My blog is not an investment blog. It’s a personal finance blog. However, I’ve gotten some comments from friends that some of the dribble I’m churning out nearly every day doesn’t make very much sense, and not just because I’m a terrible writer. I believe I’m probably only reaching a quarter of my audience with my posts on investing. So over the course of the next couple weeks, I’m starting a series on the basics of investments.  Consider this the table of contents, and the introductory article.

  • Investment Accounts - Brokerage, Mutual Fund Account, 401K - Today’s Topic
  • Fixed Income Investments (Savings Accounts, CDs, Government Bonds, Corporate Bonds)
  • Stocks
  • Mutual Funds
  • Options
  • “Exotic” Investments - Commodities, Future Contracts

I think many individuals who are new to investing often confuse investment accounts with investments.
Brokerage Account, 401k, IRAs ARE NOT Investments.

Brokerage, 401k, and IRA accounts are just that, accounts. To use a metaphor, these accounts are nothing more than folder to hold actual investments which are stocks, bonds, cash, gold, etc. Of course some of these accounts like a 401k or Roth IRA have some special tax features that basically make them invisible temporarily to taxes (401k, standard IRA) , or permanently so (Roth IRA, Roth 401k).

Brokerage Accounts
Brokerages are not very different from standard Banks. Instead of just dealing with just cash, brokerages also hold stocks, bonds, and mutual funds for their customers. While it’s possible to buy stocks and bonds directly, and even hold the those in physical form, it’s generally not recommended. A brokerage account serves as the intermediate. The brokerage helps you buy and sell those investments, handle the bookkeeping, and consolidate all the holdings. For these services customer pay in terms trading fees (i.e. 19.95 per trade), annual account fees, and interest (if you borrow money to from the brokerage to invest).

Mutual Fund Accounts
While you can buy mutual funds through your brokerage, and some mutual fund companies offer extensive brokerage arms (Fidelity comes into mind), you can also buy Mutual Funds directly through the mutual fund company. The benefit of buying mutual funds directly through the company that operates the mutual funds is that for many fund it’s generally free to do so. For instance I own Dodge & Cox’s DODFX (Dodge & Cox International) in my E*Trade brokerage account. However I could’ve just as easily opened an account with Dodge & Cox and brought shares for free instead of paying 19.95 for each buy and sell I make through E*Trade, and that’s what I’ve done in the case of Vanguard. I have Vanguard account and because they have such a wide variety of index funds from which I can choose, it’s a perfect account to my brokerage account.

401k, Traditional IRA, Non-Deductble IRA, Roth IRA
These retirement accounts are not really types of accounts because in the case of IRA (Individual Retirement Accounts) accounts each of them is usually either a brokerage account or a mutual fund account wrapped within different tax rules. The tax shelter that each of these accounts confer is intended to encourage retirement savings.

  • 401k - Ok, 401ks really are different type of account since they operated on behalf of employers, and are funded via payroll deductions.  The specifics vary from plan to plan. Some offer great investment choices, and others not at all.
  • Roth IRA, Roth 401k - Offers the ability to invest after tax dollars and never pay taxes again. After tax income is income that you’ve already paid taxes. For instance let’s say you make $1500, and pay $500 in taxes, you have $1000 in after tax income in which you put into a Roth IRA. No taxes are avoided initially, but after 50 years when that $1000 has grown to $70,000 no taxes are owed either. In typical investment account, you would have to pay taxes on the gain of $69,000.   A Roth 401K behaves exactly like a Roth IRA, but like a standard 401k is employer sponsored and funded by payroll deductions.
  • Traditional IRA or Deductible IRA - A traditional deductible IRA if you qualify to open allows you to shelter taxes now and while the investments are in the IRA. Going back to the example in which you have $1500 in income, you could put the full $1500 into a deductible IRA and avoid paying $500 in taxes. (I’ve simplified a bit here since you can’t avoid payroll taxes such as social security and medicare). Of course upon withdrawal you owe full income taxes
  • Non Deductible IRA - Like a Roth IRA in that you put after tax dollars, and at withdrawal you owe income taxes on the gains. Doesn’t sound like much of deal does it? The only taxes you avoid is incremental annual taxes. So for instance if you make $100 in interest, typically you’d have to pay taxes on that $100 in a taxable account and would then only have let’s say $70 of that interest to invest for the next year. Within a non-deductible IRA, the full amount is available for reinvestment where taxes are only paid at distribution. This is tax-deferral.

These are only a few of the different types of investment accounts. There are 529 plans, SEP-IRA, Simple IRAs, and more. However these accounts are the basics, and that’s what I’m trying to cover in this series, the basics.