By Jane Mepham
I recently had a very interesting conversation with a potential client on different types of accounts. She wasn’t clear on what a brokerage account was or why she’d need one, separate from her retirement accounts.
She is maxing out her retirement accounts at work, has a few savings accounts in different banks, as well as a 529 account for her kids.
We ended up discussing what a brokerage account is, who can open one, the benefits of the account, what the account can be used for and what to watch out for. The following is a high-level summary of the discussion.
What’s a Brokerage Account and Who Can Open One?
A brokerage account is also known as an investment account, a securities account or simply a taxable account. It can be opened by anyone over the age of 18 if they have a social security number or tax ID number (ITIN) and a US address. Non-citizens and non-permanent residents are eligible to open the account as well. The account can be opened at an online brokerage like Vanguard, or at a robot-advisor like Betterment.
It takes a very short time to open one of these accounts online. Simply go to the firm’s home page and fill out a new account application form. When starting out, look for firms where the account’s minimum is close to zero, with great customer support, and access to a broad range of investing options. There are three high-level investing methods.
- Online brokerage account – you are on your own in picking out the investments.
- Robo-advisor – you answer a series of questions on your goals, risk profile etc. This allows the algorithm to design a portfolio that fits your described needs.
- A managed account – As the name implies, even though it’s a brokerage account, it’s being managed by a financial advisor.
A brokerage account is great for somebody looking to start learning about investing on their own.
There are many ways of funding the account, the easiest is a direct transfer from your bank to the newly created account. Linking your bank account means you can move money in both directions.
You can invest in just about anything ranging from individual stocks to mutual funds to ETF’s.
The account is taxable, meaning you pay taxes on the gains or the profit. If you hold onto the security (mutual fund, stocks, etc.) for a year plus then you pay capital gains taxes which are lower than ordinary income tax. The capital gains tax is 0%, 15% or 20% depending on your taxable income and filing status.
The Benefits of Having a Brokerage Account and How to Use it
- The account allows for tax-loss harvesting which is one of the best ways for an investor to reduce taxes. It works like this – you sell one security that’s gone down in value (a loss), to offset the increase of a second security that’s gone up in value, thus eliminating the capital gains tax liability.
- The same account is also key if looking to take advantage of tax-gain harvesting. This strategy involves selling assets that have increased in value, then re-buying them again (the 30-day wash sales rule does not apply here). It basically increases your cost basis, leading to a lower capital gain in the future. This works best during the years when you are in an extremely low-income tax bracket, and you have highly appreciated securities in the taxable account.
- The brokerage account is the best saving vehicle for mid to long-term goals outside of retirement. Future expenses that are five years out (some advisors choose to go 3 + depending on what's invested in the account) are best left to grow in this account.
- For example, if you are looking at saving for future health expenses while giving yourself some flexibility, this account is your best option, beyond the Health Savings Account.
- When it comes to saving for college, most families will use a 529 plan. The account grows tax-free if the money is used for qualified education expenses. If you use the money for anything else, you pay taxes on the growth and a 10% penalty. For families who are not sure about the 529 plan or whether they’ll use the money, a taxable brokerage account makes sense.
A specific example applies to foreign-born families in the country, whose kids don’t have social security numbers yet (foreign-born). There is a very good possibility that they’ll never be able to use the 529 plan for them. In this case, the brokerage account is the way to go.
Things to watch out for with a Brokerage Account
When opening the account, you have the option of making it a margin account or a cash account. A margin account allows you to borrow money from the brokerage firm to buy securities. The securities act as the collateral for the loan. Due to the potential to lose money, this option should only be used by sophisticated investors. So, avoid margin accounts and go with a cash account.
Don’t invest your emergency fund here, as there is a real possibility of losing what you invest in a brokerage account.
Don’t use it as a retirement vehicle, instead use accounts like 401k, traditional IRAs, Roth IRAs, etc. for retirement saving.
There is one specific case where it may make sense to forgo the traditional retirement accounts and save the money in a brokerage account. If you are a foreign national, living in the U.S. and you intend to move back to your home country before retirement age, and your home country does not recognize the tax preferential treatment of retirement accounts like the Roth IRA, then this might be your best bet for starting to save for retirement.
About the author: Jane Mepham
Jane Mepham is the founder & principal advisor at Elgon Financial Advisors, a registered investment advisor in the state of Texas. She enjoys simplifying the complexities of the financial system for immigrants and foreign-born individuals nationwide.