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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.

Basic investment account types

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. 

Reasons to open a standard brokerage account

A standard brokerage account has several advantages. Generally, it is the less-restrictive of the two options. Here's why:

  • There's no contribution limit for a standard brokerage account.
  • You can withdraw your money anytime and for any reason. 
  • You can trade with margin (borrowed money). This isn't always a great idea, but there are some instances where margin privileges can be a nice asset.
  • Some investment vehicles are available in a brokerage account that aren't in an IRA. For example, you generally can't buy options in an IRA.

Downsides of a standard brokerage account

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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One big reason to invest through an IRA instead

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:

  • Simple IRA: Employers and employees can contribute to a simple IRA, and these are especially well suited for small employers.
  • SEP IRA: Employers can contribute to IRAs set up for employees, and businesses of any size (including a one-person business) can use these.
  • Rollover IRA: This term refers to moving the funds from an old IRA to a new one, but without paying a penalty for (or taxes on) the IRA withdrawal. An IRA rollover is often necessary when a person changes jobs.
  • Inherited IRA: A beneficiary inherits one of these after the account holder dies. There are special rules about how to manage an inherited IRA. If you inherit someone's IRA, discuss your options with a knowledgeable advisor.
  • Self-directed IRA: This can be either a traditional IRA or a Roth IRA. The difference is that in addition to common securities (stocks, bonds, mutual fund investments, CDs, and ETFs), this account can hold assets that are not allowed in other IRAs. Those might include precious metals, real estate, tax lien certificates, and other alternative investments.

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.

Do you qualify to open and contribute to an IRA?

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:

2022 Tax Filing Status Income Limit for a Full Traditional IRA Deduction Deduction Phases Out Entirely for Income Above
Single $68,000 $78,000
Married Filing Jointly $109,000 $129,000
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 $204,000 and the phase-out limit is $214,000.

With a Roth IRA, the ability to open and contribute to an account is income-restricted. Here's a chart of the 2022 Roth income limits:

2022 Tax Filing Status Income Limit for a Full Roth IRA Contribution Roth Contribution Phases Out Entirely for Income Above
Single and Head of Household $129,000 $144,000
Married Filing Jointly $204,000 $214,000
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 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. 
  • If your AGI is higher than the upper threshold, you can't take advantage of the benefits of that type of IRA.

Drawbacks of IRA investing

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:

  • There's a limit to how much you can contribute to an IRA. For 2022, you can contribute $6,000 to your IRA, with an additional $1,000 catch-up contribution allowed if you're 50 or older.
  • You generally can't trade on margin in an IRA. And you can only use certain options strategies (such as selling covered calls).

The main downside to an IRA

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.

Which is best for you?

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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