Brokerage Accounts: A Simple Explanation of How They Work

Here’s everything you need to know before you consider your first brokerage account, including how a brokerage accounts works and if they're right for you.
Last updated Oct 20, 2020 | By Alaina Tweddale
Brokerage Accounts

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Not sure how a brokerage account works or whether one is right for you? Turns out, you’re far from alone. Two-thirds of American respondents scored 50% or lower on a recent quiz on financial knowledge, according to FINRA. Still, whether you work with a financial advisor or you invest on your own, at some point, you may want a brokerage account to house your non-retirement fund assets.

Even so, brokerage accounts come in many financial varieties and flavors, which can complicate that how-to-invest-money choice. That’s why we broke down the details here, so you can figure out exactly how these accounts work and which one is right for you.

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What is a brokerage account?

A brokerage account is a vehicle that allows you to invest in non-tax-sheltered assets like stocks, bonds, mutual funds, or exchange-traded funds. Unlike retirement fund assets, which generally benefit from some type of tax advantage, brokerage assets are generally subject to short- and long-term capital gains taxes. On the plus side, these accounts can be accessed at any time, penalty-free.

With a brokerage account, you can:

  • Buy or sell a variety of investment products, typically including stocks, bonds, mutual funds, or ETFs
  • Educate yourself with your brokerage provider’s investment research, education platform, or other available tools
  • Invest outside of your self-directed or employer-led retirement account
  • Gain access to the potential long-term growth associated with a longstanding investment in the securities market

What are the different types of brokerage accounts?

Once upon a time, there was only one type of brokerage account — the full-service brokerage — which reserved its services exclusively for the ultra-wealthy. About 50 years ago, discount brokerages arrived on the scene, offering never-before-seen investing opportunities to the mass affluent and middle class.

Later, as the internet rose to everyday prominence, some discount brokerages moved online, whereas new internet-only players entered the industry. Finally, over time, an array of robo-advisors and investing apps entered the market, giving would-be investors hand-held access to different types of assets and varying levels of financial advice.

With so many options available today, it’s not always easy to decide which companies offer the best brokerage accounts to meet your individual needs. To make it easier, let’s break it down.

What’s the difference between a full-service broker, a discount broker, and a robo-advisor?

In general, the differences between account types boil down to fee structure (how you pay for the service), access to financial advice, and the overall management structure of the brokerage account in question.

Full-service brokerages generally offer comprehensive and customized financial support, often including wealth management advice, portfolio review, estate planning, and tax guidance. These firms — which include well-known names like Fidelity, Edward Jones, and Merrill Lynch — typically offer walk-in offices where clients can sit down and chat with their financial planner face-to-face.

These firms generally charge a fee of 1% to 2% of assets under management (so typically between $1,000 and $2,000 for every $100,000 managed), sometimes in addition to any commissions paid out by individual investments purchased on your behalf. Many full-service brokerages only open their doors to investors who have at least $100,000 to $250,000 in investable assets.

Discount and online brokerages don’t generally offer investment advice or other related services but will carry out buy and sell orders, usually online, at a discounted — and increasingly often commission-free — price. Because these platforms don’t typically offer access to a live person, discount and online brokers are well-suited for the investor who knows what securities they want to buy or sell and is comfortable executing and timing trades on their own. Many full-service brokerages also offer discount brokerage services — Merrill Edge, for example — but so do well-recognized online brokerage powerhouses like E-Trade and Ameritrade.

Robo-advisors like Betterment, Wealthfront, and Ellevest use computer algorithms and software modeling to step in and offer financial solutions traditionally provided by a live, in-person financial planner. In general, portfolio recommendations are determined by answers to an online questionnaire and investment options typically consist of low-cost ETFs and index-tracking mutual funds. Both investment types typically mirror the performance of particular, chosen slices of domestic or global economies (the largest 500 companies within the U.S., for example).

Account minimum requirements vary a bit with robo-advisors — from a few hundred dollars up to $5,000 or more, but these asset levels still make robo-platforms highly accessible to the everyday or cost-conscious investor. Annual management fees usually range between .25% to .40% of assets under management, but there are a few cheaper or even free options on the market.

Do I want a cash account or margin account?

Within a brokerage account, there are two account types: cash and margin. The cash account is the more straight-forward of the two. As a cash investor, you pay the full amount for the securities you buy.

With a margin account, you can use the value of the already-existing securities in your account to borrow money from your brokerage firm to buy even more securities. This is called buying on margin, which increases your buying potential but also increases investment risk, sometimes substantially.

Investing on margin can be a high-stakes game, which is why it’s a strategy that is typically only selected by investors with the highest risk tolerance.

What’s the difference between a brokerage and retirement account?

A brokerage account—sometimes called a taxable account or standard brokerage account—generally describes a non-retirement investment account and can house any number of investment securities like stocks, bonds, mutual funds, and ETFs.

