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  • Writer's pictureNathan Zarcaro

Roth IRAs vs. Brokerage Accounts: Differences and When to Use Each


One of the aspects of saving money that doesn't get talked about enough is which account to use for what purposes. With IRAs, 401(k)s, Joint, Brokerage, and more options out there, it can be really difficult to know how much to save in each account and when to use each.


Today, I'm back to talk about the differences between Roth IRAs and brokerage accounts and help you understand the purpose of each.



What is a Roth IRA?


Roth IRAs are a type of tax advantaged retirement account that allows Americans to save up to $6,500 per year towards their retirement.


Contributions are made on a post-tax basis, but all investment earnings and qualifying withdrawals (after age 59 1/2) occur on a tax-free basis. They are a great tool to help Americans prepare for retirement.


I've written extensively about Roth IRAs here on the blog, so you can find all the information you're looking for in my IRA guide.



Roth IRA advantages


There are numerous benefits to Roth IRAs, particularly over individual brokerage accounts, including:


  • Tax-free investment gains: As long as you make qualifying withdrawals in the future, you will not pay taxes on your investment earnings or on your dividends. As we'll see in a minute, this is certainly not the case with brokerage accounts.


  • No required minimum distributions (RMDs): Some retirement accounts, like Traditional IRAs to name one, require you to take cash distributions from your accounts once you hit a certain age (currently 72). Neither Roth IRAs, nor brokerage accounts, are subject to these rules.



Roth IRA disadvantages


There are a couple of potential negatives to Roth IRAs that I recommend every American balancing IRAs vs brokerage accounts should consider.



1. Taxes and penalties for early withdrawals


When you save money in your Roth, you should have the mentality that you will not touch this money until you retire. And while this can be great come retirement time, you may not be touch these funds for decades until then.


You may opt to under extenuating circumstances, but you'll likely need to pay taxes and a 10% penalty, unless you meet certain criteria, like paying health insurance premiums following a job loss.


Of course, brokerage accounts have no such rule.



2. Income requirements


Another potential con of Roth IRAs is that you may lose access to make contributions in the future should your income grow.


Currently, those earning over $153,000 as an individual and $228,000 as a couple lose eligibility.


Of course, brokerage accounts have no maximum income for use.



What is a brokerage account?


A brokerage account is a basic type of financial account that allows investors to invest in a number of different equity and debt securities, including:


  • Stocks

  • Bonds

  • Mutual Funds

  • ETFs


Some accounts allow investors to link a debit card to their account, giving them instant access to cash that is not invested. In fact, this is how I have my Fidelity brokerage account (known as an individual) account. I can invest whatever cash I want, but also maintain as much liquidity as needed.


The real benefit here is that I can sell assets and then spend the money if need be.


In fact, I like to think of brokerage accounts as functioning similar to traditional savings accounts with banks, except for the fact that I can invest some or all of my savings if I want to.



Types of brokerage accounts


There are two dominant types of brokerage accounts out there today:


  1. Cash accounts

  2. Margin accounts


Cash accounts are what most people think about when they think of individual brokerage accounts. Basically, this means that the only funds that you can invest are dollars that you have saved in your account.


Then, there are margin accounts, which allow investors to borrow money from a financial services firm in an attempt to magnify investment returns. Buying on margin is incredibly risky, and while I am not licensed to provide investment advice, per se, it is something that I would never do.



Advantages of brokerage accounts


There are many advantages to individual brokerage accounts, none more important than:


  • The diversity of investment options available to you

  • The liquidity of your cash



1. Investment options


Like I alluded to earlier, there are a number of investment options available to buy within a brokerage account. This flexibility is one of biggest things going for these accounts. Now, there may similar investment options available in retirement accounts like IRAs, but being able to access these investments here can be a great advantage.



2. Cash liquidity


Unlike any type of retirement account, your cash is highly liquid and can likely be accessed on a moment's notice. My Fidelity account even allows me to sell an investment and access my cash immediately.


And while different firms may have different rules for the time it takes funds to clear, brokerage accounts are far more liquid than any type of retirement account.



Disadvantages of brokerage accounts


Just like any other type of account, there are a few disadvantages to brokerage accounts, headlined by the taxes you are likely to face. In fact, I can come up with four different taxes those with brokerage accounts are subject to:


  • Income taxes

  • Capital gains taxes

  • Interest taxes

  • Dividend taxes



1. Income taxes


I've decided to income taxes here, since you'll have them deducted prior to making contributions into your account. Of course, Roth IRAs work in the same way.


