401k vs. Brokerage Account: Which is the Better Choice for You?
There are benefits and drawbacks to both brokerage accounts and 401(k) accounts. With a brokerage account, your money is taxable, but you have more flexibility in investing it. You get tax advantages with a 401(k) account but can’t touch the money until you retire. You should consider your goals and see a financial professional to choose the proper account.
401(k)s and Brokerage Accounts
Many employers provide 401(k) plans as retirement savings options. Employees save money for retirement by putting money into the account before taxes are taken out. It lets the money grow without being taxed until you retire and take it out. Employers can also match part of employees’ savings, which is a bonus.
A brokerage account is a type of account that investors use to buy stocks and other securities. With a brokerage account, you can borrow money from the broker to invest in stocks. You can also trade options and other securities with a brokerage account.
Many investors have both a 401(k) and a brokerage account. These accounts can help people save for different goals, like retirement or buying a house. A brokerage account is suitable for buying stocks or other investments, while a 401(k) account is good for saving money.
Pros and Cons of a 401(k)
The main benefit of a 401(k) plan is the tax deferral advantage. Employees can put money into the plan when earning income and withdraw the funds after they retire. The idea is that they will be paying a lower tax rate during retirement. The money in the plans also generates earnings, which accumulate tax-free until they are withdrawn.
People with 401(k) accounts can set them up through their employers. Not all employers offer the plans, but people can borrow money from their 401(k) account for other things besides retirement.
The big drawback of 401(k) plans is that the money is not easily accessible. Participants cannot withdraw the money without paying the penalty before they reach age 59.5. The penalty for early withdrawal is 10% of the amount withdrawn, plus income taxes are due on early withdrawals at the participant’s regular tax rate.
The IRS also limits how much you can contribute to a 401(k) every year. This amount goes up every year. For 2022, the limit for most people is $20,500 per year. When someone contributing to a 401(k) turns 70.5 years old, they must take the required minimum distributions from the plan. It can limit someone’s flexibility in planning their taxes and other concerns when they retire.
One of the drawbacks of 401(k) plans is that there are not many investment options. Employers usually only offer a few mutual funds that employees can choose from to set up their portfolios. It can limit the amount of money people make from their investments. Additionally, some 401(k) plans to charge extra fees on top of the fees charged by mutual funds. These additional fees reduce the return to participants. Over the long term, these fees can add up and cost people a lot of money.
Another drawback of 401(k) plans is that not every employer offers them. Self-employed people can set up their tax-advantaged plans. Still, people whose employer doesn’t offer a 401(k) plan cannot use this retirement planning vehicle.
Pros and Cons of a Brokerage Account
A brokerage account is more liquid than a 401(k) account. It means you can take your money out anywhere without getting in trouble. However, if you sell your stocks when the market is down, you might lose some money. A brokerage account allows you to deposit any money, which is why people who have already contributed the maximum to their 401(k) account frequently use them.
An investor can leave their money in a brokerage account for as long as they want. They can also choose to take out the money at any time; there are no age requirements. Investors can buy and sell any investment security, including stocks, bonds, mutual funds, ETFs, and options. Margin accounts allow investors to trade with borrowed money.
Setting up a brokerage account is easy. You can do it at a bank or brokerage in person or online. The only thing you need is enough money to purchase investments.
The main downside of having a brokerage account is no tax advantage. That means that any profits you make from your investments will be taxed. Investing in tax-favored assets, such as municipal bonds, and planning to take advantage of reduced long-term capital gains rates are two ways to reduce your taxable income.
What 401(k)s and Brokerage Accounts Are Used For
Most people think that 401(k) plans are for retirement. That’s because they usually restrict how much money you can take out whenever you want. It is, so people don’t use the money for other things, like buying a house or paying for college. But even though there are rules about this, account holders can still take out a 401(k) loan in some cases. Before you borrow money, make sure you can pay it back.
Brokerage accounts are best for shorter-term goals. It might be saving up to buy a house or car or pay for college or a wedding. They are flexible, so you can use the money anytime without getting in trouble. Just try not to sell your investments too quickly because you will have to pay taxes on your money.
