Roth IRA vs. Brokerage Account Showdown: Discover the ultimate investment vehicle for maximizing your financial future
Roth Individual Retirement Accounts (IRAs) and brokerage accounts are two popular avenues for individuals to invest and grow their wealth. A Roth IRA is a retirement savings account that allows your money to grow tax-free, with contributions made after taxes. It shines in its ability to provide tax-free income in retirement, making it a powerful tool for long-term financial planning.
Brokerage accounts, on the other hand, offer more flexibility. These are investment accounts where you can buy and sell a wide variety of securities like stocks, bonds, and mutual funds. Unlike Roth IRAs, brokerage accounts do not have the same tax advantages, and you pay taxes on dividends, interest, and capital gains as they are incurred.
Benefits of a Roth IRA
There are several benefits of a Roth IRA that may make this investment option slightly more advantageous than a brokerage account.
Tax-free Growth and Withdrawals
Roth Individual Retirement Accounts (IRAs) offer unique tax advantages that can make them an attractive option for retirement savings. Here are the primary benefits related to tax-free growth and withdrawals:
Tax-free growth: Unlike traditional IRAs, where contributions are made pre-tax and then taxed upon withdrawal, Roth IRA contributions are made with after-tax dollars. This means that any growth or earnings within the account (from interest, dividends, or capital gains) are not taxed yearly as they would be in a regular brokerage account. Instead, they grow tax-free.
Tax-free withdrawals in retirement: Once you reach age 59.5 and have held the Roth IRA for at least five years, all withdrawals, including both contributions and earnings, are tax-free. This contrasts with Traditional IRAs where withdrawals are taxed as ordinary income. This feature can be particularly advantageous if you expect to be in a higher tax bracket in retirement than you are when you make the contributions.
No required Minimum Distributions
Unlike traditional IRAs, which require you to start taking minimum distributions at age 72, Roth IRAs do not have Required Minimum Distributions during the owner’s lifetime. This allows your investments to grow tax-free for a longer period if you do not need the money.
Potential for early withdrawal of contributions without penalty
Since contributions to a Roth IRA are made with after-tax dollars, you can withdraw the amount you contributed (but not the earnings) at any time, for any reason, without penalty or income tax. This is not the case with a Traditional IRA, where early withdrawals may be subject to income tax and a 10% penalty.
Estate planning benefits
Roth IRAs can also provide some key advantages when it comes to estate planning. Here are a few of them:
- Stretching the IRA: Although the SECURE Act of 2019 generally requires non-spouse beneficiaries to withdraw all funds from an inherited IRA within 10 years, those distributions are tax-free with a Roth IRA, while they would be taxable with a traditional IRA. This can provide a significant tax advantage for the beneficiary.
- Tax-Free Inheritance: Because Roth IRAs are funded with after-tax dollars, the beneficiaries can typically receive the distributions tax-free, provided the account has been open for at least five years. This can be a significant benefit for heirs, especially if they are in a high tax bracket.
- Estate Tax Benefits: Although Roth IRA balances are included in the owner’s estate for estate tax purposes, heirs will not owe income tax on the distributions. Further, any estate taxes paid reduce the size of the estate, potentially resulting in tax-free assets being passed to heirs.
- Wealth Transfer: Roth IRAs can be an efficient way to pass wealth to the next generation, especially if the original account owner does not need the money for retirement expenses. The longer the money stays invested in the Roth IRA, the more opportunity for tax-free growth.
- Flexibility: Beneficiaries have the option to disclaim a Roth IRA, which can then pass to alternate beneficiaries. This might be useful in certain situations where the original beneficiary doesn’t need the money or wishes to keep the assets within the family for a longer period.
As always, estate planning can be complex and individual circumstances can greatly impact the effectiveness of various strategies.
Benefits of a Brokerage Account
There are several benefits of a brokerage account, including no contribution limits, investing flexibility, access to margin trading, and access to professional management.
No Contribution Limits
Brokerage accounts are not subject to any contribution limits set forth by the IRS. Meanwhile, as of this writing, a Roth IRA is subject to a contribution maximum of $6,000 per year.
Unlike retirement accounts, such as a 401(k) or IRA, there are no restrictions on when you can withdraw your money from a brokerage account. This makes brokerage accounts a good option for medium-term goals or for investing money that you might need access to before retirement.
Freedom in Investment Choices
Brokerage accounts typically offer a wide range of investment options. This can include individual stocks, bonds, exchange-traded funds (ETFs), mutual funds, options, futures, foreign investments, and more. There are very limited investing restrictions through brokerage accounts.
No penalties on withdrawals regardless of age
Brokerage accounts do not have any early withdrawal penalties like a Roth IRA. This means you can sell your investments and withdraw cash at any time for any reason and not be subject to any early withdrawal penalties.
Ability To Use Margin
Brokerage accounts can give you the ability to borrow money to invest, known as buying on margin, which can potentially amplify returns. There is no option to use a margin with a Roth IRA.
Access to Professional Management
Investing through an online brokerage may mean you can access professional management. For example, many brokerage firms offer robo-advisors, financial advisors, or professional money management services that can help you with investing decisions.
Comparing Roth IRA and Brokerage Account
There are several differences between a Roth IRA and brokerage account like tax implications, contribution and withdrawal rules, accessibility of funds, and the role each type of account plays in retirement planning.
