Brokerage Account vs. IRA: What is the Difference?

If you’re starting to learn about investing, chances are you’ve come across a lot of confusing terminology.

Unfortunately, the investing world has a lot of language you have to learn. Thankfully, it isn’t as hard to learn as you’d think.

One thing you must learn almost immediately is the different types of accounts you can invest in.

There are a wide variety of types to choose from that have benefits and drawbacks depending on your goals and circumstances.

You’re probably wondering what the difference between a brokerage account and an IRA is. This makes sense, as you have to choose a type of account before you start to invest.

Here’s what you need to know about these two account types before you start investing. 

What Is a Brokerage Account?

Technically, a brokerage account is an investment account held at a brokerage firm.

Brokerage firms are the companies that hold your investment accounts and facilitate your investing, such as Vanguard, Fidelity, E*TRADE or others.

In practice:

People are often talking about a taxable investment account when they refer to a brokerage account.

This can commonly be referred to as a taxable brokerage account, as well. 

People aren’t usually considering special types of brokerage accounts, such as IRAs, when they refer to a brokerage account.

What Are the Tax Consequences of a Brokerage Account?

So what does a taxable brokerage account mean? Essentially, the name describes the tax consequences of investing within the account.

A taxable brokerage account means transactions in the account will be taxable. 

If you sell investments at a gain, you may have to pay capital gains taxes. When you sell investments at a loss, you have a capital loss. This can normally be used to offset your capital gains. You pay capital gains taxes on the net gains each year.

If you receive dividend or interest income, you’ll have to pay taxes on that income, as well.

Certain other types of accounts are tax-advantaged accounts.

This means they have benefits when it comes to the taxability of the investments held within the account. A taxable brokerage account doesn’t have any of these benefits.

What Is an IRA?

IRA is short for individual retirement arrangement. Most investors think it stands for individual retirement account, though.

Others may call it a retirement plan. 

It doesn’t matter what you call IRAs. They’re a powerful investing tool.

An IRA could be a brokerage account, but it could also be one of many other types of accounts.

You can have a savings account IRA or a certificate of deposit IRA.

Brokerage accounts are typically the best place for IRAs due to their tax benefits and investment options.

Different Types of IRAs

To add another layer of complexity, there are different types of IRAs. The difference between the types of IRAs is how the tax advantages work.

No matter which type of IRA you open, there are special rules regarding taxability, contributions and withdrawals from the account. These rules exist due to the special tax advantages these accounts have.

In general, you can withdraw the money after you reach age 59.5 without any penalties. Depending on the type of IRA, you may have to pay taxes on the money.

That said, withdrawing money before you turn age 59.5 can result in a 10% early withdrawal penalty. Depending on the source and type of funds you withdraw, you may have to pay income taxes on the early withdrawals, as well.

IRAs also have contribution limits. Most people can contribute up to $6,000 per year unless you have certain other restrictions. 

If you’re 50 or older, you may be able to contribute an additional $1,000 to your IRAs through what is called a catch up contribution.

IRAs may have income limits you can’t exceed in order to qualify to contribute to them. The rules depend on your circumstances and the type of IRA. Check with the IRS to learn about IRA contribution limits and when they may apply to your situation.

Here’s what you need to know about different types of IRAs.

Roth IRA and Its Tax Implications

One type of IRA is called a Roth IRA. This type of account does not give you tax deductions when you contribute money to the account. 

The money grows tax-free within the account, too. You don’t have to pay taxes on earnings when you get them. 

It doesn’t matter if a person buys and sells stocks every day in a Roth IRA. You won’t have to pay taxes on your gains.

When you withdraw money in retirement, that money is tax-free.

Traditional IRA and Its Tax Consequences

A traditional IRA generally allows you to take a tax deduction today when you contribute to your account. 

In certain cases, you may not be able to take a tax deduction based on your income and if you or your spouse has access to a workplace retirement account. See the IRS’s guide to traditional IRA deductibility.

When you withdraw the money in retirement, you’ll pay ordinary income taxes on the amount you withdraw. Unfortunately, that means you won’t be able to take advantage of short-term and long-term capital gains tax strategies with traditional IRA money.

Because you defer paying taxes in this type of IRA, it’s commonly referred to as a tax-deferred investment option.

Traditional IRA Vs. Roth IRA

Other Types of IRAs

There are other versions of IRAs beyond traditional and Roth IRAs.

You could end up having a rollover IRA, a SEP IRA, a SIMPLE IRA, a non-deductible IRA, a spousal IRA or a self-directed IRA.

When you’re first getting started, these other types of IRAs usually aren’t what you’re looking for. That said, when you’re further along in your investing journey, it may be beneficial to use some of these types of IRAs.

Figuring Out Which Type of Investment Account to Use

Knowing whether to use a brokerage account or one of the many types of IRA accounts can be challenging to think about.

Ultimately, your goal should be to pay as little taxes as legally allowable while making sure you have access to your money when you need it.

Consider Your Tax Situation and When You Need the Money

To find the best type of account for you, you need to look at several factors. These include your current tax situation, future tax situation and when you’ll need the money.

If you need the money before age 59.5, the easiest way to access it is investing in a taxable investment account. You won’t get any tax benefits by investing this way, but you won’t pay any early withdrawal penalties, either.

There are ways you can access certain IRA investments early without penalties or taxes. It can be much more complex to figure out.

If you won’t need the money until retirement after age 59.5, using a tax-advantaged IRA may be a good fit. The question then turns to your tax situation.

You need to examine if your current marginal tax rate, or the tax rate you pay on your next dollar of additional income, is higher than your future marginal tax rate will be. If it is, you’re typically better off investing in a traditional IRA as long as you can make tax-deductible contributions.

You’re generally better off investing in a Roth IRA if the opposite is true and you qualify to make contributions into this type of account.

You can make contributions to both types of accounts if you want to take advantage of both types of tax benefits as long as you qualify. However, you cannot contribute more than the maximum limit, $6,000 in most cases in 2020 and 2021, across all IRA accounts.

Some Investments Work Better In Tax-Advantaged Accounts

You may realize there is a tax planning opportunity when you think about the different benefits of a traditional IRA and a Roth IRA.

When you invest, you normally have a target asset allocation. The allocation has some aggressive investments that should provide higher growth. It probably also has more conservative investments used to provide some stability and lower growth.

To maximize the tax advantages of these account types, you should put your more conservative investments in a traditional IRA.

Since you have to pay taxes on the withdrawals from this account in retirement, the lower growth of these investments would result in paying less taxes.

That also means putting more aggressive investments in a Roth IRA could be smart. These investments grow faster. You won’t have to pay income taxes on the earnings you receive from them when you withdraw the money in retirement.

As always, you should consult your tax professional or financial advisor.

These professionals can help analyze your plan. They can help you with optimizing your tax advantages and determining the suitability for your situation.

Open an Account That Works for You

Now that you know the difference between a brokerage account and an IRA, you can make a better-informed decision where to keep your money.

When you’re ready, open an account of the type that provides the best benefits for you.

Each person’s investing situation will be different. For that reason, it may be a good idea to have a fiduciary financial planner help you come up with a financial plan that fits your needs. 

They can help you figure out what works best for you while showing you any blind spots you may have about investing.