401k Or Invest In An After-Tax Brokerage Account
There are two different ways to save money for your retirement. You can contribute money to a 401k, a plan your employer offers, or invest in a brokerage account, where you keep your own money. This article will assist you in determining which one is best for you.
The benefit of a 401k is that you can contribute money that has already been taxed. The more tax you pay, the more money you save in the long run. If you can begin withdrawing from your 401k when your tax bracket is lower, you have successfully saved some money on taxes.
The issue with the 401k is that you must pay a 10% early withdrawal penalty if you get the money before the age of 59.5. But the government could raise that percentage or increase the age limit if they get desperate.
What Is a Brokerage Account?
You’ll need a brokerage account if you plan to invest in the stock market. A brokerage account is a way for you to buy and sell stocks, bonds, ETFs, and other assets.
An investment is something you hold for a long time. The longer you possess something, the greater its value grows. A brokerage account is an excellent place to put your investments because it lets you be flexible about what kind of investments you make. You can invest in stocks from other countries or stocks linked to things like gold and silver.
How Do Brokerage Accounts Work?
You must open a brokerage account to invest in stocks or mutual funds. You will deposit the money you want to use for the investment into the account. The bank or brokerage firm will take care of the transactions for you.
There are two main categories of brokerage accounts: full-service accounts, which include some form of financial advice, and primary accounts, or online brokerage accounts, where you manage the account yourself or with help from a “Robo-advisor.”
There are no tax advantages if you have a brokerage account. You will have to pay taxes on any money you make from selling investments, including capital gains, dividends, and interest. Taxes are based on how long you owned the investment.
For example, if you have owned the mutual fund shares for over a year and then sold them, you will only have to pay the long-term capital gains tax rate. It is a percentage of 0%, 10%, or 15%, depending on your regular income. However, if you have sold the shares within a year of buying them, the short-term capital gains tax rate will then be due, which is the same as the tax rate on your regular income.
If you get dividends from your investments, the government will tax them either as regular income (for unqualified dividends) or as long-term capital gains (for qualified dividends). It can be challenging to determine, so working with a tax advisor for assistance may be prudent.
Types of Brokerage Accounts
There are different types of brokerage accounts. You should educate yourself on each type to choose the best one.
Full-Service Brokerage Accounts
With a full-service managed brokerage account, you usually get help from a financial advisor or broker. Brokers charge a fee or commission for making trades or purchases on their client’s behalf, which drives up the price of these accounts.
Online Brokerage Accounts
Some online brokerage accounts have help from people who are called “Robo-advisors.” These individuals use computers and algorithms rather than humans to assist you in purchasing and managing your investments. It could be your best option to save money on fees.
Cash Brokerage Account
When you have a cash brokerage account, you must pay for any investments in full. That means you can’t borrow money from your broker to pay for the investment. It is good because it prevents your brokerage firm from becoming a debt collector.
Margin Brokerage Account
When you hear the word margin, think debt. A margin account means you borrow money from a brokerage firm or bank to invest. It can be risky because if the value of your investment goes down, the broker could ask you to pay back the money immediately.
It’s important to remember that borrowing money to invest is risky. In addition, interest will be charged on the amount you owe. So it’s best not to do this unless you can handle the risk.
How to Open a Brokerage Account
Opening up a brokerage account is simpler than you may think! You can quickly and easily create your account by following a few simple steps. There are only a handful of things to remember while opening it. Here’s everything that you need to do:
1. Pick a Brokerage Firm.
Before selecting the best brokerage firm for you, take some time to compare the prices, charges, and services provided by various companies. Before choosing where to put your hard-earned money, talk to an investment professional about your options.
2. Select the Kind of Brokerage Account You Desire.
Most millionaires use a financial advisor to help them achieve their net worth. They also don’t use debt to invest, so avoid margin accounts.
3. Fill Out an Application.
To open a brokerage account, you need to find a brokerage firm you want to work with. Opening an account is simple and only consumes a few minutes. You’ll probably need to sign paperwork and divulge private information, such as your Social Security number, employment history, and financial situation.
