What is a Brokerage Account?

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Definition:

A brokerage account is an investment account with a brokerage firm – It allows you to buy and sell different types of securities like stocks, bonds, and mutual funds.

🤔 Understanding a brokerage account

When you have a brokerage account with a brokerage firm, they execute investment trades on your behalf. Examples of securities that you can buy and sell through a brokerage account include stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Brokerage accounts are also known as taxable accounts because investment income from transactions is usually subject to capital gains tax. Some brokerage firms may charge commissions and other fees for transactions and account advisory, while others may waive them for certain activities like purchasing stocks. Full-service brokerage firms tend to offer extra features with their brokerage accounts, such as investment advisory, retirement planning, and tax planning. Meanwhile, discount brokers usually leave investment research up to the customer and don’t offer a lot of extra services – But they often offer low or no fees as a tradeoff. Two of the most common types of brokerage accounts are cash accounts and margin accounts.

Example

There are dozens of brokerage firms in the US where you can open a brokerage account, including Robinhood (of course), Charles Schwab, E-Trade, Interactive Brokers, and TD Ameritrade. They all vary in terms of services offered and commission rates charged.

Charles Schwab is one of the largest brokerage firms in the US, with 12.3M active brokerage accounts as of December 31, 2019. Owners of brokerage accounts at Charles Schwab completed an average of 1.64M transactions per day in the three months from March to June 2020. In the past, Charles Schwab charged a fee for buying and selling stocks through its brokerage accounts. But, in October 2019, the company opted to stop charging a stock trading fee for US stocks, exchange-traded funds (ETFs), and options.

Takeaway

A brokerage account is sort of like a power card at Dave & Buster’s…

The arcade’s power card allows you to fund it with money for playing games and store tokens that you can later redeem for prizes. Similarly, when you open a brokerage account, you load your account with money that you can use to invest in securities like stocks or bonds. Depending on your power card’s balance and other factors, you may get to play games for lower prices and receive other perks. Likewise, a brokerage firm may provide you special features on your brokerage account, such as investment advisory services, financial planning, or lower fees for maintaining a certain account balance.

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What is a brokerage account?

A brokerage account is a type of financial account that lets you buy and sell securities like stocks, bonds, and mutual funds.

A brokerage account is always associated with a licensed brokerage firm or individual broker. These businesses and individuals must be registered with the Securities and Exchange Commission — a government agency that regulates securities trading in the US – and the Financial Industry Regulatory Authority (FINRA), a nongovernmental nonprofit organization authorized by Congress to protect America’s investors.

The objective of a brokerage account is generally for you to make a profit from investments in assets like stocks and bonds. They differ from retirement accounts like 401(k)s and individual retirement accounts (IRAs) because brokerage accounts usually have fewer withdrawal restrictions, but no distinct tax advantages.

To comply with laws and regulations, brokerage firms require you to submit personal, financial, and tax information when opening a brokerage account. Additionally, you have to report the investment income or loss from your brokerage account transactions on your annual tax return. Investment income is subject to capital gains tax – a tax levied on assets that are sold for a profit. However, capital losses – which are realized when an asset is sold for less than its purchase price – can sometimes help to offset gains and reduce your taxable income.

What are the types of brokerage firms?

Historically, brokerage firms have charged commission fees for executing transaction orders and required a minimum balance to open a brokerage account. Sometimes, brokerage firms also charge other account fees (either fixed or a percentage of your assets managed) for additional services, such as investment advisory.

Today, the types of services brokers offer can range drastically from firm to firm. But generally, brokerage firms where you can open brokerage accounts fall into two main categories: full-service and discount firms.

  1. Full-service brokerage firms: Typically, full-service brokerage firms charge more per transaction, but they often have extensive research resources that their registered salespeople can use to help guide their recommendations. These brokerage firms have other financial licenses and registrations, so they can offer just about any type of financial transaction you’d like to make, and they may also offer other financial services like investment planning.
  2. Discount brokers: By contrast, discount brokers are often cheaper per transaction, but may leave investment research up to the customer, or make research available only on their site.

