Basics About Brokerage Account: 2023

If you’re a beginner and want to start investing in stocks/bonds/forex, etc., opening a brokerage account is a great first step to trade and begin your journey as an investor. This article will equip you with the knowledge you need to start like a pro. You can also learn about how to open an individual brokerage account and start investing today. Now grab the wheels and steers towards your financial future!

Defining a Brokerage Account

When people start their trading/investing journey, one of the first questions they have is: What is a Brokerage account? And the answer is simple; it is a tool or a financial account that is required to hold, buy and sell different types of securities, such as stocks, bonds, EFTs (Exchange Traded Funds), options, and even Foreign Currency. Consider it as a prepaid account in which you put money to buy securities and when you sell securities you receive money in this account. A brokerage account is opened with a brokerage firm and is linked to your bank account. We need to fund the brokerage account before buying and we can transfer money back to our linked bank account.

How does a Brokerage account function?

After understanding what is a brokerage account next thing we should know is: How a brokerage account works?

It has just two simple functions: First, we fund a brokerage account, i.e. deposit money in it and second, use the funds to, buy assets like stocks, bonds, forex, mutual funds, exchange-trade funds (we will call it ETF going forward).

There is another function too, when you sell the shared, bonds, forex, EFT, etc. the money comes into your brokerage account.

You can use a brokerage account for day trading to earn a short-term profit and/or you can do investment too, i.e. buying stocks with a long term vision. Brokerage account is maintained by a broker, consider a broker like a middleman between you and the stock market and perform the buying & selling as per your instructions.

Types of Brokerage Accounts

There are three major types of brokerage accounts:

Cash Account.
Margin Account.
Retirement Account.

Cash Account

is a type of investment account where we need to pay in full at the time of buying a stock, i.e. if we have $500 in our Cash account and then we can buy stocks worth $500 only. It means we must have sufficient cash in the cash account to cover the full cost of the securities.

Margin Account

on the other hand allows us to buy more than the funds we have in our brokerage account, i.e. we can borrow money from the broker to buy securities. For example if we have $500 in our margin account we can buy stocks worth 10 times or 100 times more than $500, i.e. with a 10% margin we can buy stocks worth $5000, the broker lends the $4500 and we contribute our $500. The investor’s portion is the margin that the broker provides to us.

Margin account allows us to leverage our investments, it enhances the returns too. This leverage is not free and comes with an increased risk. In the event when the value of the stock drops down a broker may ask us to add more money to our margin account to make up for the loss. If we don’t add more money a broker may sell some or all our stocks to pay back what we borrowed. This is a risk involved in margin account and is called a Margin Call.

Retirement Account

It’s an investment account that helps us to save money for our retirement. A retirement account (like IRA or individual retirement account) is a brokerage account and you get access to same kind of investments. To understand the difference between a Retirement account and Brokerage account we need to look at the way both are taxed. It is different than a brokerage account as tax rules are applied differently.

With a traditional IRAs and 401(K) plans we can put money before we pay income tax on our salaries and when we withdraw money at the time of retirement we pay taxes on it. However, with Roth IRAs and Roth 401 (K) plans we put in money after paying income tax and when we withdraw money at the time of retirement we don’t have to pay any taxes.

However, when we sell an investment in a brokerage account at a profit, we have to pay the taxes on the gain we make. If we hold an investment for more than a year we have to pay the long-term capital gain tax at prevailing rate and if sell it before an year and make profits then we have to pay short-term capital gain tax.

I think it will be easy to understand with the help of below table. I have mentioned few differences point-wise for people who are absolutely new to this concept and want to understand everything crystal clear:

Retirement account	Standard Brokerage account
Purpose: investment for retirement	Day trading, long-term investment, short-term goals.
Tax: IRA doesn’t tax on the withdrawals at the time of retirement. (Tax-deferred/ Tax-free)	We have to pay short-term capital gain tax or Long-term capital gain tax. (Taxable)
Annual contribution: There are restrictions on maximum annual contribution you can make to your Retirement account.	No restrictions.
Withdrawal: There are restrictions on when you can withdraw your funds.	You can withdraw any time and for any reason.

If you are enjoying reading so far, I would strongly suggest to go through “Understanding the investment” article.

Types of Brokers

1. Online Brokers –

It’s a type of broker that provides an online platform to the users to trade securities. Usually, it’s offers a self directed approach to investing, i.e. the users manage their portfolios themselves and are responsible for all their trades.

It is preferred by a vast majority as online brokers usually have lower brokerage fee as compared to full-serve brokers. The reason is that they don’t provide any personalized services or suggestions. I also use an online broker and it provides me a lot of educational resources, tools, etc. that help me to take trading or investment decision, but doesn’t directly provide any personalized service.

Most of the online brokers offer mobile apps and website interface which are very user friendly and allows the users to monitor their trades in real-time.

2. Robo Advisor –

It’s a type of Online broker that offers advisory service, often called as robo-advisory services. Just like an online broker they also provide an online platform to the users for trading and investing in addition they also provide investment/trading advice to the users and manage their portfolio based on algorithms.

Just like online broker, the Robo-advisor brokers also charge lower fees as compared to the traditional brokers. Their algorithms are usually designed to fulfill users’ investment goals based on their risk tolerance.

I have seen many robo-advisors also provide a variety of additional services like financial planning, education materials and tools and some also provide personal financial advisors.

3. Managed account –

This broker more like a financial firm and manages the account of the clients with their services. They have money managers who work for the clients i.e. the account holders. It is not exactly like robo-advisor but they provide personal service (a human is involved) and manages the client’s investment based on their financial/investment goals, risk tolerance, etc.

There are many managed account options like Separate Managed accounts (SMAs) and Unified Managed Accounts (UMAs). SMAs are mainly individual accounts that are managed on one-to-one basis by the appointed money managers. UAMs are accounts that combine many SMAs into one Single account that is managed as one.

Unlike online broker or robo-advisor you can expect a variety of services like financial planning, investment research, portfolio dashboards, etc. Managed account brokers usually charge a comparatively higher fees than online and robo-advisor.

Documents required to open a Brokerage Account

It’s now possible to create a brokerage account within minutes due to the prevalence of the internet and online services. The only prerequisites are to gather your identity documents, furnish some personal information, and have sufficient funds to begin trading.

You’ll need to provide some personal information. Here’s a rundown of what you’ll need:

• Your Social Security number or Tax Identification Number
• A government-issued ID like a driver’s license or passport
• Some details about your current job/ source of funds.
• Information on your financial status, including how much you earn and what you’re worth
• A quick summary of your investment goals