What's a Brokerage Account and Do You Need One?
It’s pretty clear that most folks need to own and fund one or more retirement accounts to help make their golden years enjoyable. However, perhaps its less clear why you should also have a regular brokerage account. In this article, we’ll describe what a brokerage account is, why you might need one and what to consider before choosing a broker.
What’s a Brokerage Account?
A brokerage account connects you to the securities markets. It’s a taxable investment account that you open with a brokerage firm or investment company. You use the money in the account to purchase securities, including stocks, mutual funds, exchange-traded funds (ETFs), CDs, money markets funds, bonds, futures, options, commodities and foreign exchange. You can use your brokerage money market fund like a bank checking account to write checks and earn interest. Most brokerage accounts are insured by the Securities Investor Protection Corporation to protect you if the broker gets into financial trouble.
Typically, there is no cost to open a brokerage account. However, you’ll pay money in the form of commissions when you buy and sell securities. You’ll not have to pay a management fee on the stocks and bonds you own in the account. That’s different from most mutual funds and ETFs that charge an annual fee based on the size of your investment. Many brokerages require a minimum opening investment of $1,000 or more.
If you qualify, a broker will offer you a margin account. This type of account lets you borrow money to pay for securities. You can borrow up to 50% of the cost of stocks, bonds and other investments on margin. This gives your investments leverage. For example, say you have $10,000 that you’d like to invest in shares of XYZ Corporation. The stock sells for $100/share. Without margin, you could buy 100 shares for your $10,000. If the stock price climbed to $105, you’d be sitting on a 5% profit of $500. Now consider the same circumstance in a margin account. You could borrow an additional $10,000 and buy 200 shares of XYZ. Now, a 5% gain in the stock would provide you a $1,000 profit, which is a 10% return on your own $10,000. Of course, a price decline hurts twice as much when it occurs in a margin account.
Be aware that:
Your broker will charge you interest on your margin loan. The interest rate is usually quite low
You may be subject to a margin call if your investment loses money. You see, the 50% you purchase with your own money acts as collateral for the 50% you buy on credit. If the price declines, you have to add cash to your account to restore your collateral level to 50%. A margin call is a request to add money to your account. Failure to do so will result in the broker selling your investment, and maybe closing your account
Some transactions require you have a margin account. Typically, these are “short” transactions in which you sell borrowed stocks or write uncovered options. The transaction proceeds remain locked in your margin account until you close the short position
Why Do You Need a Brokerage Account?
Traditional retirement accounts are great. They let you build your wealth with pretax dollars, and you don’t pay income tax until you withdraw money from the account. Why bother with a taxable brokerage account? Here are some reasons why:
Unlimited contributions: you can put as much money into your brokerage account as you like (and can afford). Retirement accounts impose annual contribution limits. Currently, IRAs allow contributions of $6,000 a year (or $7,000 if you’ve reached age 50). 401(k)s and similar accounts allow you to contribute $19,000/year (or $25,000 if you’re 50+). For many of us, that’s more than we can contribute, but if you’re a high earner, you may run up against these limits.
No income limits: a broker will never limit the size of your account contributions because you earn too much income. There aren’t income limits on a 401(k) account. However, income limits exist for Roth IRAs. In 2019, your allowable contributions to a Roth IRA are curtailed starting when your modified adjusted gross income (MAGI) hits $122,000 and completely prohibited once your income tops $137,000. If you file jointly, the MAGI numbers are $193,000 and $203,000, respectively.
Unlimited investment choices: you can open a brokerage account to invest in any kind of financial instrument, as well as gold, real estate and more. Unless your retirement account is a brokerage account, your investment options might be limited. For example, if your IRA or 401(k) is with a mutual fund company, your choices may be limited to mutual funds and cash.
No withdrawal penalties: you can take money out of your brokerage account whenever you wish (except for money that is acting as collateral in your margin account). If you take money out of a traditional retirement account before age 59 ½, the IRS might slap you with a 10% early withdrawal penalty. Granted there are some exceptions to the penalty, but they are narrow.
No required distributions: your broker will have no problem if you keep your money in the account for as long as you like. However, most retirement accounts (other than Roth IRAs) require that you start taking distributions when you reach age 70 ½. The annual required minimum distributions are based upon your age and your life expectancy (as foretold by the IRS).
Questions to Ask Before Opening a Brokerage Account
Consider the following questions before opening a taxable brokerage account:
What are the fees and commissions charged? Is there any minimum required balance?
Is the brokerage full service of discount? If it’s full service, how much extra do you pay and what do you get for the additional cost?
Do you have access to investment advice? Can you work with my own stockbroker?
What is the financial strength of the brokerage firm? Are its accounts covered by SIPC insurance? Is it in any legal hot water?
How responsive is your broker when you have questions or problems?
What does the broker charge for margin loans?
If you want to invest in stocks and other securities without the strings attached to a retirement account, a taxable brokerage account is virtually a must. However, you might be able to buy stocks without a brokerage account by subscribing to dividend reinvestment plans offered by many corporations. For most investors, a brokerage account provides many advantages at little cost.