Money has to be held in some form or the other. It could be cash, physical gold, land or more conveniently accounts. The blog post is only about the last one.

Normal accounts (or non-retirement accounts) – held at banks

  1. Checking account –
    1. Post-tax contributions
    2. Earnings are realized immediately and taxed as ordinary income
    3. Account will never down in value (insured by FDIC for upto first 250K $)
    4. money is highly liquid – can be deposited/withdrawn any time (and absolute limits on deposit/withdrawal are usually of order of 10, 000$ per day)
  2. Savings account
    1. Post-tax contributions
    2. Earnings are realized immediately and taxed as ordinary income
    3. Account will never down in value (insured by FDIC for upto first 250K $)
    4. Money can be deposited anytime but can only be withdrawn six times per month

Investment accounts (for lack of better term) – held at stock brokers
These can be held as retirement or non-retirement accounts. Tax treatment of contributions/earnings/withdrawals depends on the type of parent account they are part of.

  1. Money market account
    1. Post/Pre tax contributions (depending on whether its pre-tax account or post-tax contribution account)
    2. Earnings are realized and taxed as ordinary income
    3. Primarily used for holding money temporarily before it is used for stocks or bonds (or more exotic things like options)
    4. Account can go down in value, though it happens rarely
  2. Brokerage account
    1. Account which holds holdings in stocks/bonds
    2. Earnings are not realized till a sale happens and then taxed as ordinary income or capital gains/losses depending on the holding period

Retirement accounts – held at stock brokers

Retirement accounts provide certain tax advantage (like tax-free or tax-deferred growth), usually, these accounts come with a restriction like money cannot be withdrawn at all till age of 59.5 years or can be withdrawn before that by paying a penalty (account specific details are given below).

IRA = Individual retirement account, just like a bank account, anyone can open it at pretty much any broker.
401K = employer-sponsored account, can be opened only by employer and contributions can only be made directly via paycheck [and employer contributions], the choice of funds to invest is also controlled by employer, sometimes, employers provide a match to encourage employees.

  1. Traditional IRA
    1. Direct contributions have a maximum limit (5,500$ annual limit in 2013 for people below age 50).
    2. Contributions are tax-deductible if income is less than a certain limit (limits are pretty low, though).
    3. Earnings are tax-deferred but taxed as ordinary income on withdrawal.
    4. Money can be withdrawn after age of 59.5 (or before with 10% penalty unless it’s a case of financial hardship).
    5. On leaving an employer, its 401K plan can be converted to traditional IRA account.
    6. See more gory details at Wikipedia page.
  2. Roth IRA
    1. Direct contributions have maximum limit same as traditional IRA but income limit to make contributions is much lower.
    2. Indirect contributions can be done via rolling over 401K money (if employer allows) or backdoor Roth IRA (contribute to Traditional and convert to Roth).
    3. Earnings are tax-free.
    4. Contributions can be withdrawn after a seasoning period (5 years) with no penalties (provided there is a reason – like financial hardship).
    5. Earnings can be withdrawn after age of 59.5 tax-free or by paying both tax and penalty (10%) before that age.
    6. Roth IRA is the only retirement account with no RMD (required minimum distribution clause).
    7. See more gory details at Wikipedia page.
  3. Pre-tax 401K
    1. Contributions are pre-tax (max employee annual contribution limit $17.5K – must come directly from paycheck), employer contributions are not counted towards this limit (they are subject to a total retirement contribution limit which hovers around $50K).
    2. Earnings are tax-deferred.
    3. Withdrawals taxed at ordinary income tax at the time of withdrawal.
    4. Some 401K plans don’t allow any withdrawal (even for financial hardship) till age of 59.5
    5. An employer decides which funds will be available for 401K plan.
    6. See more gory details at wikipedia page.
  4. post-tax 401K
    1. Contributions are post-tax. (same limit at pre-tax 401K)
    2. Earnings are tax-deferred.
    3. Contributions are withdrawn tax-free, earnings are taxed at ordinary income tax at the time of withdrawal.
    4. Some people prefer post-tax since they can effectively contribute more money into the account.
  5. Roth 401K
    1. Similar to Roth IRA in the sense that contributions are post-tax (for most people) and earnings are tax-free.
    2. Withdrawal though, is controlled by employer and might not be possible without leaving the employer or attaining the age of 59.5.
    3. Usually, it’s a good idea to convert post-tax 401K to Roth 401K (or Roth IRA) if that choice is available in employer’s plan.
  6. Some other exotic options like SEP IRA, 403(b) plan – I don’t know these and they won’t be covered here
Retirement accounts (contributions vs earnings chart)

Retirement accounts (summary)

Which plan should a person go for?
See my next blog post for the same.