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Wednesday, February 28, 2024

The basics of brokerage accounts

The basics of brokerage accounts

08.25.2023

What is a brokerage account?

A brokerage account is an investment account where you can buy and sell securities. There are many different platforms to open a brokerage account, and the investments you’ll have access to depends on the platform you choose. The most popular brokerage accounts allow you to trade individual stocks and bonds as well as pooled funds like mutual funds and exchange-traded funds (ETFs).

How do brokerage accounts work?

Think of a brokerage account like any other bank account, but instead of just holding money, the account can hold securities as well. When you sign up for the account, you can connect it to your bank account and transfer funds into it. With the money in your brokerage account, you can then purchase stocks, bonds, funds, and other investments.

Investing involves risk, and there’s no guarantee you’ll earn money. However, stock market returns average about 10% annually for nearly the last century, as measured by the S&P 500 index.1 Ideally, you’ll be able to watch the assets in your brokerage account grow over time.

Depending on how you’re earning money, you may be subject to certain taxes. For example, you’ll pay taxes when you earn interest or dividends from the investments you currently hold. You may also be on the hook for capital gains taxes when you sell your investments.

When you place buy-and-sell orders within your brokerage account, the brokerage firm executes them on your behalf. In exchange for this service, the firm may charge a fee, either as a percentage of your assets or as a flat fee for each trade.

Unlike other types of investment accounts, there’s no limit to the number of taxable brokerage accounts you can open, nor is there a limit on the amount you can invest per year.

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What are 3 different types of brokerage account arrangements?

When you decide to sign up for a brokerage account, you’ll have several types to choose from. Each type of brokerage account arrangement has its own unique characteristics and benefits.

Self-directed online brokerage account

A self-directed online brokerage account is the most common type. You can open this type of account with most major brokerage firms. 

Once your account is open, you manage your own investments. You can place buy-and-sell orders at any time, building your portfolio with individual stocks, bonds, or diversified investments like mutual funds and ETFs.

These brokerage accounts are the most hands-on since you’re responsible for choosing your own investments. The self-directed brokerage account is intended for knowledgeable investors who understand the risks associated with the account. This option may not be suitable for those who don’t feel comfortable selecting their own asset allocation.

Managed brokerage account

A managed brokerage is one that’s overseen by an advisor or advisory firm. Rather than having to choose your own investments, your investment manager or financial advisor chooses them on your behalf. Before building your portfolio, your investment manager will get to know more about your financial goals, risk tolerance, and time horizon, and will choose an asset allocation that’s appropriate for you.

In exchange for them managing your portfolio, investment managers generally charge a fee for their services. In some cases, advisors may earn a commission from the products they recommend to you. In other cases, they charge a flat fee or one that’s based on a percentage of your assets under management. 1% is a fairly standard advisory fee.2

Robo-advisor brokerage account

A “robo-advisor” account is another type of managed brokerage account, but rather than being managed by an individual advisor, it’s managed by a computer algorithm. When you sign up for a robo-advisor, you’ll answer questions about your financial goals and situation. From there, the advisory firm’s algorithm will select appropriate investments.

Robo-advisors have many of the same benefits as any other managed brokerage account but generally at a lower cost. While many financial advisors charge fees of around 1%, robo-advisors usually charge fees of around 0.5%.3

With this option, you often pay less money but miss out on the benefit of having a financial professional you can talk with about life’s big money moves.

Learn more: In financial planning, AI has entered the room. Where does it fit in?

Are brokerage accounts safe?

Many people fear putting money into a brokerage account for fear of losing it. And while it’s true that a market downturn could cause your investments to lose value, you are protected against certain types of losses.

The Securities Investor Protection Corporation (SIPC)4 is a non-profit corporation that was created under the Securities Investor Protection Act. SIPC insures the cash and securities in your investment account to ensure that, if the brokerage firm goes bankrupt, you’ll be protected. The SIPC protects $500,000 per customer, per brokerage firm, with a limit of $250,000 for cash.