Investments within a brokerage account are generally subject to short- and long-term capital gains tax (as your balance grows, you pay tax on those earnings) but they’re flexible. There are no investment limits and you can put money in or take it out whenever you want.

A retirement account, on the other hand, has more advantages but is subject to more rules. There are a few different categories of retirement accounts, and the rules are a bit different for each. Let’s take a look.

Traditional retirement accounts

These accounts, which include the well-known 401(k) and traditional individual retirement account (IRA), give investors the power to put pre-tax income to work inside a retirement account that will grow on a tax-deferred basis. In short, you’ll either contribute directly from your paycheck, before taxes are paid — for a 401(k) — or deduct the amount of your contribution when you file your annual tax return — for an IRA.

Traditional retirement accounts:

  • Are funded with pre-tax dollars
  • Grow on a tax-deferred basis
  • Are taxed as regular income when a retirement distribution is made, which is great for retirees who expect to be in a lower tax bracket at retirement

Roth retirement accounts

Roth accounts also come in both 401(k) and IRA varieties, but these options flip the retirement tax advantages on their head. That said, they are not completely unlike traditional accounts in how you deposit your money. Roth 401(k) contributions can still be deducted directly from your pay, for example.

In addition, Roth accounts:

  • Are funded with income you’ve already paid taxes on
  • Grow tax-free
  • Are not taxed when a distribution is made, which can set an investor up for a tax-free income stream at retirement

Retirement accounts have contribution limits and distribution rules

Unlike the taxable brokerage account, a retirement account is subject to limits on how much you can invest each year and when and for what reasons you can withdraw money.

In 2020, the 401(k) employee contribution limit is $19,500, or $26,000 for those aged 50 or above. The 2020 IRA limit is $6,000, $7,000 if you’re age 50 or above. All limits assume you have earned income of at least the amount contributed. IRA tax benefits are also subject to additional limitations, such as income limit and whether you’re covered by a retirement plan at work.

Then, there are the distribution rules. With a few exceptions, there is a 10% penalty for taking money from a 401k or IRA before age 59 1/2. That penalty is in addition to assessed ordinary income tax.

In short, the advantages that come with retirement accounts make them a solid first stop on your investing journey. Still, the flexibility of a taxable brokerage account — the lack of distribution rules or penalties, for example — can make a brokerage account a great complement to your retirement savings, even without the tax advantages.

Which brokerage account should I choose?

Picking a brokerage account will come down to your personal financial goals and individual priorities. Do you have an idea of your short- and long-term goals or do you need guidance? Some investors are willing to pay more for a personalized advisory service. Others prefer a less expensive, do-it-yourself type platform.

Here are the factors to consider when choosing an account:

  • Level of support: Are you looking for a financial planner who can create a fully customized, robust investment strategy, looking to place a few independent trades, or seeking a fully-automated, online platform that can set and rebalance a general investment strategy? Depending on the kind of investment decisions you need to make, you may want more or less support.
  • Pricing and fees: The more support a platform offers, the pricier it's likely to be. A brokerage with low fees is likely to offer you less advice and support.
  • Required account minimum: Novice investors don’t often have a large pool of assets to start investing with, which may make robo-advisor platforms the perfect balance between a full-service brokerage and a bare-bones discount brokerage service.
  • Your investment style: Active traders may be attracted to the low (or no) commission structure offered by discount brokerage accounts. If you’re looking to enact a long-term strategy, meanwhile, you may be better served by a full-service or robo-advisor firm.

How can I open a brokerage account?

Opening an online brokerage account is quick and easy, often taking as few as 15 minutes. Just head over to your preferred firm’s brokerage website and complete the available application. If you’d rather work with an in-person advisor, call your local office to make an appointment to set up your account in person.

Either way, here are some easy tips to help you open a brokerage account

  • Plan to make a deposit or transfer funds into your new account. Check to make sure you meet the required account minimum.
  • Choose a cash or margin account.
  • Once your transferred funds hit your account, you’re ready to start trading.

Want more than one brokerage account, so you can try a few and see which works best for you? No problem. There is no limit to the number of brokerage accounts you can hold.

The bottom line on opening a brokerage account

An investment account can be one of the most effective, efficient ways to grow wealth over time and could be a way for you to explore the stock market. No matter which type of brokerage account you choose, investing involves risk, including the potential to lose your original capital.

If you’re not ready to face the markets alone—and let’s face it, few investors are—consider a professional money manager, who can help pave your path. That’s true whether you turn to an in-person investment advisor with a customized long-term strategy or an online robo-advisor with an off-the-shelf portfolio plan that meets your investment profile.

What’s most important is that you find the right level of advice, the correct brokerage platform, and the account that ultimately works best for you and your investment objectives.

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