If you are just considering getting started investing, you may be overwhelmed by the first choice on the investment account application: what type of account do you want? The truth is that there are a lot of different accounts for different purposes, so I will try to shed a little light on the more common ones that are offered at most discount brokerages.
Remember, an investment account is like a vehicle, while your actual investments are the passengers. Depending on the vehicle you own, it can only hold certain numbers and types of passengers. Plus, certain other rules will apply. That is how accounts work. Inside the account, you hold your stocks, bonds, mutual funds, etc. Some accounts have limits on how much you can put in, and there are rules about what types of investments you can hold in certain types of accounts.
First, there are two main distinctions in accounts: brokerage and retirement. Brokerage accounts can be accessed at any time to deposit and withdraw funds. Retirement accounts have restrictions on how much can be invested annually, and can usually only be withdrawn upon in retirement.
Both types also have their benefits. Brokerage accounts can invest in any investment product, and can also take on leverage and short positions. Retirement accounts are somewhat limited in what they can invest in, but they usually offer some type of tax advantage.
Brokerage Investment Accounts
Cash - A cash brokerage account is the most basic form of investment account. It’s also known as a standard brokerage account. This account type is funded by your cash, and you can only invest with the cash in the account. This account is limited in what you can do because you can only use your cash. For example, you can’t engage in certain options trading, and you can short sell either. If you’re interested in that type of trading, you should look for a margin account. You should note that everything you do in a cash account is taxable, so make sure you pick your investments wisely.
Margin - A margin account is very similar to a cash account except you have the ability to trade on margin. This means that you’re able to borrow from the brokerage when you place a trade. It still requires a certain amount of capital, and you can usually borrow up to 50% of what you have. A margin account gives you the ability to place every trade possible – including options trades and short selling. This is all due to the fact that you’re able to borrow from the broker to conduct the trade. Just like a cash account, a margin account is fully taxable.
Retirement Investing Accounts
When it comes to saving for retirement, there are a lot of different investment vehicles. IRAs are the main type that you can go an open. You may be familiar with a 401k or 403b, but those are employer sponsored plans and individuals don’t open those accounts.
Traditional IRA - A Traditional IRA (individual retirement account) is a savings vehicle that allows you to save and invest for retirement. The benefit of using a Traditional IRA is that, in many cases, the amount you contribute is tax deductible. Once you put money inside the account, everything you do or trade is tax deferred. You only pay taxes once you withdraw the money in retirement, but you will do so at ordinary income tax rates.
Roth IRA - A Roth IRA is similar to a Traditional IRA, except that you invest using after-tax money. Inside the account, both the Roth and Traditional IRA act the same. However, with the Roth IRA, when you withdraw your money in retirement, you don’t pay any taxes on it.
For these accounts, the gamble is this: do you think you’re going to be in a higher tax bracket now or later. If you are paying higher taxes now, and think you’ll pay less in retirement, a Traditional IRA makes sense because you get the tax breaks today. However, if you are in a low tax bracket now and plan to be in a higher tax bracket in retirement, a Roth IRA is the better choice.
Which Type of Investment Account Should I Open?
If you are just getting started investing, and don’t plan on accessing your investments until retirement, you should consider a retirement account. These accounts have lots of tax benefits and are designed for long term investment strategies.
If you are looking to “play” or speculate in the stock market, I would recommend a margin account. It is very similar to a cash account, but as you want to take on more advanced investment strategies, this account will provide the flexibility you will inevitability want.
What type of investment account do you have? Are you planning on opening other investment accounts?
I would start with either a retirement account or a regular brokerage account, depending on your goals and timeframes. I wouldn’t get into margin accounts until you have more money available and a higher risk tolerance.
I do all my investing in my brokerage account. I may expand out to a margin account later, because I would like to expand my use of options in the future. Once I hit financial independence I’ll probably start sheltering some money in a traditional IRA.
I opened a margin account immediately for my standard account, since it gives me options. I don’t use them often, but I like that they are there.
Great breakdown of account types Robert! Most of our accounts are IRA accounts as that is our main focus. I don’t trade a whole lot, but when I do I like knowing that I can trade and not have the tax consequences of being taxed that year for the gain. I’ve been wanting to open a separate brokerage account though for a while and will probably pull the trigger later this year and looking to have margin capability with it as I want to do a little more advanced trading.
We’ve had Roth IRAs for several years but opened a (standard) brokerage account about 1.5 years ago. We don’t forsee buying on margin or doing any trading really, we just wanted to hold some ETFs and mutual funds for a few years.
Awesome and simple breakdown. I currently have a self-directed investment account and a RothIRA with ML!
I like the Roth for younger folks, and then balance with a 401k if available. Then you are hendging the gamble, 401k for the tax advantage now, and Roth IRA for the tax advantage later. Most likely, as you get into your 40′ and 50′, those will be your peak earning years, so putting more money in a “tax advanatage now” account would be better. When you’re younger, I’d say go for the Roth IRA
I have a number of margin accounts with various brokerages but that’s just because it’s the setup that fits my goals and risk profile the best.
Margin trading is definitely a double-edged sword. If you know what you’re doing and have a plan to limit maximum risk then it’s a great tool that allows you to keep more funds available for other purposes (or simply safe in your own hands). With the wrong approach though it will magnify losses and can be quite dangerous.
Just do your due diligence and have a solid plan before diving in and you’ll be fine. Oh, and don’t forget to be absolutely sure you understand the margin rules and how a margin call is triggered. That’s definitely not something you want as a surprise!
To answer your question, I must be a collector! I’ve got each except a cash account. I don’t do any margin trading, but to answer Cody’s concern above, in most cases, you have to have a margin account to use option strategies such as covered calls. It doesn’t mean you use margin. I wouldn’t go near leveraged trading. Bring on the Tums!
You can write covered call in a standard cash account, because the trades are covered. However, in a margin account, you can write uncovered calls on a margin loan.
I’ve got a margin account, regular IRA, and roth IRA. Oh, and a 401k as well. With the margin account, I don’t actually like to short sell or deal with options, though I suppose I do have the “option” to do so (yeah, bad pun).