The primary difference between an IRA or a brokerage account is the purpose for which you are opening one. An IRA, or Individual Retirement Account, is a retirement-based account that helps you take advantage of the tax incentives that come with them. A brokerage account, on the other hand, is a platform for making traditional investments and trades — these can be taxed as income in the traditional sense. It doesn’t give you the tax benefits of a retirement account.
Brokerage accounts have been around for a long time. IRAs, on the other hand, are a younger endeavor. We saw the IRA come into the equation with the Employee Retirement Income Security Act of 1974. It was meant to create a means of retirement saving outside of employers. The account was given a $2,000 limit in 1981, making it easier for workers to have retirement savings in more than one way. Of course, as stated above, that is not the case today as workers are limited on the size of contributions if they have a work-based retirement plan.
Again, one account is not necessarily better than another. It is dependent on what you want to do with your money. An IRA gives you tax benefits that can help compound interest grow the savings. A Roth IRA helps you avoid paying taxes on your savings later in life.
What Is a Traditional IRA?
The traditional IRA is designed to improve the efficiency of your ability to build your retirement. The holdings within your account are tax-deferred until you begin taking funds out. The benefit here is that you can invest savings freely without worrying about the tax burdens of the income. This helps you save more over time. You can buy and sell without incurring the unwanted costs, and the deferred taxes increase the potential of your overall compound interest.
For the year 2020, savers can contribute $6,000 to a traditional IRA. Those aged 50 or older can contribute $7,000. This is aimed at helping older savers catch up if they are behind their desired savings goals.
You can also deduct the full contribution you make to your IRA, so long as you or your spouse don’t also have a retirement plan with their workplace.
What Is a Roth IRA?
A Roth IRA is a bit of an inverse from the traditional IRA. Your contributions are not deductible, meaning you place after-tax money into the account. The tradeoff is that your withdrawals in retirement are tax-free. Contributions are similarly maxed at $6,000, but income and filing status can change how much of that contribution you are cleared to make.
What Is a Brokerage Account?
A brokerage account is used for producing income, rather than savings. If you want to invest your money in stocks, bonds, or mutual funds, this is the account to use, as opposed to a bank or savings account. The gains and losses within the account are claimed in your taxes. This is your typical platform by which you make trades and investments outside of retirement. While you can certainly still save the money you place in a brokerage account, you don’t enjoy the tax benefits of a retirement account. The tradeoff here is that you have ready access to the money that you’re trading.
There isn’t really a limit on how much you can put in a brokerage account, so in reality an investor can create far more in gains annually compared to an IRA. The catch once again is that one will pay taxes on that income.
These days, there are a variety of ways to use a brokerage account. You may employ a registered investment adviser to manage your account, or you may choose to do it yourself with one of the many discount brokerages now available to investors. Thanks to the rising prevalence of zero commission brokerages, you can handle your own investments, and avoid the added costs of employing a financial adviser or stock broker. Yes, there are brokers managing your account at the brokerage you have your account at, but that doesn’t hit you with the costs of employing an adviser or broker to handle everything for you in the traditional way.
Brokerage Account vs. IRA - How Do You Choose?
One of the easiest ways to think about which to use, is how you forecast tax rates to be down the road. If taxes are very high when you’re getting started, perhaps it is better to use a traditional IRA in order to help get more capital into your account, without incurring the tax burden. On the flipside, if taxes are relatively low now, avoiding the cost burdens in retirement might outweigh the after-tax income that you have to use now.
Say you use after-tax income of $6,000 and put it into a Roth IRA. The tax implications of that money is now are over. If you acquire wealth and move into a higher tax bracket through life, the implications of taxes later in life may outweigh the cost of using non-deductible income in the beginning.