Retirement may seem like something only “old people” worry about. But that actually couldn’t be further from the truth. You see, the sooner you start thinking about your retirement, the better off you’ll be! Knowing how to properly invest a portion of your income to enable its growth is of the utmost importance.
As humans live longer and our costs skyrocket due to inflation, saving for retirement is becoming increasingly critical. But despite the vast majority of Americans (77%) having a retirement plan, many don’t have enough money saved to live their post-retirement life as comfortably as they did their working years. Smart investing can help bridge that gap. Keep reading to learn more about brokerage accounts and IRAs and which one might be best for your future goals.
What is a brokerage account?
Brokerage accounts are taxable accounts that enable investors to buy and sell stocks and other securities as they please, with no caps on how much you can invest. Investors in brokerage accounts also have the freedom to sell their investments anytime they want without a penalty. Brokerage account investors must pay taxes on interest, dividends, and any capital gain income.
What is an IRA?
IRA stands for “individual retirement account.” IRAs are tax-advantaged investment accounts specifically designed for people saving for retirement. Compared to brokerage accounts, IRA investment choices are much more limited. Still, any earnings grow tax-free or tax-deferred, depending on whether the investor has a Roth, traditional, or other types of IRA.
One downfall of IRAs, when compared to brokerage accounts, is that they have strict contribution limits. For the 2022 tax year, investors can only contribute up to $6K into their IRA account. Investors over age 50 can contribute $7K. What’s more, investors can only contribute these maximum amounts if their modified adjusted gross income falls below $129K for a single tax-filer and $204K for joint filers. Additionally, any withdrawals made before the investor turns 59 1/2 years old will trigger a 10% penalty. But investors can withdraw their IRA contributions anytime they please without a tax penalty or other fees.
Other common IRA types include:
- SEP IRA. A Simplified Employee Pension (SEP) is a traditional IRA set up and funded by an employer for their employees. The employer gets tax benefits for participating in this type of IRA. SEP IRA earnings grow tax-free, and withdrawals in retirement are taxed. The contribution limit for SEP IRA is also much higher than other types of IRAs — $61,000 in 2022.
- Spousal IRA. To be eligible to contribute to an IRA, you must have earned income. But married taxpayers have a workaround if one spouse does not work or brings in a low income, as both spouses are allowed to contribute to their own separate IRA accounts.
- SIMPLE IRA. A Savings Incentive Match PLan for Employees, or SIMPLE IRA, is similar to an employer-sponsored 401(k). But it’s primarily used by small businesses and people who are self-employed. Contribution limits for SIMPLE IRAs are lower than traditional 401(k) — just $14,000 for 2022.
Brokerage account vs. IRA: the taxes
It’s critically important to consider taxes when investing, as tax-efficient investing allows you to keep the largest percentage of your gains possible. There are critical differences between brokerage accounts and IRA accounts regarding taxes and what’s considered taxable.
Taxes for brokerage accounts
Brokerage accounts are taxable, meaning if an investor makes a profit because his/her investments pay interest or dividends or because their investments increase in value when the investor sells the investments, the investor is responsible for the taxes on that income. The tax liability varies by the source of income, including:
- Interest. Investments like bonds, certificates of deposit (CDs), and uninvested cash held in accounts are eligible to earn interest. Generally, interest income is taxed the same as regular income. But there are a couple of exceptions:
- State and/or local income taxes do not apply to U.S. Treasuries.
- Municipal bonds are typically exempt from federal taxes—and sometimes also state and local taxes.
- Dividends. Dividends are an investor’s share of a company’s earnings. There are two kinds of dividends, each with its own unique tax treatment:
- Qualified dividends represent the majority of dividends paid to shareholders by public companies and are taxed at the capital gains rate, which is lower and longer-term.
- Unqualified dividends are taxed at the higher, regular income tax rate and apply to business development companies (BDCs) and master limited partnerships (MLPs).
- Capital gains. When an investor sells an investment for profit, they’ll be liable for taxes on their gain. How much taxes they’ll owe depends on how long they’ve held the investment
- Short-term capital gains are gains on investments held for less than one year. These types of gains are taxed as regular income.
- Long-term capital gains refer to any gains made on investments held for more than one year. Long-term capital gains are taxed at a more favorable long-term capital gains rate.
Taxes for IRA accounts
Any contributions made to traditional IRA accounts are made with pre-tax dollars and, therefore, might be tax-deductible—all depending on the investor’s income and whether a retirement plan at work covers the investor and/or their spouse.
Contributions to Roth IRA accounts are made with after-tax dollars, meaning there’s no tax break available for the year the contribution is made. Instead, the tax benefit is available in retirement when the investor’s withdrawals are tax-free.
IRA earnings grow tax-free or tax-deferred, depending on the kind of IRA:
- Roth IRA. No upfront tax break is available, meaning contributions don’t lower the investor’s taxable income. However, all qualified withdrawals while the investor is retired are tax-free. The investor also has the freedom to withdraw their contributions whenever they want, without a penalty—no matter the reason for the withdrawal. Unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs).
- Traditional IRA. Traditional IRA contributions may be deducted from the investor’s taxable income the same year they are made, lowering their overall taxable income and tax liability. But, it’s important to note that these withdrawals are subject to income taxes, and most early withdrawals will trigger a 10% penalty. The penalty (but not the tax) can be avoided in certain situations, including if the investor uses the money toward qualified first-time homebuyer expenses.
Roth IRA vs. traditional IRA: which is better?
Now we arrive at the decades-old question, “Roth IRA or traditional IRA, which is better?” It depends on your situation.
Remember, Roth IRA contributions are not tax-deductible, but qualified withdrawals after the investor has retired are tax-free.
On the other hand, contributions to a traditional IRA account are tax-deductible, meaning the investor may save money on their tax bill. But they will still owe income taxes on withdrawals made in retirement.
Generally speaking, most people are better served by traditional IRA accounts if they expect to be in a lower tax bracket at retirement than they currently are. However, investors who expect to be in the same or higher tax bracket when they retire will be better served by Roth IRAs because these types of retirement accounts allow them to pay their tax bills before they retire. This means they get to pay them off at the current, lower tax rate.
Brokerage account vs. IRA: which is better?
You may not know that most financial experts recommend having both accounts when possible. For example, use a brokerage account for day trading, long-term investments, and saving for short-term financial goals like home renovation costs or college tuition, and use your IRA account for retirement savings.
The most significant benefits of brokerage accounts are their flexibility and the fact that they don’t have any limits on contributions, withdrawals, or income. This is especially true when compared to IRA accounts that come with quite a few limitations, including annual contribution limits, the fact that withdrawals may trigger penalties, and once a certain income threshold is reached, investors can no longer contribute to Roth IRA accounts.
Final Thoughts
Brokerage accounts and IRA accounts are both excellent options that enable investors to purchase and sell:
- Stocks.
- Bonds.
- ETFs.
- Mutual funds.
It’s a sage financial strategy to have both types of accounts, as long as you remain eligible. This allows investors to take advantage of both types of accounts while downplaying the disadvantages.
