One thing that confuses a lot of investors are the various types of Investment Accounts. This article will help people identify and distinguish between them, whether they are retirement (qualified) and non-qualified accounts, in addition to IRAs and college education accounts. This article will help you understand the difference between them, what they are designed for, and how to prioritize them.
Many people are confused by all of the naming of accounts like IRAs, 401(k)s, 529s, and non-qualified accounts. Sometimes they refer to them incorrectly as investments, but they really aren’t. The confusion is best cleared up by obtaining a financial plan. When you fill out a financial planning questionnaire, you are forced to identify and figure them out, and how they might be focused on your future goals. This too helps people to choose what investment accounts or ‘buckets’ are best for you.
Asset Classifications vs. Accounts: Asset Classifications indicates the investments that you invest your money into. The Account or ‘bucket’ is the holding label of your investment. The ‘bucket’’ label is important, because it may provide certain ownership or tax status; therefore, it is important for you to understand the difference.
- Cash or Cash Equivalents: Savings Accounts, Certificates of Deposit (CD), Money Market Accounts
- Bonds are essentially a loan between an investor and the entity, such as a corporation or a government. They can be issued for a short period of time, intermediate term, or long-term. In addition, they can be very safe or risky, depending upon the financial strength of the borrower/entity. Some bonds issued by municipalities, may have certain tax advantages, and are called municipal bonds.
- Stocks are essentially an equity investment in a corporation. They can be issued by a company in your country (Domestic) or another country (Foreign). In addition, the stock can be in a small company (Small Cap), medium size (Mid Cap), or large company (Large
- Tangibles are things like precious Metals, coins, real estate, or any collectible tangible property that has value.
Buckets or Accounts are the way your assets are titled or held. Just about any asset listed above can be invested and put into one of these asset ‘buckets:’
- College Education Accounts: These are accounts designated as 529s, Pre-paid tuition and College Savings Plans. These are similar in some ways to qualified accounts, in that the IRS provides some tax advantages.
- Minor Accounts: Minors (age 18 in most states) don’t have legal right to enter into business arrangements and sign contracts. However, to be able to invest for them, accounts can be set up in their name, giving them future rights of the money, while restricting others from having some control over it. These accounts, depending upon the state, are either Uniform Gift to Minors (UGMA) or Unified Transfer to Minors Act (UTMA) accounts.
- Non-Qualified or regular investment, means almost all other investments, and can be any type of account this is not one of the above two types of accounts. They usually don’t have a special tax advantages like the qualified accounts, but that is not to say they have some tax advantages over other investments (please consult your tax or investment adviser for full information).
- Qualified Accounts means the account is ‘tax-qualified,’ or possesses some special income tax advantages usually aimed at retirement. The Internal Revenue Service or IRS, provides some kind of tax benefit to the person or entity contributing into it. There may be a tax deduction to the company or individual for investments into a Qualified account or bucket. In addition the interest or growth may be without current income taxes being taken out of it (like other accounts might be subject to), until the money is used at retirement.
- Annuities are a little of strange, therefore they are a little hard to classify between accounts and assets. For the purpose of this discussion, they are a type of account. However, what makes them confusing, is that they can either be a non-qualified (see above) annuity with some tax advantages similar to qualified that we will cover next, or they can be qualified, and carry with them the extra tax advantageous of qualified accounts.
EXAMPLES OF QUALIFIED ACCOUNTS:
- Company plans: Retirement or Pension Plan (or Defined Benefit plan), or 401(k), Profit Sharing, Keogh, or SEP (Defined Contribution Plan)
- Individual plans: Individual Retirement Arrangement or IRA, and Roth IRA arrangements
- Not for profit plans: 403(b) and 457 plans
Asset Classification and Account Buckets
Now that you understand the difference between asset classification and account buckets, you are ready to get the next basic concept: placing your investment asset into an account. This part really confuses many people, but this is how it works. You can virtually (which means in many cases) place any of the above investment Asset types, into any type of Account Bucket. For example, you can invest or place stocks and bonds in your IRA, UGMA, College education or non-qualified Account Bucket. Each Account Bucket has specific rules and taxation, that your advisor can tell you about.
Identifying what bucket to invest in first, second, and so on depends on various factors, the overriding ones of which are those based on your financial plan. If you have a financial plan, you will know which areas that additional funding is needed, and you can allocate your investment ‘buckets’ accordingly. Here are some examples of how Assets and Accounts work together:
- Emergency Cash Reserves. These assets need to be liquid, quickly and easily accessible without risk that value may go down, in case money is needed for a car or house repair. Reserves allow for emergencies and unexpected expenses without jeopardizing cash flow, increasing risks, and taking money from accounts that are being set aside for things like college or retirement. Therefore, most people put their emergency cash reserve in a non-qualified account. Secondly, they often place some of their investments in cash equivalents in their non-qualified account, for emergencies.
- Saving for specific goals, such as a new car or the down payment on a home There are many things that require fairly large sums of money all at once, such as buying new appliances or taking a vacation. In order to ensure that you have the money you need when you need it—without borrowing it or affecting other goals, it is important to save money regularly toward these planned expenses. Therefore, you wouldn’t use college or qualified accounts for these kind of purchases. Just like in the first example, you would use a non-qualified account for saving for specific goals, most of the time. If the need for money is in a few months or years, your investment adviser would typically recommend that you place/invest in cash equivalents or short-term bonds into these accounts. If the purchase isn’t going to be for many years, your investment advisor may recommend other long-term investments for your non-qualified account.
- Retirement/Financial Independence. Most financial advisers recommend that you fully maximize the amount you are able to put into pension plans and IRAs prior to investing in other Account Buckets.’ These retirement plan accounts usually provide very good income tax advantages. Your investment advisor will recommend various Assets for these accounts.
- College Education. Most financial advisers recommend that college education savings priorities should fall behind retirement goals. Your adviser may recommend that you place money intended for college in a 529, UGMA or UTMA Account Bucket. Your adviser will then choose appropriate assets to invest in, depending upon the level of risk you are willing to take, and when the money is needed- the same criteria they will use for all of your accounts (the above are just examples)
Summary of Investments into Asset ‘Buckets.’
- Emergency Reserves: Using non-qualified account bucket
- Vacation Home and future car purchase: Non-qualified bucket usually
- College: Non-qualified and education buckets like 529, UGMA/UTMA
- Retirement: Qualified bucket (Pension, 401(k), IRA, and Annuity) & non-qualified bucket
- Specific Goals: Non-qualified bucket usually
Summary. It is important for every investor to understand the different types of investment Assets and Account Buckets, so that they are not confusing them as the same thing, as many people do.