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Before you can try your hand at investing, you'll first need an investment account. Brokerage accounts and individual retirement accounts (IRAs) are two types to choose from. Either one allows you to buy and sell stocks, bonds, exchange-traded funds (ETFs) and mutual funds, but they differ in the ways they're taxed and the rules you'll need to follow on contributions and withdrawals.
What's the difference between a brokerage account vs. an IRA? Read on for the basics.
What Is a Brokerage Account?
A brokerage account allows you to buy and sell a variety of investments including stocks, bonds, mutual funds and ETFs. You can add or withdraw your money at any time, but you may be taxed on any dividend income or capital gains you earn from your investments.
You can open a brokerage account with a number of investment firms, such as Vanguard, Fidelity, Charles Schwab or TD Ameritrade. Investment apps like Robinhood are effectively brokerage accounts as well: You use them to buy and sell investments. You might also open a brokerage account with your investment advisor—or, conversely, work with an advisor based at the investment company that holds your brokerage account.
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What Is an IRA?
An IRA is a tax-advantaged retirement account. You can open one at many of the same investment firms that offer brokerage accounts. The purpose of an IRA is to save for retirement, so although you may hold many of the same types of investments in an IRA that you do in a brokerage account, the rules governing your account activity will be different. Among the key differences between brokerage accounts and IRAs are:
- Contribution limits: The IRS limits IRA contributions to $6,000 per year with an additional $1,000 catch-up contribution if you're 50 or older. Traditional IRA contribution deductions may be further limited if you or your spouse has a retirement plan at work. Roth IRA contributions may be limited according to your income.
- Tax-deferred or tax-free earnings: Dividends and capital gains in an IRA aren't taxable, though you may ultimately pay taxes on your gains in a traditional IRA.
- Withdrawal restrictions: A 10% penalty applies to non-qualified withdrawals made from an IRA before age 59½. You may also owe income taxes on an early withdrawal.
Money in an IRA is best earmarked for retirement. Because there are contribution limits and early withdrawal penalties on IRA accounts, they aren't great accounts for short-term saving or investing. You may be able to withdraw some IRA funds for qualified purposes like buying your first home or paying for college. But in general, it's best to think of your IRA money as for retirement only. That said, if you are saving for retirement, the tax advantages of an IRA can help your investment dollars go farther.
Traditional IRA vs. Roth IRA
IRA accounts are further divided into traditional and Roth IRAs. Here's how they stack up:
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contributions | Funded with pretax dollars (reduces your gross income) | Funded with after-tax dollars (doesn't affect gross income) |
| Capital gains and dividends | Pay no taxes as your money grows | Pay no taxes as your money grows |
| Early withdrawals | Pay regular income tax + a 10% penalty if you withdraw funds before age 59½ | Withdraw contributions anytime without penalty; a 10% penalty applies on the non-qualified withdrawal of earnings before age 59½ and before the account is five years old |
| Taxes in retirement | 100% of qualified withdrawals made in retirement are taxed as regular income | Qualified withdrawals in retirement are tax-free |
| Required distributions | Starting at age 72, you must make minimum withdrawals from your account | Doesn't require minimum distributions |
How Taxes Work for Brokerage Accounts and IRAs
Brokerage accounts, traditional IRAs and Roth IRAs each have their own tax advantages and drawbacks. The way your account is taxed and regulated may influence which type of account works best for you.
Brokerage Account
Unlike an IRA, a brokerage account has no restrictions on contributions or withdrawals. But with a brokerage account, you'll need to report your gains and losses on your tax return and pay taxes on any capital gains you've made during the year. Capital gains are the profits you make after subtracting the purchase price of your investments from the price at which they were sold.
Gains are only taxable when they've been realized—typically when you sell an investment. The value of your investments can go up (or down, for that matter) without a tax consequence as long as you don't sell. If you sell an investment you've held for less than a year, you'll pay short-term capital gains tax; if you've held the investment for a year or longer, you'll pay long-term capital gains tax. You'll also pay taxes on any dividends or interest you earn along the way.
What if you sell for a loss? You may be able to use losses to offset capital gains and up to $3,000 of your ordinary income at tax time.
Capital gains taxes fall into two categories: short-term and long-term. Short-term capital gains are paid at your regular income tax rate. Long-term capital gains are taxed as follows:
| Long-Term Capital Gains Tax Rates for 2022 Tax Year | ||||
|---|---|---|---|---|
| Rate | Single | Married, Filed Jointly | Married, Filed Separately | Head of Household |
| 0% | Up to $41,675 | Up to $83,350 | Up to $41,675 | Up to $55,800 |
| 15% | $41,676 - $459,750 | $83,351 - $517,200 | $41,676 - $258,600 | $55,801 - $488,500 |
| 20% | Over $459,750 | Over $517,200 | Over $258,600 | Over $488,500 |
Source: IRS
Traditional IRA
A traditional IRA affects your taxes in three primary ways:
- Pretax contributions mean you can deduct your contribution amount from the gross income on your tax return. Since you don't pay taxes on the money you contribute, your initial contribution dollars go farther.
- Tax-deferred earnings mean you don't have to pay taxes on any gains you make or dividends you receive as your money grows. This not only saves money on your tax bill, but also makes tax accounting much simpler.
- Taxed withdrawals mean you'll ultimately pay taxes on both your contributions and your earnings when you withdraw money in retirement. The full amount of your traditional IRA withdrawals are taxed as regular income. On the upside, you won't have to account for the individual gains and earnings you've made along the way: It's all taxable when you take it out.
Roth IRA
Roth IRAs have some similarities to traditional IRAs, but with a few key differences.
- Your contributions come from after-tax dollars. You don't get to deduct Roth IRA contributions from your gross income.
- Your earnings grow tax-free. As with a traditional IRA, you don't have to account for dividends, interest or capital gains as your money grows—and you don't have to pay taxes as you go.
- Your qualified withdrawals in retirement are also tax-free. Here's the big difference between a traditional IRA and a Roth: The money you earn and the money you withdraw from a Roth account are tax-free. Every dollar you take out of your Roth IRA is yours, with $0 going to taxes.
Which Is Better: Brokerage Account or IRA?
IRAs offer tax advantages that can help boost your retirement savings significantly. If you're planning to use your funds for retirement, opening a traditional or Roth IRA allows your money to grow tax-deferred or tax-free, and provides tax benefits on either end.
But retirement isn't the only motivation for opening an investment account. If you want to try making money in the stock market or with mutual funds, a brokerage account gives you the flexibility to contribute as much as you want and enjoy your earnings whenever you like. Active trading can add to your tax bill, though—especially if you're doing frequent trades—so set aside money to cover your tax bill and be sure to account for investment gains and losses on your tax return.
Ideally, you may want to open both a brokerage account and an IRA (or two) to give yourself the flexibility and tax advantages of both types of accounts. In the meantime, the best account for you is the one that serves your purposes to maximize tax benefits for retirement or give yourself the freedom to buy, sell, contribute and withdraw whenever you please.