If you’ve read any of my articles, chances are, you’ve probably heard me talk about a brokerage account. There are a few different types of brokerage accounts, each with different pros and cons. A brokerage account is an important, and extremely beneficial, part of personal finance. They allow you to preserve and grow your money, meaning you can save for retirement or simply generate some extra income. In this article, I’ll be exploring a couple different types of brokerage accounts so you can select the account that's right for you.
To quickly summarize, a brokerage account is an account that allows you to buy and sell various different investments, most commonly, stocks. Historically, the US stock market has provided significant returns, meaning investments in the stock market typically do well for investors. This is why stocks and stock-based funds are so popular. I speak more about the stock market in this article.
If you’re interested in exploring and investing in the stock market, or in other assets like bonds and you earn taxable income, meaning you earn income that you pay taxes on, there are a couple of special brokerage accounts for.
Just to clarify, taxable income would be money from a job at a retail store or a restaurant, but if you get paid money for, say, mowing lawns, and you don’t report that income to the IRS and pay whatever taxes are due, it would not qualify as taxable income.
If you're earning taxable income, the two most popular brokerage account types are Individual Retirement Accounts, or IRA, and 401(k). Both of these accounts have sub-categories that specifically define the terms, with a Roth and Traditional variant available for IRAs and 401(k)s.
Before we discuss the benefits, here's a quick rundown of each account. IRA’s are opened by an individual, hence the name, meaning anyone earning taxable income can go online and open one. On the other hand, 401(k) plans are offered by your employer, so depending on the company you work for, you may or may not have access to a 401(k).
Despite this difference, both of these accounts allow you to invest money and receive some kind of tax benefit.
With a traditional IRA and traditional 401(k), you deposit pre-tax money into your brokerage account, meaning it's money that you haven't paid taxes on yet. You can then invest this money however you please. However, when you decide to withdraw your money, you will have to pay income tax on the profits.
On the other hand, with a Roth IRA or Roth 401(k), you get to deposit post-tax money, meaning you’ve already paid taxes on it. Once you deposit this money, you can invest it however you’d like. Because you already paid taxes on the money you deposited, once you decide to sell your investments and withdraw your money, you will not have to pay any capital gains tax. Capital gains tax is a tax you have to pay anytime you profit from selling an asset.
With that said, the two main kinds of tax-advantaged brokerage accounts are centered around retirement, so while they do have their advantages, there are a few restrictions.
There is a limit for the maximum amount you can deposit, because both types are tax-advantaged. Both kinds of IRA’s are capped at $6,000 per year and both kinds of 401(k) plans max out at $19,500 per year. This means you can contribute up to $6,000/$19,500 every year, but no more.
Additionally, and more importantly, you have to be over 59.5 years to withdraw profits from these accounts, and if you withdraw money while you're younger, you will have to pay taxes on the withdrawal amount and an additional penalty in certain cases. It is important to note you can withdraw contributions without any penalty/fee; only gains are taxed if withdrawn before 59.5 years.
This is why it's important to only contribute money you will not need in the near future if you're young. This is intended to save for retirement, so if you want to save for, say a house, consider storing money in a savings account.
Another type of brokerage account is the normal, taxable account anyone can open. So if you already contributed the maximum to a tax-advantaged account or if you don't want your money locked up, this is the account for you.
You can open this account at any online broker, like Vanguard or Fidelity. Add as much money as you’d like and invest it however you please. But, you will have to pay taxes on any profit you make.
If you have a more specific purpose for your money, like funding your, or your child's, education, there are specific brokerages to suit these needs too. Accounts like the Coverdell Education Savings Account or the 529 plan are tax-advantaged brokerage accounts specifically meant for education. Because these are more niche and have a ton of details, I’ll dedicate a future article to them.
In short, whatever your goals for the future, there are ways to invest and save in a variety of assets. For those a lot of time ahead and those who want to save for retirement, IRAs and 401(k) plans are great. If you want to explore the markets, have less time, or have already contributed to a tax-advantaged account, a regular brokerage account is for you. And if you're planning on saving for school or college, an account like Coverdell will cover (see what I did there) your needs perfectly.