How to open a brokerage account

Opening a brokerage account is a simple process that can often be done in just a few minutes. Here’s how to get started:

  1. Choose a brokerage account provider: There are many different brokerage firms on the market, making it difficult to know where you open your account. Start by identifying the type of brokerage account you want to open (self-directed account vs. managed account vs. robo-advisor). From there, you can choose a firm that fits your investment needs.
  2. Complete an application: To open your account, you’ll generally have to be at least 18 years of age. You’ll also have to provide your Social Security number, contact information, and other personal information. Your account may be immediately opened, or the broker may need a bit of time to look over your application.
  3. Fund your account: Before you can invest in your brokerage account, you’ll have to provide a way to fund it. For taxable brokerage accounts, often the simplest way is to connect your bank account to your brokerage account and transfer funds in. You may also be able to fund your account with a debit card.
  4. Start trading: Once your account is open, you can start placing buy-and-sell orders. Before you do, consider spending some time exploring your new account to make sure you know where everything is and how it works. The brokerage firm should have a customer service contact if you run into questions along the way.

Can I open a brokerage account for my kids?

Although you must generally be at least 18 years old to open a brokerage account, parents and other adults can open brokerage accounts on behalf of minors.

These accounts, known as custodial accounts, allow an adult — the custodian — to open an account on behalf of a young person. The custodian is responsible for managing the investments until the child reaches adulthood.

While a custodian manages the account, anything transferred into it is the legal property of the minor. So if you contribute money to your child’s custodial account, you can’t take it back. Once the child reaches adulthood, they’ll get full control of the custodial account and can use the money for anything they want.

If you aren’t comfortable with your child gaining access to a large sum of money when they turn 18, there are ways around it. Many parents choose to open a brokerage account in their own name with the funds inside it earmarked for their child’s future.

Taxable brokerage accounts vs. retirement accounts

One of the most common questions people have about taxable brokerage accounts is how they differ from retirement accounts. And while the two have some important similarities, they also have several differences.

Both brokerage accounts and retirement accounts are investment accounts where you can buy and sell securities. However, the money in your brokerage account can be used for anything, while the funds in your retirement account are meant to be saved for retirement.

Let’s consider several distinctions:

 

Taxable brokerage account

Retirement account

Taxes

May incur capital gains tax on investment income; investments sold 1 year or less after buying are subject to ordinary income tax

Typically no capital gains tax; tax-deferred or tax-free growth depending on the account type

Contributions

Unlimited

Caps on annual contributions

Withdrawals

No limits or penalties

Penalties for withdrawing before a certain age, unless exceptions are met

Primary use

Stock trading, additional long-term investments

Long-term growth, retirement savings

Tax treatment

There are no real tax benefits to investing in a taxable brokerage account. You fund your account with after-tax money, pay taxes on the interest and dividends you earn on your current holdings, and pay capital gains taxes when you sell an investment for more than you bought it.

In the case of a retirement account, your contributions are traditionally tax-deferred. Either they come out of your paycheck before taxes, or you can deduct them on your income tax return. Once the funds are in your account, they grow tax-free until you withdraw them.

You can buy and sell securities as often as you want without incurring taxes. Then, you’ll pay income taxes on the money when you withdraw it from your retirement account.

There are certain types of retirement accounts that use Roth contributions. In this case, you contribute with after-tax dollars, just as you would a brokerage account. The difference is the money in your Roth retirement account grows tax-free, and you can take tax-free distributions during retirement.

Contribution limits

There are no contribution limits on taxable brokerage accounts. You can invest as much as you want in any year. But for retirement accounts, there are some limits.

The amount you can contribute to your retirement account depends on the type of account it is and your age. For a 401(k) plan in 2023, you can contribute up to $22,500 per year, with an additional $7,500 catch-up contribution allowed if you’re 50 or older. For individual retirement accounts (IRAs) in 2023, the contribution limit is $6,000 per year with an additional $1,000 catch-up contribution.

