I have read a book on personal finance and I keep seeing mentions to 401(k), IRA and taxable accounts. What are these things? Are these US specific issues? Are there equivalent things in Europe?
One important thing to understand in this article is the difference between an investment and an investment wrapper. An investment would be the asset you hold, in this case an ETF or an index fund. The wrapper, also known as an investment vehicle, can be seen as the package where those investments are held. The investments in the wrapper may be diverse: ETFs, shares in mutual funds, stocks, bonds, etc. The wrapper matters because due to it investors might enjoy tax benefits which increase their returns on the long run.
A 401(k) is a company sponsored retirement savings scheme. These are very common in the US. Under this scheme, the employer contributes (financially) to the employee’s retirement (401k) account. Essentially, if you participate you get “free money” to your retirement account which is a great deal for employees. Moreover, an employee’s contributions are deducted from his salary pre-tax and capital gains are not subject to capital gains taxes. Withdrawals can only be made without penalties after age 59. A 401(k) is an investment wrapper.
In Europe similar company pension schemes exist for some employers, typically in large companies or for senior public officials. The tax benefits naturally change from country to country. These types of employer related retirement plans are often called the second pillar of a pension system.
An individual retirement account – IRA (e.g. Traditional IRA, Roth IRA) – is an investment wrapper solely funded by an individual investor. The tax advantages of the IRAs vary with the type of IRA but may include:
- not paying taxes on interest, dividends and capital gains on the account
- deducting the contributions in the annual tax filing
- making pre-tax salary contributions and paying income taxes on withdrawals during retirement
- making post-tax salary contributions and not paying any taxes on withdrawals during retirement
Withdrawals can only be made without penalties after age 59. These type of investment wrappers are very country specific since they highly depend on the fiscal laws of each country. A few European countries have similar schemes: in the UK this would be a Lifetime ISA, in Germany it would be the Riester Rente and Rürup Rente. These types of privately funded retirement accounts are often called the third pillar of a pension system.
A taxable account is a normal brokerage account which does not have the tax benefits of the investment wrappers mentioned above. For example, an account on DeGiro or Interactive Brokers would be a taxable account. Since these accounts are not tax advantaged they also don’t have the requirements that the retirement investment wrappers have: you can withdraw them when you want and you don’t have limits in the contributions.
Investing in index funds is about focusing on the things you control: picking an asset allocation; choosing a broad diversified index fund; having regular contributions. One of the things under your control is choosing investment vehicles which minimize your tax liabilities and as a result increase your returns. That is where investment wrappers come in.