Investment Account Types

Before we begin investing, we need to establish a goal, because different goals require different account types. Think of accounts as the boxes into which you put your investments. One can save for retirement in an account designed to defer taxes until later in life. These are called pre-tax accounts and they allow us to make investment returns on money we would have otherwise paid in taxes. However, if you may need some of that money before retirement time, you may want to choose an account without tax deferral. This is called an after-tax account. Below are some common account types and purposes they serve.

Pre-Tax Accounts

Employer-Sponsored 

If your employer is a Hospital or Education Institution (governmental) you may have the following types of pre-tax accounts available to you:

  • 403(b) Tax Deferred Annuity
  • 457(b) Deferred Compensation
  • 401(k) Retirement Savings Plan
  • 401(a) Pension (may be defined contribution or defined benefit with/or without a participatory contribution)

If your employer is private, you may have:

  • 401K Plan with matching contribution and possibly profit sharing
  • Very old, large employers may also have a defined benefit pension plan

A small employer may have:

  • Simplified Employee Pension (SEP) IRA
  • Savings Incentive Match for People (SIMPLE)
  • Single K – for sole proprietors with only family as employees

An Individual may establish:

  • A Traditional IRA (This can be with new contributions, or a rollover of an employer sponsored plan)

What all the accounts above have in common are that:

  1. Contributions by individuals and employers into the proper accounts are made before taxes are deducted. Payroll taxes (like Social Security, Medicare Tax are deducted), but not Federal or State income taxes. 
  2. There are no taxes on any money contributed to, or moved between, the above Plans until the money is received by the account holder as a distribution. 
  3. This allows the employee to save more money faster, because one gets to invest what one would have otherwise paid in taxes. 
  4. Beneficiaries are named to receive the assets in the event the account holder dies. A living primary beneficiary would inherit before a contingent beneficiary.
  5. With the exception of the 457(b) Plan, all the above accounts charge a 10% penalty for withdrawal prior to age 59.5. That is, 10% over and above the ordinary income tax one must pay on normal withdrawals. On the ROTH IRA, this only applies to gains made, not the original contributions.

Each Plan type has contribution and money movement rules associated with it, so look before you leap. 

ROTH Contributions to Employer-sponsored Plans

Many employers make ROTH (After-Tax) contributions available in their 401K, 403(b) and 457(b) Plans. Highly compensated individuals may find that they cannot contribute to a ROTH IRA, but they may still want to make after-tax contributions to a tax-deferred retirement plan, and so they may wish to take advantage of their Employer Sponsored Plan with a ROTH feature. ROTH Employer Sponsored Plans can be consolidated into ROTH IRAs when one leaves the employer.

Generally, non-highly compensated employees are better off saving using the pre-tax contribution sources than the ROTH feature, because they can invest more money and have more money in their pocket each payday.

ROTH IRAs 

A ROTH is a type of IRA made with after-tax dollars. It grows tax free (no capital gains tax) and the distributions after age 59.5 are not subject to income tax either. This makes ROTHs the ideal vehicle for someone who wishes to establish a portfolio with a really long time-horizon. Distributions from inherited ROTHs are also tax free to beneficiaries inheriting them. 

The rules governing how much one can earn in salary and still contribute to a ROTH IRA change every year. Each year the Internal Revenue Service (IRS) publishes phase out contribution tables for individuals and couples filing jointly. The amount one can contribute to a ROTH is the same as for any other IRA, and this may change from year to year as well.

Please remember that IRA contributions cannot exceed the annual maximum for all IRA plan types. For example, let’s assume the maximum contribution for a person over age 50 is $7,000. One can divide the maximum contribution between a pre-tax traditional IRA and a ROTH IRA, but the total contribution to all plan types cannot exceed $7,000.

One can always withdraw one’s own after-tax contribution to a ROTH IRA, but the investment gains cannot be withdrawn before age 59.5, assuming the account has existed for at least five years.

Unless you are a highly compensated employee as defined by the IRS, you are likely better off contributing pre-tax dollars to your employer sponsored plan and starting a ROTH IRA on your own if you wish to make additional, after-tax investments.

Beneficiary IRA

If you inherit pre-tax accounts, you can consolidate these into a Beneficiary IRA. Also called an IRA-Beneficiary Distribution Account (IRA-BDA). Tax treatment of inherited pre-tax accounts depends on:

  1. Who you are:
    1. Spouse – can establish a spousal beneficiary IRA or incorporate to their own IRA.
      1. A Spousal Beneficiary IRA will not allow the spouse to add contributions to the IRA, but distributions can be made at any time without incurring a 10% penalty for early withdrawal. This is especially useful for spouses who are under age 59.5. Distributions are considered income for State and Federal Taxes purposes in the year received.
      2. If the Spouse wishes to consolidate the deceased spouse’s pre-tax assets with their own, they can. All the rules associated with surviving spouse’s IRA will apply. That means no penalty free distributions until age 59.5.
    2. Non-Spouse person (Child, Sibling or any other person)
      1. Must establish a Beneficiary IRA
      2. Contributions cannot be made to the Beneficiary IRA, but consolidations of several pre-tax accounts of the deceased individual can be consolidated into one Beneficiary IRA per beneficiary.
  2. When you inherited the account
    1. Before 2020 – Non-spouse can use life-time distribution rule
    2. 2020 or After – Non-spouse must take all distributions by the end of 10th year after the death of the original account holder. Distributions from pre-tax accounts will be considered income to the beneficiary in the year the distribution is made.
    3. ROTH IRAs can also be inherited and follow the same distribution rules. ROTH distributions are tax free to the beneficiary.

