What Is A Brokerage Account? Why Do I Need One?

How Does a Brokerage Account Work?

You deposit cash in a brokerage account and use the funds to purchase investment assets like stocks, bonds, mutual funds and exchange-traded funds (ETFs). Brokerage accounts are used for day trading to earn short-term profits, as well as investing for long-term goals. Most brokerage accounts also provide a way to earn a decent yield on uninvested cash.

A broker maintains your brokerage account and acts as the custodian for the securities you own in your account. It acts as an the intermediary between you and the stock market, buying and selling assets on your instructions.

You can open a brokerage account at a wide range of firms, from full-service brokers with a complete menu of financial services, to automated robo-advisors and online brokers. Fees and requirements vary. There may be a minimum balance required to open an account, some firms may charge management fees and there may be trading commissions to buy or sell certain assets.

Margin Account vs. Cash Account: What’s the Difference?

There are two main types of brokerage accounts: cash accounts and margin accounts. The difference between them is how you purchase your investments.

What Is a Brokerage Cash Account?

When you have a cash account at a brokerage, you buy securities with the money deposited in the account. “If you have $100, you can only buy $100 worth of stock,” says Matthew Boersen, a certified financial planner in Jenison, Michigan. If you don’t have more money in your account, you can’t purchase additional securities.

What Is a Brokerage Margin Account?

With a margin account, you can borrow money to buy investments, and the investments themselves are collateral for the loan. “If you have $100, you could potentially buy more than $100 worth of stock,” Boersen says. “The custodian will give you a loan so you can buy additional stock. You have to pay interest on the loan, but it’s a loan internally, inside your account.”

A margin account allows you to execute more complex trading strategies, such as short selling, but there are risks to using debt, instead of cash, to invest. For instance, if the value of your investments falls, your brokerage firm may ask you to pay back your margin debt immediately—this is known as a margin call. The firm also has the right to sell any of the investments in your portfolio, without advance notice, to cover an account deficit.

Brokerage Accounts vs. Retirement Accounts

Brokerage accounts and retirement accounts both can help you save for the future by providing a way to invest your money in the financial markets. However, there are big differences between these types of accounts, especially when it comes to the range of investing options they offer and tax treatment.

Brokerage Account Flexibility

Brokerage accounts lack the rules and restrictions that govern retirement accounts, like 401(k)s and IRAs, among others. Annual contributions to retirement accounts are capped, there are strict rules on when you can withdraw funds and some retirement accounts may offer a limited choice of investable assets and securities. The latter is especially true in 401(k) accounts.

Brokerage accounts offer much greater flexibility. You may deposit as much money as you want in a brokerage account, and you can invest in any of the assets or securities offered by your broker. “You can put the money in whenever you want, take the money out whenever you want,” Boersen says. “And there’s really no limit on what the investment options are.”

Brokerage Accounts and Taxes

Brokerage accounts and retirement accounts are taxed differently. Contributions to traditional IRAs and regular 401(k)s are made before you pay income taxes on your salary, the balance grows tax-free over time and you pay taxes when you withdraw money in retirement. With Roth IRAs and Roth 401(k)s, contributions are made after you have paid income taxes, the money grows tax-free over time and you pay no taxes when you withdraw funds in retirement.

With brokerage accounts, when you sell an investment for a gain, you pay capital gains taxes. Generally, if you’ve held the investment for more than a year, you’ll pay the long-term capital gains tax rate on the proceeds and if you’ve owned it for less than a year, you’ll pay the short-term capital gains tax rate.

You will owe taxes when you receive income from investments held in your brokerage account, such as dividends or interest, or when cash in your account earns interest. If a stock you own pays out cash dividends or qualified dividends, the proceeds may be taxed. Taxes on interest income from bonds are more complicated.

One tax strategy available to investors with a brokerage account is called tax-loss harvesting. Under certain conditions, when you sell an investment for less than you paid for it, you may use some of the loss to offset other taxable gains in your portfolio.

If you invest strategically using your brokerage account, you can minimize the taxes you’ll owe. “For some people, the brokerage account may be equally as beneficial as some of the retirement accounts, if managed correctly from a tax standpoint,” Boersen says.

Where Can You Get Brokerage Accounts?

You can open a brokerage account with these different kinds of brokers:

• Online brokers. For self-directed investors, an online brokerage account lets you manage your investing portfolio yourself, with little or no guidance from algorithms or professionals.
• Robo-advisors. For hands-off investors or people who are new to investing, robo-advisors offer automated management and occasional human assistance. You answer a few questions about your goals, timeline and risk tolerance, and a robo designs a diversified portfolio of ETFs or low-cost mutual funds tailored to your needs. They typically charge fees.
• Managed accounts. Full-service brokers and financial advisors manage brokerage accounts for you. With managed accounts, you typically get advice about other aspects of your financial life, such as estate and retirement planning. Fees on this kind of account will be the highest, with average registered investment advisors charging an annual fee of 1.17% of your balance.

Is My Money Safe in a Brokerage Account?

Cash and securities in a brokerage account are insured by the Securities Investor Protection Corporation (SIPC). The insurance provided by SIPC covers only the custodial function of a brokerage: It replaces or refunds a customer’s cash and assets if a brokerage firm goes bankrupt.

SIPC protects $500,000 per customer, including only up to $250,000 in cash. SIPC does not protect you from bad investment decisions or a loss in value of your investments, either due to your own choices or poor investment advice.

What Kind of Brokerage Account Should You Choose?

Choosing a brokerage account depends on your investing experience, the amount of time you can devote to managing your portfolio and how much you want to pay.

“If you’re somebody who wants to keep it super simple and buy a single stock or a single fund, or if you’re willing to do your own legwork and make your own choices, you may decide that an online brokerage would be the best choice,” Boersen says.

A downside to the self-directed approach with an online brokerage is that when the market gets tough, there’s no one around to keep you from reacting emotionally and making poor investment decisions. For instance, big market dips can drive unseasoned investors to sell their investments, which is often a suboptimal choice.

On the other hand, working with a financial advisor or a full-service broker gives you access to professionals with deep understanding of markets and investing. When you take full advantage of managed brokerage accounts, you help ensure your portfolio matches a plan and goals you and a professional have developed together. The right investment professional “can help delineate between the millions of investment strategies out there and determine the best one for the client,” Boersen says.

Robo-advisors fall somewhere in the middle. They’re great for someone who doesn’t want to make all the decisions themselves and yet isn’t ready to pay higher prices for a managed brokerage account.