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.
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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 a brokerage account.
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 or restrictions and 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 realized capital gains and dividends. Investors must pay capital gains 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 IRS 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.
Douglas Feldman, chief investment officer at Stash, says IRAs offer investors tremendous tax advantages.
“If the goal is to save for retirement and the extra cash won’t be needed in the near term, it’s beneficial to invest in either a Roth IRA, where investors can get tax-free withdrawals in the future (the contributions are after-tax dollars), or a traditional IRA, where investors aren’t taxed on contributions until the money is withdrawn during retirement,” Feldman says.
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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 $7,000 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 2024, individuals earning more than $77,000 are only allowed a partial tax deduction, while individuals earning more than $87,000 get no deduction at all.
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.
Joseph Carpenito, financial advisor at Materetsky Financial Group, says investors should think about their personal financial goals before choosing between an IRA and a brokerage account.
“An IRA is a good option for someone looking to save for retirement and is comfortable with the long-term horizon. A brokerage account, on the other hand, is a better option for more flexibility and short-term investments,” Carpenito says.
Before automatically dumping cash into an IRA, Feldman says investors should carefully consider whether or not they may need access to their money anytime soon.
“Just remember that there are penalties for early withdrawal, so only invest the amount in an IRA that you are prepared to keep invested until retirement,” Feldman says.
Katelyn Bombardiere, financial advisor at Commas, says she typically recommends her clients take advantage of Roth IRA tax benefits, if possible.
“If you have extra cash, first make sure your emergency fund and short-term goals are funded, and that any high-interest consumer debt is paid off,” Bombardiere says.
“Then, if possible, max out your Roth IRA … and use the rest to invest in a taxable account.”
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Brokerage Account vs. IRA: Which Should You Invest In? originally appeared on usnews.com
Update 05/14/24: This story was previously published at an earlier date and has been updated with new information.
