Brokerage Account vs. IRA: What's the Right Move?
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You're ready to open an investment account and start building a nest egg. When it comes to a traditional IRA vs. brokerage account, you'll find pros and cons to both. We've created this primer to help you decide which one might be right for you.
Let's compare a traditional IRA vs. brokerage account. To start investing, there are two main types of accounts you can choose from: an individual retirement account (IRA) or a standard taxable brokerage account. Here's a rundown of what you should consider before making a decision.
Before we get started, note that I often use a few terms to describe the same thing. "Brokerage account," "taxable brokerage account," and "standard brokerage account" are different names for a non-retirement investment account. Technically speaking, all investment accounts can be described as brokerage accounts. Taxable accounts and IRAs are both offered by brokerages.
A standard brokerage account has several advantages. Generally, it is the less-restrictive of the two options. Here's why:
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In the toss-up between a traditional IRA vs. brokerage account, the biggest disadvantage is that a brokerage account is not tax-advantaged. Since it's a taxable account, you'll have to pay taxes on earnings in your account, including capital gains and dividends.
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 profits on investments you held for over a year. They 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 even 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.
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When comparing the traditional IRA vs. brokerage account, the biggest incentive to open an IRA instead of a brokerage account is for the tax-advantaged status. The two main types of IRA are traditional and Roth, and the main difference between them is the type of tax advantages.
A traditional IRA is a tax-deferred investment account. 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 taxable income. So 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, and you'll pay taxes based on your current tax rate. Many people earn more -- and pay higher taxes -- while working than in retirement. That's why a traditional IRA can be a way to save money on taxes.
A Roth IRA account is an after-tax retirement saving account. You don't get a tax deduction for Roth IRA contributions, but you still get a significant tax benefit. Investments grow without capital gains or dividend taxes, and any qualified Roth IRA withdrawals are 100% tax free, no matter what tax bracket you're in at the time of the withdrawal.
Here are a few other kinds of IRAs:
When it comes time to choose a traditional IRA vs. brokerage account, the best IRA account for you will depend on your situation, your goals, and your comfort level with investing.
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Before you land on a traditional IRA vs. brokerage account, you'll need to find out if you qualify to open and contribute to an IRA. The answer 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 vs. brokerage account, 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 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, your adjusted gross income, or AGI, needs to be less than the limit for your filing status to take the deduction:
| 2023 Tax Filing Status | Income Limit for a Full Traditional IRA Deduction | Deduction Phases Out Entirely for Income Above |
|---|---|---|
| Single | $73,000 | $83,000 |
| Married Filing Jointly | $116,000 | $136,000 |
| Married Filing Separately | $0 | $10,000 |
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 $218,000 and the phase-out limit is $228,000.
With a Roth IRA, the ability to open and contribute to an account is income-restricted. Here's a chart of the 2023 Roth income limits:
| 2023 Tax Filing Status | Income Limit for a Full Roth IRA Contribution | Roth Contribution Phases Out Entirely for Income Above |
|---|---|---|
| Single and Head of Household | $138,000 | $153,000 |
| Married Filing Jointly | $218,000 | $228,000 |
| Married Filing Separately | $0 | $10,000 |
Here's how to interpret these tables:
Learn more: Best Roth IRA Accounts
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 a traditional IRA 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 owe on the withdrawal.
The two most common exceptions to this are 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 toward a first-time home purchase for you or someone else. Or, you can withdraw any amount to use toward 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.
While there are certainly some good reasons to use a taxable brokerage account -- especially when it comes to withdrawal flexibility -- the money you have in a traditional IRA vs. brokerage account 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 the pros and cons of a traditional IRA vs. brokerage account before opening either. 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. Start a conversation with one of the best online brokers to discuss your specific goals and questions.
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