Both IRAs and brokerage accounts can be an important part of any investor’s financial planning. Both accounts can be personally managed or automated, and both allow for a range of investment options and saving potential. However, there is a more than one important difference between brokerage accounts and IRAs. Here’s how these accounts differ, what they offer, and how to make each one part of a strategic retirement plan.
What’s a brokerage account?
Whether it’s part of a short or long term investing strategy, a brokerage account can be a valuable tool in any financial portfolio.
A brokerage account is a financial product offered by a brokerage firm, which allows investors to buy, sell, and hold various securities. These could include stocks, bonds, mutual funds, exchange-traded funds (ETFs), cryptocurrency, and options, to name a few.
Investors add funds to their brokerage account, which can then be used to purchase shares of securities. The account can be self-directed (through an online brokerage), fully managed by a personal broker, or automated, as with a robo-advisor.
Unlike retirement-specific accounts, the money and assets held in a brokerage account can be added or withdrawn anytime without penalty. However, these assets are typically subject to either short or long term capital gains taxes, as well as taxes on any dividends received throughout the year.
Types of brokerage accounts
There are three types of brokerage accounts that individuals can own, depending on their preferred level of involvement and threshold for costs.
Self-managed. These brokerage accounts are established and managed by the investor. This is often done through an online brokerage platform, which may charge minimal fees for allowing investors to buy, sell, and track their portfolio over time.
Robo-advisor. These brokerage accounts are automated according to the investor’s settings and preferences. This usually means choosing a portfolio allocation and then contributing funds regularly; the robo platform will purchase securities accordingly, then rebalance the portfolio over time, as needed.
Actively managed. With this type of brokerage account, investors receive a tailored investment experience. Funds are chosen by a financial professional, according to the investor’s goals and preferences. This hired manager will monitor and adjust the portfolio as needed.
Advantages of a brokerage account
There are some key benefits to owning and investing in a brokerage account.
- No contribution limits. Unlike 401(k) plans and IRAs, there are no contribution limits to a brokerage account. Investors can contribute as much—or as little—as they want to the account each year.
- No early withdrawal penalties. The funds and assets held in a brokerage account can be withdrawn at any time without penalty.
- Investors have unlimited flexibility. Through a brokerage account, investors can buy (or sell) the stocks, cryptocurrencies, bonds, ETFs, mutual funds, and more that interest them. Portfolios can be balanced according to investors’ needs and proximity to retirement, and securities can be bought or sold at any time.
- No income requirements or limits. When opening a taxable brokerage account, there are no minimum income requirements or maximum income limits.
Disadvantages of a brokerage account
Of course, brokerage accounts have certain disadvantages.
- Growth is subject to taxes. Whenever an investor sells an asset held in a brokerage account for a gain, they’ll be responsible for paying taxes on that gain. The rate of taxation varies, depending on how long the investor held the asset. If an investor held it for less than a year, they may find themselves paying higher taxes for the short term capital gains.
- There are no tax advantages. Contributions to certain retirement accounts are tax-deferred, meaning that investors don’t pay taxes on that money in the year it was earned; rather, they pay taxes on it in retirement, when their income tax rate may be lower. However, there are no such benefits when contributing to a brokerage account.
- More research and attention is required. When buying and selling through a brokerage account, investors need to do their homework to determine what to buy and when, as well as when they should sell certain securities. Robo-advisors and managed investment accounts do this on the investor’s behalf, but investors must still research firms before investing.
What’s an individual retirement account?
An individual retirement account, or IRA, is a retirement-specific savings vehicle. This account allows for tax-advantaged savings.
Most IRAs are opened by the individual themselves and can be established at a number of financial institutions such as banks, credit unions, and brokerages. The funds held within an IRA can then be invested in a variety of securities such as stocks, bonds, mutual funds, ETFs, and even real estate.
Types of IRAs
The three most common types of IRAs are the traditional, Roth, and SEP IRA.
Traditional IRA. For investors who meet eligibility criteria, a traditional IRA allows for tax-deductible contributions, which can help reduce one’s taxable income.
Roth IRA. With a Roth IRA, contributions are made with after-tax funds, which are not deductible. Instead the funds will grow tax-free over time, and both the contributions and growth can be withdrawn in retirement without any additional taxes.
SEP IRA. A Simplified Employee Pension IRA is designed for self-employed individuals and small business owners. This account works very similarly to a traditional IRA, with tax-deductible contributions; the difference is that employers are required to contribute as much to their employees’ accounts as they contribute to their own.
Advantages of IRAs
When it comes to saving for retirement, IRAs offer a number of benefits.
- Savings are tax-advantaged. Depending on the type of IRA an investor chooses (traditional or Roth), they’ll receive certain tax benefits. Traditional IRAs offer tax advantages when funds are contributed; Roth IRA contributions see tax advantages when funds are withdrawn.
- Growth can be tax-free. With a Roth IRA, any growth on contributions is tax-free.
- Investors control their IRA investment strategy. They can choose to open an account at any number of financial institutions and can have complete control over the securities and assets in which they invest.
Disadvantages of IRAs
As with any other investment account or product, there are certain downsides to note when it comes to IRAs.
- Annual contribution limits are low. Whether an individual is contributing to a Roth IRA, a traditional IRA, or both, they’re limited to $6,000 in contributions per year (as of 2022). If they’re 50 or older, this is bumped to $7,000, but that still might not be enough to meet one’s goals.
- There can be required minimum distributions and income limits. Depending on the type of IRA chosen, an investor may be subject to take required minimum distributions (RMDs) from the account once they reach age 72. If their employer offers another retirement plan option, there may also be income limits that determine eligibility for their IRA’s tax advantages.
- Investors typically need to set up their own account. Most IRAs are opened and funded independently, so investors will need to do some research in terms of the institution itself, any fees, and the investments offered.
- Early withdrawal penalties may exist. With traditional IRAs, investors cannot withdraw contributions before age 59 ½ without incurring an early withdrawal penalty and triggering taxes. They can withdraw contributions from a Roth IRA at any time without penalty, but they cannot touch growth prior to retirement age without taxes and penalties.
What are the main differences between a brokerage account and an IRA?
While there are many similarities between brokerage accounts and IRAs, there are some important distinctions to be made. Here are some of the main differences between the two.
- IRAs provide tax benefits. An IRA will provide tax advantages either on the front- or back-end, depending on the type of IRA. A brokerage account, on the other hand, is a taxable account and does not offer any retirement tax advantages.
- Brokerage accounts have no limits. For 2021 and 2022, IRA contributions are capped at $6,000 (or $7,000 for those over 50). However, investors can contribute as much as they want to a brokerage account.
- IRAs can have required withdrawals. Once an investor turns 72, they will be required to take minimum annual withdrawals from their traditional IRA. Roth IRAs have required distributions, too, but only after the primary account owner dies and passes the account on to a beneficiary. Brokerage accounts, on the other hand, have no such requirements.
- Brokerage accounts can offer more liquidity. Early withdrawal penalties are possible with both traditional and Roth IRAs, depending on the circumstances. With a brokerage account, though, investors can buy, sell, or otherwise liquidate any assets at any time, without penalty.
The bottom line
Both IRAs and brokerage accounts can play an important role in a retirement strategy. While there are some similarities between these two types of savings vehicles, there are many important distinctions to be made. IRAs and brokerage accounts are handled very differently when it comes to tax advantages, liquidity, and even the timing of withdrawals.