What are the types of brokerage accounts?

Two of the most common types of brokerage accounts are cash accounts and margin accounts. The key difference between them is the way in which you purchase your investments.

Cash account

A cash account is a type of brokerage account that you need to fund with your own cash prior to buying or selling securities. If you don’t have cash available in your brokerage account, you can’t make any trades. The brokerage firm requires you to pay for the full amount at the time of the transaction.

Typically, you will use your bank’s routing number and the bank account number of your checking or savings account to transfer funds into your brokerage account. However, some brokerage firms may allow you to fund your brokerage account in other ways.

Margin account

A margin account is a type of brokerage account that allows you to buy on margin – This is the practice of borrowing funds directly from the brokerage firm to buy securities. The securities in your portfolio serve as the loan’s collateral (aka the assets you agree to give up if you default on the loan). You also pay any applicable interest charges for borrowing the money (similar to any other loan) and account fees.

Buying on margin is risky and can amplify your investment loss, so it’s subject to additional rules and regulations from the Federal Reserve Board (FRB) and the Financial Industry Regulatory Authority (FINRA). One rule for buying on margin is that a brokerage firm can only lend you up to 50% of the value of the investment purchase – That is, at least 50% of the money must come from you, the investor.

Only someone with a higher risk tolerance should engage in the practice. Trading stocks is a risky business with a lot of potential rewards. Buying on margin amplifies those potential rewards, but also sharply increases the risks.

How do brokerage accounts work?

When you use a brokerage account, you’re requesting that a broker (an individual or a brokerage firm) trade securities (like stocks and bonds) on your behalf. The broker matches investors who want to buy or sell securities with the other side of the transaction. For instance, if you want to buy Microsoft stock through your brokerage account, the brokerage firm will find a seller and complete the stock purchase for you.

Typically, a brokerage account needs to have an initial deposit from you before you can complete your first purchase order. If you have a cash account, your purchase limit is set by your existing available balance. Alternatively, if you have a margin account, you may be allowed to borrow up to 50% of the total purchase value from the brokerage firm.

Some brokerage accounts charge fees for a variety of reasons. Examples of brokerage fees include commissions (charges for buying or selling securities like mutual funds or ETFs), account maintenance fees, and margin interest (interest on money borrowed through a margin account).

Most brokerage accounts provide a monthly account statement, detailing your trade activity and balance of owned securities for that month. Often, this statement will also include information on your rate of return (aka how your investments are performing).

Usually between January and March of each year, the brokerage firm will issue a form 1099 for your brokerage account. This form summarizes all of your investment gains (e.g., profit from a stock sale, dividend payment from common or preferred stock, and interest payment from bonds) and losses for the year.

Should I open a brokerage account or an individual retirement account (IRA)?

Two factors that tend to influence someone’s choice between opening a brokerage account or an individual retirement account (IRA) include the timing of the payment of applicable taxes and the availability of funds.

Timing of taxes

  • A brokerage account is sometimes referred to as a taxable account or taxable brokerage account because all investment income from it is subject to capital gains tax that you must pay each year. There is no distinct tax advantage to a brokerage account.
  • An individual retirement account (IRA), meanwhile, is a tax-advantaged account that allows people to save money for retirement. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. While all IRAs are tax-advantaged, the tax benefit comes at a different time and with different contribution limits depending on which type of IRA you’re using.

Availability of funds

  • Typically, a brokerage account allows you to liquidate your securities (aka convert them to cash) faster and at a lower cost than an IRA. There aren’t usually penalties for withdrawing your money from investments beyond applicable account fees that the broker may charge.
  • Since an IRA is a retirement savings account, the early withdrawal of funds is typically discouraged by imposing monetary penalties and slower processing times. The Internal Revenue Service (IRS) usually levies an additional 10% penalty (on top of applicable income and capital gains taxes) for most IRA withdrawals before age 59 1/2. There are some exceptions for hardships and other circumstances, but generally you’ll be hit with a penalty if you choose to withdraw money from your IRA early.

