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.
Brokerage Account vs. IRA: An Overview
Brokerage accounts and IRAs are investment accounts that allow you to buy and sell stocks, ETFs, bonds, mutual funds, real estate investment trusts (REITs), and other securities.
It can be a smart financial move to have both types of accounts. That way you can take advantage of the brokerage account’s flexibility and the IRA’s tax benefits simultaneously. Financial planners often recommend investing in this order:
What Is a Brokerage Account?
As noted, a brokerage account is a taxable account that enables you to buy and sell stocks and other securities. You can buy and sell securities freely, with no caps on the amount you invest—and you can sell your investments anytime without penalty. As far as tax treatment goes, you’ll pay taxes on interest, dividend, and capital gain income in the tax year you earn it.
There are dozens of brokerage firms, and choosing the best broker for you depends on your investing style, preferred investments, and the features you want in a trading platform. Once you decide on a brokerage firm, you can open and fund an account online, usually in a matter of minutes.
What Is an IRA?
An individual retirement account, or IRA, is a tax-advantaged investment account designed for retirement savers. The investment choices are limited compared to brokerage accounts (for example, you can’t hold naked options), but earnings grow tax-free or tax-deferred, depending on whether you have a Roth or traditional IRA.
Unlike brokerage accounts, IRAs have strict contribution limits. For the 2021 and 2022 tax years, you can contribute up to $6,000 to your IRA accounts, or $7,000 if you’re age 50 or older.
Roth IRAs (but not traditional IRAs) also have income limits: For 2021, you can only contribute the full amount if your income is less than $125,000 for single filers or $198,000 if you’re married filing jointly.3 These limits increase for the 2022 tax year when the phaseout begins at $129,000 for single filers and $204,000 for married couples filing jointly.
You can open an IRA with a bank or brokerage firm. Keep in mind that an IRA is not an investment itself—it’s an account that holds the investments you choose. You can pick from a variety of investments, including stocks, bonds, mutual funds, ETFs, REITs, and even real estate.
How Are Brokerage Accounts and IRAs Taxed?
Nobody would argue that picking profitable investments is a vital part of investing and growing wealth. Still, investing in a tax-efficient manner is equally important since it lets you keep as much of your gains as possible. Depending on the type of account you have, earnings from dividends, interest, and capital gains may or may not be taxable—which brings us to a key difference between brokerage accounts and IRAs.
Brokerage Account Taxes
Brokerage accounts are taxable investment accounts. If you make money because your investments pay interest or dividends, or because your investments increase in value, you’ll owe tax on that income. The tax liability depends on the source of income:
- Interest. You might earn interest from investments like bonds, certificates of deposit (CDs), or from any uninvested cash you hold in the account. In general, interest income is taxed as ordinary income, with two exceptions: U.S. Treasuries are not subject to state or local income tax, and municipal bonds are usually exempt from federal taxes (and sometimes state and local taxes, too).
- Dividends. Dividends are your share of a company’s earnings. There are two types of dividends, and each has a specific tax treatment. Qualified dividends—which represent most dividends paid to shareholders by public companies—are taxed at the lower, long-term capital gains rate. Unqualified dividends—which usually apply to REITs, master limited partnerships (MLPs), and business development companies (BDCs)—are taxed at the higher, ordinary income tax rate.
- Capital gains. If you sell an investment for a profit, you will owe tax on that gain—but how much tax depends on how long you held the investment. Gains on investments you held for less than a year are considered short-term capital gains and taxed as ordinary income. On the other hand, gains on investments you held for more than a year are taxed at the more favorable, long-term capital gains rate.
IRA Account Taxes
Contributions made to a traditional IRA are made with pre-tax dollars and may be tax-deductible, depending on your income and if you or your spouse are covered by a retirement plan at work. Roth IRA contributions are made with after-tax dollars, so there’s no tax break the year you make the contribution. Instead, the tax benefit comes in retirement, when your withdrawals are tax-free.
Earnings in IRAs grow tax-free or tax-deferred, depending on the type of IRA you have:
- Roth IRA. There’s no upfront tax break, so contributions don’t lower your taxable income. But qualified withdrawals in retirement are tax-free, and you can withdraw your contributions at any time—for any reason—without penalty. And, unlike traditional IRAs, there are no required minimum distributions (RMDs) for Roth IRAs.
- Traditional IRA. You may be able to deduct traditional IRA contributions the year you make them, which can lower your taxable income (and your tax liability). But withdrawals are subject to income taxes and early withdrawals usually trigger a 10% penalty. You can avoid the penalty (but not the tax) in certain circumstances—like using the money to pay for qualified first-time homebuyer expenses.
Should I Open an IRA at a Bank or Brokerage Firm?
While you can open an IRA at a bank or brokerage firm, you will have more investment options—and higher potential earnings—at the latter. Banks tend to offer very limited, low-yield investment options, such as savings accounts and certificates of deposit (CDs). These low-risk investments may appeal to some retirement savers, but they won’t allow your nest egg to grow substantially—even over the long haul. You will generally find a much broader selection of investments and greater potential growth if you open an IRA at a brokerage account.
Is There a Minimum To Open a Brokerage Account?
That depends on the brokerage firm. Many brokers today offer very low minimum deposits (e.g., even zero) to get started. Of course, you will need to deposit at least $2,000 if you want to enable margin trading.
Is a Roth or Traditional IRA Better?
With a Roth IRA, contributions are not tax-deductible, but qualified withdrawals in retirement are tax-free (even for earnings). Traditional IRA contributions are tax-deductible, so you could save money at tax time for the year you contribute. But you will owe income taxes on withdrawals in retirement—including on all that growth. In general, you’re better off with a traditional IRA if you expect to be in a lower tax bracket when you retire than you are now. If you think you will be in the same tax bracket or higher when you retire, a Roth may be the better choice because you’ll get your tax bill out of the way at your current, lower tax rate.
The Bottom Line
Financial planners recommend having both accounts, if possible. You can use a brokerage account for day trading, long-term investing, and to save for short-term financial goals, while an IRA is intended for retirement savings. Brokerage accounts offer more flexibility, and there are no limits on contributions, withdrawals, or income to fund one. IRAs, on the other hand, have lower annual contribution limits, withdrawals may trigger a penalty, and if your income is too high, you might not be able to contribute.