Brokerage accounts provide investors with the opportunity to invest in a wide range of securities. We’ll discuss the various account types eligible for trading in this chapter, including:
We’ll also discuss various account features that may be added to these account types toward the end of this chapter.
When a cash or margin account is opened at a financial firm, the customer must choose a specific registration for the account. The registration is dependent on several factors, including who owns the account and how they’re taxed.
An individual account is owned by one person (obviously). Individual accounts can also be transfer on death (TOD) accounts, which are accounts with a listed beneficiary. When a beneficiary exists on a brokerage account, the account avoids probate and goes directly to the beneficiary.
Probate court involves distributing assets to surviving family and friends after someone dies. When an account lacks a beneficiary, it’s handled by the probate courts. Whether the decedent (deceased person) had a will or not, the court determines the estate distribution process and who runs it. Probate is a complicated and difficult process to go through, and many investors plan to avoid it. TOD accounts are not involved in probate and only require a death certificate to be submitted in order for the account to be claimed.
If an individual account lacks a TOD designation, it is included in probate. In order to claim the account, the executor or administrator of the estate must submit court documents that prove their status. Executors and administrators are granted the power by the probate court to act on behalf of the estate. This is the person who is responsible for paying off the debts of the decedent and distributing estate assets.
Whether a person is named as the executor in a will or not, the probate courts must officially appoint them. Once the executor receives their court appointment document, they submit it to the financial firm to gain control of the decedent’s account. From there, the executor works to distribute the assets to the beneficiaries of the estate.
Accounts with more than one owner are joint accounts. There are two primary types of 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 of the owners passes away, the remaining owners fully own the account. For example, assume John and Stacey own a joint WROS account together. If John passes away, Stacey now owns the entire account. As long as there’s a surviving owner on the account, joint WROS accounts avoid probate.
Joint WROS accounts may also have a transfer on death (TOD) designation, which only applies if all owners on the account pass away. If that were to occur, the assets would become the property of the account beneficiaries.
Joint accounts may also be set up as tenants in common (TIC) accounts. TIC accounts provide specific ownership allotments to their owners. If one of the owners passes away, their allotment goes to their estate and is handled in probate court. For example, assume Jim owns 40% of a TIC account and Jada owns 60%. If Jada were to pass away, her 60% would become the property of her estate and be handled in probate court. Jim keeps his 40% and moves it to an individual account in his name.
Regardless of the type of joint account, both WROS and TIC accounts work the same when all account owners are alive. Even if there are 15 account owners on the joint account, any one owner can submit trading instructions, receive all the mail, manage the account, and request withdrawals from the account without the permission of the other owners. However, all of the account owners’ names must appear on any check being issued, regardless of who requested the check.
The next few account types discussed in this chapter are known as fiduciary accounts. A fiduciary is a third party overseeing another person’s assets. Fiduciaries must put their client’s interests before their own and act in their best interest. All of the accounts in this section share this characteristic in common.
Fiduciary accounts are governed by the Uniform Prudent Investor Act (UPIA), which requires fiduciaries to invest assets with a holistic (big picture) perspective. For example, assume you’re managing an account for a risk-averse investor. A few aggressive investments could exist in the portfolio as long as the overall structure reflected a conservative outlook. A fiduciary’s performance is not based on one or a few investments, but on the comprehensive output of the portfolios they construct.
Additionally, the UPIA explicitly calls for fiduciaries to prioritize diversification. This involves investing in multiple asset classes (e.g., stocks, bonds, real estate) and individual securities. Diversification greatly reduces non-systematic risk, which is a risk that applies to a single investment or a small portion of the market.
We’ll discuss these fiduciary registrations in this section:
A discretionary account provides a financial professional with trading authority over an account. If you didn’t have the time or knowledge necessary to manage your own brokerage account, you could give your broker power of attorney (POA), which allows them to make investment decisions on your behalf. When a firm has POA over a customer’s account, they make investment decisions for them without prior customer approval.
In order for the firm and/or broker to make suitable decisions, customers must answer all suitability questions posed by the firm. Questions related to a client’s suitability profile (like net worth and annual income) are voluntary for customers to answer. However, if they are unanswered, the customer cannot be provided with recommendations. The same rule applies to discretionary accounts.
