You’ve got your savings accounts under control and you want to up your game when it comes to your finances. If you’re ready to make your money work for you, then you’re probably ready to consider investing. Before you dive in headfirst, take the time to learn more about brokerage accounts and how they work.
In most cases, this type of account is the best way to actively manage your investments. But there are many considerations you should take into account, such as the fees involved and your plans for the money you invest.
Don’t be alarmed — we’ve done the hard part for you and compiled a comprehensive guide to getting started with a brokerage account. Keep reading to find all the answers to your burning investment questions. Then you’ll be ready to make an informed decision and open a brokerage account.
How does a brokerage account work?
Brokerage accounts allow you to buy and sell stocks and funds through an online platform. You can typically deposit funds by cash or check and pay your brokerage firm a pre-determined commission.
The amount of the fee you must pay varies depending on the level of service you receive and the level of automation on your chosen platform. Rather than earning a fixed interest rate on your deposits as you would with a savings account, brokerage accounts earn (or loses) money based on the performance of your chosen investments.
While there is much greater risk involved, you’re likely to see higher returns compared to a low-interest savings account. But if you have a strong risk appetite, particularly if you’re looking to invest over the long-term, then it may be worth considering a brokerage account as part of your savings portfolio.
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What can you invest in with a brokerage account?
There are actually a wide variety of options available. You may want to pick one type to start off with, or you could choose several in order to diversify your portfolio. Perhaps the most familiar type of investment is a common stock, in which you essentially purchase shares of a specific company.
If you work for a large public company, you might receive shares as part of your compensation package. Or you can choose from any of the companies listed in the stock market, ranging from behemoths like Facebook to successful small niche companies. On top of common stocks, you can also add the following to your brokerage account:
- Preferred stocks
- Corporate or sovereign bonds
- Real estate investment trusts (REITs)
- Stock options
- Certificates of deposit
- Money markets
- Exchange-traded funds (ETFs)
- Mutual funds
- Master limited partnerships (MLPs)
What should you consider when picking an online broker?
The first thing to consider is whether you want a full-service or discount broker. A full-service brokerage firm invariably comes with higher fees. But the upside is that you get a specific broker who is dedicated to your account. You discuss your financial situation and future monetary goals with your broker and continue to build an ongoing relationship.
Your broker performs trades for you based on your conversations about goals and risk appetite. If you have questions or concerns, you can directly communicate with your broker by phone, email, or even an in-person meeting. You’re likely to pay commissions that are exponentially higher than those of a discount broker, but you have access to a seasoned professional at all times.
Discount Brokerage Firms
Discount brokerage firms, on the other hand, typically operate solely online. You execute all of your own trades in a truly do-it-yourself fashion. The advantage is that you can save lots of money. The disadvantage is that you have to rely solely on your own market research to develop your portfolio and can cost yourself money by making mistakes out of sheer inexperience.
Still, if you want to be hands-on with your investments, online discount brokers make the stock market accessible — and affordable — in a way it has never been before. Here are a few other things to think about when choosing your brokerage firm.
There are typically two types of costs associated with an online brokerage account. The first is a commission fee, which can range anywhere between $5 and $10 for each trade you make. These fees usually apply to stocks and options, and sometimes ETFs, plus transaction fees for mutual funds.
However, some brokerage accounts offer fee-free trades for ETFs and mutual funds. If either of those is a large part of your investment strategy, you may benefit from choosing a brokerage that doesn’t charge any fees for those.
The second cost you’ll come across is a variety of potential account fees. These can include an annual fee for maintaining your account, inactivity fees, and research and data fees for information provided by your broker.
Withdrawal & Transfer Fees
You may also incur fees for withdrawing or transferring your funds. Think about how often you plan to trade and what resources you want access to when assessing the value of these fees at different companies. If your annual fee is high but you’ll save money on lower trading fees, it might be worth it.
Similarly, if you don’t plan on trading very frequently, you might want to find a brokerage firm with low or no inactivity fees. Be sure to do a full review of all costs involved to make sure you get the best value across the board for your specific needs. Otherwise, your trades could end up costing you money over time, rather than earning you money.
