When youâ€™re not quite sure where life might take you â€” or what youâ€™ll need your money to do for you â€” you want flexibility. That might be one reason why a growing number of Americans are turning to the old-school brokerage account.
Unlike retirement accounts, brokerage accounts â€” also known as taxable investment accounts â€” put very few limits on your money. You can withdraw what you need, when you need it, for any reason.
That might explain why 42% of U.S. investors said they had a taxable brokerage account in 2018, up from 32% in 2010, according to a survey from Hearts & Wallets, a data research firm.
Thereâ€™s a â€œthirst for liquidity,â€ says Laura Varas, founder and chief executive of Hearts & Wallets. â€œMore and more consumers are recognizing the tension between the ability to defer taxes through accounts like 401(k)s and the need for ready access.â€
Hold on, you might be saying. Donâ€™t checking and savings accounts offer easy access to my money? Yes, they do. But even with some bank accounts paying upward of 2%, a diversified investment account has the potential to earn more.
â€œWith a taxable brokerage, consumers can often see their money grow and compound in a way that other, similar liquid accounts, like checking and saving accounts, canâ€™t match,â€ Varas says.
Is a brokerage account right for you?
Along with liquidity, brokerage accounts are easy to open. You pick an online broker or investment app, fill out a short application online and start investing. Hereâ€™s more on how to open a brokerage account
In contrast, retirement accounts have contribution limits, income phaseouts and other fine print to consider. But itâ€™s worth jumping through those hoops if youâ€™re saving for retirement, because of valuable tax benefits.
For example, 401(k)s and traditional IRAs let you defer taxes until you retire. With Roth 401(k)s and Roth IRAs, you pay taxes on your money upfront, but then your money grows tax-free. (Similarly, 529 college savings plans offer tax benefits for money set aside for college costs.)
But if youâ€™re on trackÂ saving for retirement and youâ€™ve got other goals youâ€™re working on â€” maybe a down payment for a house â€” then a brokerage account may make sense. (A brokerage account might also be useful if you want to retire early, because many retirement accounts penalize withdrawals before age 59 1/2.)
Brokerage accounts can be really beneficial for medium-term goals, says Riley Poppy, a certified financial planner and founder of Ignite Financial Planning in Seattle. â€œYou can have multiple brokerage accounts set up for different goals, and you can access the money whenever.â€
Why that time horizon? Money for a midterm goal thatâ€™s 10 or more years away could â€” dare we say should? â€” be invested at least partly in stocks or stock mutual funds for growth. And that time frame gives you the leeway to avoid selling during a steep downturn.
If youâ€™ll need your money in five years or less, consider a high-yield savings account or bank certificate of deposit, where you wonâ€™t face investment volatility.
Brokerage accounts arenâ€™t perfect
Thereâ€™s a lot to love about brokerage accounts. But thereâ€™s also a major downside: Generally, youâ€™re going to owe taxes on the investments in the account every year.
For example, if you sell an investment for a gain, youâ€™ll likely owe tax on that sale in the year you make it. You may also owe tax on any interest or dividend income in the year you receive it, even if you reinvest that money in the account.
And if the investments that your mutual fund owns have gains, you could owe tax on those gains, even if you never saw them.
â€œThat mutual fund could have had a loss that year â€” the price of the fund could have gone down â€” but internally [that fund] sold a holding, a company, at a gain, so there would be a tax hit from that sale,â€ says Eric Maldonado, a certified financial planner with Aquila Wealth Advisors in San Luis Obispo, California.
That said, while taxes can be a disadvantage, theyâ€™re not a deal-breaker because there are a number of ways to reduce your tax bill.
For example, if you own an investment for at least a year before selling it, then any gain will be taxed at long-term capital gains rates, which are substantially lower than short-term capital gains rates â€” as low as zero if youâ€™re in a low income-tax bracket.
Another strategy is to sell losing investments to offset the gains from winning ones, thus reducing your tax bill. If you have more investment losses than gains, you can deduct up to $3,000 of those losses on your tax return.
And if all of this talk about investing for growth and managing your tax bill has your head spinning, keep in mind that you can open a taxable brokerage account and have someone else manage it for you. For a relatively low fee, many of the computer-aided investment managers known as robo-advisorsÂ will help you pick the right accounts and investments for your financial situation, and theyâ€™ll help you navigate those tax strategies, too.
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Andrea Coombes is a writer at NerdWallet. Email: firstname.lastname@example.org. Twitter: @andreacoombes.
The article Why This Investment Account Is Becoming More Popular originally appeared on NerdWallet.