Hi Reader,

Last week we talked about how investments are taxed and identified the four different types of accounts through which you can invest. And yes, some of those account types will enable you to receive a tax deduction. So let's dive back in!

Four Account Types

Here are the four account types.

1. “Ordinary” brokerage accounts (these are taxable accounts)
2. Traditional retirement accounts (one type of tax-advantaged account)
3. Roth retirement accounts (the second type of tax-advantaged account)
4. Hybrid tax-advantaged accounts (other ‘flavors’ of tax-advantaged accounts)

“Ordinary” Brokerage Account

The first type of account is the “ordinary” brokerage account. Folks in the investment business often describe brokerage accounts as “taxable accounts.” The reason is because this account type offers no tax advantages. Taxes on the capital gains and periodic income distributions we discussed above have to be paid each year.

When you invest through an “ordinary” taxable brokerage account you’re usually not eligible for any tax deduction or special tax treatment. This doesn’t make taxable accounts bad. The main benefit is that you always have easy, penalty-free access to your investments. And that access is something you usually don’t have in tax-advantaged accounts.

A brokerage account is the default account that investment companies like Vanguard will have you open to get started investing.

Traditional Retirement Accounts

Second, there are traditional retirement accounts. When you make a contribution to a traditional retirement account, you get a tax deduction. That deduction reduces your taxable income - which means you pay less in tax! This is why your accountant may have encouraged you to open a SEP-IRA or traditional IRA to save on taxes.

The investments within that Traditional Retirement account also grow on a tax-deferred basis. What the heck does that mean? That means you don’t have to pay taxes on those two types of investment income we discussed earlier. You can sell for a huge profit and receive substantial dividend payments and you won’t have to pay any tax (yet).

Does that mean you never pay taxes when you invest through a traditional retirement account? Afraid not. You’ll pay income taxes when you take funds out of these investment account. This is called a “distribution” from your retirement account. And you’ll pay income tax on every cent of that distribution.

And if you take a distribution before you turn 59.5, you’ll also incur an early withdrawal penalty. There are great tax perks here - but they come with restrictions that will cost you if you violate them!

Traditional retirement accounts are found in virtually every retirement plan. 403(b), SEP-IRA, SIMPLE IRA, traditional IRA and 401(k) retirement plans are all places you can find a traditional retirement accounts.

Roth Retirement Accounts

Third, there are Roth accounts. Roth accounts are tax-advantaged, but in a different way than traditional retirement accounts.

When you contribute to a Roth account, you don’t reduce your taxable income. In other words, you don’t get a tax deduction — and therefore you don’t pay less in income taxes.

But in exchange for no tax break in the beginning - you get a big tax break in the future. In fact, once you contribute money into a Roth account, you never pay taxes on those investments again. That includes when you take distributions out of your Roth account in retirement (again, you must follow all the rules to get this benefit).

This tax treatment is the opposite of that for a traditional retirement account. Remember in a traditional retirement account, every cent of your distribution is subject to income tax. Not the case with a Roth. With a Roth, you don’t get a tax break in the beginning - when you initially contributed to the Roth account - so you get the tax break of not having to pay any income tax when you take the money out in a distribution.

The tax treatment of Roth accounts sounds pretty sweet (and it is) but a Roth isn’t necessarily a better deal than traditional retirement accounts. (More about that in the future!)

To get the great tax benefits of a Roth, you need to follow all the rules, including not taking distributions out of the account until you’re older than 59.5. (And there are additional rules as well!)

Roth accounts are still less common than traditional retirement accounts. You can find Roth accounts in some 403(b) and 401(k) plans and, of course, in a Roth IRA.

Hybrid Tax-Advantaged Accounts

Beyond traditional and Roth retirement accounts, there are a handful of other tax-advantaged accounts. Two of the most common are HSAs (Health Savings Accounts) and 529 Savings Plans for educational expenses. The specific tax treatment of these hybrid accounts varies, but they all offer some form of tax advantage, including not having to pay taxes each year you receive any form of investment income. (The general term for this is deferred tax treatment - because you’re deferring when you have to pay the tax.)

What type of account is right for you?

Like virtually everything in finance, the right account depends on the specifics of your life and your goals. But for most of us, it makes sense to invest some (but not all!) of your money in a retirement account. I’ll discuss how to decide whether a traditional or Roth account is the better choice for you in a future email.

It’s also important not to put all of your money in tax-advantaged accounts. The reason is that all tax-advantaged accounts come with restrictions around your ability to access those funds. If you need access to money for an emergency, in most cases tapping into your retirement accounts will come with hefty fees and penalties.

Confused yet? 😖

This is complicated stuff. Everyone gets confused when first diving into the world of investing.

If you find your head swimming, or aren’t quite sure what the right next step is for you, HIT REPLY and let me know what’s on your mind. I read and respond to every email!

I hope you have a great remainder of your week!

Dave