There are some other limitations on who can contribute to retirement accounts and how much. You can only contribute to a 401(k) if your employer offers one. For IRAs, you may be limited as to whether you can contribute, how much you can contribute, and whether you can deduct your contributions based on your household income.

Withdrawal rules

When you invest in a taxable brokerage account, you can withdraw money at any time and for any reason. But with a retirement account, you’re generally required to leave the money in the account until you reach age 59½. If you take money out early, you could be on the hook for a 10% penalty on top of any income taxes you owe.

There are some exceptions to the retirement withdrawal rules, including withdrawals for someone facing financial hardship, for the purchase of your first home, and more.

Margin account vs. cash account

When you open a taxable brokerage account, you can choose between a cash account and a margin account. We’ll discuss each type of account further below.

What is a brokerage cash account?

A brokerage cash account is the most common type. It allows you to buy securities with money you transfer into your account. If you have $1,000 of cash in your brokerage account, you can buy up to $1,000 of securities.

What is a brokerage margin account?

A brokerage margin account allows you to buy securities worth more than the money you have in the account. Rather than having to pay for your investments with your account balance, you borrow money from the brokerage firm to buy them. You’re responsible for providing a percentage of the funds, and the securities themselves serve as the collateral for the loan.

Is a brokerage account right for me?

Whether a brokerage account is right for you depends on several factors, including your other investment accounts, your financial goals, and more.

In general, experts recommend prioritizing your retirement savings over other investments. If you’re just getting started with investing, focus on your retirement accounts first. Contribute enough to your 401(k) to get your employer match, if you’re eligible for one. Additionally, make sure you’re contributing enough to retirement accounts to reach your retirement goals. If you aren’t sure what that looks like, use Empower’s free Retirement Planner to find out how much you should be saving.

Once you’re contributing enough to your various retirement accounts to meet your long-term goals, consider opening a brokerage account, too. These accounts come with more flexibility, meaning you can use the funds for mid-term goals that you wouldn’t be able to fund with a retirement account. Of course, this flexibility also comes at a cost, since you’ll face a higher tax burden on investments in a taxable brokerage account than in a retirement account.

Experts don’t recommend investing any money you plan to need within the next few years. If you’re saving for a house you plan to buy in three years, you may not want to save in an investment account. But for goals more than five years out but before retirement, a brokerage account may be the right option for you.

Next steps

When you’re ready to start investing, Empower can help. Using our free financial dashboard, you can set investment goals, analyze your fees, and review your investment performance.

1 https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

2 https://www.riainabox.com/resources/2019-ria-industry-study-total-average-fee-is-117

3 https://smartasset.com/investing/robo-advisor-fees

4 https://www.sipc.org/about-sipc/sipc-mission

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ETFs are a type of exchange-traded investment product that must register as either an open-end investment company (generally known as “funds”) or a unit investment trust. ETFs are not mutual funds.

Unlike mutual funds, individual shares of ETFs are not redeemable directly with the issuer. ETF shares are a collection of securities bought and sold at market price, which may be higher or lower than the net asset value. Investment returns will vary based on market conditions and volatility, so an investor's shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are subject to risks like those of their underlying securities.

Erin Gobler

Contributor

Erin Gobler is a money coach who helps people pay off debt and reach their big financial goals without giving up spending on the things they love. She is a freelance writer for Empower.

Author is not a client of Empower Advisory Group, LLC, and is compensated as a freelance writer.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Compensation for freelance contributions not to exceed $1,250. Third-party data is obtained from sources believed to be reliable; however, Empower cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third-party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Empower of the contents on such third-party websites. 

Certain sections of this blog may contain forward-looking statements that are based on our reasonable expectations, estimates, projections and assumptions. Past performance is not a guarantee of future return, nor is it indicative of future performance. Investing involves risk. The value of your investment will fluctuate and you may lose money. 

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