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Investment accounts: What they are and how to use them for wealth accumulation

At a glance:

Investments such as stocks, bonds, mutual funds, and the like are the vehicles in which we invest our money with the anticipation of accumulating wealth. To make them work, we need to have accounts for them.

There are accounts for many uses and purposes beyond just saving money—many of these accounts are used to save up funds for retirement. Others are for education. Some are in the form of trusts. Having an account with a purpose in mind can help you set goals for funding.

Brokerage accounts

To buy and sell most kinds of investment instruments, you will need the help of a broker or investment advisor. Brokers can help you execute buy orders and sell orders for your account.

Investment advisors can help manage your entire portfolio. The degree of service you receive from your broker or investment advisor will also influence how much you pay for the help and advice.

The most common type of brokerage account is the cash account. Cash accounts are trading accounts in which the investor pays fully for all securities purchased. In other words, the investor cannot borrow funds from the broker-dealer to purchase securities.

Setting up a cash account

In order to establish a cash account, the investor must provide basic personal information, including his or her name, address, and phone number, a tax ID or Social Security number, and proof that he or she is of legal age. Once the account is established, the account owner is responsible for honoring all trades entered into.

All brokers and investment advisors charge for their services. A broker may be paid by commission (a charge levied on each transaction, usually based on a percentage of the transaction).

It is common for an investment advisor to collect a periodic fee based on the value of the holdings in a customer's account—sometimes referred to as a "wrap fee."

The two main types of brokers

Brokerage companies are grouped into two basic categories, depending on the kind and degree of service they provide. Discount brokers simply process your transaction order: they buy and sell what you tell them to buy and sell, when you tell them to do it.

Full-service brokers provide that service too, but can also provide a wide range of investment advisor services as well, including research, advice, and recommendations on which stocks to buy and sell. Full-service providers typically charge higher fees or commissions for the extra service they provide.

FILE - In this Dec. 13, 2019, file photo trader Ashley Lara works on the floor of the New York Stock Exchange. The U.S. stock market opens at 9:30 a.m. EST on Tuesday, Dec. 24. (AP Photo/Richard Drew, File)
FILE - In this Dec. 13, 2019, file photo trader Ashley Lara works on the floor of the New York Stock Exchange. The U.S. stock market opens at 9:30 a.m. EST on Tuesday, Dec. 24. (AP Photo/Richard Drew, File)

Full-service brokers or investment advisors may provide the following services as well:

  • Investment planning. They can review your investment goals, help you put together an investment plan, and suggest actual investments for them.

  • Research. They have access to a lot of information about specific securities, the advice of industry analysts, and information about market trends.

  • Suggesting good investments. They are typically always on the lookout for investment opportunities that are right for their clients.

  • Tracking performance. They can monitor the performance of specific investments and your entire portfolio, and can advise you on whether the time is right to sell one of your holdings.

  • Limited tax strategies. They can also set up customized tax-deferred retirement accounts for you.

  • Margin accounts. If you want to buy securities via borrowing, they can set up a margin account for you.

  • Asset management accounts. They can set up an account that combines securities trading with banking services like checking and credit cards.

  • Access to IPOs. They can offer their customers an opportunity to get in on the ground floor of a new stock offering.

What type is right for you? The answer depends on how much service you wish to have and how much of that service you want or can do for yourself.

Individual retirement accounts

The individual retirement account (IRA) and Roth IRA are personal accounts for people who are employed and their spouses, if not working.

You can set up an IRA at almost any bank, credit union, brokerage, insurance company, or mutual fund. There are a wide variety of investment options to choose from, and any earnings are not taxed as they grow.

Why have an IRA?

The traditional individual retirement account (IRA) is a popular retirement plan for many investors because it is easy to set up, can be done independently of one's workplace, and can provide a tax deduction for the contributions made to it.

In return for these tax deductions, you must agree to leave your money in there until a certain age, generally 59½. Distributions taken prior to age 59½ are subject to an additional 10% federal tax penalty. By age 70½, you are required to begin taking distributions out.

Traditional IRAs are very flexible and allow many kinds of investments to be held within them. An important part of establishing a traditional IRA is having a custodian for the account. The custodian holds the assets that you contribute.

The Roth IRA

The Roth IRA is a variation that lets you withdraw principal and earnings tax-free after age 59½, as long as the contributions have been in the plan at least five years.

Unlike traditional IRAs, Roth IRAs don't require you to take distributions at age 70½, and you can keep contributing to them as long as you like as long as you have earned income.

