Everything You Need to Know About Brokerage Accounts

Main Idea: Brokerage accounts are often pushed to the side because of retirement accounts (which are also great), but they can offer many great benefits that have very practical use including more flexibility, more simplicity, and less legal jargon.

There are two things I love about a brokerage account: simplicity and flexibility.

Unlike retirement accounts, there are very few strings attached.

Unfortunately, much of what is taught and encouraged at companies both large and small is to max out your retirement accounts and move on with your day.

Which is great, don't me wrong, but can leave some people out to dry when they get into retirement and are left with serious tax hurdles.

Brokerage accounts, in my opinion, should not be your first go-to when looking for the right account to place more cash into, but offers several benefits that your retirement accounts can't.

Today, I'm using Ted, who is totally fictional, to share some examples of how I've seen brokerage accounts be used in an ideal way and of course a less than ideal way.

As always, these examples are not recommendations or financial advice, as your personal situation will dictate what is best for you. Always be sure to consult your tax and financial advisor before making financial decisions.

Before that, a few quick rules on a brokerage account you need to know about, or be refreshed on.

1. A brokerage account can go by other names such as taxable account, joint account, individual account, and so forth. They're all the same, and they all work the same way.
2. Like other non-qualified accounts, a brokerage account is after-tax money, meaning you cannot take a tax deduction when investing.
3. Unlike qualified accounts* (401k, IRA, etc.) only the gains are taxed with a brokerage account. This means only your dividends or realized gains will be taxed.
4. Unlike qualified accounts, brokerage accounts can be taxed in two different ways.**
5. There are no required minimum distributions, annual contribution amounts, or age rules with a taxable account. It is one of the most flexible investment account options you can open.

*For the purpose of "qualified account", I'm not referring to any Roth accounts in this article.

**With investment gains, any position held for 12 months or less is taxed at your ordinary income tax rate (think highest possible tax bracket you're in). Meanwhile anything held for over 12 months is taxed at more favorable rates creatively dubbed "long term capital gains rates". Click here if you'd like more.

Here are a few great ways I've seen brokerage accounts used (with Ted as my example-person):

• Early retirement account (pre-59.5): Ted retires at 56 y/o because he crushed his career, but now he wants to make sure he's covered until 59.5*, when his retirement accounts "open". He also needs to make sure he can pay for his private health insurance of which he will need to cover until 65 y/o when Medicare begins.

*Certain provisions can potentially allow for retirement accounts to be accessed before 59.5, but we'll say for this scenario Ted doesn't want to do that.

• Medium-term goal: Ted started saving 10 years ago for a house, now his initial investment has more than doubled, and he uses this portion to pay for a new home.
• Short to long term cash holdings: It hurts my soul to see people (like Ted here) leave too much cash in checking and savings where it earns .002%. A brokerage account can be a great place to leave cash on the sidelines, and still earn some interest.
• Tax loss harvesting: Ted uses his brokerage account to sell investments at a loss to offset capital gains or ordinary income (up to $3,000 per year). This can lower Ted's overall tax bill.
• Tax gain harvesting: Because Ted loves tax optimization, he also uses this account to harvest gains, where he sells appreciated investments to intentionally realize capital gains. He's got his eye on doing this after retiring when he's in a lower tax bracket where those gains may be taxed at 0% (for long-term capital gains).
• Passive Income: Ted has heard the young and hip crowd talk about passive investing, so he also uses his brokerage account to receive qualified dividends.
• Charitable Efficiency: Ted has a charity that is near and dear to him, so he uses the appreciated positions in his brokerage account to send to that charity from time to time rather than sending cash. This way, he wins, the charity wins, the IRS loses...good day.

Okay, that's enough of the good. Now a few bad examples I want to share. Again using our friend, Ted.

• Overtrading: This is one of the more common issues people like Ted have with their brokerage account. Because it's non-qualified, there is no tax deferral, meaning every action you take with it will have tax consequences. It may not seem like it, but constantly trading in an account can add up Ted's tax bill rather quickly, especially if he's selling positions held 12 mo's or less.
• Mutual Funds: Ted doesn't understand that mutual funds have managers that trade in them annually, leaving Ted with the tax bill at the end of the year without realizing it. What's more frustrating, is even if Ted buys a mutual fund in October, it only goes down in value, he will be liable for the fund's full-year performance, which was positive, leading to taxes on earnings he didn't even collect!
• Holding the Wrong Positions: Ted has an opportunity to leave his investments that have the greatest growth in his retirement accounts, but instead he leaves them in his taxable account. While he could potentially be saving thousands in taxes, he leaves these positions in his taxable account for decades, allowing them to become a huge tax bomb in the future.
• Failing to Track Realized Gains: Ted forgets to balance out his gains with losses, so he builds up a large tax bill throughout the year, leaving him a with a hefty bill owed to the IRS come next April.
• Using Robinhood: This is a totally personal one. But I don't think anyone should use Robinhood. With it's user interface, it uses sleekness and other psychologically backed tricks to encourage trading (the only way they make money). I love boring apps. Ones that don't encourage you to trade all the time.

Okay Ted, that's all for today buddy. Thanks.

Remember: Titling (selecting a beneficiary) is very important with a brokerage account as with all accounts. This means in order to avoid probate, you will want to make sure your beneficiary is accounted for.

One of the most unique benefits of a brokerage account is it receives a step-up in basis, meaning once the owner passes away and the account is passed to the beneficiary, the "cost" that your beneficiary received the holdings at is the current market value, not what you originally bought them for. See below for this.

CONCLUSION

At the end of the day, brokerage accounts should be used in a strategy that fits your personal needs, goals, and timeline.

With that said, they can become overlooked because it's easy to max out your 401(k) and call it an investment strategy.

In combo with your Roth 401(k) or IRA, your 401(k), IRA, and other accounts, the brokerage account can add strong diversification for both tax and investment reasons.

Be sure to reach out to your advisor or tax pro today to dig more into this!

Follow Up to Read or Watch: To learn more about how your specific custodian allows you to open a brokerage account click one of the following for options:

Fidelity

Schwab

Vanguard

Action Item: Discuss your options, including what accounts you want to be more aggressive in, what your long-term plans are with the funds in those accounts, and more with your financial advisor.

My name is Jordan McFarland and I'm a CERTIFIED FINANCIAL PLANNER? at SageSpring Wealth Partners in Dallas, TX.

My goal with these brief articles is not to make you an expert, but get you thinking about ways you can optimize your finances and get ahead for tomorrow.

If any questions or thoughts come up during your reading, you can email me at [email protected].

Unfortunately, I must keep these articles rather vanilla and short in order that I do not trip any compliance wires. I'd be happy to meet with you to hear about your specific goals when the time comes.

This content reflects the opinions of the author and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as financial, legal, tax, or investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not indicative of future results. All investing involves risk, including the potential for loss of principal. The information contained in the commentaries is derived from sources deemed to be reliable, but its accuracy and completeness cannot be guaranteed. This material does not have regard to specific investment objectives, financial situation, or the particular needs of any specific reader. Any views regarding future prospects may or may not be realized. Asset allocation nor diversification guarantees a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.