You may be in a situation where your employer doesn’t offer a 401(k) or you’ve maxed out your 401(k) and are considering other options, such as an IRA or a brokerage account with unique features that may benefit your overall investing strategy.
Each account has different purposes. Broadly speaking, a brokerage account is for investing in the stock market, while IRAs focus on retirement planning.
The different tax treatments of each type of account are what can ultimately sell an investor on one over the other, given that the money will be subject to taxation at some point. Here’s what you need to know about IRAs and brokerage accounts to help you invest for the long term:
— What is an IRA?
— What is a brokerage account?
— Pairing a brokerage account with an IRA.
What Is an IRA?
An IRA is an investment vehicle that offers certain tax advantages for your retirement savings. It allows your retirement money to compound in growth, and contributions are not taxed until you make a withdrawal. This means earnings in your traditional IRA account can grow tax-deferred. You won’t pay taxes on your investment returns at the current tax rate, but rather at the tax rate at the time the money is withdrawn.
For IRA accounts in 2022, total contributions cannot be more than $6,000. Account holders who are 50 or older can make contributions up to $7,000. Apart from a traditional IRA, there are other types of IRAs:
Roth IRA. With a Roth IRA, you make after-tax contributions. So earnings grow tax-free and you don’t pay taxes on your withdrawals, as long as you are 59½ or older and have held the account for five years or more. This allows you to take full advantage of compounding growth over time.
SEP IRA. A Simplified Employee Pension IRA is a tax-deferred retirement plan for those who are self-employed. This is different than a Savings Incentive Match Plan for Employees, or SIMPLE IRA, which gives employees and employers the chance to contribute to the employee’s traditional IRA.
There is no income limit for a traditional IRA, although there are contribution limits that depend on income. For a Roth IRA, investors can only contribute the full amount if their modified adjusted gross income is less than $129,000 if filing as a single taxpayer or $204,000 if married and filing jointly for tax year 2022. Brokerage accounts have no restrictions on contributions.
If you wish to withdraw money from your IRA, you may incur withdrawal penalties when the money is taken out too early. In general, with a traditional IRA, you have to wait until the age of 59½ to withdraw money without a penalty, with certain exceptions. Otherwise, you may incur a 10% penalty along with federal and state taxes. At age 59½, you can start to withdraw money from your IRA with no penalties but are subject to taxes that may be due.
You can open an IRA with a bank or a brokerage company. Once you open your IRA, be sure to choose investments for your contributions. You can choose mutual funds, exchange-traded funds or individual securities, among many other investments.
“You can usually invest in the same securities in your IRA that you can in a taxable brokerage,” says Nikki Dunn, a certified financial planner based in Houston. Dunn explains that this gives people a wide array of investment options while taking advantage of tax rules.
Choose investments that fit your investor profile, risk tolerance, time horizon and overall investing goals. By contributing to your IRA on a consistent cadence — either monthly, quarterly or annually — this tax-advantaged retirement account will likely appreciate over time.
You can open an IRA with any starting amount. But the investments you choose for your account, like mutual funds offered by particular brokerages, may require a minimum deposit.
What Is a Brokerage Account?
If you invest in the stock market, a standard brokerage account is a necessity. A brokerage account is an investment vehicle that allows investors to access stocks; bonds; exchange-traded funds, or ETFs; and many other assets they can buy and sell through a brokerage.
Investments are held in the brokerage account for the long term, so the value of the assets grows over time. A distinct advantage brokerage accounts have over other investment accounts is that they allow flexibility in the types of investments the account holder can purchase. Apart from domestic stocks, you can invest in some international stocks or publicly traded companies linked to commodities like gold and silver.
When thinking about what investments to choose in your brokerage account, retail investors need to consider a few things, including how long the money will be invested and their ability to tolerate risk when the markets get volatile, says Nancy Anderson, regional planning specialist at Key Private Bank in Park City, Utah.
“Equities provide the best long-term growth over time,” Anderson says, referring to stocks. That said, she notes that it’s easier to get diversification and, over the long term, better results from a portfolio composed of mutual funds or ETFs.
Brokerage accounts are taxable accounts, but they can offer some tax flexibility. Generally, investors seek a return on their invested capital by purchasing investments through their broker that they hope will increase in value. Investors can sell them at a later date and generate profits.
When you sell securities at a profit, you are then charged capital gains tax. You will also pay taxes on dividends or interest income. Depending on the type of investments and the length of time they are held, capital gains can be taxed at varying rates. Short-term gains, or gains on investments held for less than a year, are taxed as ordinary income. Long-term capital gains, those on investments held for at least a year, are taxed at a lower rate, currently 0%, 15% or 20%, depending on your income.
Brokerage accounts are taxable accounts. This means that while there are no tax benefits that come with having them, compared with tax-advantaged accounts such as IRAs and 401(k)s, they do have other specific advantages. For example, brokerage accounts have no fees associated with opening the account and no contribution limits. You can have more than one brokerage account, and they allow investors to deposit and withdraw money at any given amount in any given period with no penalties for withdrawals.
“Accessibility is a double-edged sword, since funds could be withdrawn for any reason,” Anderson says.
Anderson notes that since investors must pay taxes on underlying investments in the account, they must be careful about what investments they hold in their brokerage accounts.
“The key is strategizing on ways to minimize the taxes in the brokerage account each year by choosing tax-favored investments, harvesting losses against gains and aiming for the tax-favored, long-term capital gains tax treatment,” she explains.
The rise of robo advisors has made opening a brokerage account easier than ever. Robo advisors allow you to easily invest and track your investments to see how you’re reaching your goals. You can either customize your own portfolio, or the algorithm will tailor an investment plan for you and will manage your investment portfolio regularly, based on answers you provide to questions the robo advisor asks about your preferences.
Brokerages provide full-scale online tools and resources with which investors can do thorough analysis by accessing financial reports, statements, analyst recommendations and more.
Pairing a Brokerage Account With an IRA
Investors don’t necessarily have to choose between a brokerage account and an IRA; anyone can have both. Each account has its purposes, involves different strategies and yields different results.
“Having both an IRA and brokerage account allows you to focus on saving for retirement, along with shorter-term financial goals, like buying a house or a car,” says Mindy Yu, director of investments at Stash, a personal finance and investing app.
In both cases, Yu says, you’re helping to put your money to work for you — via the potential of earning a return on your investments, as well as staying ahead of inflation.
“We always recommend investing regularly, thinking long term and maintaining a diversified portfolio,” Yu adds, regardless of the type of investment account. “These three tips can help you minimize risk and better position you to hit your unique financial goals.”
According to Anderson, “Since a taxable brokerage account and an IRA tax-deferred retirement account each has its benefits and drawbacks, pairing the two can be a perfect solution for investors.”
When your focus is saving for retirement, IRAs may be the better option over brokerages, considering their tax advantages. “A taxable brokerage account won’t give you the tax deferral or even tax advantages that an IRA does,” Dunn says.
Experts say you may want to start by first opening an IRA and then investing in a taxable brokerage account.
Consider opening a brokerage account when you want to contribute more money than an IRA allows. The more money invested, the greater the opportunities for it to grow over the long run. Keeping up with this practice can result in a more comfortable transition to retirement.
You may be more comfortable investing for the long term with a retirement vehicle such as an IRA or 401(k), but investors who have a strategy for reaching certain goals can justify using both an IRA and a brokerage account — to take advantage of the benefits both types of accounts provide.
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Brokerage Account vs. IRA: Which Should You Invest In? originally appeared on usnews.com
Update 06/02/22: This story was previously published at an earlier date and has been updated with new information.