A traditional IRA brokerage account, a Roth IRA and a traditional brokerage account all have different tax advantages. Traditional IRAs let you save on taxes immediately, Roth IRAs let your funds grow essentially tax-free and brokerage accounts allow you to invest as much as you wish and claim capital losses on any investment losses when you sell your securities.
How a Traditional IRA Works
An individual retirement account, or IRA, is a retirement account you can open for yourself. There are plenty of IRA companies that will open the account for you, including many banks, credit unions and brokerages.
You can contribute up to $5,500 per year to traditional and Roth IRAs, or up to $6,500 once you reach age 50. Contributions must be no more than you and your spouse earned that year.
You deduct contributions to a traditional IRA from your taxes and pay tax after retirement age, when you withdraw money from the account. This can be advantageous if you anticipate you'll be in the same tax bracket or a lower tax bracket after you retire, as many people are since they'll no longer have the income from work.
If you withdraw money before age 59 1/2, you must pay an additional tax penalty of 10 percent, unless certain exceptions apply.
How a Roth IRA Works
With a Roth IRA, you also contribute money to your account as you're working, but you pay tax on it as normal. When you retire and withdraw money, you don't pay any additional tax on anything you withdraw, including investment earnings.
This allows your investments to effectively grow tax-free. That's a potentially big advantage if you anticipate that you're going to earn a lot of money on your investments or that you're going to be in a high tax bracket when you retire.
You can withdraw money you deposited into a Roth IRA early without penalty, except that you'll lose the benefits of future tax-free growth. If you withdraw earnings before age 59 1/2, you'll have to pay tax on them at your ordinary income rate and pay the usual 10 percent tax penalty.
Brokerage Account Taxes
If you hold stocks, bonds, certificates of deposit or any other asset in a traditional brokerage account outside of a retirement account, you will need to pay capital gains tax on the amount any asset gains when you sell it. You don't pay tax on the asset's growth or see a tax benefit from any loss until you actually sell the investment.
If you have investments that pay interest or dividends, you must pay tax on those the year you earn them, even if you reinvest the dividends in the same security.
Understanding Capital Gains and Losses
If you hold the asset for a year or more, you can pay tax at the long-term capital gains rate, which is generally less than your ordinary income rate. For 2017 and 2018, long-term capital gains rates are either 0 percent, 15 percent or 20 percent, based on your total income, and most taxpayers will pay 15 percent. If you've had it for less than a year, you pay tax on any gain at your ordinary income rate.
If an investment loses money, you can take a capital loss on the amount you lost when you sell the asset or if it becomes worthless.
You can deduct capital losses from your capital gains and, if you have additional losses, deduct up to $3,000 in capital losses from ordinary income each year. Roll additional capital losses into future tax years, where they can continue to offset capital gains and ordinary income according to the same rules.
Roth IRA vs. Investment Account
The big advantage of a Roth IRA over an investment account is the tax-free growth of your investment. You do not have to pay additional capital gains tax when you sell the assets in a Roth IRA, nor do you incur ordinary income tax on any interest or dividends you earn.
On the other hand, you can't deduct capital losses within a Roth IRA, so if some or all of your investments lose money, you may end up with a higher net tax bill than if you invested with a traditional brokerage account.
Since you're limited in how much you can put into a Roth IRA each year, many people with high net worths will end up having both IRAs and brokerage accounts. You may want to decide which investments you hold in each type of account based on your retirement plans, expected risk or other factors.
Early IRA Withdrawals
One advantage of a brokerage account is that you can sell securities and withdraw money from it at any time without a tax penalty.
You can only withdraw traditional IRA funds or Roth IRA earnings under special circumstances without paying a penalty if you're under 59 1/2. You can generally do so if you're called up to active military duty from the military reserves or the National Guard or if you become permanently disabled.
If you're unemployed and need to buy health insurance for yourself and your family, you can do so with IRA money without paying a penalty. You can use IRA money to pay for medical expenses in excess of 7.5 percent of your adjusted gross income without owing the 10 percent penalty.
If you're buying your first home, you can withdraw up to $10,000 in IRA money without paying a penalty in order to pay for related expenses. Certain higher education expenses for yourself can also be paid with IRA funds without any penalty.
Required Minimum Distributions
One quirk around traditional IRAs and other tax-deferred retirement accounts, such as employer-based 401(k) and 403(b), is that once you reach age 70 1/2, you must start withdrawing money from the account at a certain rate each year.
You can figure out the amount of these mandatory withdrawals, which the IRS calls required minimum distributions, using tables published by the IRS or online calculators provided by many investment sites and brokerages. They're determined based on your age and the amount in your accounts.
These can force you to sell holdings even in growing investments to meet the minimum distribution requirements. Roth IRAs aren't subject to required minimum distributions unless you inherit one. Inherited IRAs, in general, have special rules around required minimum distributions.
Borrowing Against Your Accounts
One other advantage brokerage accounts can have over IRAs is that you can borrow against your accounts if your brokerage allows it. Usually, you must pay interest on such a loan, using your stocks as collateral, and there are often restrictions on what you can do with the money. Buying more stocks is usually not allowed.
You cannot borrow against or from a Roth or traditional IRA. Some employer-sponsored 401(k) plans do let you borrow money from your retirement account, though you will have to pay yourself back with interest and will face taxes and penalties if you don't keep up with required payments.
If you take money out of an IRA, you must put it back in that IRA or another IRA within 60 days under IRA rollover rules or you will be considered to have taken a withdrawal. You can only do one such rollover once in a one-year period.
- IRS: Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Topic Number 409 - Capital Gains and Losses
- IRS: Publication 550, Investment Income and Expenses
- The Motley Fool: Wall Street's Hottest Loan Product: Borrow Against Your Stocks
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.