A Roth IRA Versus A Taxable Brokerage Account

A Roth IRA versus a taxable brokerage account... Which one is best?

The answer, of course, depends on which one is the right fit for your individual financial situation.

Whether you choose to invest in a Roth IRA or a regular taxable brokerage account, you need to ask yourself, "Does this plan feature..."

• Tax Deductible Contributions?
• Tax Deferred Investment Gains?
• A Maximum Income Limit for Contributions?
• Taxation of Withdrawals?
• Early Withdrawal Penalties?
• Required Withdrawals?

You should take all of these factors into account when comparing a Roth IRA vs. a taxable brokerage account.

To determine your best course of action, let's examine each factor individually.

Tax Deductible Contributions

Neither a Roth IRA nor a taxable brokerage account is tax deductible.

What does this mean?

It means you can only fund a brokerage account or a Roth IRA with after-tax dollars... In other words, your take home pay.

So a Roth IRA doesn't have any real advantage over a regular taxable brokerage account when it comes to saving money on your income taxes or when it comes to finding any tax deductions.

So when it comes to tax deductibility, your Roth IRA fights to a draw in a battle with your ordinary taxable brokerage account.

Tax Deferred Investment Gains

So what about tax deferred investment gains?

Which is better, a Roth IRA or a taxable brokerage account?

The obvious winner here is the Roth IRA.

Once you fund your Roth IRA with after-tax contributions, you never have to pay taxes again if you wait to withdraw that money in a retirement.

A taxable brokerage account, however, is subject to capital gains and income taxes.

Don't think this really matters?

Think again.

Let's say you invest $1,000 in both a Roth IRA and a regular taxable brokerage account.

In year one, you double your money in a hot stock and quickly sell it.

With a Roth IRA, you can reinvest the full $2,000.

With a taxable brokerage account, you'll probably owe at least 20% in federal and state taxes. So you only have $1,800 to reinvest.

Let's say that each sum is reinvested for 20 years at a 10% annual rate of return.

Twenty years later, you have an extra $6,727.50 from your reinvested $1,000 capital gain with a Roth IRA, but only $5,382.00 from your reinvested $800 capital gain with a taxable brokerage account.

That's a difference of $1,345.50...

And that's assuming you don't incur any additional taxes on your brokerage account investment gains along the way!

See how much of a difference tax deferral can make?

Chalk up a win for your Roth IRA versus a regular taxable brokerage account.

The Maximum Income Limit For Contributions

So how does a Roth IRA fair against a taxable brokerage account when it comes to a maximum income limit?

If you're a high income earner, the taxable brokerage account wins out.

By law, you're barred from contributing to a Roth IRA if you earn more than $120,000 per year as a single individual or more than $176,000 as a married individual.

So if you earn more than the Roth IRA income limits allow, you don't have to worry about what's best. You don't even get the option of investing in one.

With a regular taxable brokerage account, you aren't subject to any income limitations. You can contribute as much after-tax income as you want without regard to how much you earn.

Taxation of Withdrawals

Just as it does with tax deferred investment gains, a Roth IRA wins out over a taxable brokerage account.

Why?

All qualified withdrawals from a Roth IRA are tax-free.

With a taxable brokerage account, you can withdraw you original contributions at any time tax-free. But any investment gains are always subject to either income taxes or capital gains taxes.

As a result, a Roth IRA dollar is worth more than a taxable brokerage account dollar once you reach retirement age.

For example, let's say the prevailing tax rate is 20% and you have $1 million dollars in a Roth IRA and $1 million in a taxable brokerage account.

Do you really have the same amount of money in both accounts?

Nope.

Well, why not?

Because the Roth IRA funds are tax-free, meaning they're worth the full $1 million.

But the taxable brokerage account funds are subject to taxes, meaning they're worth only $800,000.

So when it comes to taxation of withdrawals (distributions), a Roth IRA is superior to a regular taxable brokerage account.

Early Withdrawal Penalties

Of course, unqualified withdrawals from a Roth IRA are subject to a 10% Roth IRA early withdrawal penalty.

This is never the case with a taxable brokerage account.

You can withdraw your money any time for any reason. Of course, any withdrawals will be subject to applicable taxes.

But you'll pay taxes on unqualified Roth IRA withdrawals too.

So if easy access to your money is a primary concern, you might want to consider a traditional taxable brokerage account instead of a Roth IRA. With the former, you never have to worry about early withdrawal penalties.

Required Withdrawals

Neither a Roth IRA nor a taxable brokerage account require account holders to withdraw funds once they reach a certain age.

You can contribute to either account regardless of age (assuming you have qualified income to contribute to a Roth IRA), so this is not a concern when choosing between the two.

Conclusion

A Roth IRA versus a taxable brokerage account... Which is best?

Such a question always depends on your personal financial goals.

But rarely, if ever, is it wise to forego funding your Roth IRA in order to fund a taxable brokerage account.

Why?

Taxes.

Once you fund your Roth IRA, you NEVER pay taxes again.

The money you save by avoiding taxes adds up to an enormous sum of money over time.

While a traditional taxable brokerage account offers you far more flexibility in terms of getting your hands on your money before retirement, the benefits of a Roth IRA are just too good to pass up.

After all, you're saving money for retirement. You shouldn't be trying to get your hands on it until you reach retirement age.

So before funding your regular taxable brokerage account, make sure you max out your Roth IRA first. If you don't meet the Roth IRA eligibility requirements, then make sure you max out a Traditional IRA instead.

Whatever you do, don't pass up the opportunity to grow your money tax-free... It can have a life-altering effect in your retirement years!