Also unlike the traditional IRA, Roth IRA contributions are made with after-tax dollars—no deduction is allowed for Roth contributions.

However, when you take withdrawals (as long as you obey the rules), you don't pay taxes on any of them, including any earnings that accrue. These earnings include dividends, interest, and capital gains.

Other versions

The SIMPLE IRA and the SEP IRA are two versions that employers can make available to their employees. These IRAs have different rules from the traditional and Roth IRAs regarding participation, contributions, and the like.

If you are currently in a high tax bracket but foresee being in a lower one after you retire, you can benefit greatly from a traditional IRA, because your withdrawals will be taxed at your rate in retirement.

Employee stock ownership plan accounts

An employee stock ownership plan (ESOP) is an employee benefit plan that allocates company stock to employees. By receiving company shares, employees gain partial ownership of the company they work for, including voting rights.

In an ESOP, a company sets up a trust fund and then contributes shares or cash to buy shares for the fund. In a trust fund, financial control of the fund's assets is in the hands of an outside trustee.

The ESOP can borrow money to buy more shares, paying the loan back with contributions made to the trust. As contributions are made, shares are allocated to employee accounts in the trust.

ESOPs get favorable tax treatment

ESOPs are known as qualified stock plans because they meet Internal Revenue Service requirements to receive favorable tax treatment. Company contributions to the ESOP fund are tax-deductible within certain limits.

You may already know from your own experience that people tend to work harder when they feel a sense of ownership in their jobs. Giving employees the ability to own company stock can make them feel like an important part of the company they work for, increasing their dedication and work effort.

Employee uses for ESOPs

Besides increased morale, the employee also gets a wide variety of benefits from participating in an ESOP. Employees can use the stock ownership to supplement their other retirement plans. Participating in an ESOP gives employees the possibility of potential investment growth.

How do employees participate in ESOPs?

Shares of an employee stock ownership plan are allocated to employees based on the rules of the plan.

When you get your money

ESOP benefits are generally paid to employees after they leave the company. The income an employee receives from an ESOP depends on the contributions made to the plan and the performance of plan investments, rather than a pre-determined benefit based on a set formula.

The value of shares allocated to employees' accounts each year is usually different from the amount needed to pay off any outstanding trust loan used to buy more shares. If share prices rise, the value of shares allocated will be higher than the amount used to pay off the loan. If they fall, it will be less.

If you leave early …

Employees who leave the company before they are fully vested typically forfeit some or all of their shares. Some ESOP plans pay dividends to employees while they are still employed.

Tax benefits for employees

Employees don't pay any income tax on their stock allocations until they begin receiving their distributions.

If distributions are taken in the form of stock shares, then income tax on a portion of the value of the stock received may be further deferred until the shares are sold depending on whether the employee qualifies to use the special net unrealized appreciation rules.

The employee should consult with a tax advisor before taking any distributions to determine if they want to do this.

Employer-sponsored retirement plan accounts

The employer-sponsored retirement plan has traditionally been a major incentive for staying with a company. Over the years, there have been many evolutions of the corporate retirement plan. They have gone from elaborate defined benefit plans to simple employee contribution plans.

Whatever type of corporate retirement plan your company has, it is a good idea to take full advantage of its benefits so that you are doing all you can to have a comfortable retirement.

The benefits to investing in qualified corporate retirement plans are their tax advantages. A qualified plan is one that meets a series of federal government requirements and therefore qualifies for favorable tax treatment.

Money invested in a qualified plan has the potential to grow tax-deferred until it is withdrawn. In addition, money you invest in a traditional qualified plan is done so before it is taxed as income (making it pre-tax). Employers' contributions are also deducted for income tax purposes.

Qualified plans are set up as legal entities (trusts) or through custodians (such as banks, credit unions, or insurance companies) assigned by the employer. The custodian or trustee holds and safeguards the invested assets of the plan for the employer.

How the government helps

The government has established a number of ways to save and invest for your retirement that allow you to defer your income and earnings from taxes.

The tax-deferred savings program that your employer may offer is an example, and you can invest your contributions in a variety of investment choices.

The following are the most common plans available to help you pay for your retirement:

  • 401(k) plan. An employer-sponsored retirement plan that is usually funded by personal, non-taxable contributions from an employee's earnings as well as by contributions from the employer. There are limits to how much the employer and employees can contribute.

