What is a Brokerage Account & Why Do I Need One?
Key Points
A brokerage account is an investment account which combines aspects of a traditional checking/savings account with the full-service, market-trading capabilities of an IRA or 401(k).
While brokerage and retirement accounts share some similarities, there are a few key differences you’ll want to be mindful of.
A brokerage account requires much more maintenance and fine-tuning compared to an IRA or 401(k); however, a brokerage account can play an important role in your overall financial plan when managed correctly.
While a brokerage account won’t provide you with the same tax benefits as an IRA or 401(k), it can complement your emergency reserve, provide additional liquidity before retirement, and help fund larger expenses down the line.
Maxing out your 401(k) or contributing to a traditional or Roth IRA forms the foundation of a sound financial plan. Company-sponsored retirement accounts offer tremendous tax benefits, often come with a company match, and give ordinary investors an easy way to gain access to the stock market.
There is another type of account, however, that’s just as important as a 401(k) or IRA but often overlooked. That account is a brokerage account. An investment account, a brokerage account combines aspects of a traditional checking/savings account with the full-service, market-trading capabilities of an IRA or 401(k).
Brokerage Account vs. 401(k) and IRA
A brokerage account is like a retirement account in that money can be contributed and invested into various financial securities, such as stocks, bonds, ETFs, and mutual funds. While brokerage and retirement accounts share some similarities, there are a few key differences you should be mindful of.
The main benefits of a brokerage account are its flexibility and accessibility. Unlike a retirement account, there are no limits on how much you can contribute or take out. More importantly, funds can be accessed at any point-in-time without penalty. This lets you participate in the capital markets while simultaneously not locking up your money until retirement. The draw back of a brokerage account is that it’s not a tax-efficient investment vehicle.
Maximizing Your Brokerage Account’s Tax Efficiency
When considering your investment strategy, taxes might not be your primary concern. Taxes, however, just like investment growth, compound over time. We always consider taxes in our investment advice because they can quickly negatively impact your return through, what’s known as tax drag. The income generated within the account is fully subject to tax.
Overtime, tax drag can deteriorate one’s nest egg. If we assume an initial investment of $20,000 and a pre-tax return of 10.20%, you’d have an account balance of $486,702.73 after 40 years. If the after-tax return on that same investment is 8.20%, the account balance would only be $230,497.99. That’s a difference of more than $250,000!
*Past performance is no guarantee of future results. This is for illustration purposes only and not indicative of any investment. Stocks are represented by the Ibbotson Large Company Stock Index. Bonds are represented by the 20-year U.S. Government bond. This data assumes reinvestment of income and does not account for transaction cost.
Source: https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/tax-efficient-investing.pdf
Luckily, there are a few strategies that can help minimize tax drag:
Sell securities after 365 days to have gains taxed at preferential rates.
Pick investments that produce income which is taxed at preferential rates (e.g., qualified and REIT dividends, municipal bond interest)
Pick passive, or tax-efficiently managed, broadly diversified funds to minimize security sales at the fund level.
4 Benefits of Brokerage Accounts
A brokerage account requires much more maintenance and fine-tuning when compared to an IRA or 401(k). A brokerage account can still play an important role in one’s overall financial plan if managed correctly. The flexibility it provides can lead to many planning opportunities unavailable in a retirement account.
Here are a 5 benefits of brokerage accounts:
Since funds can be accessed at any point-in-time, a brokerage account can be used to supplement your emergency reserve in your regular checking / savings accounts.
Funds in a brokerage account can be invested to help you reach your savings goals sooner. Investing in stocks and bonds can also help combat inflation.
If you’re thinking about retiring early, a brokerage account can bridge the income gap between your retirement date and when you start to collect social security or begin required minimum distributions from your retirement accounts.
In years where capital markets generate negative returns, you can harvest tax losses in your brokerage account to reduce your taxable income or offset other capital gains.
In years where you have low taxable income, you can accelerate/recognize capital gains to take advantage of preferential tax rates.
Again, there are many considerations to keep in mind when opening this type of account. You’ll want to check with a Certified Financial Planner®, like Capstone Financial Advisors in Downers Grove, IL, to see how it can fit into your overall financial plan.
Disclosures:
This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.