Brokerage accounts give investors access to a wide range of securities. This chapter covers the main account types eligible for trading, including:
Toward the end of the chapter, you’ll also see common account features that can be added to these registrations.
Brokerage firms generally offer two main account types: cash accounts and margin accounts.
When you borrow money to invest, you’re using leverage. Leverage can amplify both gains and losses. With a margin account, you can potentially earn more when your investments perform well, but you can also lose more when the market moves against you.
Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. You take all $10,000 to the casino and bet it on one game.
Borrowing to invest works the same way: it can increase returns, but it can also increase losses. Because of that added risk, margin accounts are only suitable for risk-tolerant investors who can withstand significant losses.
When you open a cash or margin account at a financial firm, you must choose an account registration. Registration depends on factors such as who owns the account and how it’s taxed.
An individual account is owned by one person. Individual accounts can also be registered as transfer on death (TOD) accounts, meaning the account has a named beneficiary. When a brokerage account has a beneficiary, it avoids probate and passes directly to that beneficiary.
Probate court is the legal process used to distribute assets after someone dies. If an account has no beneficiary, it’s handled through probate. Whether the decedent (the deceased person) had a will or not, the court oversees the distribution process and appoints someone to manage the estate. Probate can be complex, so many investors try to avoid it. A TOD account avoids probate and typically requires only a death certificate for the beneficiary to claim the account.
If an individual account does not have a TOD designation, it becomes part of the probate estate. To claim the account, the executor or administrator of the estate must provide court documents proving their authority. Executors and administrators are empowered by the probate court to act on behalf of the estate, pay the decedent’s debts, and distribute estate assets.
Even if someone is named as executor in a will, the probate court must officially appoint them. After the executor receives the court appointment document, they submit it to the financial firm to gain control of the decedent’s account. The executor then works to distribute the assets to the estate’s beneficiaries.
Accounts with more than one owner are joint accounts. The two primary types are joint accounts with rights of survivorship and tenants in common.
Joint with rights of survivorship (WROS) accounts provide equal ownership rights to all owners. If one owner dies, the surviving owner(s) automatically own the account. For example, if John and Stacey own a joint WROS account and John dies, Stacey becomes the sole owner. As long as at least one owner is still living, joint WROS accounts avoid probate.
Joint WROS accounts may also include a transfer on death (TOD) designation. In a joint WROS account, TOD applies only if all owners die. If that happens, the assets pass to the listed beneficiaries.
Joint accounts can also be registered as tenants in common (TIC). TIC accounts assign specific ownership percentages to each owner. If one owner dies, that owner’s percentage becomes part of their estate and is handled through probate.
For example, assume Jim owns 40% of a TIC account and Jada owns 60%. If Jada dies, her 60% becomes property of her estate and goes through probate. Jim keeps his 40% and moves it to an individual account in his name.
While all owners are alive, WROS and TIC accounts function similarly in day-to-day operations. Even if there are many owners, any one owner can submit trading instructions, receive mail, manage the account, and request withdrawals without permission from the other owners. However, any check issued from the account must include all owners’ names, regardless of who requested it.
The next few account types are fiduciary accounts. A fiduciary is a third party who oversees another person’s assets. Fiduciaries must put the client’s interests ahead of their own and act in the client’s best interest. All of the accounts in this section share that core feature.
Fiduciary accounts are governed by the Uniform Prudent Investor Act (UPIA). UPIA requires fiduciaries to invest with a holistic (big-picture) perspective. For example, if you’re managing assets for a risk-averse investor, the portfolio could still include a few aggressive investments as long as the overall structure remains conservative. Under UPIA, a fiduciary’s performance is evaluated based on the portfolio as a whole, not on one or two individual holdings.
This section covers these fiduciary registrations:
A discretionary account gives a financial professional trading authority over an account. If you don’t have the time or knowledge to manage your own brokerage account, you can grant your broker power of attorney (POA). POA allows the broker to make investment decisions on your behalf without getting your approval before each trade.
