Brokerage accounts vs IRAs - What’s best for you?

Taxable brokerage accounts, also known as standard brokerage accounts, allow you to buy and sell a variety of investment vehicles, including stocks, bonds, options, futures, exchange-traded funds (ETFs) and mutual funds. Brokerage accounts can be opened at brokers, including discount and online brokers. After setting up and funding your brokerage account, you can start making trades as often as you want with as much capital as you want. These accounts have no contribution limits, you can transfer as much of your money to and from them as you choose. People typically set up brokerage accounts to make short-term profit (by day trading for example).

Brokerage accounts provide great flexibility both in terms of investment options and the specific purpose for which you want to use your earnings (e.g. there are no penalties for withdrawing before reaching retirement). It is up to you if you want to use the money in your brokerage account to fund an exotic vacation or start a new business. The money you have in your account is also yours to withdraw whenever you want, this can be an important factor even if you are not day trading.

As far as the taxman is concerned, the gains you make on your investments will be taxed depending on the term of your investment. Short-term investments (held less than 1 year) are treated as ordinary income and are subject to whichever tax bracket you fall under. Long-term capital gains are taxed at 0%, 15% or 20%, depending on your income.

In addition, trading through a brokerage account entails a set of expenses, which can be grouped into trading and non-trading costs. Trading costs include fees, commissions, and financing rates while non-trading fees consist of account opening, maintenance and inactivity charges. These costs vary from broker to broker. Zero commission on trades and no account maintenance fees are becoming the norm at US brokerages.

Even though IRAs operate similarly to brokerage accounts they are designed for the specific purpose of saving for retirement. The two most common types, traditional and Roth IRAs, offer tax advantages that make a strong argument for contributing to one of these. The way an IRA is operated makes it similar to a brokerage account: you choose a service provider (typically a bank or a brokerage firm), open an account, fund the account and begin to invest.

The difference lies in taxation as your tax liability can be significantly less than with having a standard brokerage account. If you choose a traditional IRA, you may be able to deduct the total amount of your annual contributions and with a Roth IRA you’ll avoid paying taxes on withdrawals when you retire. IRAs are tax-advantaged investment vehicles, meaning you won’t have to pay capital gains taxes.

The institution where you opened your IRA account will act as the trustee or custodian of the account. It is responsible for ensuring that the tax-advantaged status of the account is preserved by verifying that all investments are allowed by the Internal Revenue Service (IRS) and all trades are made according to IRS rules and regulations.

As opposed to a brokerage account, the amount of funds you can pay into an IRA is limited by the IRS. In 2021, the contribution cap is $6,000 per year per person or $7,000 if you are 50 or older. Roth IRAs also come with an income cap. Another important IRA limitation is that IRAs are only for people who have earned income. Unless you have earned a wage or a salary from employment or self-employment, you will not be eligible to set up an IRA. Brokerage accounts come without such a rule.

Additionally, withdrawals from an IRA account are subject to strict rules as the state wants you to use IRA funds for retirement. If you withdraw money for a purpose not specifically allowed before the official retirement age, you may have to pay a 10% early withdrawal penalty. Naturally, passive investors who seek long-term capital gains by holding index linked ETFs prefer IRAs.

You can open an IRA as a brokerage account and by doing so you will be able to enjoy both the benefits of a brokerage account and the advantages of an IRA.

You can make your investment decisions, build a portfolio and actively trade inside the account. As a result, you can maintain the tax-deferred status of an IRA while maintaining your own independence when it comes to investment choices and you can trade at will.

In light of the above discussed differences between the two types of accounts, it's clear that your investment and retirement plans should include different types of accounts, financial products and savings options. In fact, a lot of investors operate both regular and retirement accounts.