Stock Investing Basics: Chapter 5 -- Investment Accounts

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Chapter 5
Investment Accounts

We touched on this a little earlier. You can buy investment securities (stocks and bonds and all their variants) in various investment accounts:

• Brokerage account (see eTrade, Scottrade, and Sharebuilder). Can be taxable or tax-sheltered
• Mutual Fund company account
• 401k retirement account (or an equivalent like a 403b)

When you open an eTrade account, you can open a taxable brokerage account, an IRA, a Roth IRA, or an Education Savings Account (also known as a Coverdell Account). For most people, you'd open a taxable brokerage account or some sort of IRA to invest in stocks, stock mutual funds, and ETFs.

If you open an account with Fidelity, T. Rowe Price, or Vanguard (three of the most popular mutual fund companies), you can open a taxable or retirement account, with the investment vehicles being mutual funds. Some mutual fund companies are also brokerage companies (and some offer 401k services as well), so the water can get a little muddy; however, if you choose a company like Fidelity, you can conceivably manage ALL of your investments with one company and one logon.

Your 401k, if you're so lucky to be enrolled in one, is one of the better retirement plans concocted by the federal government. Named after the IRS tax code that enabled it, 401k plans allow you to shelter pre- and/or post-tax income in mutual funds, stocks, bonds, and conceivably any other security investment you can think of. This money grows until you retire and begin withdrawing funds. Fidelity, Hewitt, and Merryl Lynch are the three biggest 401k plan administrators.

IMPORTANT NOTE about your 401k: Choose your investments wisely! Many HR departments, for some reason, don't want you to have many choices. It's as if they think their employees are stupid and if given too many choices they'll not choose anything at all, or – WORSE YET – invest in the default instrument, the company stock.

DON'T EVER INVEST IN YOUR COMPANY STOCK WITH YOUR RETIREMENT FUNDS.

If you do, and your company pulls the same stunts as Enron, you deserve what you get: NOTHING. I'm sorry to be so harsh, but it's just foolhardy to put your employment and 401k in the hands of a single employer. If the company's prospects go south, you could lose your job and your retirement!

In each of these types of accounts, you can invest in the “stock market,” and, in general, it won't really matter which one we're talking about because the mechanisms are similar (buy, sell, hold). Surely, there are specific strategies that you could employ to minimize the tax bite or mitigate risk, but, in the grand scheme, these considerations are rather insignificant.

Except for one thing: Your time horizon. Assuming you're in your 50s or younger, you may want to have a longer time horizon (or holding period) in your retirement funds (invested in a form or IRA or 401k/403b) compared with a shorter time horizon in your taxable accounts. You may.

It all depends upon your goals and risk tolerance. For example, if you are 25, have a baby, and want to fund his college education, your time horizon for an ESA or 529 is about 18 years (assuming your child goes off to college as soon as he graduates high school), whereas your time horizon for retirement might be 30-40 years. You can obviously take on less risky investments if your time horizon is shorter. However, you also have less time to earn money so your objective might be to earn a cumulative return of 12 percent on your ESA money but an 8 percent return on your IRA money, for example.