Key Takeaways
- A brokerage account is a type of financial account that allows a person to trade investment products.
- Many different kinds of investment products can be held in an investment account, including stocks, bonds, mutual funds, and much more.
- Brokerage accounts offer fewer tax shelters than retirement accounts, but there are also fewer restrictions on when a trader can contribute or withdraw money.
Definition and Example of a Brokerage Account
A brokerage account is a type of taxable investment account that can be opened with a brokerage firm.The account holder can order trades, such as buying or selling stocks, and those orders are executed by the brokerage firm.
- Alternate name: Taxable account
Brokerage accounts are the more basic alternative to retirement investment accounts, like 401(k) plans and Roth IRAs. Unlike retirement accounts, which have special rules and tax advantages, brokerage accounts have very few restrictions, and any gains or losses (including dividends) are reflected on your taxes for that year.
How Does a Brokerage Account Work?
Brokerage accounts are easy to open. The process is similar to opening a checking account with a bank. Someone who wants a brokerage account files an application with a brokerage firm. The application will ask for basic personal information, such as your name, address, and Social Security number.
Once your application is approved, you deposit money into the account by writing a check, wiring money, or transferring money from your checking or savings account.After your deposited funds settle, you can use the money to buy different types of investment securities.
Note
In exchange for executing your buy and sell orders, you may pay the brokerage a commission fee. Fees vary by brokerage, so, before opening an account, shop around and pick a brokerage with a fee structure that works best for you.
There is no limit to the number of non-retirement brokerage accounts you are allowed to have.You can have as many or few brokerage accounts as you want, unless an institution chooses not to allow you to open a brokerage account. You can have multiple brokerage accounts at the same institution, segregating assets by investing strategy.You can have multiple brokerage accounts at different institutions, diversifying your relationships and exposure.
As you shop for a brokerage, take note of the financial strength of your broker and the extent of its SIPC coverage, which is the insurance that compensates investors if their stock brokerage firm goes bankrupt.Different types of assets have different levels of coverage, and some—like commodities—have no coverage at all.
What Can You Trade with a Brokerage Account?
You can trade more than a dozen types of investment products within a brokerage account. These investment products include but are not limited to:
- Common stocks and preferred stocks, which give investors partial ownership in a company
- Bonds, including U.S. Treasury securities, savings bonds, corporate bonds, tax-free municipal bonds, and agency bonds
- Mutual funds, such as index funds, which are pooled investment portfolios that combine funds from many investors to buy more shares than investors could buy on their own
- Exchange-traded funds (ETFs), which are a type of security that combines elements of both stocks and mutual funds
- Real estate investment trusts (REITs), such as hotel REITs, which are a type of ETF that deals with real estate investments
- Stock options and other derivatives
- Cryptocurrencies like Bitcoin
- Master limited partnerships (MLPs), which are complex partnerships with tax advantages (and potential tax consequences)
- Money markets and certificates of deposit (CDs), which are generally regarded as safer investments designed to protect cash while earning some income
Note
Some brokerage accounts will allow you to hold membership units in a limited liability company or limited partnership units in a limited partnership. These products are typically tied to investing in a hedge fund, so it may be difficult for new investors or less-wealthy individuals to access these options.
Types of Brokerage Accounts
While brokerage accounts have fewer special rules than retirement accounts, there are a few different kinds of brokerage accounts. When you're shopping for a brokerage account, pay attention to whether the account falls into one of the following categories.
Discount Brokerage
A discount brokerage account, or discount broker, is the most common form of brokerage account for casual investors who are just starting out. It may be an online-only brokerage, or there may be a few branch offices around the country.Everything is pretty much do-it-yourself, and you have to execute your own trades. As a result, you save on fees.
Full-Service Account
A full-service brokerage account is a brokerage account that pairs you with a dedicated broker who knows you, your family, and your financial situation.You can pick up the phone and speak to them, or walk into their office and regularly have meetings to discuss your portfolio.In exchange for that personalized service, you'll pay higher fees. These fees may be bundled into your commission fees, or they may be charged to your account in some other form.
Note
Some financial institutions offer both discount and full-service brokerage accounts.
Cash Brokerage Account
A cash brokerage account is one that requires you to deposit cash before you can start trading. In other words, the brokerage won't lend you any money, and you can't spend what you don't have. If you want to buy a stock worth $20, you have to deposit at least $20 into your account and use those funds to complete the trade. This limits traders to basic trades—they can't short a stock, for instance.
Cash accounts can be either discount or full-service accounts.
Margin Account
A margin account, as opposed to a cash account, allows you to borrow money to make trades. The broker essentially doubles as a lender, giving you what amounts to low-interest loans for the specific purpose of making trades. These loans allow for more advanced trades, such as shorting.
As with cash accounts, margin accounts can be either discount or full-service brokerage accounts.
While borrowing money to make trades enhances your potential gains, it also adds to your risk. Only experienced traders should consider using a margin account. Consider these factors:
- Margin brokerage accounts add more complexity to the way you collect dividends on your stocks.If things don't work out exactly right, you might not qualify for the lower dividend tax rates. Instead, you might be forced to pay ordinary tax rates, which can significantly increase your tax liability.
- Using margin can end in a financial disaster, no matter how confident you are in a trade. You can ultimately lose much more money than you initially invest, whereas, with a cash account, you can only lose the money you deposit into the account. A poor decision in a volatile market can land a trader in debt, and they'll be on the hook for contributing more money into their margin account just to settle that debt.
