When you start investing, you have a number of options. The first investments many people make are often through retirement accounts like 401(k)s and IRAs, which offer tax benefits that can help your money grow more over time. That’s a great benefit. However, tapping into these accounts prior to retirement could lead to penalties and a big tax bill. Likewise, 529 college savings accounts offer powerful tax advantages — so long as you use the proceeds on qualified educational expenses.
You may be wondering, then: What type of investment account should you use if you are saving for something other than retirement or education, or if you just don’t want your savings tied to a specific goal?
Enter a brokerage account.
Below, we take a closer look at what a brokerage account is and how it works. We also compare it to other common investment account types and look at how you might incorporate a brokerage account into your overall financial plan.
What is a brokerage account?
Brokerage accounts are offered by specific types of financial institutions known as brokerages, which are licensed and regulated by the Financial Industry Regulation Authority (FINRA).
Brokerage accounts vs. managed accounts
In a standard brokerage account, you make all of your ongoing investment decisions. If you’re working with a financial advisor, he or she might make recommendations about what to buy based on your goals and situation. However, with a brokerage account, it’s then up to you to keep tabs on the account and make any changes if needed.
In a managed investment account, on the other hand, most of these investment decisions are made by a financial advisor or wealth manager acting on your behalf. This option is ideal for investors who prefer to be more hands-off in their investment approach, who don’t have the proper level of market knowledge to build and manage their own portfolios, or who simply are not interested in the day-to-day management of their portfolios. Managed investment accounts also tend to have more substantial minimum investment amounts than brokerage accounts.
Types of investments you can make with a brokerage account
While brokerage accounts vary from firm to firm, in most cases, you’ll have access to a wide range of potential investments. This could include:
- Mutual funds
- Exchange-traded funds (ETFs)
Opening a brokerage account is, typically, as easy as opening a savings or checking account. Once the account is open, you’ll need to fund the account. This can be done via wire transfer or electronic fund transfer or even by depositing a check (depending on the options offered by your brokerage)
After the account has been funded, you can begin buying and selling investments as you see fit. Depending on the brokerage you use, you may or may not be charged a transaction fee every time you complete a transaction.
Other considerations to bear in mind include:
Brokerage accounts are taxable.
Certain kinds of investment accounts — such as 401(k)s, IRAs, and other types of retirement accounts — are sometimes referred to as tax-advantaged accounts because they carry specific tax benefits. Among the benefits, gains in these accounts are typically not taxed while the funds remain in the account.
Brokerage accounts are not tax-advantaged accounts. This means that when you use your brokerage account to sell an investment at a profit, you will need to pay capital gains taxes on that profit. And if you hold mutual funds or ETFs, you may owe tax on a yearly basis even if you don’t sell the fund — because assets within the fund are typically bought and sold through the year, or some holdings may pay dividends that are paid out to shareholders of the fund.
Exactly how much you pay in taxes will depend on how long you hold the investment. If you hold the investment for less than one year before selling it, then you will be required to pay the short-term capital gains tax on any profit, which is your ordinary income tax rate. If you hold the investment for at least one year before selling it, on the other hand, you will be required to pay the long-term capital gains tax, which is currently lower than the ordinary income tax rate.
Note: If you use your brokerage account to sell an investment at a loss, you can typically write off some of those losses come tax time through a process known as tax-loss harvesting.
Brokerage accounts are flexible.
Access to assets in most tax-advantaged investment accounts is fairly restricted once you invest money in them. That’s because you are typically limited as to when you are able to access the funds (as is the case for most retirement accounts) or what you can spend those funds on (as is the case for 529 college savings accounts). Failure to comply with these rules will in most cases translate into penalties.
The good news is that brokerage accounts are much more flexible in that regard. You can sell investments held in your brokerage account and withdraw the proceeds of that sale at any time without paying a penalty— though, as discussed above, you may be charged a transaction fee and on be the hook for capital gains taxes when you sell for a profit.
It’s for this reason that brokerage accounts are often used by investors who want the flexibility to access their money whenever they need it without having to worry about restrictions or penalties . They are also often used by investors who have maxed out their contributions to tax-advantaged accounts such as 401(k)s or IRAs.
Brokerage accounts can hold a range of investments.
As mentioned above, you can use a brokerage account to invest in many different types of securities. This includes stocks, bonds, ETFs, mutual funds, other types of funds, derivatives (such as options and futures) and even real estate (in the form of REITs).
You can also hold cash in your brokerage account, much as you would in a savings account or checking account. Depending on the brokerage you use, this cash may or may not earn interest.
Brokerage accounts are SIPC insured.
It’s important to note that, unlike savings accounts and checking accounts, brokerage accounts are not FDIC insured. Instead, they are insured by the Securities Investor Protection Corporation (SIPC).
What does this mean? In short, it means that if the brokerage holding your account were to go bankrupt or otherwise fail, you’d be protected — up to a maximum of $250,000 for cash held in your brokerage account or $500,000 split between cash and assets. Coverage also protects you against theft and unauthorized trading taking place in your brokerage account
SIPC insurance does not, however, protect you from investment losses or account hacking.
Alternatives to brokerage accounts
If you are looking for a flexible means of investing without worrying about withdrawal rules or penalties, brokerage accounts offer you a path for achieving that goal.
But, of course, it is not your only option for an investment account. In fact, most investors will invest through a variety of account types throughout their lives, depending on the specific goals that they are working toward. Some of these alternatives include:
- 401(k): A 401(k) is an employer-sponsored retirement account. This means that it is available only to qualified employees working at a company sponsoring such an account. A 401(k) offers a number of tax benefits that makes it ideal for investors specifically saving for retirement.
- IRA: An IRA is a type of retirement account that anyone with earned income can open, regardless of whether or not access to a 401(k) is offered. Like 401(k)s, these come with a variety of tax benefits.
- 529 college savings account: These accounts are specifically used to save and invest for a child’s educational expenses. While originally designed to pay for college expenses, funds in these accounts can also be used to cover earlier educational expenses.
- Custodial account: A custodial account is an investment account that you can open and manage for a child or other minor. It can be a great way of giving children in your life a head start on their financial goals.
Making a brokerage account part of your financial plan
Whether or not you should be investing in a brokerage account will depend on a number of factors, including (but not limited to) the following:
- The specific financial goals you are working toward
- How accessible you need your investments to be
- Your overall tax management strategy
- Whether or not you have maximized savings in tax-advantaged accounts
A financial advisor can help you weigh these considerations based on an understanding of your financial situation. This individual can also help you design and manage a portfolio that makes most sense for your personal risk tolerance and investment timeline.
This article is for informational and educational purposes only and should not be interpreted as financial or investment advice. This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.