Chapter 5: Brokerages
We've covered a wide range of investment types and a few common styles. Let's cover what brokerages are out there and what type of investment accounts to open. There are a number of different brokerages out there that all work very simulary. A few major ones are Morgan Stanley, J.P Morgan, Charles Schwabb, Fidelity, E*Trade and TD Ameritrade. Robinhood is also a brokerage popular amongst new investors however it falls short in comparison to the competition in many areas. Once you've settled on a brokerage to use its time to open some investment accounts. There are a few different types of accounts one can open, the type of account you open will depend on your investment goals.
Standard Brokerage Accounts
A standard brokerage account, sometimes called a taxable brokerage account or a non-retirement account, provides access to a broad range of investments, including stocks, mutual funds, bonds, exchange-traded funds and more. Any interest or dividends you earn on investments, as well as any gains on investments that you sell, are subject to taxes in the year that the money is received.
When you open a brokerage account, the firm will likely ask you whether you want a cash account or a margin account. A cash account is appropriate for the majority of investors. It allows you to buy investments with money you deposit into the account. A margin account is for investors who want to borrow money from the broker to buy investments. Margin trading is a riskier type of investing that is best suited for advanced traders.
Eligibility: You must be a legal adult (at least 18 years old) and have a Social Security number or a tax ID number to open a brokerage account.
There are no limits on how much money you can contribute to a taxable brokerage account, and money can be withdrawn at any time, although you may owe taxes if the investments you sell to cash out have increased in value. The amount of taxes you owe will depend on how long you held the investment for. Short-term capital gains tax is a tax on profits from the sale of an asset held for one year or less. The short-term capital gains tax rate equals your ordinary income tax rate, your tax bracket. Long-term capital gains tax is a tax on profits from the sale of an asset held for more than a year (also known as a long term investment). The long-term capital gains tax rate is 0%, 15% or 20% depending on your taxable income and filing status. They are generally lower than short-term capital gains tax rates.
Retirement Accounts (IRA’s, 401k’s)
A retirement account, such as an IRA, or individual retirement account, is a standard brokerage account with access to the same range of investments. The biggest difference between a retirement account and a brokerage account is how the IRS taxes — or doesn’t tax — contributions, investment gains and withdrawals.
The most common types of retirement accounts are traditional IRAs and Roth IRAs. Many brokers also offer specialty retirement savings accounts for small-business owners and self-employed individuals, such as SEP IRAs, SIMPLE IRAs and Solo 401(k)s. Depending on the type of IRA you choose, you get either an upfront tax break in the year you make contributions to the account (with a traditional IRA) or a back-end tax break that makes your withdrawals in retirement tax-free (via a Roth IRA). Roth IRA’s are very powerful investment accounts, the earlier you begin the more time it will have to grow tax free.
Eligibility: You must have earned income to be eligible to contribute to an IRA. There are also income limits for contributing to a Roth IRA and for deducting contributions to a traditional IRA.
The maximum an individual is allowed to contribute to an IRA is $6,500 in 2023 ($7,500 if age 50 and older). Per IRS rules, there may be taxes and penalties for dipping into IRAs before age 59 ½. If you think you’ll need access to the money early, the Roth IRA provides more penalty-free options.
A 401(k) is a retirement savings and investing plan that employers offer. A 401(k) plan gives employees a tax break on money they contribute. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing (from a list of available offerings). 401(k)s have an annual contribution limit of $20,500 in 2022 ($27,000 for those age 50 or older) and $22,500 in 2023. Money contributed to a 401(k) is deducted from taxable income, lowering your owed taxes for the year. Many companies offer a 401(k) plan and match a portion of the money you save in that account.