It may seem like a no-brainer to know the difference, but it’s a common misconception — especially for those not in the finance world — that an account is synonymous with an investment.
I often hear statements such as:
“I want to invest in something that will make me money, so, which account should I get?”
and
“Does a Roth IRA make more money than a 401(k) or an IRA?”
How well your account performs depends on the investments you own inside the account.
There are no accounts that are more superior than the other in terms of performance.
For example, let’s say you own a checking account with $5,000 cash and a Roth IRA that contains $5,000 cash, as well. Both accounts “perform” exactly alike because they both contain the same amount of cash; neither account is more superior than the other.
Think of an account as a container that can hold different types of food. The container is the account and the different types of food are the various investments you can own inside that account.
Accounts are simply empty containers until you fill them up with various investments.
You may hear the term “holdings” to represent anything you own inside your accounts.
When you use the term “investing,” generally it means that you are using your cash to purchase something that can either potentially grow in value, earn you interest, or both. You can invest in a house, a stock, or a money market, for example.
The investment income that you earn is simply any interest or dividend you receive from an investment you own.
For example, if you invest $10,000 in a 3-year Certificate of Deposit (CD) that pays a 2% interest rate annually, you earn $200 that year. That $200 is considered investment income or more specifically “interest income.”
Each type of account you own has its own tax implications and rules.
For simplicity, there are two categories: taxable accounts and tax-deferred/tax-free accounts. Most tax-deferred and tax-free accounts are retirement accounts.
Using that same example above, if you own that CD in a taxable account, you will have to pay taxes on that $200 you earned that year.
If you own the CD in a tax deferred account such as an IRA or 401(k), the taxation on the $200 is deferred until you withdraw the money later. Similarly, if the CD is held in a tax-free account, such as a Roth IRA, you won’t have to pay any taxes on the $200; that is why Roth IRAs are so popular and tax-advantageous.
Here’s a list of common account types:
-
Taxable accounts: checking, savings, investment account
-
Tax-deferred accounts: Traditional IRA, Traditional 401(k), Thrift Savings Plan (TSP), 403(b)
-
Tax-free accounts: Roth IRA, Roth 401(k), 529 college savings accounts
Here’s a list of common investments you can own inside an account:
-
Certificate of Deposit (CD)
-
money market
-
mutual funds
-
stocks
-
bonds
-
exchange traded funds (ETF)
Typically, checking accounts and savings accounts can only contain cash. With all other types of accounts, you can own a combination of the investments listed above, including cash.
When you are creating a financial plan, determining the types of accounts that are appropriate for your financial goal is step one. Laying out a map of the various types of accounts to own will help with your tax planning and how to optimize tax efficiency. From there, you develop an investment strategy and portfolio for each of those accounts depending on how long you intend to keep them, your risk tolerance, your goals, and how much available cash you have available to invest.