Most financial advisors recommend setting up a retirement account and an emergency fund before opening a brokerage account. A retirement account is a cornerstone of any financial strategy – It allows you to build wealth for your later years when you’ll stop having a steady paycheck from your job. Meanwhile, an emergency fund helps you cover necessary yet unexpected expenses, such as a bill from a car accident or medical procedure.

Having a retirement account and emergency fund provides you with the necessary foundation to be able to progress to other financial goals, such as investing through a brokerage account or saving for a home.

How do you open a brokerage account?

There are five standard steps that are usually required to open a brokerage account.

1. Provide personal, financial, and tax information

Brokerage firms must comply with rules and regulations from the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) – In order to do so, they are mandated to gather key information from you.

Examples of information they may collect include your name, mailing address, Social Security number (SSN), employment status, annual income, net worth, and investment objectives. Under the USA Patriot Act, you’ll often be required to submit the number and/or copy of a government-issued document like your passport or driver’s license.

2. Choose between cash account or margin account

If the brokerage firm offers both cash and margin accounts, you’ll have to specify what type of brokerage account you want. A cash account requires that you pay in full at the time of purchasing securities. Meanwhile, a margin account gives you the option to borrow from the brokerage firm up to the permissible limit to purchase investments.

The rules of margin accounts vary per brokerage firm. Make sure to read the customer service agreement to make an informed decision and understand all applicable rules.

3. Decide what happens with uninvested cash

Brokerage accounts often offer options to manage uninvested cash sitting in your account. These cash management programs vary across a number of dimensions, including interest rate, insurance coverage, and availability of funds.

4. Choose who makes final decisions

You always have the choice to be the only person who’s allowed to make final decisions regarding the investments in your brokerage account. However, some brokerage firms will enable you to assign that power to other individuals like a spouse or financial advisor.

5. Fund your brokerage account

Once you have completed all the steps above, you’re now ready to fund your brokerage account. Typically, you fund your brokerage account using your bank’s routing number and the bank account number of your checking or savings account.

How much money do you need to open a brokerage account?

The minimum amount needed to open a brokerage account varies greatly across providers. Initial deposits to open a brokerage account start from as little as $1 and increase from there.

To open a brokerage account with Robinhood, you don’t need to put any money down. However, you must be age 18 or older, have a valid Social Security number and legal US residential address, and either be a US citizen, US permanent resident, or have a valid US visa.

Once you’re ready to buy your first stock, you’ll have to fund your account with the necessary amount to pay for that stock purchase in full.

Do you have to pay taxes on a brokerage account?

You have to pay applicable taxes on all investment profits from your brokerage account. The brokerage firm associated with your account is required to file a form 1099 with the Internal Revenue Service (IRS) by January 31st of every year. Typically, you’ll receive your form 1099 sometime between January and March. This form shows all applicable gains and losses in your account that will help determine the amount of taxes you are required to pay.

What are brokerage account considerations for beginners?

Goals vary from investor to investor. However, beginners should generally look for brokerage accounts with the following features:

  • No fees: Fees reduce the amount of profit you get to keep from your transactions. This is why a beginner (who may not have a lot of upfront money to invest) could benefit from opening an account with a brokerage firm that doesn’t charge fees, like Robinhood.
  • Cash account: Sticking to paying for the securities you purchase with your own money is a good practice for first-time and novice investors. Margin accounts involve the repayment of loan interest to the brokerage firm and have the potential to amplify your losses – These accounts involve substantially higher risks and are intended for more experienced investors.
  • No minimum (or a very low) initial deposit: Some brokerage accounts like Robinhood only require you to fund your account with the amount equal to your first purchase, making it easy to get started.
  • Fractional shares: It may be overwhelming for a first-time investor to sink $300 into one stock share. A brokerage firm that allows for the purchase of fractional shares means that investors can buy a fraction of that $300 share (e.g., $20, $50, or $100), so it lessens the upfront cash commitment.
Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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