To make suitable decisions, the firm must collect suitability information from the customer. Questions related to a client’s suitability profile (such as net worth and annual income) are voluntary to answer. However, if they aren’t answered, the customer can’t receive recommendations. The same rule applies to discretionary accounts.
Discretionary accounts require additional supervision because of the authority they give financial professionals. Trades placed with discretion must be marked as “discretionary” and reviewed more frequently by principals (supervisors). All discretionary trades must be reviewed promptly after submission.
A discretionary order is one where the financial professional makes a decision for the customer about any of the following:
Asset: what security is being bought or sold
Action: if the security is being bought or sold
Amount: how many shares or units are being bought or sold
Many people remember this as the “AAA” rule. If the professional chooses the asset, action, or amount, the order is discretionary and requires POA.
Some choices can be made without POA and without treating the trade as discretionary. Both of the following may be decided without POA or discretionary status:
Price of the security
Time of the trade
A professional may choose the price and/or time and still keep the order non-discretionary, as long as the trade is completed within one day. If it takes more than one day to complete, the order becomes discretionary and requires POA.
Discretionary accounts are often marketed as wrap accounts. These accounts bundle services - typically investment management and account maintenance - into a single fee rather than charging separate commissions and service charges.
Wrap account fees are usually charged as assets under management (AUM) fees. For example, a customer with a $100,000 account would pay an annual fee of $1,000 if the wrap fee is 1% of AUM.
Wrap accounts are considered investment advisory products. Financial professionals must be properly licensed as investment adviser representatives (IAR) to sell them. If you’re planning on taking (or already have taken) the Series 65 or 66, that’s the licensing path toward becoming an IAR.
Custodial accounts are opened for minors under age 18. A custodian opens the account and manages the assets for the minor, but the assets legally belong to the minor. Custodians are typically parents, but they can be anyone. Each custodial account allows only one custodian and one minor.
To open a custodial account, you generally need the minor’s social security number (SSN), since taxes are reported under the minor’s SSN. Reporting taxes under the minor’s SSN can be beneficial because minors often have little or no reportable income.
The two types of custodial accounts are UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfer to Minors Act), named after the laws that created them.
Custodians must act in the minor’s best interest, and they also must avoid certain aggressive strategies in UGMA/UTMA accounts. Specifically, short sales*, margin, and option strategies involving unlimited risk (naked options) are prohibited due to the risk involved.
*A short sale involves the sale of borrowed securities, typically as a means of betting against that security. If the security rises in price, the investor faces unlimited loss potential.
Contributions to a custodial account are irrevocable gifts to the minor - they can’t be taken back. The custodian may withdraw funds only to pay for items that directly benefit the child*, or they may leave the assets in the account until they must be turned over at adulthood. Also, assets in a custodial account can never be transferred to a different beneficiary. Once a contribution is made, it’s the minor’s money.
*Withdrawals from custodial accounts may not be used for essential living expenses, which include food, clothing, and shelter. However, they may be spent on non-essential items that will directly benefit the child, including the cost of summer camp, a computer, a car, education expenses, etc.
When someone can’t manage their own finances, a court may appoint a guardian to oversee that person’s assets. Guardianship accounts are opened after the financial firm receives the required court appointment documents. The account owner’s assets are then placed into a guardianship account and may be managed only by the court-appointed guardian.
Similar to custodial accounts, guardianship accounts must avoid risky strategies involving short sales, margin, and option strategies with unlimited risk potential.
Now that you’ve seen the main account types, let’s look at common features that can be added.
Investment accounts can include features such as check writing, option trading abilities, margin, and cash management. The primary feature covered here is trading authorization. If an account owner wants to give a third party the authority to act on their behalf, they can grant POA.
If the POA is non-durable, it ends if the account owner becomes incapacitated. Incapacitation includes medical comas and mental incompetency. Durable POA remains in effect even if the account owner becomes incapacitated.
POA always ends when the account owner dies. At that point, control shifts to the executor or administrator of the estate. POA can also be revoked at any time by the account owner.
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