What’s a Brokerage Account? And Do I Need One?
What is a brokerage account?
Simply, a brokerage account is an account where you can buy, hold, and sell investments. That’s it.
It’s like a bank account, in that you can open it online and put in money and take out money, but there are some important differences between a brokerage account and your regular savings account.
Brokerage account v. bank account
The most important difference between a brokerage and bank account is how you use them.
A savings account is meant to hold money that you may need in the next 5 years: emergency savings, travel savings, down-payment for a house, or wedding fund.
A savings account is very stable, and you are nearly guaranteed to have that money available to you the second you need it.
A brokerage account, on the other hand, is an account that holds investments: stocks, bonds, T-bills, REITs and any other investments.
Investing is an important part of building your wealth because compounding helps you grow your money exponentially faster than saving.
BUT, nothing is guaranteed in the stock market, so it’s a poor place to put money that you might need to access quickly.
If you held your emergency savings in stocks, and then stock prices went down - what would you do when you needed to pay for an emergency appendectomy?
As a general rule, savings should be for money that you may need in the next 5 years. Investments should be used for wealth building and money you will need in more than 5 years.
What’s the difference between a brokerage account and my retirement account?
You may already be familiar with investing through your retirement account. While brokerage accounts and retirement accounts are similar, they do have one very important difference: taxes.
Whether you have a 401k or an IRA, retirement accounts have tax advantages to encourage you to use them. They also have restrictions because of those tax advantages, like maximum contribution limits and early withdrawal penalties.
Brokerage accounts have no tax advantages. You’re taxed on the money you put into them, then you pay capital gains taxes on the money you take out.
But, luckily, capital gains taxes tend to be much lower than regular income taxes. Whereas you might pay 25%+ taxes on your salary, you usually pay around 15% on capital gains taxes.
Another benefit of brokerage accounts is that there are no contribution limits and no early withdrawal penalties. You can access the money at any time as long as you pay the taxes.
Is a brokerage account right for me?
There are some very simple steps to know if investing through a brokerage account is right for you.
Do you have an emergency savings? If no, complete this step. If yes, move to Step 2.
Have you maxed out your 401k? If no, complete this step. If yes, move to Step 3.
Have you maxed out your IRA? If no, complete this step. If yes, move to Step 4.
Have you contributed to other savings goals, like vacation funds, a wedding fund or a down-payment for a house? If no, complete this step. If yes, move to Step 5.
Yes. A brokerage account is right for you.
If I lost you at Step 2 - don’t worry! A brokerage account isn’t right for you at the moment, but it may be right for you in the future. When the time comes, you’ll want to have the knowledge you need to open your account.
Where should I open my brokerage account?
You have a couple of different options for where to open your brokerage account. The one you choose depends on how comfortable you are choosing your investments, and how much you want to pay in fees to an advisor (hint: you want it to be as close to $0 as possible!)
Option 1: A discount broker
A discount broker is an online broker that executes orders to buy or sell investments with low-cost or $0 commissions. Basically, we ordinary folk can’t actually buy or sell investments directly, so the broker does it for us and only charges us a small fee.
Discount brokers are considered “self-service” because their platform will provide tons of investment options and you have to choose the ones you want to buy yourself.
Think of it like a frozen yogurt store, where the store provides a plethora of delicious flavors, but it’s up to you to fill your cup with the flavors you want and choose how much of each to get.
It can be great to have so many different options, but if you’re new to frozen yogurt all of the flavors can be overwhelming. There’s too many to choose from!
Likewise, if you’re new to investing, discount brokerage accounts can be overwhelming. There’s a lot of options, a lot of numbers and graphs on the homepages and it’s very easy for analysis paralysis to set in.
Because these brokers are self-serve, they are also the cheapest. Apart from a small commission you pay for purchasing your investments, there are very few fees involved in maintaining your account.
You can open up a discount brokerage account with companies like Fidelity or Charles Schwab.
Option 2: Robo-advisor
The next option you have is a robo-advisor. A robo-advisor will ask you some questions before opening your account like “what is your risk tolerance?” and “what is your time horizon for this money?” and it will help you create an investment portfolio from a specific set of options.
Robo-advisors can be a great option because they can help you customize your investment portfolio, even if you’re a total newbie.
The downside is, robo-advisors tend to have higher fees than discount brokers and they don’t really help you learn how to manage your investments yourself. They’ll create a portfolio based on how you answer some questions, but won’t help you decide when your asset allocation should change or when it’s worth it to take more risk in your investments.
Option 3: Full-service broker
Your third option is to go with a full-service broker. Now, if you’re like me and read full-service and think, “Yeah, I want all the services!” you might want to think twice on this one.
Although full service brokers offer the most support and personalized guidance, you will PAY for it. We’re talking 1-2% AUM (assets under management). I know 1% of your portfolio might not seem like a lot, but it can add up to thousands or hundreds of thousands of dollars over your lifetime.
Put it this way, we all hope to be millionaires someday. Let’s say you work hard and your portfolio reaches $1,000,000. Amazing work!!
With a full service broker taking 1% AUM, you will pay them $10,000 per year for investing your money for you. Do you really want to give away $10,000 just because learning to invest is intimidating?
So while full-service brokers may sound amazing, especially if you’re an investing novice and want someone to show you what to do, I highly discourage anyone from choosing a full-service broker.
I get that investing is confusing and maybe you’re not a “math person”. But you CAN do this.
It is worth it for the thousands of dollars you’ll be saving by learning to invest yourself.
You don’t need to build the most perfect investing portfolio ever seen. You just need to build one that works for you and helps your money grow.
Final Thoughts
Brokerage accounts are incredible wealth building tools. You use them to invest in stocks, bonds and other investments to grow your money exponentially faster than you can ever do by saving alone.
That being said, you’ll want to start by maxing out your tax-advantaged retirement accounts first. Retirement is the biggest expense any of us will have in our lives, and retirement accounts like a 401k or Roth IRA are great tools to use.
But if you’re ready for the next step, it’s time for a brokerage account. Put in any money you can that won’t be needed for the next 5 years and watch the magic of compound interest transform your money!
Your life may not be perfect, but it is imperfectly yours. The only way to live it is your way.
