Investment Accounts

The type of brokerage account best suited for an individual investor depends on the potential use for the funds, the taxation of the account, and the strategy used in the account. Once an investor knows what assets they want to invest in, an account type is selected, such as individual, joint, or IRA.

Different accounts have different rules regarding tax liability. Stocks, options (if approved), mutual funds, ETFs, and bonds are available in most account types, and investors can apply to trade futures and forex in certain accounts.

Standard accounts

Standard or individual brokerage accounts have one owner and are not tax-advantaged. The account owner is responsible for reporting gains, losses, interest income, and dividends for each tax year.

There are no required distributions in standard individual brokerage accounts, and funds may be deposited or withdrawn from the account at any time. Typically, individual accounts are selected for investors with excess funds beyond retirement account contributions or for those who want access to the funds before retirement.

Cash accounts are brokerage accounts where the investor pays the full amount for securities purchased. Cash accounts are the most basic form of standard accounts. Cash accounts do not utilize leverage through margin. Transactions in a cash account must be settled and paid for in full on the settlement date. Cash liquidation violations, good faith violations, and freeriding are all potential violations of actively trading in a cash account.

Cash liquidation violations occur when a security is sold, and the sale proceeds are used to buy a different security purchased on a prior date. Good faith violations occur when an investor uses unsettled funds to settle a purchase. Freeriding occurs when a cash account is traded as if it were a margin account by purchasing a security with unsettled funds and then selling the security before depositing funds to pay for its purchase. 

Margin accounts are brokerage accounts where investors may borrow money from their broker to purchase securities. The account is used as collateral when borrowing funds from the broker.

Margin accounts provide increased purchasing power beyond the funds deposited in the account. This increased purchasing power is called leverage and may magnify returns, both positive and negative.

Margin accounts require an initial investment of at least $2,000 or 100% of the purchase price of the securities in the account, whichever is less. Many brokers require at least $2,000 to be deposited to open a margin account.

Under Reg T, investors may borrow up to 50% of the purchase price of equity securities that may be purchased on margin. The initial margin is the amount of margin required to initiate a trade, which is 50% under Reg T. Maintenance margin is the amount of margin that must be maintained as long as the position remains in the account. The maintenance margin is at least 25% and may be increased by the brokerage firm.

For example, $10,000 worth of stock may be purchased in a margin account with an initial deposit of $5,000 of margin. At least $2,500 must be maintained under maintenance margin requirements or the position may be liquidated or subject to a margin call.

Qualified retirement plans

Individual Retirement Arrangements (IRAs), Roth IRAs, 401(k) Plans, 403(b) Plans, SIMPLE IRA Plans, SEP Plans, and other tax-advantaged retirement plans were created to encourage saving for retirement. By deferring taxation on income or allowing earnings to grow tax-free, qualified retirement plans provide a distinct advantage over individual accounts for saving money on taxes. 

In traditional IRAs, no taxes on earnings are paid until withdrawals are made after age 59½. Contributions to traditional IRAs may be tax-deductible, and early withdrawals (before age 59 ½) are penalized. Withdrawals after 59½ are taxed at the ordinary income tax rate.

Roth IRAs are funded with after-tax contributions, and the contributions are not tax-deductible. However, Roth IRA assets grow tax-free, as earnings can be withdrawn tax-free and without penalty beginning at age 59 ½.

For example, assume Bob has contributed $3,000 per year into his traditional IRA as he saved for retirement. Bob has built up almost $500,000 in his IRA and is ready to begin making withdrawals now that he is retiring. Bob is 65 years old, and his traditional IRA withdrawals are taxed as ordinary income. If Bob had contributed to a Roth IRA instead, his withdrawals in retirement would be tax-free. 

401(k) and 403(b) plans are employer-sponsored plans and typically have traditional or Roth contribution types available.

SIMPLE IRAs are available to small businesses and allow employers to match employee contributions, and SEP IRAs are available to self-employed individuals, sole proprietorships, partnerships, and small business owners. Like traditional IRAs, SIMPLE and SEP IRA contributions are tax-deferred.

Traditional IRA contributions are generally deductible in the year the contribution is made, and income taxes are paid on distributions during retirement. Roth contributions are not deductible in the year the contribution is made, but qualified distributions are not taxable.

The primary difference between traditional and Roth accounts is when taxes are paid on the funds: traditional IRAs have pre-tax contributions, while Roth IRAs have after-tax contributions. 

When trading in a qualified retirement account, the year to year gains and losses are essentially deferred in traditional plans (no taxes are paid until distributions are taken in retirement) or tax-free in a Roth plan (taxes are paid on the fund contributions and distributions should be tax-free).

Other account types

Joint Tenants with Rights of Survivorship, or more commonly referred to as joint accounts, have two or more account owners. Each owner has an undivided interest in the account. Joint accounts may be cash accounts or margin accounts. If one account owner dies, the ownership interest is retained by the other account owner. 

Partnership Accounts are accounts where a partnership with an established partnership agreement conducts business in the account for profit. Partnership accounts are not subject to taxation because the tax liability is each partner’s responsibility based on the ownership interest in the account. Partnership accounts may be cash accounts or margin accounts. 

Custodial Accounts are accounts established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) by an adult to benefit a minor. Custodial accounts are different from trust accounts in that deposits into a custodial account are immediate and irrevocable. The custodian manages the assets within the account for the benefit of the minor until a specified age. Custodial accounts are typically cash accounts. 

Trust Accounts are accounts where the account owner transfers assets such as cash or securities to one or more recipients who hold legal title to the assets and manage the assets for the benefit of the owner or other beneficiaries. Trust accounts may be established as taxable living, revocable, irrevocable, or testamentary trusts. Trust accounts may be cash accounts or margin accounts. 

Estate accounts are accounts where an estate’s executor consolidates an estate’s assets to manage and distribute the assets, pay taxes, and cover expenses. Estate accounts are cash accounts.