Discretionary accounts require added supervision due to the power they give financial professionals. If your broker has POA on your account, they have a lot of control over your financial assets. Therefore, all trades made on behalf of customers must be marked as ‘discretionary’ and must be reviewed more often by principals (supervisors). All discretionary trades must be reviewed promptly after being submitted.
A discretionary order is defined as one where the financial professional is making a decision on behalf of the customer pertaining to 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 financial professional chooses the asset, action, or amount for a trade, the order is considered discretionary and requires POA to be submitted.
Sometimes, financial professionals can make certain choices for customers and avoid the trade being considered discretionary. Both of the following can be decided without POA or discretionary status:
Price of the security
Time of the trade
Financial professionals can choose the price and/or time of a transaction without the trade being considered discretionary. Regardless, the trade must be completed within one day in order to maintain its non-discretionary status. If it takes more than one day to complete, the order reverts back to discretionary status and requires a POA.
Discretionary accounts are usually marketed to customers as “wrap” accounts. These accounts come with a list of services, which typically include asset management and general account maintenance. Instead of paying the firm for separate services and trade commissions, wrap accounts have all of their services “wrapped” up into one fee.
Wrap account fees are usually charged as asset under management (AUM) fees. For example, a customer with a $100,000 account would pay an annual fee of $1,000 if their wrap account fee was 1% of AUM.
Wrap accounts are considered investment advisory products and require financial professionals to be properly licensed as investment adviser representatives (IAR) in order to sell them. Good news - the passing this exam (in addition to the SIE and Series 7) will allow you to register as an IAR!
Custodial accounts are opened for minors under the age of 18. A custodian must open the account and manage the assets on behalf of the minor, but the assets in the account are the property of the minor. Custodians are typically parents, but technically can be anyone. Only one custodian and minor are allowed per custodial account.
If you want to open a custodial account for a child, all you need is their social security number (SSN), as all of the taxes are reported under the minor’s SSN. Reporting taxes under the minor’s SSN is a big benefit. Minors typically pay little or no taxes due to their lack of 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. The UGMA was the first version of a custodial account, which requires custodians to give control of the assets to the minor at the age of majority (usually 18 or 21 depending on the state). UTMAs were created later and allow custodians to delay the transfer of assets (up to the age of 25 depending on the state).
In addition to acting in their best interest, custodians cannot pursue some aggressive investment strategies in UGMA or UTMA accounts. In particular, short sales, margin, and option strategies involving unlimited risk (naked options and covered puts) are forbidden in custodial accounts due to the risk involved.
All gifts made to a minor’s custodial account are irrevocable, and cannot be taken back. The custodian may only take withdrawals to spend money on items that will directly benefit the child*, or they may keep the assets in the account until they must be turned over at adulthood. Additionally, the assets in a custodial account can never be transferred to another beneficiary. Bottom line - as soon as the account receives a contribution, 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 cannot manage their own finances, a court-mandated guardian may be appointed to oversee that person’s assets. Typically involving mental incapacitation or an inability to manage money, guardianship accounts are opened by financial firms when they receive proper court appointments. At that point, the account owner’s assets are placed into a guardianship account and can only be managed by the court-appointed guardian.
Similar to custodial accounts, they must avoid risky investment strategies involving short sales, margin, and option strategies with unlimited risk potential.
Now that we’ve discussed various account types, let’s discuss account features that can be added.
Investment accounts can have numerous features, including check writing, option trading abilities, margin, and cash management. The primary feature we’ll discuss in this section relates to trading authorization. If an account owner wants to provide a third party the power to act on their behalf, they can obtain a power of attorney (POA).
Limited POA allows the third party to perform account transactions, allowing the authorized person to buy and sell securities on behalf of the account owner. However, they cannot request withdrawals from the account. Full POA allows the third party to buy and sell securities as well as request withdrawals.
If the POA is non-durable, it ceases to exist if the account owner becomes incapacitated. Incapacitation includes medical comas and mental incompetency. Regardless of the reason, a non-durable POA is revoked if this occurs. Durable POA survives incapacitation and remains in effect.
POA always ceases to exist if the account owner were to pass away. At that point, the executor of the estate would take over control of the decedent’s (deceased person’s) assets. Also, POA can be revoked at any time by the account owner.
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