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401(k)s vs. Brokerage Accounts

Brokerage accounts and 401(k)s offer different advantages and disadvantages for investors and savers alike. Brokerage accounts are taxable, but provide much greater liquidity and investment flexibility. 401(k) accounts offer significant tax advantages at the cost of tying up funds until retirement. Both types of accounts can be useful for helping you reach your ultimate financial goals, retirement or otherwise. Consider working with a financial advisor as you pursue your investment and retirement goals.

The Basics of 401(k)s and Brokerage Accounts

A 401(k) plan is part of many employer-sponsored retirement savings plans. These let employees save for retirement using pre-tax dollars taken directly from their paychecks. The funds in a 401(k) can be invested, usually in mutual funds, in an effort to make them grow. Savers don’t have to pay taxes on contributions or on earnings from investments until they withdraw in retirement. Employers also can match part of the employees’ contributions as a perk.

A brokerage account lets investors buy stocks and other securities using the services of a brokerage. You may hear these accounts also go by the name asset management accounts. They can hold other types of assets besides stocks, including cash, mutual funds, exchange-traded funds (ETFs), money market funds, bonds and commodities. Brokerage accounts allow investors trade on margin, using funds borrowed from the broker. They can also facilitate trading in options and other securities.

Many investors have both a 401(k) and brokerage account, as well as others. These could include an individual retirement account (IRA), savings account and checking account. Brokerage and 401(k) accounts work well together to help people achieve a variety of financial goals.

What Are the Pros and Cons of a 401(k)?

The major benefit of a 401(k) plan is the tax deferral advantage. Employees can put money into the plans when they are earning income and then, after retirement, withdraw the funds. The idea is that during retirement they’ll be paying a lower tax rate. The money in the plans also generates earnings, which accumulate tax-free until they are withdrawn.

Owners of 401(k) accounts can set them up through their employers, although not all employers offer the plans. And participants can borrow funds from their plans to use for other purposes than retirement.

Illiquidity is the big drawback of 401(k) plans. Once money is placed in the plan, it can’t be withdrawn without paying a penalty before the participant has reached age 59.5. The penalty for early withdrawal is 10% of the amount withdrawn. Plus, income taxes are due on early withdrawals at the participants’ regular tax rate.

The IRS also limits the amount you can contribute to a 401(k) annually. This amount goes up annually. For 2021, the limit for most savers is $19,500 per year.

When a 401(k) participant reaches ages 70.5, he or she has to start taking required minimum distributions (RMDs) from the plan. This can limit a retiree’s flexibility to plan for taxes and other concerns.

Limited investment options represent another drawback of 401(k) plans. Most employers offer only a small selection of mutual funds that employees can choose from to set up their portfolios. Also, many 401(k) plans impose additional fees on top of the fees charged by mutual funds. These extra fees reduce the return to the participants. Over the long term, these fees can really add up.

Finally, not every employer offers 401(k) plans. Self-employed people can set up their own tax-advantaged plans. But people whose employer doesn’t offer a 401(k) plan can’t use this retirement planning vehicle.

What Are the Pros and Cons of a Brokerage Account?

401(k)s vs. Brokerage Accounts

The major plus to a brokerage account is its superior liquidity in comparison to a 401(k) account. There is no penalty for withdrawing funds at any time, although an investor may experience losses if he or she sells when the market is down. Brokerages also impose no contribution limits. An investor can put any amount desired into the account. For this reason, they are often used by savers who have reached their maximum annual allowed 401(k) contribution.

Similarly, there are no requirements to begin withdrawals from a brokerage account at 70.5 or any other age. An investor can leave money in the account for as long as he or she wishes.

Brokerage accounts allow investors to put money into any type of investment security. You can buy or sell any stock, bond, mutual fund or ETF that’s on the exchange where the brokerage does business. Similarly, brokerage account holders can trade options, commodities and futures. With margin accounts, they can trade using money borrowed from the broker.

Brokerage accounts are easy to set up online or in person at any bank or brokerage. The only requirement is that the account holder has enough money to purchase investments.

The major drawback of a brokerage account is that there is no tax advantage. Investors can only put after-tax funds in the accounts, and any returns on the accounts are also subject to taxes.

Brokerage account investors can manage their taxes by using strategies to take advantage of lower long-term capital gains rates. They can also invest in tax-advantaged securities, such as municipal bonds.

What 401(k)s and Brokerage Accounts Are Used For

It’s generally understood that 401(k) plans are for retirement planning. Because of their liquidity restrictions, they usually aren’t for helping people reach other pre-retirement financial goals, such as buying a house and paying for college. However, account holders can often take out a 401(k) loan in these instances. There are stringent rules around these loans, though, so make sure you can pay back the money to your 401(k) before looking into it.

Brokerage accounts are best for shorter-range goals, such as saving to buy a house or car, or to pay for college or a wedding. Because of their overall flexibility, they allow account holders to use their funds for any purpose at any time, without incurring penalties. Even still, try to avoid selling money from investments too quickly, as capital gains taxes can hit pretty hard if not planned for correctly.

Bottom Line

401(k)s vs. Brokerage Accounts

Brokerage accounts and 401(k) accounts each offer advantages and disadvantages. Retirement goals are best for 401(k)s and other accounts with long-term tax perks. But the liquidity restrictions on these accounts makes them of limited use for reaching other financial objectives.

Brokerage accounts are useful after 401(k) savers have reached the maximum allowed annual contribution. They can help people accumulate funds for homes, cars, college and other pre-retirement goals. Many savers and investors use both 401(k) and brokerage accounts.

Tips on Investing

  • Deciding when and how to use 401(k) and brokerage accounts can be a complex decision that depends on the specifics of your situation. A financial advisor can be so valuable to you during this time. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • How much money will you need to retire comfortably? Are you on track? If you don’t know the answer to either question, try out SmartAsset’s free retirement calculator to see how much your savings will be worth by the time you retire.

Photo credit: ©iStock.com/iQoncept, ©iStock.com/ArLawKa AungTun, ©iStock.com/hxyume

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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