by Matt Frankel, CFP | March 11, 2019
Here's what you should consider before opening your first investment account.
If you want to get started investing, there are two main types of accounts you can choose from. You can choose to invest through an individual retirement account, or IRA, or you can choose a standard taxable brokerage account. Both have their pros and cons, so here's a rundown of the things you should consider before making a decision.
Before we get started, note that I often used the terms "brokerage account," "taxable brokerage account," and "standard brokerage account" to describe the same thing -- a non-retirement investment account. Technically speaking, all investment accounts can be described as brokerage accounts, as taxable accounts and IRAs are both offered by brokerages.
A standard brokerage account has several advantages. Generally speaking, it is the less-restrictive of the two options. Here's why:
The biggest disadvantage to a brokerage account is that it's not tax-advantaged. You'll have to pay taxes on earnings in your account, including capital gains and dividends.
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Capital gains taxes kick in when you sell investments at a profit. For example, if you pay a total of $5,000 to buy a stock and sell your shares for $7,000, you have $2,000 in capital gains.
The IRS considers two types of capital gains -- long-term and short-term. Long-term capital gains are defined as profits on investments you held for over a year, and are taxed at favorable rates of 0%, 15%, or 20%, depending on your taxable income. On the other hand, short-term capital gains are profits on investments you held for a year or less and are taxed as ordinary income.
Capital losses can be used to offset capital gains and can even be used to reduce your other taxable income by as much as $3,000 per year (with any excess carried over). As a simplified example, if you sold one long-term holding at a $2,000 profit, another for a $1,500 profit, and another at a $1,000 loss, your long-term capital gain for the year would be $2,500 in the eyes of the IRS.
Most dividends you receive are considered "qualified dividends" and get the same favorable tax treatment as long-term capital gains. Some don't meet the IRS definition of qualified dividends -- such as dividends from some foreign companies -- and are treated as ordinary income for tax purposes.
As the last section implied, the biggest incentive to open an IRA instead of a brokerage account is for the tax-advantaged status these accounts enjoy. The two main types of IRA that are available to most people are traditional and Roth, and the main difference between the two is the type of tax advantages.
Traditional IRAs are tax-deferred investment accounts. For those who qualify, traditional IRA contributions are tax-deductible in the year they are made. While the money is in the account, investments grow on a tax-deferred basis, meaning that there are no capital gains or dividend taxes to worry about on an annual basis. However, withdrawals from traditional IRAs are considered taxable income. In other words, if you withdraw $20,000 from a traditional IRA in a year, the IRS treats it as if you received a salary of that amount.
Roth IRAs are after-tax accounts. You don't get a deduction for Roth IRA contributions, but investments grow without capital gains or dividend taxes, and any qualified Roth IRA withdrawals are 100% tax-free.
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The answer to this question depends on the type of IRA you're talking about, as well as a few other factors.
To be clear, everyone can open and contribute to a traditional IRA. However, the ability to take the deduction, which is the main reason to use a traditional IRA, is limited in some cases. If you don't have access to an employer's retirement plan, there's no restriction -- you can take the traditional IRA deduction regardless of how much money you earn.
On the other hand, if you or your spouse (if applicable) can participate in an employer's plan, the ability to take the traditional IRA deduction is restricted. If you have a retirement plan at work, in order to take the traditional IRA deduction, your adjusted gross income, or AGI, needs to be less than the appropriate limit for your filing status:
|2019 Tax Filing Status||Income Limit for a Full Traditional IRA Deduction||Deduction Phases Out Entirely for Income Above|
|Married Filing Jointly||$103,000||$123,000|
|Married Filing Separately||$0||$10,000|
Data source: IRS.
If you aren't eligible to participate in an employer's plan, your ability to contribute to an IRA is only restricted if your spouse has an employer-sponsored retirement plan. If this is the case, the limit for a full traditional IRA deduction is $193,000 and the phase-out limit is $203,000.
With a Roth IRA, the ability to open and contribute to an account is income-restricted. Here's a chart of the 2019 Roth income limits:
|2019 Tax Filing Status||Income Limit for a Full Roth IRA Contribution||Roth Contribution Phases Out Entirely for Income Above|
|Single and Head of Household||$122,000||$137,000|
|Married Filing Jointly||$193,000||$203,000|
|Married Filing Separately||$0||$10,000|
Data source: IRS.
Here's how to interpret these tables. If your AGI is less than the lower threshold for your situation and filing status, you can deduct your entire traditional IRA contribution or make a full Roth IRA contribution. If your AGI is greater than the lower limit but less than the higher one, you can take a partial deduction or make a partial Roth contribution. And finally, if your AGI is higher than the upper threshold, you can't take advantage of the benefits of that type of IRA.
I mentioned earlier that the general advantage of taxable brokerage accounts is their flexibility. Conversely, the downside to IRA investing is that it can be somewhat restrictive in certain ways. Specifically:
The most significant drawback to investing in an IRA as opposed to a taxable brokerage account is access to your funds.
To be perfectly clear, you can withdraw money from your IRA at any time. However, if you aren't at least 59 1/2 years old or otherwise qualified for an exception, you'll have to pay a 10% early-withdrawal penalty to the IRS, in addition to any taxes you might owe on the withdrawal.
What are the exceptions? With IRAs, the two most common are the exceptions for first-time home purchases and educational expenses. Specifically, you can withdraw as much as $10,000 from your IRA penalty-free (but not tax-free) to put towards a first-time home purchase for you or someone else. Or, you can withdraw any amount to use towards higher education expenses. In fact, IRAs (especially Roth IRAs) are often used as college-savings vehicles precisely for this reason.
Speaking of Roth IRAs, there's another exception to the penalty. Because you're contributing money on an after-tax basis, you are free to withdraw your original contributions -- but not any investment gains -- at any time, and for any reason. For example, if you deposit $5,000 into a Roth IRA and the account's value grows to $8,000 in a year, you can withdraw your initial $5,000 contribution without paying any taxes or penalties whatsoever.
The point is that while there are certainly some good reasons, especially when it comes to withdrawal flexibility, to use a taxable brokerage account, the money you have in an IRA may not be quite as "tied up" as you think.
There's no one-size-fits-all answer to the question, and it's important to consider all of the pros and cons before opening your first investment account. The best answer may be "both" -- many investors take advantage of the flexibility of a taxable brokerage account while also actively contributing to a tax-advantaged IRA for retirement.
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