Importance of a brokerage account: Fifth in a series of financial tools to master

 

Looking up stocks!

Welcome back!  This post will cover brokerage accounts, which is the fifth topic in a series of financial tools to master.  Brokerage accounts are used by many early retirees of the FIRE (financial independence retire early) movement to get them by until the official retirement age of 59 1/2.  Sometimes it’s used exclusively as their only retirement vehicle. 

If you’ve missed any of the previous posts on ‘financial tools to master’ series, please see the links at the bottom of this page.

What are brokerage accounts?

A brokerage account is an investment account that allows you to buy and sell things like stocks, bonds, mutual funds, money market funds, etc.  There are many brokerages like Charles Schwab, Fidelity, TD Ameritrade, Vanguard, E-Trade, Robinhood, etc., that you can choose.

You can’t go wrong with any of them, but I would recommend researching these to figure out what works for you.  I recommend ‘discount brokerage firms’ like Charles Schwab, Fidelity, etc., as their fees are usually lower than so called full service brokerage firms.  Fees such as sales loads (fee to buy and sell), brokerage fee (to maintain your account), transaction fees (selling of stocks or mutual funds), etc., can eat into your money.  Many discount brokerage firms waive most if not all of these fees.  Be sure to confirm these things before choosing one.  *Many of these discount brokerage firms also provide full services like retirement services, tutorials, performance analysis, etc.  

Why do I need a brokerage account?

Because most early retirees typically have money tied up in retirement accounts like the 401k, they need money to live on until they turn 59 1/2 years of age (or later), to avoid paying early withdrawal penalty of 10%.  There are always exceptions to this rule, in that some FIRE movement adherents have been known to withdraw money solely from their retirement accounts (if that’s the only retirement vehicle), even if they’re paying the early withdrawal penalty.  

In cases where you have most net worth tied up in retirement accounts, brokerage accounts will perform this task well.  

For someone that has an IRA / Roth IRA, but not a 401k, the yearly allowable amount to save into that is limited at either $6,000 or $7,000 (if over 50).  For these individuals, brokerage accounts will provide a way to save more money after maxing out the IRA / Roth IRA.  

What type of investments should I buy for this brokerage account?

Many FIRE movement followers are buying simple S&P 500 index funds, which have returned about 10% yearly.  These are easy to understand as you won’t need to do any reallocating of your investment choices.  You’re simply buying shares of every company that’s in an index.

The power of index funds has been well documented.  Warren Buffett, the Oracle of Omaha, who is one of the most revered investors of our time, made a bet with the hedge fund industry of $1 million dollars in 2008 to see whether index funds or their funds would come out ahead in 10 years.  One company, Protege Partners LLC accepted the challenge, but they conceded defeat in 2015, two years ahead of the 10 year mark.

The advantage of an index fund is also their low expense ratios compared to other mutual funds.  Generally an index fund would have an expense ratio of around .02% to .2% while actively managed funds may be around .5% to .75% range.  

The expense ratio difference may not look like much in the beginning, but if you calculate that over 30+ years, it will be a hefty sum.  See these examples below:

1. Starting from $0 dollars, saving $12,000 per year, looking at 30 year timeframe, returning 8% per year, with expense ratio of .05% will end up costing $14000+ in fees.
2. The same scenario above, but now has .75% expense ratio will end up costing $196,000+ in fees.

This is over $182,000+ difference!

Choosing the right investments for your retirement is something you should seriously think about.  Consider your tolerance for risk and your timeframe.  Research different investment options, consult with professionals when needed, then make your decision. 

As mentioned above, you can’t go wrong with buying index funds for majority of your money, then having a year or two years expenses in a savings account just in case stock market is in a downturn.  (Or a ‘bear market’, where stocks drop about 20% or more from their peak.) *This strategy is the more common method for FIRE movement followers.

If you don’t like all your money in stocks, you can consider other strategies like buying 60% stock index funds and 40% bond index funds, which is another popular asset allocation strategy.  

Once again, be comfortable with your decision.  If you feel uneasy buying stock index funds, you can buy mostly bond funds like municipal bond mutual funds, which are tax exempt (federal tax exempt usually, may be state or local tax exempt depending on what you buy).  Always seek help from a professional (your brokerage firm for example) as needed.

Tip:  Know stocks are the most volatile type of assets while bonds are less volatile.  The key here is your timeframe.  If you only have 5 years before you retire, then you would invest more conservatively vs someone who has 20 years before retiring.  Stocks over long term have always done well...

How to open a brokerage account:

• Google ‘discount brokerage firms’ then select the one you like.  In this example below, I’m choosing Charles Schwab.  Click ‘Open an Account’.

• Select the type of account:  individual or joint

• You’ll need your social security number and employer info

• Once you complete the application, you’ll need to fund the account from your checking account or savings account.  After that, select the investment option(s).  Don’t forget, you can always get help from the brokerage firm if you have questions about any of these.  

In conclusion:

Opening a brokerage account may work for someone who has funds tied up mostly in a retirement account.  In cases where retiree does not have any retirement account, then brokerage account is the only option.  

In the scenario where you have majority of your funds tied up in retirement accounts, then you would keep the retirement account as it is, so it can continue to grow until you’re withdrawing money out of it at 59 1/2 or later.

Like most things in life, there is no one size fits all.  There are different ways to do the same thing.  While majority of FIRE movement followers are using investment vehicles like the 401k, there are many others who are doing it differently.  Some may use real estate and brokerage account while others may use a combination of real estate, brokerage account, and a retirement account.  

Whatever works for you, is usually the right answer!

*Disclaimer:  Everyone’s situation is different.  Please use this post as an informational purposes as it may or may not describe your situation.  Always get help from various sources and seek professional help as needed.

Thank you all for reading!

Jake

Wandering Money Pig 

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