Another deciding factor in finding a brokerage account is how much money you plan to initially invest. Some online brokerages have a minimum amount just to get started, often requiring at least a few thousand dollars. Others don’t have any minimum requirements. In either case, you may notice varying fees depending on how much you invest.
For example, you may receive a discount by meeting a certain deposit threshold. In those cases, it also means you’ll end up paying more if have a lower account balance. Carefully consider how much you intend to invest and where you receive the best perks for that amount.
In addition to research and data made available online (and often resulting in fees), consider what type of personal service you receive. Would you like an annual check-in with a real financial advisor? Do you prefer to have 24/7 email or chat support? Or do you need something more hands-on?
Just as the level of service varies between full-service brokers and discount brokers, you’ll see a difference even among different online brokers. Pay attention to your needs and don’t be afraid to change your account further down the road if you feel you need more or less attention.
Cash Account vs. Margin Account
Yet another breakdown in types of brokerage accounts is a cash account versus a margin account. So what’s the difference? A cash account is extremely straightforward: you simply trade with the exact amount of funds currently available in your account. This can be somewhat restrictive for a couple of different reasons.
First, cash used to purchase new stocks must be settled in your account, so if a previous transaction is still pending, you can’t use that money for a new trade. Second, you can’t make any withdrawals from a cash account until the money is fully settled.
Trading on Margin
Margin accounts essentially allow you to borrow money from your brokerage firm to cover short-term capital needs. The advantage is that it gives you a bit more flexibility in making time-sensitive trades.
One of the disadvantages is that you’ll have to pay a margin rate, which serves as interest on the short-term loan. Additionally, you may need to place a higher account minimum to compensate for the risk of the broker potentially losing money.
You can potentially qualify for a lower margin rate by permitting rehypothecation, which allows brokerage firms to reuse your own collateral for its own purposes. Clearly, this brings additional risk to your portfolio.
If you’re a beginning investor, it’s probably wise to stick to a straightforward cash trading. As you become more comfortable and active with the trading process, you can begin exploring the intricacies of margin trading with your broker.
How do you open a brokerage account?
Opening a brokerage account isn’t terribly difficult and just requires a few pieces of personal information and, of course, money. When you’re ready to get started, gather basic materials such as your social security number or tax ID number, driver’s license, date of birth, and contact information.
You’ll also need employment and income information, including your employer, annual income (usually submitted using a W9 form), and your net worth. Assuming this information is easy for you to pull together, the process is both quick and easy, especially if you opt to open an account online.
You’ll also need cash to open an account. You cannot use a credit card to deposit funds. Instead, you’ll likely need to perform an electronic funds transfer using a checking account.
Keep a paper check on hand to facilitate the transfer. This process can take anywhere between a few days and a week so that the money can be verified. Once the funds hit your account, you can get started trading!
Should you use a brokerage account for retirement funds?
This is a very personal question and depends upon your retirement savings goals. First and foremost, it’s critical to take advantage of any employer-sponsored accounts like a 401(k), especially if you receive a company match for your own contributions. Then, consider contributing to an account such as an IRA or Roth IRA.
There are limits on how much you can contribute each year, but you do both to enjoy different tax advantages. For example, a traditional IRA is not taxed until you begin withdrawing, making your annual contributions tax-deductible. Roth IRA contributions, on the other hand, are taxed when you make them.
The upside is that you don’t pay taxes when you start to withdraw, potentially saving you money during your retirement. If you’ve maxed out an appropriate amount of these account types, you might consider supplementing your retirement savings with a brokerage account.
Before you do, consider a few things. First, the earnings you make on selling investments are taxable, usually as capital gains tax. You’ll also want to review the amount of risk in your portfolio as you approach retirement age. Remember to review your holdings regularly, especially if you’re not a frequent trader.
With so many options available for brokerage accounts today, investing is more accessible — and affordable — than ever before. If you’re just beginning to get your feet wet, start off investing just a small amount of money to help you learn through rookie mistakes. Then you can grow into more sophisticated trading methods as you learn the full potential of your account.
Alternatively, you can switch to a more service-oriented account to take the day-to-day trading out of your hands. The options are quite limitless when it comes to managing your own brokerage account.