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Finance Tip #15: Tax Deferred Accounts vs Brokerage Accounts

Chart Arrow Businessman Stock  - mohamed_hassan / Pixabay

Interested in investing in the stock market? Are you wanting to reduce your tax obligations? Wanting to retire early? Then listen up! You want to diversify your investments and ensure you are investing in the stock market to meet your financial goals. You can invest in the stock market either through a tax deferred account or a brokerage account. Many people don’t understand the differences, so that is what this tip is about.

A tax deferred account would be your 401k and traditional IRA. These accounts allow you to invest with PRE-TAX money. Essentially, the money is invested before Uncle Sam takes his cut. The downside is that you will pay taxes on this money in the future when you withdraw from it in retirement, but a good aspect with this is that your income level will be LOWER in retirement, therefore you will be taxed at a LOWER tax bracket that what you are at now. This is a tax reduction strategy for the future. I personally would rather be taxed at a lower income bracket than the 35% bracket I am in now (VOMIT!). This is why everyone should have at least one tax deferred account. It will SAVE YOU MONEY!

On the other hand, a brokerage account is an account where you can invest in the stock market with POST-TAX money. You invest with income that has already been taxed basically. For example, if you make $10,000 one month AFTER taxes, then you can invest that $10,000 freely in a brokerage account. The advantage here is that you don’t have to wait until you are 59 and a half years old to withdraw from this account like the 401k/IRA. You can withdraw from this account at ANYTIME. Another advantage is that the money you withdraw from this account only incurs a capital gains tax! The capital gains tax is around 0-20% depending on your income level. This is another tax saving strategy. If you had $1,000,000 in your brokerage account (my goal), then you could withdraw $80,000 a year from this account and only pay 15% in tax! This is critically important if you want to retire early, as you will live off this income.

I recommend you consult with an accountant if this is complicated. But this is the take home message: you need to be investing in tax deferred accounts for retirement and tax savings now, WHILE investing money into a brokerage account so you have money you can withdraw anytime from or if you want to retire early.

I just use TD Ameritrade for my brokerage account and Vanguard for my IRA. Anyone can setup these accounts themselves at their websites.

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