Taxable Account vs. IRA: Which Is Best for Investing?

Your retirement goals can help you choose an account

Black woman looking closely at laptop.
•••

Sarah Waiswa/Getty Images

Table of Contents
Table of Contents

When you're ready to start thinking about saving for retirement, you have options. These fall into two main categories: taxable accounts and individual retirement accounts (IRAs). Taxable accounts are generalized savings and investing tools. IRAs are built with retirement in mind. Each type of account has distinct features.

Finding the best account type for your goals can be simple. Start by learning the basic facts and benefits of taxable accounts and IRAs. Here's a breakdown of how each type works and its main benefits.

What's the Difference Between Taxable Accounts and IRAs?

Taxable Account IRA
Investments can be tailored to your preferences and risk tolerance profile Investments are managed by professional firm with set plan options
Taxed as income (with potential for taxation as capital gains and dividends) Tax-advantaged (bypasses income tax or defers until withdrawal; growth is tax-free)
 Managed through a broker Often sponsored by employer
 No contribution limits Government regulated limits on contribution

A taxable brokerage account is an account set up for trading (buying and selling) investment securities. These securities may include stocks, bonds, mutual funds, or exchange-traded funds (ETFs). These accounts are referred to as taxable brokerage accounts because you may have to pay taxes on gains.

An IRA is an account designed with retirement in mind. It offers tax advantages to incentivize contributions. These accounts are often sponsored by an employer. IRAs may be included as part of a benefits package. IRAs come in many forms. The traditional and the Roth are the most common.

Diversification

When you invest in an IRA, either through your employer or a private fund, you may not have much say in how the plan invests. These accounts are often managed by firms with clear risk profiles and growth goals. Your contributions form part of their larger plan.

Investing in a taxable brokerage account can provide tax diversification. This is a reduction in risk by spreading savings and investment assets among different types of accounts. By using multiple account types with varying taxation, investors can have more flexibility in the timing and taxation of withdrawals.

Withdrawals

One of the downsides of IRAs is that you are penalized for early withdrawals. If you are saving for retirement and you think you may need some of your long-term savings prior to age 59 1/2, you can avoid the 10% "early withdrawal penalty" by choosing the taxable account.

Taxable accounts are designed for general investing purposes. Though some types of funds may have maturity dates, you will not incur the same level of penalties for early withdrawal that you would with IRAs.

Taxation

IRAs are tax-advantaged because they allow you to defer or skip the taxes on the money you deposit until it is withdrawn. In traditional IRAs, money is deposited on a pre-tax basis. This means it is not subject to income tax. Taxation is deferred until you take it out years later. In that time your money can grow tax-free. Contributions to Roth IRAs happen after they are taxed as income. But, once in your account, this money can also grow tax-free.

Long-term gains on investments sold from taxable accounts are taxed at the 15% capital gains rate. For some investors, this rate is lower than their federal income tax rate. For this reason, a taxable brokerage account may be a better choice for wealthy people in higher tax brackets compared to traditional IRAs, where withdrawals are taxed as ordinary income.

Taxes incurred in a taxable brokerage account include realized capital gains and dividends or interest earned.

Income Limits

IRAs receive tax advantages as part of a benefit managed by the IRS. So, there are limits to how much you can deposit into your account. Thresholds are subject to change each year. These limits will also vary by your filing status.

Some people have the lucky problem of not being able to contribute to an IRA because of income limits. For instance, a couple who file joint tax returns and are covered by their employer's retirement plan will be phased out of making traditional IRA contributions starting at $104,000 in 2020 and $105,000 in 2021.

Which Is Right for You?

There are a few things you'll need to consider before choosing the best account type for you. Should you invest all of your long-term savings in an IRA? When is it best to use taxable investment accounts? Or is it better to use several account types? Here is a breakdown of when to invest in a taxable account, a traditional IRA, or a Roth IRA.

Who Should Invest in a Taxable Brokerage Account?

A taxable brokerage account may be best for you if your income exceeds the maximum for contributing to IRAs and you want to invest a bit more aggressively. Or, if you've maxed out your contributions to an IRA and your employer-sponsored retirement plan, such as a 401(k), you can open a taxable account for further savings.

But what if you are not looking for a more robust savings method and think you may need to make withdrawals from your investment account prior to age 59 1/2? In that case, a taxable account offers more flexibility than an IRA.

Who Should Invest in an IRA?

First, if your employer offers an IRA, it's worth looking into the options.

A traditional IRA might be best for you if you need tax deductions from income. It may also be better if you expect to be in a lower tax bracket after you retire. Also, don't overlook the value of an employer match program. If your firm offers a 401(k) with a match, it's wise to put in at least enough into that plan to get the match.

If you don't need tax deductions from your taxable income or you expect to be in a higher tax bracket when you retire than you are now, a Roth IRA might be right for you. If you can afford to invest beyond your employer's 401(k), it's often wise to contribute to a Roth IRA. This type of account has a maximum contribution of $6,000 ($7,000 if you are 50 or older) in 2020 and 2021.

If you move from a job that sponsored your 401(k), you may be able to transfer your contributions without penalty to a "rollover account." This is a type of traditional IRA for qualified plans such as 401(k) or 403(b).

The Bottom Line

Consider your financial situation now, as compared to your financial situation when you plan to retire. Will you benefit more from tax perks now or then? You may be able to take advantage of multiple account types. If you are able to save more, open a taxable brokerage account or joint brokerage account and save as much as you can there. Can you afford to take greater risk or do you prefer a more conservative approach?

Ultimately, you can explore these options to see how each works with your personal plan. Don't be afraid to employ more than one approach.