IRA vs Brokerage Account: What’s the Difference?

Should you invest in an IRA, a brokerage account, or both? We look at the differences between an IRA and a brokerage account.

To help you decide where to invest if you are new to investing, it might be helpful to compare a brokerage account vs. an IRA account. 

You can also invest in stocks or other securities in either account, so what is the difference?

Broadly speaking, brokerage accounts allow you to buy and sell investments at any time you like. There are no withdrawal penalties or contribution limits. 

On the other hand, IRAs are tax-deferred accounts. Depending on the type you choose, there are strict contribution limits. Withdrawals may result in a penalty.

Let’s take a closer look at the differences between brokerage accounts and IRAs.

Overview of Brokerage Accounts and IRAs

Brokerage accounts allow you to trade stocks, ETFs, mutual funds, and real estate business investment trusts.

Investors use brokerage accounts to trade, invest long-term, and save money for immediate financial goals, such as buying a house or a car. 

IRAs are a tax-advantaged method to save for retirement.

Both accounts can make sense financially. This allows you to take advantage of both the flexibility offered by a brokerage account and the tax advantages that come with an IRA. This is what financial planners recommend:

• Contribute enough to your 401(k), so you can get the company matching first. It’s almost like having free money.
• Maximize your IRAs in order to reap the tax benefits and power compounding.
• Invest via your brokerage account

What Is a Brokerage Account?

A brokerage account, which is a taxable account, allows you to purchase and sell stocks and securities. You can freely buy and sell securities, without restrictions on the amount that you can invest.

And you can also sell your investments at any time without penalty.

Tax treatment is simple. You’ll be taxed on the income you earn in the year you earned it, including dividends, capital gains, and interest.

There are many brokerage firms. The best broker depends on your investment style, preferred investments, and what features you need in a trading platform. 

After you have chosen a brokerage company, it is easy to open an account online and fund it. This usually takes less than a minute.

💡Read more: Best investment apps

What Is an IRA?

Individual retirement accounts, also known as IRAs, are tax-advantaged investment accounts that are designed for retirement savers. 

The investment options are limited compared with brokerage accounts (e.g., you cannot hold naked), but earnings grow either tax-free or deferred depending on whether you have a traditional IRA.

IRAs are not like brokerage accounts. Unlike brokerage accounts, IRAs have strict contribution limits.

The income limits for Roth IRAs will increase for 2022 when the phaseout starts at $129,000 for single filers and $204,000 for married couples. 

Withdrawals before the age of 59 1/2 will trigger a 10% penalty with any type of IRA. However, there are exceptions to this rule. You can withdraw your Roth IRA contributions anytime, tax-free, and without penalty

There are many investments you can choose from, including stocks and bonds, mutual funds as well as ETFs, and REITs.

💡Read more: IRAs vs 401(k)s

Opening an IRA

You can open an IRA at a bank, brokerage firm, or other financial institution. However, the former will offer more investment options and higher potential earnings. 

The bank will offer limited investment options with low yields, such as certificates of deposit (CDs) and savings accounts.

Although these low-risk investments might appeal to retirement savers who are looking to increase their nest egg, they will not allow it to grow significantly over the long term. 

An IRA opened at a brokerage account will offer a wider range of investments and more potential growth.

Traditional IRA vs Brokerage Account

Investors use brokerage accounts for long-term trading, day trading, and even saving for short-term goals. Whereas traditional IRAs are aimed at retirement savers and it has tax advantages.

Traditional IRA contributions can be deducted from your tax, which could help you save money on taxes for the year that you contributed.

Unlike a brokerage account, a traditional IRA has limits to the contributions you can make. You can contribute up to $6,500 to your IRA accounts or $7,500 if you are above the age of 50.

Roth IRA vs Brokerage Account

Roth IRA contributions are not tax-deductible but qualified withdrawals in retirement (even earnings) are exempt from tax. 

If you anticipate being in a lower tax bracket after retirement, a traditional IRA is better than a Roth. Similarly, a Roth IRA is better if you expect to be in the same or higher tax bracket when you retire.

Just like traditional IRAs, Roth IRAs also have income limits. You can’t contribute more than $125,000 for single filers, or $198,000 for married filers. 

Brokerage accounts offer more flexibility than Roth IRAs and there are no limits on contributions, income needed to fund one, or for withdrawals. While Roth IRAs are intended for savings, brokerage accounts are intended to make money.

How Are Brokerage Accounts and IRAs Taxed?

It is obvious that profitable investments are a crucial part of growing wealth and investing. Investing in a tax-efficient way is just as important as it allows you to keep as much as possible of your gains. 

Depending on your account type, dividends, interest, and capital gains might be taxable. This is why we need to distinguish between brokerage accounts from IRAs.

Brokerage Account Taxes

Brokerage accounts can be considered taxable investment accounts. You will owe taxes on any income you earn from investments that pay dividends or interest, or from investments that increase in value. 

The source of your income will determine the tax liability.

Interest 

You could earn interest through investments such as bonds, certificates of deposit (CDs), and any cash that you do not invest. 

Interest income is generally taxed the same as regular income. There are two exceptions to this rule: U.S. Treasuries do not have to be subject to any state or local income taxes and municipal bonds are exempt from state and local taxes.

Dividends 

Dividends are your share of a company’s earnings. There are two types, each with a different tax treatment. 

Qualified Dividends, which are most dividends paid by public companies to shareholders, are subject to the lower long-term capital gains tax rate. 

Unqualified dividends, which are usually REITs master limited partnerships (MLPs), or business development companies (BDCs), are subject to the higher, ordinary-income rate.

Capital Gains 

You will be liable for tax if you sell your investment for profit. How long have you had the investment? Short-term capital gains are taxed as ordinary income if the investment was held for less than one year. 

Gains on investments held for less than one year are considered short-term capital gains and taxed as ordinary income.

IRA Account Taxes

Traditional IRA contributions are funded with pre-tax dollars. They may be tax-deductible depending on your income or if your spouse is covered under a retirement plan.

Roth IRA contributions are made using after-tax dollars. This means that there is no tax break in the year you make the contribution. Your retirement benefits are tax-free, so the tax benefit is not in your year of contribution.

Earnings in IRAs are tax-free or tax-deferred depending on your type of IRA.

Roth-IRA

Contributions don’t reduce your taxable income and there’s no tax break up front. Qualified withdrawals in retirement, however, are exempt from tax and can be withdrawn at any time without penalty. 

Unlike traditional IRAs, Roth IRAs do not have minimum distributions (RMDs). 

Traditional IRA

Traditional IRA. withdrawals will be subject to income taxes. Early withdrawals can result in a 10% penalty. However, you can avoid the penalty (but the tax) under certain circumstances.

For example, you could use the money to fund first-time homebuyer costs.

💡Read more about investment types

The Bottom Line

Both accounts are recommended by financial planners. A brokerage account can be used for day trading and long-term investments, as well as to save money for your short-term goals.

An IRA is for retirement savings. Brokerage accounts are more flexible and allow for unlimited income, withdrawals, contributions, and withdrawals. 

IRAs have lower annual contribution limits.

Withdrawals may result in a penalty. Brokerage accounts also offer more flexibility, as there are no restrictions on income, contributions, or withdrawals.