But unlike 401(k)s, HSAs, or Traditional IRAs, there is no option to contribute to a brokerage account on a pre-tax basis.


Not a huge deal, but something to keep in mind.



2. Capital gains taxes


Unlike Roth IRAs or Roth 401(k)s, your investment earnings will be subject to capital gains taxes. Rates vary based on the length of time you hold a security as well as your income, but long-term gains (defined as more than one year) will be subject to a tax rate of either 0%, 15%, or 20% of your gains.


If you sell securities after less than one year of holding them, your gains will be subject to a rate equal to whatever income tax bracket you're currently in.


As a long-term investor, I generally always try to make investment decisions with the intent to hold securities longer than one year, but this is not always possible in a brokerage account if you need to access funds.


For this reason, it is generally recommended to invest funds you'll need in the short to medium term (less than five years or so) in cash or safe investments, like fixed income.



3. Interest taxes


Some accounts allow you to save your money in interest earning money market funds or high yield saving type products. For example, my account at Fidelity allows me to keep my cash in a core position that currently yields nearly 5% (rates offered are tied to the United States Federal Funds Rate).


The best part is, for all intents and purposes, this money is cash. I can spend this money at any point via my linked debit card, which I mentioned earlier.


You may think this option is free from taxes, but alas, it is not. Any interest that you earn, which is usually paid monthly, over $10 per calendar year, is taxed by the United States government come tax time.



4. Dividend taxes


Last are dividend taxes. Not only will you be taxed on your investment earnings once you liquidate a position, but you will also be taxed on any dividends that any of your investment positions paid out while you owned them.


For example, stocks and mutual funds commonly pay dividends to shareholders to compensate them for holding the investment. Most companies pay these dividends quarterly, though the exact cadence may vary somewhat. Regardless, these dividend payments are reported to the IRS, and Uncle Sam will come calling for his piece.


 

Still, with all of these taxes, if you need to prepare for short- or medium-term goals and you're not near retirement age, your options are limited if you're looking to limit your taxes owed.



Roth IRAs vs. brokerage accounts


Now that you're well versed in the differences between Roth IRAs and individual brokerage accounts, I want to provide you with a little insight as to the purposes/objectives of each account type.



What to use a Roth IRA to save for


To avoid paying any penalties, fees, or unnecessary taxes, you should invest in a Roth IRA for the sole purpose of saving for retirement. Of course, there are exceptions that may allow you to access cash in an IRA, like for a first-time home purchase, but in general, you should expect to not have access to your savings until you turn 59 1/2 years old.


This is exactly what I do.


This means that a Roth IRA is likely not your best option if you're looking to save an emergency fund, save for home repairs/maintenance, or vacation.



What to use a brokerage account to save for


As you'll probably guess, I use my brokerage account for more short-term savings and investing goals. My wife and I also use our brokerage accounts (as well as our joint account) to pay our monthly and annual bills, like groceries or utilities, as well as pay for any entertainment and travel we decide to splurge on.


Remember - it is important to strike a balance between investing in different accounts, especially since there is no tax benefit to doing so in a brokerage account. But at the same time, it is very important to maintain the liquidity that these accounts offer.



Where to open Roth IRAs or brokerage accounts


Many financial services firms offer both Roth IRAs and brokerage accounts to


In fact, given their differences and the distinct pros and cons of each account type, it can be a good idea to open both accounts. To keep your finances easier to manage, if you do open both accounts, I recommend that you do so with the same company.


So this begs the question: where should you open your IRA and brokerage account?


Generally, I like to do business with some of the biggest financial services firms on the market, since they are less likely to experience technology problems and are more likely to offer solutions and unique features that may be beneficial to you.


In 2023, I recommend a few firms in particular, in no particular order:


  1. Fidelity Investments

  2. Vanguard

  3. Charles Schwab



Conclusion


Roth IRAs and brokerage accounts are very different and have different purposes. Regardless, both are an important component of a solid financial plan and future. Do you have both types of accounts? And if so, how do you balance them?


Tell me in the comments below!




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About Nathan Zarcaro

Nathan Zarcaro is the founder of The Student Debt Destroyer and is passionate about personal finance related causes.  A 2018 graduate of Providence College's Liberal Arts Honors Program, Nathan studied Finance, and has worked for industry leaders in both finance and healthcare.  In his free time, Nathan enjoys playing golf and traveling with his wife Brigid.

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