  • 403(b) plan. A retirement plan for employees in nonprofit organizations. It invests employee contributions and lets them potentially grow tax-deferred until withdrawal. There are limits on how much an employee can contribute.

  • 457 plan. A defined contribution retirement plan for those employed by a state or local government or a tax-exempt 501(c) organization.

  • Defined-benefit plan. A type of pension plan in which the amount paid to the pension holder is determined by a formula.

  • Money-purchase plan. In a money purchase plan, your employer is required to contribute a fixed percentage of your compensation to your account each year. Employees are not allowed to contribute to a money purchase pension plan.

  • Keogh plan. A retirement plan for self-employed individuals or non-incorporated businesses.

You have several options for receiving your retirement benefits. These include the following:

  • Lump sum: This is a payout of your benefits at retirement. Lump sums can be subject to additional taxation if they are premature distributions.

  • Single-life annuity: You receive equal periodic benefit payments (monthly, quarterly, etc.) for the rest of your life.

  • Joint and last survivor annuity: Annuity payments are continued to your spouse after you die. The payment must be at least 50 percent of the periodic amount you received during your lifetime.

  • Survivor's benefits: If you die before you receive your benefits, all your benefits will automatically go to your surviving spouse or other named beneficiary (with your spouse's written consent).

Benefits received before age 59½ (or age 55 in certain circumstances) must be received as substantially equal periodic payments to avoid the 10% early withdrawal tax penalty.

Depending on your situation, there are other exceptions to the 10% early withdrawal penalty. There are many things to consider before deciding on a distribution method. Research all of your options carefully.

College savings: Coverdell and 529 accounts

You need not save money in a bank account for education. There are special types of tax-advantaged accounts that you can use instead. Let's look at two of them here.

Coverdell education savings accounts

The Coverdell education savings account is a convenient way to start saving for a child's education.

Anyone may fund a Coverdell education savings account (formerly education IRA) for a child beneficiary, provided their modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return).

The maximum allowed contribution is $2,000 per year in aggregate, up until the beneficiary's 18th birthday, unless the beneficiary is a special-needs beneficiary. The earnings remain tax-free when they are withdrawn and used for qualified educational expenses.

All assets must be distributed within 30 days of the beneficiary's attaining age 30, unless the beneficiary is a special-needs beneficiary.

It is important to note that contributions to Coverdell accounts are not tax deductible. IRS Publication 970 provides more information on Coverdells and other tax incentives for education.

Qualified State Tuition plans (529 plans)

States have pre-paid tuition programs allowing families to save for a student's higher education. These plans qualify for special tax treatment if the funds are used for qualified expenses at a post-secondary school that meets US Department of Education standards for student aid eligibility or for certain K-12 tuition expenses or for certain K-12 tuition expenses.

These plans are generally referred to as 529 plans for the tax code section that describes how they are treated for tax purposes. States offering such plans may also give favorable tax treatment for contributions. State tuition plans fall into two categories: pre-paid tuition plans and college savings plans.

How to buy pre-paid tuition plans

Pre-paid tuition plans allow participants to buy tomorrow's education at today's prices. They may be purchased with a single lump sum or a series of payments. The state typically guarantees that the pre-payments will cover the future cost of education at the state college.

If the student chooses not to attend the state college, the state will often make available the amount of money equivalent to the cost of the state education at maturity.

Savings plans

State college savings plans have become more popular because of investment flexibility and the alluring possibility that, with investment skill and luck, proceeds may exceed the actual costs of education.

These plans have some tax incentives, too. While the contributions generally are not tax-deductible at the federal level, the earnings within the plans are tax-deferred until withdrawn. The earnings are federal income tax-free and, in most cases, state income tax-free if used for qualified educational expenses.

Summary of types of accounts

In this tutorial we covered some of the more popular uses for accounts. You may already have one or two of them. If you do not, here are some ideas you can use to explore them further.

Practical ideas you can start with today

  • Ask your employer whether it offers an employee stock ownership plan (ESOP).

  • If your employer offers an ESOP, gather information on it and decide whether to join it.

  • Open up an IRA to begin saving extra funds for your retirement.

  • Learn how much I can contribute to an IRA.

  • Estimate how much retirement income my IRA can provide.

  • Inquire about participating in my company's corporate retirement plan(s).

  • Set up a tax-advantaged Coverdell education savings account for your child, if you are eligible.

  • Research qualified state tuition plans (529 plans) if your state offers them.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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