One of the most significant differences between a Roth IRA and a Brokerage Account are their tax treatments.
While both a Roth IRA and a brokerage account contributions are made with after-tax dollars, withdrawals from a Roth IRA are generally tax free assuming you meet the requirements set forth by the IRS. Meanwhile, you are required to capital gains tax when an investment is sold or dividends are earned.
The capital gains tax can be either a long term capital gain (securities held for at least 1 year) or a short term capital tax, securities held less than 1 year. The long term capital gain tax rate is lower than the short term capital gains tax rate; n
- Roth IRA: Contributions are made with post-tax income. As of 2021, the maximum annual contribution is $6,000, or $7,000 if you’re 50 or older. These limits may change in the future. There are also income limits to be eligible to contribute to a Roth IRA.
- Brokerage Account: There are no limits to the amount you can contribute to a brokerage account, and contributions are also made with post-tax income. There are no income limits for contributing to a brokerage account.
Roth IRAs have income eligibility limits, so high-income earners may not be able to contribute directly to a Roth IRA. For 2022, the income limit for single filers is $140,000, and for married filing jointly, it’s $208,000. Meanwhile, there are no income restrictions for opening a brokerage account.
Roth IRA: Qualified withdrawals are tax-free, as contributions are made post-tax. A withdrawal is qualified if it’s made at least five years after the first contribution to the account and the account holder is at least 59½ years old, becomes disabled, passes away, or uses up to $10,000 towards the purchase of a first home. Non-qualified withdrawals may be subject to taxes and penalties.
Brokerage Account: When you sell an investment in a brokerage account, the gains are subject to capital gains tax. The rate depends on your income and how long you’ve held the investment. If held for less than a year, it’s considered short-term and is generally taxed at your ordinary income tax rate. If held for a year or more, it’s considered long-term and is generally taxed at a lower rate. Withdrawals of the original amount you contributed (your cost basis) are not taxed.
Accessibility of Funds
The accessibility of funds in a Roth Individual Retirement Account (IRA) and a brokerage account is quite different due to the specific purposes of these accounts.
- Roth IRAs are designed for retirement savings. As such, they come with rules to discourage early withdrawals.
- You can withdraw the contributions you’ve made to your Roth IRA at any time, without taxes or penalties. This is because contributions are made with post-tax dollars.
- However, the earnings in your Roth IRA (i.e., the interest, dividends, and capital gains) are subject to more stringent rules. If you withdraw earnings before age 59½ and before the account has been open for five years, you may have to pay income tax on the earnings, plus a 10% early withdrawal penalty.
- There are some exceptions to these rules for things like purchasing a first home, certain educational expenses, and a few other specific situations.
- Brokerage accounts are far more flexible when it comes to accessing your funds. You can typically buy and sell investments and withdraw your money at any time.
- However, when you sell investments, you’ll have to deal with capital gains tax. If you’ve held the investment for a year or less, it’s considered a short-term capital gain and is usually taxed at your ordinary income tax rate. If you’ve held the investment for more than a year, it’s considered a long-term capital gain and is typically taxed at a lower rate.
- Additionally, there are no penalties for withdrawing from a brokerage account, regardless of your age or the purpose of the withdrawal.
Brokerage accounts offer more flexibility in terms of investment options. While Roth IRAs are somewhat limited by IRS rules, brokerage accounts can hold almost any type of investment.
Which to Choose?
Deciding on a brokerage account or a Roth IRA can be a tough call for many investors. Below we look at some case scenarios and explain which option is more advantageous based on their unique circumstances.
Choosing between a brokerage account and an IRA (Individual Retirement Account) largely depends on your personal financial situation, goals, and tax circumstances. Here are some case scenarios that might help clarify which option might be more suitable:
Case 1: Long-Term Retirement Savings
If you’re focused on saving for retirement and would like to take advantage of potential tax benefits, an IRA, specifically a Roth IRA or a Traditional IRA, can be an excellent choice. The tax advantages these accounts offer can help your savings grow more significantly over the long term.
Case 2: High-Income Earner
If you’re a high-income earner who isn’t eligible to contribute to a Roth IRA due to income limits, you may consider a brokerage account. In this case, you could also look into a “backdoor” Roth IRA contribution, where you contribute to a Traditional IRA (no income limit) and then convert it to a Roth IRA.
Case 3: Need for Flexibility
If you anticipate needing access to your investment funds before retirement age, a brokerage account might be a better choice. While you can withdraw contributions from a Roth IRA without penalty, earnings are another story. Brokerage accounts, on the other hand, allow you to withdraw at any time without penalties, although you’ll have to pay capital gains tax on any profits.
Case 4: Maximizing Retirement Savings
If you’re already maximizing your IRA contributions and are looking for additional ways to save and invest for retirement, opening a brokerage account can be a good strategy. This allows you to invest more than the annual IRA contribution limit.
Case 5: Diversifying Tax Implications
If you’re looking to diversify your tax situation in retirement, you might consider using both. A Roth IRA will give you tax-free income in retirement, while a brokerage account might provide some flexibility for managing your tax burden since you can control when you realize capital gains.
Remember, it’s essential to consult with a financial advisor to understand which option is best for your specific financial situation and long-term goals. This is a general guideline and may not cover all individual circumstances.
The Bottom Line
Choosing between a Roth IRA and a brokerage account is an individual choice that should be made based on your individual tax circumstances, income level, and financial goals.