A Brokerage Account vs. an IRA: What to Know
While they both hold financial assets, a brokerage account and an IRA (Individual Retirement Account) are two different types of accounts. The main difference between the two is that an IRA is an account used for the purpose of accumulating assets for use in retirement. Several tax advantages exist for the IRA that do not for a traditional brokerage account. Let’s look at these two different account types in further detail, so you can decide what’s best for you.
The Pros of a Brokerage Account
Below are the reasons and benefits of opening and maintaining a traditional brokerage account.
No contribution limits
There’s no threshold or limit associated with a brokerage account. The 2020 and 2021 IRA contribution limits are $6,000 for individuals under 50 and $7,000 for those 50 and older.
Freedom to withdraw
You can withdraw your money from a brokerage account at any time and for any reason.
Trading on margin permitted
You can trade on margin, or borrowed money, in a brokerage account. For more experienced investors, margin privileges are a welcome asset. Trading on margin is not allowed in an IRA because the IRS prohibits the use of IRA funds as collateral.
Broader range of asset classes and investment vehicles
There are some investment vehicles available in a traditional brokerage account that are generally not offered in an IRA. Options, for example, are usually not offered for IRAs.
The Cons of a Brokerage Account
The biggest disadvantage with a traditional brokerage account is that there are no special tax advantages that are available in an IRA. Regular brokerage account holders need to pay taxes on all earnings in the account, including both short and long-term capital gains and dividends.
When an investment is sold at a profit, capital gains taxes must be paid. The IRS considers two types of capital gains — long-term and short-term. Long-term capital gains are defined as profits on investments held for over a year; short-term capital gains are profits on investments held for a year or less and are taxed as ordinary income.
The Pros of an IRA
As mentioned earlier, the main difference between the two types of accounts — and the main reason incentivizing people to open an IRA — is the tax-advantage. The two main types of IRAs are Traditional and Roth; the differences between the two lie in how the accounts are taxed.
Traditional IRAs are tax-deferred investment accounts. For those who qualify, traditional IRA contributions are tax-deductible in the year they are made. Further, investments in the account grow on a tax-deferred basis: investors need not worry about paying capital gains or dividend taxes on the investments in the IRA.
Roth IRAs are after-tax accounts. There is no annual tax deduction allowed for Roth IRA contributions; however, as with the Traditional IRA, investments grow without capital gains or dividend taxes, and any qualified Roth IRA withdrawals are 100% tax-free.
The Cons of an IRA
Perhaps the biggest downside of an IRA lies in the contribution limits: $6,000 for individuals under 50 and $7,000 for those 50 and older.
The other main issue with an IRA is access to funds. While in a traditional brokerage an investor can make withdrawals whenever she pleases, withdrawals from traditional IRAs are considered taxable income. For example, if you withdraw $10,000 from a traditional IRA this year, the IRS would consider that income and you have to pay taxes on that.
In addition to any taxes that might be owed on a withdrawal, there are other fees owed. Investors who are not at least 59 1/2 years old or otherwise qualified for an exception need to pay a 10% early-withdrawal penalty to the IRS.
For more sophisticated, active investors, an IRA might seem like a humdrum investment account. For those seeking a safe(r) haven to grow their retirement savings, an IRA might be just what the doctor ordered. Some people maintain both types of accounts. Consult with a financial advisor and weigh your options wisely.