4. Fund the Account and Start Investing.
You can set up your account by making an initial deposit or setting up automatic withdrawals from your bank each month. Once you have funded your account, you can start investing. It’s that easy!
What Is a 401(k)?
401(k) retirement savings programs have become more popular over time. Between 2006 and 2009, when new regulations were put in place, around 60% of people participated. Now, almost 90% of earners use these accounts to save for retirement. Millions of workers and their employers contribute billions of dollars annually to these accounts. The amount saved for retirement has continued to grow over time and was estimated at $7.3 trillion in 2022.
Using a 401(k) account to save money for retirement is a wise decision. Your employer will put money into it, and they won’t have to pay for a pension. Employers usually match how much you save up to a limit. This account appeals to people who make a lot of money but also helps most workers.
You will invest some of your money into different financial vehicles, like 401(k) accounts. You will do this throughout your life to save money for when you are old. A lot of Americans are doing this now, and it is making the stock market more popular.
Some company plans let you get a group rate, saving you money and giving you access to exclusive funds. However, most of these services are not available to workers for free. Two conditions, it is argued, must be met for 401(k) accounts to remain affordable for wage earners:
- The expenses must be reduced in some way
- The policies that penalize lower-income earners must be changed.
It is unlikely that either of these things will happen. The severity of the crisis will almost certainly determine the number of middle-class investors in the stock and mutual fund markets. Businesses will continue offering 401(k) plans to employees lucky enough to keep their jobs (with and without matching funds). Even if they do not contribute, the majority of employees earning more than the minimum wage expect their employers to pay for the account to be established on their behalf.
Your contribution to your 401(k) plan each year may vary. The limit for individuals in 2022 is $20,500. 50-year-olds can add $6,500 annually. Retirement savings can be substantial. For 30–40 years.
People with the most money in their houses and savings accounts lose a lot when the stock market drops. It is because they have most of their money in those places.
Depending on how actively the fund invests in stocks, the 401(k) account lost 20-40% between 2008 and 2022. The first quarter of 2022 also reported a 4.5% drop in value, raising concerns about the security and flexibility of retirement money, including 401(k) accounts.
A 401(k) plan is a financial instrument to store future money. It is different from life insurance because you must wait longer to withdraw the money. Most people use 401(k) plans so they can have access to the funds while they are still living.
People have gotten used to having a good return on their investments in the stock market. It is reasonable because the stock market has done well over many years. When we figure out who should pay for the financial crisis that started in 2007, there will be a lot of discussion about it.
People have long known that retirement savings banking alternatives have high costs and management issues, such as those aggressively promoted in the 2000s. It includes many people’s 401(k) accounts.
Benefits of a 401(k)
401(k) plans offer several benefits that other retirement accounts do not provide.
1. Employer Matching Contributions
Consider your employer’s matching contributions when deciding between a Roth IRA and a 401(k). Employers typically match up to a certain amount of your 401(k) contributions. It essentially amounts to free money.
The employer match usually comes with a catch: you can’t get the money immediately. You have to wait for a certain amount of time. It is to ensure that you remain with the company. For example, if your employer has a graduated vesting schedule, you could become vested at a 25% annual rate. You would have to stay with the company for four years to receive the full amount of your employer’s contribution. Companies can choose their vesting schedule, but the maximum allowed is six years.
2. Pre-tax Contributions + Tax-Deferred Growth
Contributions to a 401(k) are deducted from your pretax income. It reduces the amount of tax you must pay on your earnings. For example, if you make $3,000 a month and contribute $100 to your 401(k), you will only be taxed on the first $2,900. While your money is in the account, your investment earnings grow tax-free. However, you must pay your contributions and earnings taxes when you withdraw.
3. High Contribution Limits
The yearly contribution limit for 401(k)s is way higher than the Roth IRA limit. For instance, in 2022:
- Employees are allowed to contribute up to $20,500.
- Employees over the age of 50 can contribute an additional $6,500.
