You’re ready to open an investment account and start building a nest egg. When it comes to a traditional IRA vs. brokerage account, you’ll find pros and cons to both. We’ve created this primer to help you decide which one might be right for you.
Basic investment account types
Let’s compare a traditional IRA vs. brokerage account. To start investing, there are two main types of accounts you can choose from: an individual retirement account (IRA) or a standard taxable brokerage account. Here’s a rundown of what you should consider before making a decision.
Before we get started, note that I often use a few terms to describe the same thing. “Brokerage account,” “taxable brokerage account,” and “standard brokerage account” are different names for a non-retirement investment account. Technically speaking, all investment accounts can be described as brokerage accounts. Taxable accounts and IRAs are both offered by brokerages.
Reasons to open a standard brokerage account
A standard brokerage account has several advantages. Generally, it is the less-restrictive of the two options. Here’s why:
- There’s no contribution limit for a standard brokerage account.
- You can withdraw your money anytime and for any reason.
- You can trade with margin (borrowed money). This isn’t always a great idea, but there are some instances where margin privileges can be a nice asset.
- Some investment vehicles are available in a brokerage account that aren’t in an IRA. For example, you generally can’t buy options in an IRA.
Downsides of a standard brokerage account
In the toss-up between a traditional IRA vs. brokerage account, the biggest disadvantage is that a brokerage account is not tax-advantaged. Since it’s a taxable account, you’ll have to pay taxes on earnings in your account, including capital gains and dividends.
Capital gains taxes kick in when you sell investments at a profit. For example, if you pay a total of $5,000 to buy a stock and sell your shares for $7,000, you have $2,000 in capital gains.
The IRS considers two types of capital gains — long-term and short-term. Long-term capital gains are profits on investments you held for over a year. They are taxed at favorable rates of 0%, 15%, or 20%, depending on your taxable income. On the other hand, short-term capital gains are profits on investments you held for a year or less and are taxed as ordinary income.
Capital losses can be used to offset capital gains and even to reduce your other taxable income by as much as $3,000 per year (with any excess carried over). As a simplified example, if you sold one long-term holding at a $2,000 profit, another for a $1,500 profit, and another at a $1,000 loss, your long-term capital gain for the year would be $2,500 in the eyes of the IRS.
Most dividends you receive are considered “qualified dividends” and get the same favorable tax treatment as long-term capital gains. Some don’t meet the IRS definition of qualified dividends — such as dividends from some foreign companies — and are treated as ordinary income for tax purposes.
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