Investing is one of the best ways to grow a retirement nest egg, and the first step in the process is selecting an investing account. Two common retirement investing account options are brokerage accounts and individual retirement accounts, or IRAs.
Investors can buy and sell stocks, bonds, exchange-traded funds and mutual funds in both IRAs and brokerage accounts, but IRAs have special tax rules and guidelines for contributions and withdrawals that investors need to fully understand.
Here’s everything you need to know to use IRAs and brokerage accounts to maximize your investing returns.
— What is a brokerage account?
— What is an IRA?
— Choosing between an IRA and brokerage account.
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What Is a Brokerage Account?
A brokerage account is a basic investment account that has relatively few restrictions compared to IRAs and other retirement account types. Standard brokerage accounts have no contribution limits, restrictions or penalties associated with the timing or size of withdrawals. Brokerage account investors can trade stocks and other assets on margin, which is money borrowed from the brokerage. Some brokerage accounts also provide access to certain assets that may not be available to retirement account investors, such as stock options.
But while brokerage accounts provide investors with more freedom than IRAs, they are not tax advantaged. Investors must pay taxes on any earnings generated in a brokerage account, including capital gains and dividends. Investors must pay capital gains taxes on profitable trades in the same tax year they complete the sale, even if they keep the cash in the brokerage account or use it to invest in another asset.
The Internal Revenue Service taxes capital gains from a brokerage account at one of two possible rates depending on how long an investor held an asset prior to selling. Profits on assets held for less than a year are considered short-term capital gains and are taxed as ordinary income. Profits on assets held for more than a year are considered long-term capital gains and are taxed at discounted rates of either 0%, 15% or 20% depending on an investor’s income. Most dividends paid by U.S. companies are classified as “qualified dividends” and are also taxed as long-term capital gains.
What Is an IRA?
An IRA is a type of retirement account investors can open with a bank or brokerage that provides tax advantages for retirement investors. The two main types of IRAs are traditional IRAs and Roth IRAs.
A traditional IRA is a tax-deferred investment account, meaning qualified contributions are tax deductible in the year they are made. As long as that money stays in the traditional IRA account, it is not taxed. Investors can even buy and sell stocks and other assets repeatedly for large gains in a traditional IRA account and not be subject to capital gains taxes or taxes on dividends. However, withdrawals from a traditional IRA are taxed. The IRS treats IRA withdrawals as income, and investors pay taxes on those withdrawals based on their current income tax bracket. Because most IRA investors withdraw their contributions during retirement, they pay a lower tax rate than they likely would have paid when they were working.
A Roth IRA account is an after-tax retirement investing account. Roth IRA contributions are not tax deductible, but qualified withdrawals are completely tax free. In addition, Roth IRA investments are not subject to capital gains or dividend taxes, meaning investments can grow completely tax free.
[Read: How to Open a Roth IRA.]
Brian Rellihan, senior financial advisor for Wise Wealth Partners, says qualified investors should take advantage of the tax management benefits of Roth IRAs.
“You get the long-term benefits of tax-free withdrawals and tax-free year-over-year growth, with no capital gains, dividends or interest to claim on your 1040,” Rellihan says.
There are also several other types of IRAs with unique rules and advantages. A SIMPLE IRA allows both employers and employees to contribute and is geared toward small businesses. A SEP IRA allows employers of any size to contribute to IRAs set up for employees. A rollover IRA allows investors to move funds from an old employer-sponsored retirement plan, such as a 401(k), into an IRA without paying taxes or a penalty. An inherited IRA is an IRA account inherited from another person when they die. A self-directed IRA allows investors to buy certain types of assets that are not allowed in traditional or Roth IRAs, such as precious metals, real estate and tax lien certificates.
The two main disadvantages of IRA investing are contribution limits and access restrictions. Investors can currently only contribute up to $6,500 annually to an IRA account. Investors over the age of 50 are allowed an additional $1,000 catch-up contribution per year.
While investors can withdraw their money from an IRA account at any time, they must pay a 10% early withdrawal penalty to the IRS if they withdraw prior to the age of 59.5 years. This 10% penalty comes in addition to any other taxes the investor owes on the withdrawal. There are certain exceptions to the early IRA withdrawal penalty, including money withdrawn for a first-time home purchase and money withdrawn to fund education.
There are also qualification restrictions for different types of IRA accounts. You must have earned income to contribute to a traditional IRA, and your annual contributions must not exceed your income for the same year. There are income limits associated with the traditional IRA contribution tax deduction as well. For example, in 2023, individuals earning between $73,000 and $83,000 are only allowed a partial tax deduction, while individuals earning more than $83,000 get no deduction at all.
[Read: IRA Rules: Contributions, Deductions, Withdrawals.]
Choosing Between an IRA and a Brokerage Account
As a rule of thumb, most retirement investors come out ahead in the long term when they prioritize IRA investing over investing in a brokerage account. In addition, investors who begin contributing to an IRA account at an earlier age will get more of a long-term benefit from their investments compounding tax free over time.
An IRA may be a particularly attractive option to any worker who does not have a 401(k) plan or other employee-sponsored retirement plan.
Aviva Pinto, managing director at Wealthspire Advisors, says retirement savers should max out their $6,500 annual IRA contribution each year if they have extra cash to put in the market.
“Regardless of your time horizon, if you are working, it makes sense to set up an IRA and invest the extra cash that way. You can make it as aggressive or conservative as you want depending on your time horizon and your risk tolerance,” Pinto says.
Kristin McKenna, president of Darrow Wealth Management, says investors should first carefully consider whether or not they may need access to their money anytime soon.
“If you’re going to need the money in the next five to 10 years and before age 59 and a half, then investing in an IRA when you may face penalties to access the money doesn’t make sense,” McKenna says.
She says retirement investors can also use brokerage accounts for tax bucketing, a strategy that involves allocating different types of assets to different accounts to optimize the tax advantages provided by each.
“If most of your money is in retirement accounts, it can be advantageous to diversify from a tax standpoint by having assets in a brokerage account. Capital gains tax rates are less than regular income for most taxpayers,” McKenna says.
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Brokerage Account vs. IRA: Which Should You Invest In? originally appeared on usnews.com
Update 01/19/23: This story was previously published at an earlier date and has been updated with new information.