- Contributions with the employer match cannot exceed $61,000 or $67,500 for employees over 50.
Like Roth IRAs, there are some contribution limits to 401(k)s. If you earn over $305,000, your maximum contribution may be reduced.
4. Special Protections Under ERISA
1974 Employee Retirement Income Security Act (ERISA)safeguards retirement funds held in certain investment accounts, such as 401(k)s. It sets rules about how the accounts must work, what information you must be given about your account, and how the company running the account must be held accountable. Even if something goes wrong with your investments, ERISA will ensure that you still have access to your retirement funds. The act also protects your plan from creditors if you or your employer go bankrupt.
Disadvantages of a 401(k)
401(k)s have some disadvantages that you should think about.
1. Fewer Investment Options
Roth IRAs let you put your money into many different investments, while 401(k)s usually have fewer investment options. Most 401(k)s only have a few mutual funds. You might also be unable to switch your investments as often as you want.
2. Potential for Higher Taxes
The tax advantages of 401(k)s, like Roth IRAs, are not guaranteed. Pretax contributions can save you money in the short term. Still, if you withdraw funds after retirement age, you may be taxed more heavily. It could mean you’ll pay more taxes on your contributions and earnings.
3. Potential for Higher Fees
401(k)s are highly regulated, requiring more active management. That can lead to higher fees.
4. Strict Withdrawal Rules
You will face penalties if you get funds from your 401(k) before the age of 59 and a half. If you are in a challenging financial situation, you can get a loan from your 401(k) plan. You also can’t keep your money in the account forever; by age 72, you must start making withdrawals.
Both have a brokerage account, and a 401(k) account has benefits and drawbacks. The 401(k) account is good for long-term savings goals because of the tax perks. But, it can be hard to use the money in this account for other short-term purposes. A brokerage account is suitable for people who have saved the maximum amount in their 401(k) account. They can use this account to save money for things like homes, cars, and college costs. Many people use both a 401(k) and a brokerage account.
Frequently Asked Questions About 401k vs. Brokerage Accounts.
Having both a brokerage account and an IRA can be a smart financial move because they each have different advantages. For example, investors use brokerage accounts for day trading, long-term investing, or saving money for short-term goals like purchasing a house or car. On the other hand, IRAs offer investors tax benefits as they save money for retirement.
A brokerage account can be helpful if you need money before retirement. It also provides some tax benefits and can help fund more considerable expenses in the future.
The annual percentage yields (APYs) brokerages offer on savings, money market, and interest checking accounts are typically lower than the best online banks. It is because brokerages don’t have physical locations where employees handle cash. Additionally, brokerage accounts don’t offer all the services traditional banks offer.
The plan administrator holds a self-directed brokerage 401(k) account. Still, the plan participant has an account where they can make transactions themselves.
According to experts, you should start by opening an IRA and then investing in a taxable brokerage account. If you want to invest more money than an IRA allows, consider opening a brokerage account. The more money you invest, the greater the opportunities for it to grow over time.
The self-directed brokerage account (SDBA) or 401(k) brokerage window option allows investors to take much more significant risks with their retirement savings than they previously could. It has raised eyebrows in fiduciary circles, as it will enable investors to invest in more aggressive options.
A Roth IRA is a kind of account in which you do not receive a tax deduction when you deposit money but do not have to pay taxes on the funds when you withdraw it.
A taxable account is something like a brokerage account. Any profits you make from the account will be subject to taxation. However, these accounts provide greater flexibility and freedom than tax-advantaged accounts such as IRAs and 401(k)s.
You will have a balance of $263,697 in your 401(k) account after 20 years if you make no changes. If you make small changes, your account balance will be more significant. For example, if you start with $5,000 instead of $0, your account balance will grow to $283,891.
Some 401(k) plans have administrative costs. It means that the company that offers the 401(k) plan charges you money to use it. However, if your employer covers some or all of these costs, it is worth having a 401(k). On the other hand, if your employer does not offer a match and the investment options are poor, it might not be worth having a 401(k).