Brokerage Account vs. IRA : Which Should You Invest In?

·8 min read

Saving for retirement is a long-haul kind of game.

While there are many ways to save and invest your hard-earned money, you want to make sure you're picking the best investment tools that are right for you.

You may be in a situation where you've maxed out your 401(k) and are considering other options like an individual retirement account or a brokerage account that have 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, given that money is subject to taxation at some point in time. Here's what you need to know about IRAs and brokerage accounts that may help you efficiently invest for the long term:

-- What is an IRA?

-- What is a brokerage account?

-- Which one is best for you?

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What Is an IRA?

An IRA is a retirement investment vehicle that offers tax advantages for your retirement savings.

Investing in an IRA allows you to grow your money tax-deferred. This means you won't pay taxes on your investment returns at the current tax rate but rather at the tax rate at the point at which the money is withdrawn, so the money grows tax-free. This allows your money to compound in exponential growth.

For IRA contributions between 2019 through 2021, the total contributions allowed annually to traditional and Roth IRAs can't exceed $6,000. If you're age 50 or older, then you're allowed catch-up contributions, and the maximum annual amount is $7,000.

Apart from a traditional IRA, there are several other types of IRAs. A Roth IRA also allows your money to grow tax-free like a traditional IRA, but what's different with a Roth is that investors can take tax-free withdrawals on contributions. A Roth has similar contribution limits to its traditional counterpart.

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 plan, 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 is a contribution limit. For a Roth IRA, investors can only contribute the full amount if their modified adjusted gross income is less than $125,000 for 2021. Brokerage accounts have no restrictions on how much money you contribute.

If you wish to withdraw money from your IRA, you may incur withdrawal penalties when the money is taken out too early. The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, allowed special distribution options for retirement plans and IRAs and provided expanded loan options for eligible retirement plans for those who suffered economic hardship from the pandemic. This coronavirus-related distribution was to be made from an eligible retirement plan to a qualified individual from Jan. 1, 2020 to Dec. 30, 2020, up to an aggregate limit of $100,000 from all plans and IRAs, according to the IRS.

In general, with a traditional IRA, you have to wait until the age of 59 ½ to withdraw money without a penalty; otherwise, you will incur a 10% penalty along with federal and state charges. At age 59 ½, 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, make sure to fund it with investments. You can choose mutual funds, exchange-traded funds and 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 this gives people a wide array of investment options while taking advantage of tax-deferral.

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 eventually appreciate over time.

You can open an IRA with any starting amount as there are no account minimums. But depending on the investments you choose for your account, they may require a minimum dollar amount.

What Is a Brokerage Account?

A brokerage account is an investment account that allows you to buy and sell investments, such as stocks, bonds, mutual funds, ETFs and other assets.

Investors use brokerage accounts for long-term investing, saving up for particular life goals or day trading. There are many investment options through your brokerage. Apart from stocks and funds, you may be able to invest in commodities like gold and silver, or access international investments, options trades or trading on margin. This type of account allows you to manage investments in a way that's suitable for you, whether it's on your own, with a financial advisor or through automation.

When thinking about what investments to choose in your brokerage account, Nancy Anderson, regional planning specialist at Key Private Bank in Park City, Utah, says 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.

When incorporating stocks into your portfolio, Anderson says "equities provide the best long-term growth over time." 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 through purchasing investments through their broker that will hopefully increase in future value, in which case investors can sell 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. This is more efficient than paying the income tax rate. Compared to a pretax IRA, where your investments increase in value, and when it comes time to withdraw money, you will need to pay income tax on any gains.

[READ: The Difference Between ETFs and Mutual Funds.]

Today, many brokerages do not have fees for opening an account and offer commission-free investment options. But investors are subject to fees on investments they purchase.

Brokerage accounts allow investors to deposit and withdraw money at any given amount in any given period. There are 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 buy 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, by answering several questions about yourself, the algorithm will tailor an investment plan just for you and will manage your investment portfolio regularly.

Brokerages provide full-scale online tools and resources with which investors can do thorough analysis by accessing financial reports, statements, analyst recommendations and more. This gives investors the independence to make sound financial decisions.

Brokerage Account vs. IRA

Investors don't necessarily have to choose between a brokerage account or an IRA; you 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."

[Read: How to Open a Brokerage Account for Your Kids.]

According to Anderson, "Since a taxable brokerage account and an IRA tax-deferred retirement account each has their 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 opening an IRA and then invest 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 compound and for it to grow over the long run. Keeping up with this practice can result in more funds to live off of as you ease into retirement.

Takeaway

While you may be more comfortable having long-term retirement vehicles in an IRA or 401(k), investors who can identify their life goals and have an investing strategy can justify using both an IRA and a brokerage account -- getting the added benefits both services provide.

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