bottom Line
And that’s a wrap to this post! Hopefully, by the time you finish reading this, you’d have a better understanding of the different types of investment accounts and which one would fit you best. In our case, we have a mix of 401k, Roth IRA, and taxable accounts, but this does not mean that it’s the best combination out there (do your own research). One thing we know for sure is that as soon as you are able to, shop around and start your investing journey!