I get a lot of questions about the different types of investment accounts and there’s an overarching theme to all of the questions. And that theme is…confusion!

With all the different investment accounts out there, it can be confusing to understand what each one is and what purpose it serves. So, let's break it down very simply.

These terms—brokerage account, IRA, 401k—get tossed around quite a bit, but they're not interchangeable by any means.

A brokerage account is just a standard investment account that anyone can open regardless of income, employment status, etc. 

An IRA (Individual Retirement Account) is a tax-advantaged retirement account that you open yourself if you have earned income.

A 401k is a tax-advantaged retirement account that must be offered by your employer. You cannot open one yourself.

Now note that this is not an exhaustive list of all the investment account options out there, but they are the most common.

401k vs IRA

401k vs IRA — which one is better?! And which one should I have?!

Spoiler alert: they’re both great accounts, but offer different benefits. The first thing to know, though, is that both the 401k and the IRA are retirement accounts.

An IRA is an Individual Retirement Account.

Actually, fun fact: the technical name is Individual Retirement Arrangement, but we as a people have taken that term over and decided “account” works just fine.

IRAs are personal retirement accounts that you open on your own. It takes less than 10 minutes to open an account and start investing, and you open them at places like Fidelity, Charles Schwab, and Vanguard, amongst others. This account is intended for retirement and has a few rules:

→ You must have earned income. This means the income you are reporting to the government. If you're doing work under the table and aren't reporting this to Uncle Sam, you aren't eligible to contribute to an IRA (also, that’s illegal, but I’m not the police, so you do you). The exception to this rule is if you are married, filing jointly, you can open a Spousal IRA.

→ You can only contribute $7,000 (for the year 2024)

Because you own the account, you have all the power in your hands and can buy pretty much any stock under the sun within it.

A 401k, on the other hand, is an employer-sponsored retirement account. You cannot open this account yourself - your employer has to offer it. One significant advantage of the 401k is the higher annual contribution limit ($23,000 for the year 2024) compared to IRAs, allowing you to save more for retirement. Additionally, many employers match part of your contributions, which is a 100% return on your investment…talk about #gains.

Because a 401k is offered by your employer, you are going to be limited in what you can buy within it. Employers work with brokerage firms to create a package of offerings from which their employees can select. You might have a handful of crappy things to pick from, or get lucky and have several low-cost options. It’s all up to their discretion.

Now, bear with me for this next part…

Roth IRA and Roth 401k

You are taxed NOW when you invest your money. When you withdraw the money, you don’t pay taxes because you already did that! This is a great option for people in a lower tax bracket today or who think taxes will be higher at their retirement. ROTH is the magical keyword here.

Traditional IRA and Traditional 401k

You don't pay any taxes now and are taxed LATER when you withdraw your money. This is a great option for people in a higher tax bracket today or who are banking on lower taxes in the future. 

✨ Special Callouts ✨

→ Roth IRA: There is an income limit to be able to directly contribute to the Roth IRA (MAGI must be less than $161k if single and less than $240k if married, filing jointly in 2024). If you’re over the limit and want to contribute to one, you can check out the loophole that is the Backdoor Roth IRA. There isn't an income limit for the Roth 401k, though!

→ Traditional IRA: If you have a retirement plan offered at work, then you must fall into a special bucket to take advantage of the tax-deductible contribution. You probably want to check to see if you’re eligible for that deduction as you decide which account you want to prioritize.

You can have both a 401k and an IRA and still contribute the maximum to each one! Note that the max is for the whole account, though. For example, you can’t contribute $23,000 to a Roth 401k and $23,000 to a Traditional 401k. You could contribute $23,000 to the Traditional 401k, or $11,500 to the Traditional 401k and $11,500 to the Roth 401k, etc., but the overall limit still stands.

“But Amanda, my company doesn’t offer a 401k! How is it fair that some people get to invest so much more than me for retirement?!”

I couldn’t agree with you more that it’s totally not fair! If I were the one making the rules, I’d allow everyone to max out their 401k, regardless of whether their employer offered one 🫶 It’s a weird stipulation, in my opinion, but unfortunately, dems da rules. The only way to get around this is if you decide to start your own company, then you get to be the employer and open one up.

However, if you’re uninterested in starting a whole company, there is still another way that you can —and should! — invest. That brings us to the next type of account…

Brokerage accounts are regular standard investment accounts any individual can open. Unlike the IRA and the 401k, you can buy, sell, and withdraw as often as you want. You're not going to be hit with some big penalty like you would with the IRA or 401k because those are intended for retirement. You can still use a brokerage account for retirement, but you can also use it for those big dream purchases!

How to Open a Brokerage Account

You can open these at places like Fidelity, Charles Schwab, and Vanguard, amongst others. Within them, you can buy and sell a wide range of things like stocks, bonds, mutual funds, ETFs, and more. These accounts are great, but the tax breaks aren't quite as good as retirement accounts. You pay taxes on any money you put into the account and taxes on any growth – though you do get to pay a special lower tax rate if you hold your stocks for at least one year and one day, called long-term capital gains taxes. There is no limit to how much you can contribute to this account.

Why You Want a Brokerage Account

I like to think of a brokerage account as a super-sized savings account for those future goals I don't even know I want yet! You can access funds from a brokerage account at any time without penalty. Think about it: Did you know exactly what you wanted today 10 years ago? Probably not! That’s why I like investing at least some cash in there, even if there isn’t something specific that I desperately want today.

Though you can use this account for retirement, it is perfect for those other long-term financial goals outside of retirement. For example, if you know you want to buy a house in 10 years, stash that money in a brokerage account. If you can’t think of anything you want, still stash some in there. If nothing comes up, maybe you can just fund an earlier retirement for yourself😎.

Taxes on Brokerage Accounts

You pay a capital gains tax when you withdraw money from a brokerage account. If you buy and sell your investments in less than 365 days, you will be subject to Short Term Capital Gains Taxes. That means any money you make will be taxed as if it’s regular income (so whatever the current federal income tax rates are, the year you go to withdraw). However, if you buy and hold your investments for at least 366 days, the government rewards you, and you pay Long Term Capital Gains Taxes (these are significantly lower, which means you keep more of the money you make!).

Here are the current rates for 2024 short-term and long-term capital gains taxes:

Wrapping Up

Each of these different investment accounts serves a unique purpose. IRAs and 401ks are geared toward retirement savings, offering tax advantages and specific contribution limits, while brokerage accounts provide flexibility and accessibility for various goals outside of retirement. While there is an investing order of operations to take into account to get the most bang for your buck tax-wise, remember that investing is better than not investing at all. Don’t wait until you feel like an expert, or you might never start.

If you want to learn more about investing and how to invest, check out my upcoming free investing class. Hope to see you there!