Ok, this is a very basic one. But occasionally I see confusion from brand new investors who will ask a question along the lines of:
I hear people saying to invest in a low cost Vanguard index fund like VTSAX, but others say to max my 401(k). What should I do?
Yes, this person is confused. They are conflating a specific investment with the investment vehicle.
These are three different things going on here:
1. Investment Vehicle or Account Type
There are a number of types of accounts that you can choose to invest in. Think of the account type as a blanket that wraps the investments, or a suitcase that holds investments – it is distinct from the investments themselves.
So choosing an account type has nothing (or little) to do with the investments they hold. It primarily affects the tax treatment of the account. People invest in accounts like a 401(k), 457, 401, IRA, Roth IRA, or Health Savings Account (HSA), because of the favorable tax treatment.
A. Roth Retirement Account
Once money is invested in a Roth account, it uses after-tax money, but it will never be taxed again. So if you earn $1,250, and pay $250 in taxes, you’d be left with $1,000. If you then invested $1,000, and through dividends and capital gains, the money grew to $2,000, you could withdraw the whole $2,000 without paying any additional tax.
B. Traditional Retirement Account
In a traditional retirement account, such as a 401(k), pre-tax money goes in. So if you earn and invest $1,250, $1,250 would go in. This allows you to lower your tax burden for that year. The tax on that money, as well as the tax on the growth is deferred until it is withdrawn. It would then all be taxed at your ordinary income rate. A 529 (education) account works the same way.
C. Health Savings Account
A HSA is actually triple tax advantaged combining the benefits of A and B above.
D. Regular Taxable Account
The alternative to these tax advantaged accounts is a regular taxable brokerage account. The benefit is that there are no restrictions, withdrawal penalties, or contribution limits. But typically, it should be the last to be funded because growth and dividends within the account are subject taxes. Short-term investments held less than a year are taxed at ordinary income rates, while long-term investments are usually taxed at a lower capital gains rate (0%, 15%, or 20% depending on tax bracket).
So it’s generally smart to maximize tax-advantaged accounts before investing in a taxable account.
2. Company that Holds the Account(s)
Here’s another point of confusion:
Should I open a Roth IRA? Or should I just open an account with Vanguard?
Again, this person is conflating the type of account with a specific company.
Your work based 401(k) or 457 plan may be with a specific company because that’s what your company has chosen. But other than that, you are free to open an account wherever you see fit.
3. Investments within the Account
Let’s say you have decided that you want to open a Roth IRA account with Vanguard. Now you need to decide what investments to pick within the account. This would also apply if you open a taxable brokerage account with TD Ameritrade. Again, this is because the investments are distinct from the (1) account type and (2) company you hold the account with.
So you are free to hold stocks, bonds, ETFs, index funds, commodities, real estate funds, etc., in any of the accounts at any of the companies, as long as that investment is available at the company.
That’s not to say that there’s no relevance to company or account type in choosing investments. For example, Vanguard offers free trades of Vanguard index funds, while at another brokerage, you might pay $5-7 for each trade. So it makes sense to choose funds that will be be free of any transaction fee.
Additionally, it’s wise to think about holding investments in each account that make sense for the tax treatment they will be given. For example, it would make no sense to hold tax-exempt municipal bonds in a Roth account, because that account is already tax-exempt. And tax inefficient investment such as a REIT should be placed in a tax-advantaged account. Bogleheads wiki has a great entry about tax efficient fund placement.
Remember to think of your investments in terms of your overall asset allocation. See below for further reading.