Should You Invest in Taxable Accounts or IRAs or Both? (2024)

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 individual retirement account (IRA) is an account designed with retirement in mind. It offers tax advantages to incentivize contributions. IRAs come in different forms, including traditional and Roth.

Diversification

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 traditional 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 59½, 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IRAs are tax-advantaged because they allow you to defer or skip the taxes on the money you deposit until it is withdrawn. With traditional IRAs, contributions are tax-deductible in the year you make them. Taxation is deferred until you withdraw the money in retirement, meaning you don't pay capital gains taxes over the years on any of the earnings.

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.

IRA Contribution Limits

The Internal Revenue Service (IRS) establishes a limit as to how you can contribute to an IRA each year.

• In 2022, you can contribute $6,000 annually and $7,000 if you’re age 50 and older.
• In 2023, you can contribute $6,500, and if you’re age 50 and older, you can contribute $7,500.
  

Income Limits for Tax Deduction

Although there are no income limits on deductible contributions to a traditional IRA, there are income limits for you to receive a tax deduction in the year of the contribution if you (or your spouse) are covered by a retirement plan at work. For instance, a couple who files joint tax returns and are each covered by their employer's retirement plan will have their tax deduction phased out starting at $109,000 in 2022 and $116,000 in 2023.

Roth IRAs

A Roth IRA is similar to a traditional IRA, but there are distinct differences. With a Roth, your contributions are funded with after-tax dollars, meaning you don't get a tax deduction in the year of the contribution. However, your investment earnings grow tax-free, and there are no income taxes when you withdraw your money in retirement.

You can also withdraw your Roth contributions at any time, including before age 59½, but you can't withdraw your earnings penalty-free until the account is at least five years old and you're at least age 59½.

The annual contribution limits for Roth IRAs are the same as traditional IRAs. However, there are income limits for being able to contribute to a Roth. You can only make Roth IRA contributions if you earn less than $144,000 as a single filer in 2022 ($153,000 in 2023) and $214,000 if you're married and filing jointly in 2022 ($228,000 in 2023).

In short, you don't get a tax deduction upfront with a Roth IRA, but your withdrawals in retirement are tax-free. However, if you're a high-income earner, the income limits might prevent you from contributing to a Roth.

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 better 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 better for you if your income exceeds the maximum for contributing to IRAs and you want to invest a bit more aggressively. If you've maxed out your contributions to an IRA, 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 59½? In that case, a taxable account might offer more flexibility than an IRA.

Who Should Invest in an IRA?

A traditional IRA might be better for you if you need tax deductions to reduce your tax bill in the year of your contribution. It may also be better if you expect to be in a lower tax bracket after you retire. 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.

It's also important to consider a 401(k) if your employer offers it. Contributions are made with pre-tax dollars, giving you an upfront reduction in taxable income. However, withdrawals are taxed at your income tax rate in retirement, similar to a traditional IRA. The contribution limits for 401(k)s are much higher than for traditional and Roth IRAs.

• For 2022, you can contribute up to $20,500 of pre-tax income to a 401(k), and if you are 50 or older, you can contribute another $6,500 as a catch-up contribution.
• For 2023, you can contribute up to $22,500 to a 401(k) and another $7,500 in catch-up contributions if you are 50 or older.
  

However, some companies offer an employer match program, which is when the employer adds a percentage of your salary to your retirement account. For example, your employer might contribute 3% of your salary as long as you contribute 6%. It's wise to contribute at least enough to the plan to qualify for the match since it's free money. If you can afford to invest beyond your employer's 401(k), it might also be wise to contribute to a Roth IRA so that some of your withdrawals in retirement would be tax-free.

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 a 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.

Frequently Asked Questions (FAQs)