Investing - Part X

Choosing the right account

OK. This is the tenth and final part of my four part series on investing basics. This time, we're going to focus on making the right account type selection.

How hard can it be? You go and open an account with whatever broker you chose after going through the questions, right?

But do you open a brokerage account, a margin account, an options account, an asset management account, an IRA, a Roth IRA, a 401k...which choice is the right one?

Depends on what you're looking to achieve in your investing. Are you looking for maximum flexibility and nearly immediate access to your money? Are you looking to defer some taxes and are willing to give up penalty free access to the money? What kind of trading are you looking to do in the account? These are all factors in deciding which type of account to open.

For most people, one of the most important factors in deciding which type of account to open first will be whether or not your employer has a 401k with matching. If they do, and you're not maximizing the portion that they match, putting extra money in the 401k needs to be a top priority. The matching money - it's free money. Take advantage of it!

Once you're sure that you're not leaving any free money on the table, then we can look at opening an actual account with a broker. First question needs to be: why am I investing this money? Is it for retirement? Is it for a new home purchase? Is it for a vacation? What is my reason?

If your reason is retirement (or a down payment on a house) then an IRA account will probably be the best way to go. IRAs have a few advantages, and a couple of significant restrictions.

First, your money in an IRA will grow either tax deferred, in the case of a Traditional IRA, or tax free, in the case of a Roth IRA. With a Traditional IRA you also get to deduct the contribution from your income for this year (but you have to pay taxes on everything as ordinary income when you take it out). A Roth IRA is funded with after tax money, but as long as you wait until 59 1/2, you can take it out tax free - plus with a Roth you can always take out your contributions with no penalty because the money was already taxed.

With any IRA account, to reap the full benefit of the account, you need to leave the money in until age 59 1/2 (it can also be used the fund a portion of a first time home purchase with no penalty, as well as a few other oddball penalty exceptions that are almost never used). If it is taken out early it will be subject to a 10% penalty, on top of any other taxes that may become due on the funds.

Also, IRA accounts have other, special rules. For instance there is virtually no options trading allowed in IRAs, only covered calls (or protective puts - see CBOE.com for more information on these strategies). There is also no margin allowed in IRAs. And finally they are all Cash Up Front or CUF, meaning that the money has to be in the account before a purchase can be made. There are no extensions available in IRA accounts.

If for you're investing for most any other reason, or if you want to trade options (or short stock - ie: borrow it to sell and buy back later for less) then you'll probably want to look into a standard, taxable brokerage account. Regular brokerage accounts come in several different flavors, which represent different features and trading possibilities.

You really have three main features on brokerage accounts: margin accounts, asset management accounts, and option accounts. Your account may have any combination of these features, none of them or all of them. But why would you want them?

The margin account feature is the most common for an account. Essentially it lets you borrow money against your existing stock or you can borrow stock from others to short. Margin is the one feature that brokerage firms are the most loose with and is also the most dangerous. Margin calls (a condition where your ownership in the account is less than the company or the NYSE requires) can and have wiped out entire fortunes. If you're not careful, you can end up with nothing except a debt to the brokerage firm. Make absolutely sure that you understand the firm's rules for margin before adding or using this feature on your account.

The asset management feature is really the brokerage industry's first foray into the banking world. Essentially they give you checks and a VISA/MasterCard debit card for easy access to the money in your account. Usually the free cash balance in these accounts will be interest bearing (although not much interest), giving them a slight advantage over traditional bank checking accounts. There are disadvantages in most cases. Most brokerage firms don't accept cash. Branches are usually only one or two per town. Checks, from anyone - including major corporations, are usually held for up to a week before the funds are cleared. Make sure to check into fees, minimums and restrictions before making any decisions about this type of account at your firm.

Finally is the options account. This is basically the additional qualifying that the firm is required to perform before allowing you to trade options at their firm. Differing levels of experience and financial resources will allow for different trading strategies. Usually riskier strategies will require more experience and resources. Firms have put this in place as options do have additional risk involved and they want to make absolutely sure that they are covered from liability in case you manage to make a mistake. Check with your broker and find out what exactly their requirements are and what you can do at the different levels of approval.

Selecting the right type of account for your investing really isn't all that difficult, but it is very important to do it right. Take some time to research your different options and their various fees and restrictions. Also look at the fee waivers that might be available from your firm. Then with your goal and strategies in mind, the right account will usually present itself.