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When it comes to investing for the future, there are a variety of options available, from tax-advantaged retirement accounts such as 401(k)s to taxable investment accounts such as brokerage accounts.
In this article, we’ll explore the key differences and similarities between 401(k)s and brokerage accounts to help you make an informed decision about which type of account is best for your financial goals and circumstances.
What is a 401(k)?
A 401(k) is a retirement savings plan offered by employers to help their employees save for their retirement.
It allows employees to contribute a portion of their pre-tax income directly into an investment account. The contributions grow tax-deferred until retirement, at which time they are taxed at the individual’s current income tax rate.
The name “401(k)” comes from the section of the IRS code that governs this type of plan. There are two main types of 401(k) plans: a traditional 401(k) and Roth 401(k).
We will discuss these below.
In a traditional 401(k) plan, contributions are made with pre-tax dollars, meaning that the amount you contribute reduces your taxable income for the year.
This lowers your current tax bill, but you will pay taxes on the contributions and their earnings when you withdraw the money during retirement.
In a Roth 401(k) plan, the contributions are made with after-tax dollars, so you don’t get a tax break upfront. However, your contributions and their earnings grow tax-free, and you won’t have to pay taxes on them when you withdraw the money during retirement.
This can be beneficial for those who anticipate being in a higher tax bracket during retirement than they are now. Both types of 401(k) plans have contribution limits that the IRS sets, and many employers offer a matching contribution to encourage their employees to save.
Advantages of 401(k)s
401(k)s have several important advantages:
- Tax-deferred savings – contributions made by employees are not taxed until they are withdrawn during retirement, which allows more money to grow and compound over time within the investment account.
- Matching contributions – are a benefit of 401(k)s, in which an employer contributes a percentage of the employee’s contribution to their retirement account. This helps employees to save more for their future and increases their retirement savings.
- Late-saver benefits – in relation to 401(k)s refer to the catch-up contribution option, which allows individuals over 50 years of age to contribute additional funds to their retirement account each year. This enables you to make up for any lost time in saving for retirement.
- Pre-tax contributions – allow employees to contribute to their retirement account with income that has not yet been taxed, reducing their taxable income for the year and potentially lowering their current tax bill.
- Shelter from creditors – funds within the account are generally protected from creditors or bankruptcy, providing additional security and protecting retirement savings from potential financial setbacks.
Drawbacks of 401(k)s
While 401(k)s have many benefits, they also have a few potential pitfalls.
- Withdrawals are taxed – one drawback of a 401(k) is that withdrawals from the account during retirement are taxed as ordinary income, which means that the amount that is withdrawn is added to an individual’s taxable income for the year. This could increase their tax liability and reduce the overall amount of money available for retirement.
- Age requirements – a potential drawback of a 401(k) is that individuals cannot withdraw funds from their account penalty-free before age 59 ½. If they do, they may incur a 10% early withdrawal penalty, which limits access to the funds in cases of financial hardship or unexpected expenses.
- Mandatory withdrawals – one drawback of a 401(k) is that individuals are required to start taking mandatory withdrawals, known as required minimum distributions, from their account by age 72, which may result in a higher tax bill and limit the amount of money available for continued investment or future use.
- Limited investment options – a negative aspect of 401(k)s is that individuals may have limited investment options within the plan, which can limit their ability to diversify their portfolio or choose investments that align with their specific financial goals and risk tolerance.
What is a Brokerage Account?
A brokerage account is an investment account that allows individuals to buy and sell various securities, including stocks, bonds, mutual funds, and ETFs.
Brokerage accounts are typically opened with a brokerage firm, which acts as an intermediary between the investor and the securities markets.
To use a brokerage account, an individual typically opens an account with a brokerage firm and then deposits funds into the account. They can then use those funds to buy securities through the brokerage firm.
When the investor decides to sell their securities, the brokerage firm handles the transaction and deposits the proceeds back into the investor’s account, minus any fees or commissions.
Brokerage accounts offer individuals flexibility and control over their investments, as they can choose which securities to buy and sell and when to do so. However, they also carry risks, as the value of securities can fluctuate, and investments can lose value.