After-Tax Accounts (also known as “Retail” Accounts)

An after-tax account is different than a pre-tax retirement account. Pre-tax retirement accounts whether individual or employer-sponsored, require the account holder to name a beneficiary in the event of the account holder’s death. The same is not true for after-tax accounts. 

After tax accounts also move differently than pre-tax accounts. A person can move money from their IRA to their employer-sponsored retirement plan and vice-versa assuming the individual has met the money movement requirements of the particular employer-sponsored plan (generally either age 59.5 for in-service distributions, or severance of employment). After-tax accounts can be consolidated from brokerage house to brokerage house only when the registration between accounts is exactly the same. 

The operative word here is “exactly.” If one brokerage house used an Individual account and the account holder wants to consolidate to a joint account at the receiving brokerage house, the account holder will first need to establish an Individual account at the receiving brokerage, then journal the assets to the Joint account once they arrive in the Individual account at the receiving brokerage house. If a woman used her maiden name for her middle initial at the first brokerage house, and the receiving brokerage house uses her given middle name for the middle initial, the accounts are considered different. In this case, the client will sign a one-in-the-same letter using both versions of the name.

Below is a list of account registration types.

Individual Account – this registration allows only the individual named as the account holder to transact business on behalf of this account. The individual can transfer trading authority to professional portfolio manager making the individual account a discretionary account, but the movement of money into and out of the account is still completely controlled by the account holder.

Individual Transfer on Death (TOD) – Like the Individual account above the account holder controls all aspects of this account during their lifetime. This account is established with instructions for the disposal of account assets to a beneficiary upon the death of the account holder. Because the TOD beneficiary did not have access to the account during the account holder’s lifetime, the full value of the account will step-up to the market value upon the account holder’s death. If the TOD beneficiary wishes to receive cash or realign the assets in the account to their own purposes, they may wish to do so sooner than later to avoid a capital gains windfall.

Joint with Rights of Survivorship (JTWROS) – This is the most common type of after-tax account for married couples. Both members of the couple are equal owners of the assets inside this account. Both have equal rights to transact account business (contribute, trade, distribute) assets without the express approval of the other. This comes in handy if one member of the couple becomes incapacitated and cannot transact business, then the other can step in. If one member of the couple dies, the survivor inherits the assets of the deceased. In this case, the half that represents the deceased person’s half would have a cost basis that is stepped-up to the market value on the date of death.

Joint, Tenants in Common – This kind of account may be used by business partners. One partner may have a greater share of the account than the other partner. For example, a 60%, 40% split. Each partner’s share is wholly owned by that partner. In this type of account, the partners should be calling the advisor when they are together to deliver trade instructions, so both can demonstrate agreement with the arrangements in real time. Unlike the JTWROS, the percentage share of each tenant can be passed by will to anyone the tenant wishes to name. 

Joint with Rights of Survivorship and Transfer on Death (JTWROS/TOD) – This account is a favorite of couples with children and a very simple Last Will and Testament. The account acts as a JTWROS while both joint tenants survive. If one were to die, the whole account is inherited by the survivor and half the cost basis is stepped up. (I would encourage the survivor to establish some type of Individual account at this point.)

What is unique about the JTWROS/TOD account happens it both the joint accountholders were to die at the same time. Then the account will be distributed to the TOD beneficiaries as described on the TOD Beneficiary Designation form. Like the Individual TOD account, this will transfer regardless of what a Last Will and Testament might prescribe.

Section 529 College Savings Accounts

Nearly every state in the Union offers a 529 College Savings account. Some states even offer contributors tax incentives to make contributions to that state’s 529 within certain income ranges. Some states will also tax the investment proceeds of another state’s 529 if a resident of that state uses the other state’s 529 to pay for college expenses. So, check your state’s rules before you set up a plan for your child.

Section 529 Plans are used exclusively to pay for college expenses. Generally, it does not matter if the child wishes to attend a public or private college or university. Under the IRS rules for Section 529, individuals can set aside after-tax dollars that will grow tax-free and be distributed tax-free as long as the contributions and proceeds are used to fund accredited college or University expenses. These include tuition, room, board, books and supplies. The account holder must match withdrawals from the 529 to qualified educational expenses each year in order to receive the tax exemption.

If distributions are used for some other purpose than qualified educational expenses, the withdrawals are taxed as any other investment, plus there is a 10% excise tax. This was added to prevent people from over-funding the 529 and using the proceeds for another purpose.

No blood relationship required: Account holders, contributors and beneficiaries do not have to be related. One can set up or contribute to a co-worker’s child’s 529 Plan.

One beneficiary per account: The account holder establishes the account on behalf of a future student (beneficiary). There is only beneficiary per account, but the primary account holder can name a successor to hold the account for the beneficiary’s benefit in the event of their death.

Scholarship and Re-purposing: If a child were to win a scholarship, the account holder can either take a tax-free withdrawal equal to the scholarship amount, or re-purpose the 529 for another beneficiary. For example, a pair of grandparents establish 529 accounts for each of their five grandchildren. The first grandchild receives a full scholarship, so the grandparents re-apportion the sum in the first grandchild’s account to the other four grandchildren. 

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