What is a Brokerage Account? How Does It Work?

Investing
Updated: 8th Apr 2021
Written by Meagan Drew
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Investing
April 8, 2021
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Are you ready to plan for your future? Are you ready to start investing? To invest in the market, you need to be able to trade securities – and to trade securities, you need to have access to a brokerage account.

The only way to trade on the stock exchange is with a brokerage account.

What is a Brokerage Account?

A brokerage account is a type of investment account at a brokerage firm that allows the firm to make trades, such as buying and selling securities, on behalf of the account owner.

Even though the brokerage firm makes trades for the customer, all of the assets inside the account belong to the account owner and not the firm.

BLUF Brokerage Account Quick Facts

  • Allows access to the stock market and other securities
  • Money can be withdrawn or added at any time with no limits
  • Money is taxed before it enters the account and taxed when it leaves the account
  • Suitable for investors with all levels of experience
  • SIPC Insured against insolvency of brokerage firm up to $500,000, which includes a $250,000 limit on cash.

>> Next Steps: Best Online Stock Brokers

How Do Brokerage Accounts Work?

Brokerage accounts look a lot like checking accounts because account owners are free to add or remove money from the account at any time.

The difference between a checking account and a brokerage account is that brokerage accounts allow access to the stock market and other investments.

Money can be withdrawn or added to the account at any time with no penalty.

Is My Money Safe in a Brokerage Account?

The Securities Investor Protection Corporation (SIPC) protects brokerage accounts at member-registered broker firms up to $500,000 total with only $250,000 coming from cash.

New investors should be careful to understand that SIPC insurance does not mean you are protected from the decline in value of your investments, but rather protection against your broker firm becoming insolvent.

Investing is an inherently risky activity, but not because your brokerage firm goes belly up. SIPC covers that.

What Can You Trade in a Brokerage Account?

Brokerage Accounts allow access to a myriad of investment products for those who are interested in entering the market to save money for retirement, plan for the future, or just to have a little fun.

The investment you can trade with a brokerage account that gets the most press is stocks trading on the stock exchange, but brokerage accounts also allow access to a variety of other products, such as:

Different Types of Brokerage Accounts

Brokerage Accounts are not one-sized fits all. Just like every investor has individualized goals for the brokerage account, they have different types of accounts with which they are comfortable.

Some accounts are full service, while some accounts are completely hands-off, and some accounts are a little of both.

Here is a list of the types of brokerage accounts:

#1. Discount Brokerage Account

Discount brokerage accounts, or discount brokers, can be thought of as plug-and-chug. These brokerage accounts offer a full range of products, but they offer no financial analysis or recommendations.

Discount brokerage accounts simply do what the customer’s order them to do. Most of these types of brokerage firms are online-only, but a few have actual brick-and-mortar firms too.

These types of accounts are best for people wanting to keep costs low and do not require complicated trades.

#2. Managed Brokerage Account

If you decide on a managed brokerage account, you are essentially allowing the brokerage firm and money manager to make investments on your behalf.

Managed Brokerage Accounts are nearly the opposite of Discount Brokerage Accounts because the owners of these types of accounts are not always involved in the trades that take place.

Advisors use information collected from the customer in the initial interview to guide customers toward their goals.

In these types of accounts, the brokerage firm charges commissions for any transactions that take place and/or commissions on assets under management.

These fees are higher than other types of accounts because you are paying a firm for your advisor’s time and expertise.

#3. Cash Brokerage Account

Cash Brokerage Accounts are accounts in which all transactions in the account must be backed by money that is already in the account.

Oftentimes the brokerage firm or money manager makes decisions about which assets will be sold to fund other purchases. All accounts must be settled by the end of the day.

Because these accounts demand that all trades are cash-backed, investors in these accounts cannot make short sales.

The major upside to cash accounts is that the amount that can be lost is always capped at the amount that is invested- no more.

These accounts are best for new investors.

Learn More: What Is a Cash Management Account?

#4. Margin Account

Margin Accounts allow account owners to “borrow” money against the value of their securities for other purchases.

The assumption is that the stocks purchased with a loan will grow faster than what you borrowed.

These accounts are best for investors looking to take advantage of both bull and bearish market moves by taking loans against their current market positions.

Margin Accounts are not suited for new investors.

#5. Robo-Advisors Accounts

Robo-Advisor Accounts are like a hybrid between a Discount Brokerage Account and a Managed Brokerage Account.

Robo-Advisors offer lower prices while they also offer some advisement.

Rather than having a financial advisor you can call on the phone, the recommendations in these accounts come from the use of algorithms and computers.

Robo-Advisors are a step-up from discount brokers as they do offer some recommendations.

These accounts are likely best suited for investors with uncomplicated needs and portfolios, but still desiring some direction.

How to Open a Brokerage Account

Once you have decided which brokerage account is right for you, setting up your brokerage account is a lot like opening a checking account.

You will need to fill out an application and be required to fill out a risk tolerance survey. The risk tolerance survey indicates to the brokerage firm how much risk you can comfortably assume.

Any investments that are recommended to you should fall within your risk category. Also, you must disclose your existing financial knowledge, time horizon until any invested money is needed, and your investment objectives.

Once your account is opened, you can fund your account by transferring money from other accounts, wire transfer, check, or cash deposit.

>> Compare Your Options: Best Stock Brokers for Beginners

What Documents Do I Need to Open a Brokerage Account?

The first document you will need to open a brokerage account is a document that can verify your identity such as a driver’s license or passport.

You will also need to provide your social security number, but not your social security card. Some brokerage firms will also require your mother’s maiden name.

Applications for brokerage accounts are both online and in-person depending on the type of brokerage account you decided was best for you.

If you are uncomfortable inputting all or any of this information online, you can always go into a brick-and-mortar brokerage firm in your area to apply in person.

Differences Between Brokerage Accounts and Retirement Accounts

Brokerage accounts are sometimes also referred to a “taxable account” as most of your investment earnings will be taxed.

Brokerage accounts do not have yearly limits on how much you can deposit. In brokerage accounts, you can pull your money out at any time and for any reason.

Uncle Sam will request his chunk of your earnings in the form of taxes and then the money is yours to use however you please.

Can you use brokerage accounts to save for retirement?

Yes. However, retirement accounts are a better choice for at least part of your money because of the tax implications.

Retirement accounts are “tax-advantaged accounts” where money can be invested in all of the same vehicles as in a brokerage account.

They are considered “tax-advantaged” because money is either taxed on the way in or on the way out depending on which type of account you have chosen.

Roth IRAs invest money that has already been taxed. When money is withdrawn at retirement age (59.5 years old) there are no tax implications.

Traditional IRAs reduce your taxable income in the year the money is invested and there are taxes on the money withdrawn at retirement age.

There are also yearly limits on the number of funds that may be invested in one year: $6,000. Retirement accounts cannot be withdrawn from before the age of 59.5 and you don’t have to start taking minimum withdrawals until 72.

Can You Lose Money in a Brokerage Account? Are Brokerage Accounts Safe?

Bottom Line: yes. Investing is not without risk. The SIPC Insurance detailed above only protects assets from mismanagement on the part of the brokerage firm.

There is no insurance for investments that go South because of market downturns, bad luck, or poor choice.

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Meagan Drew
Meagan Drew
Meagan Drew is a personal finance writer with 7 years experience in wealth management. As a former Series 7 and 63 certified advisor, Meagan specializes in making financial topics relatable and consumable, no matter the reader’s experience level. Meagan is a veteran, military spouse, and mom of 4 currently living in Colorado Springs.