Advantages of Brokerage Accounts
Brokerage accounts offer a wide range of benefits:
- No contribution limits – an advantage of a brokerage account is that there are no contribution limits, meaning individuals can invest as much as they want and grow their wealth faster than with other types of investment accounts.
- Withdraw money anytime – one advantage of a brokerage account is that individuals can typically withdraw money at any time without penalty, which provides more flexibility and liquidity than other types of investment accounts that may have restrictions or penalties for early withdrawals.
- Borrow money – an advantage of a brokerage account is that individuals may be able to borrow money against their investment portfolio, which is known as margin trading. This can provide additional liquidity and investment opportunities. However, this also carries risks, and individuals should carefully consider their options and the associated costs and risks before engaging in margin trading.
- FDIC Insurance – is typically only offered for deposit accounts, such as savings or checking accounts, and not for investment accounts. However, some brokerage firms may offer additional insurance or protections for their client’s investment accounts.
- Lots of investment options – brokerage accounts offer a wide range of investment options, including stocks, bonds, mutual funds, ETFs, options and more. This allows investors to diversify their portfolios and choose investments that align with their financial goals and risk tolerance.
Drawbacks of Brokerage Accounts
While the benefits of brokerage accounts are appealing, it’s important to also understand their potential risks.
- No tax advantages – brokerage accounts don’t offer any tax advantages, as any gains or dividends earned from investments held in the account are subject to capital gains taxes. Investors may also be subject to taxes on interest or dividend income that they receive from their investments.
- Capital gains taxes – are a disadvantage of a brokerage account because investors must pay taxes on any gains made when selling securities, which can significantly reduce their overall investment returns.
- Limited financial advice – unlike a 401(k), which curates investment options and provides investment advice, investors in a brokerage account must make investment decisions and manage their portfolio independently, which may not be suitable for all individuals.
- Commissions and fees – can add up quickly and eat into investment returns, potentially eroding the value of an investor’s portfolio over time.
Brokerage Account vs 401(k): How do they compare?
Here’s a quick look at their key similarities and differences:
|Ability to Invest in Stocks, ETFs and Mutual Funds||Yes||Yes|
|Dividends on Stocks||Yes||Yes|
|No Contribution Limits||Yes||No|
|Withdraw Money Anytime||Yes||No|
|Lots of Investment Options||Yes||No|
|Capital Gains Taxes||Yes||No|
Which is Better: 401(k) or Brokerage Account?
Choosing between a 401(k) and a brokerage account can have a major impact on your finances, so you want to carefully consider the type of investor you are and your level of investing experience.
- You want tax-deferred savings, potentially reducing your current tax burden and allowing your investments to grow tax-free until withdrawal.
- You want matching contributions from an employer, providing an immediate return on your investment and helping accelerate your retirement savings.
- You want to catch up on your retirement savings through the Late-Saver program, as the contribution limits are higher than those for other types of retirement accounts, and individuals over the age of 50 can make additional “catch-up” contributions.
- You want maximum flexibility, as there are typically no contribution limits or restrictions on withdrawals, providing more control over investment decisions.
- You want the ability to invest in a wide range of securities, including stocks, bonds, ETFs and mutual funds.
- You are interested in more advanced trading strategies, such as options or margin trading.
Here are the answers to common questions about 401(k)s and brokerage accounts.
Should I max out my 401(k) before using a brokerage?
It depends on your financial goals and individual circumstances, but maximizing contributions to your 401(k) can be a smart long-term strategy for retirement savings, while a brokerage account can provide more flexibility and potentially higher returns for short-term goals.
Are brokerage accounts good for retirement?
Brokerage accounts can be a useful tool for retirement savings, particularly for investors who have already maxed out their tax-advantaged retirement accounts and are looking for additional ways to grow their wealth over the long term.
Can I move my 401(k) into a brokerage account?
Yes, it is possible to roll over a 401(k) into a brokerage account, although the process may involve fees and taxes, and you should carefully consider the implications before making the switch.