Brokerage Account

A brokerage account is an account held at a broker-dealer through which an investor buys, holds and sells securities. The regulatory vocabulary differs from the marketing vocabulary and is worth knowing once, because the protections attach to the regulatory terms. The account is a securities account and the holder is a customer of the broker-dealer, and it is customer status, under rules such as the SEC's customer protection rule at 17 CFR 240.15c3-3, that determines how the assets must be held and what happens if the firm fails.

A boundary is needed at the outset, because the phrase is used two ways. Individual retirement arrangements, workplace plan accounts and other tax-advantaged accounts are also, in the ordinary sense, held at brokerages, and people naturally say they have an IRA at their brokerage. What makes those accounts behave differently is the tax wrapper Congress put around them, not the firm holding the securities. This page is about the account with no wrapper, sometimes called a taxable brokerage account or an individual account. Everything here about custody, street name and SIPC applies equally to a retirement account at the same firm; everything here about taxation does not.

The taxable account is the one with no rules, and that cuts both ways. There is no contribution limit, no income test, no age at which money becomes available or must come out, and no penalty for taking it. Nothing is deducted going in. In exchange, dividends and interest are taxable in the year received and gains are taxable in the year realised. The tax treatment is not merely the absence of a benefit, though. Long-term gains receive preferential capital gains rates, losses can offset gains, there is no restriction on what the money is used for, and assets held at death may receive a step-up in basis. A complete plan generally uses both kinds of account and decides deliberately which assets belong where.

Street name is a custody arrangement, and the precise rule is narrower than the reassuring summary. Securities are ordinarily registered in the brokerage's name and held for the customer's benefit, which is what makes transfers, dividends and corporate actions work without paper certificates. The SEC's customer protection rule at 17 CFR 240.15c3-3(b)(1) requires a broker or dealer to promptly obtain and thereafter maintain physical possession or control of all fully-paid securities and excess margin securities carried for the account of customers. Note what that covers. Fully paid securities and the portion of margin securities exceeding the firm's permitted collateral must be segregated; securities pledged as collateral against a margin loan, within the permitted limits, are treated differently and may be used by the firm. So the shorthand that "your shares are held separately from the firm's" is right for an unleveraged account and incomplete for a margin account.

SIPC is the most misunderstood thing on this page, and the misunderstanding runs in the wrong direction. SIPC states plainly that it does not protect against the decline in value of your securities and does not bail investors out when their holdings fall for any reason. It responds to the failure of a brokerage, restoring cash and securities that should have been there. It is not deposit insurance, and it does not make a bad investment good.

The $500,000 figure is quoted constantly and almost always described incorrectly. 15 USC 78fff-3(a) provides that SIPC shall advance to the trustee such moneys, not to exceed $500,000 for each customer, as may be required to satisfy claims for the amount by which the net equity of each customer exceeds his ratable share of customer property. Read that again slowly, because the structure matters. In a liquidation the customer property actually held by the failed firm is distributed to customers first. SIPC's advance fills what is left of the gap, capped at $500,000 per customer. So it is a top-up on a shortfall rather than a ceiling on recovery, and a customer with far more than $500,000 can be made whole in full when the firm's records and holdings are largely intact. Within that, cash is separately limited: an advance to satisfy a claim for cash cannot exceed the standard maximum cash advance amount, defined at 78fff-3(d) as $250,000 and adjustable under a five-yearly SIPC board review at (e) that parallels the FDIC's.

Two further provisions are worth knowing. Under 78fff-3(a)(2) a customer who holds accounts with the debtor in separate capacities is deemed to be a different customer in each capacity, which multiplies coverage in a way structurally similar to the FDIC's ownership categories, though the categories themselves are different. And under 78fff-3(a)(4) no advance is made to insiders of the failed firm, including officers, directors and holders of five percent or more of a class of its equity.

On basis, the folk wisdom misdirects. Moving a brokerage account does not lose your cost basis. IRC 6045A requires transfer statements to carry basis information for covered securities, so the information travels with the position. The line that actually matters is the covered and noncovered boundary, which turns on when the security was acquired rather than on how many times the account has moved. The depth belongs with cost basis, which is where the acquisition dates and the lot identification rules live.

Finally, titling. An ordinary individual brokerage account can usually carry a transfer-on-death designation, which passes it directly to a named beneficiary outside probate, in the same way a payable-on-death designation works on a bank account. That is a document at the brokerage rather than a provision of a will, and it overrides the will for that account.

You open the account with the firm, fund it by transfer, and place orders that the firm routes and executes. Securities are held in street name for your benefit, dividends and interest are credited, and the firm reports proceeds and, for covered securities, cost basis to you and to the IRS on Form 1099-B. Money can be added or withdrawn at any time in any amount. Tax arrives every year on the income and on whatever gains you realise.

A hypothetical example of what SIPC's $500,000 actually does, using an assumed recovery rate purely to make the mechanism visible. Suppose a brokerage fails and, after the trustee's work, the customer property on hand covers 90% of what customers are collectively owed. That 90% is an assumption of this example, not a typical figure, since real recoveries vary enormously.

A customer with $600,000 of net equity receives $540,000 as her ratable share of customer property ($600,000 × 0.90). Her shortfall is $60,000 ($600,000 − $540,000), and SIPC advances all of it, well inside the $500,000 cap.

A customer with $2,000,000 of net equity receives $1,800,000 as his ratable share ($2,000,000 × 0.90). His shortfall is $200,000, and SIPC advances all of that too, even though his account was four times the figure people describe as the coverage limit.

A customer with $6,000,000 receives $5,400,000 in customer property, a shortfall of $600,000. Here the cap binds. SIPC advances $500,000 and $100,000 is unrecovered.

The pattern is the point. The cap applies to the gap, not to the account, so quoting $500,000 as the amount protected understates the position of almost every customer and would badly misdescribe the second case. And none of it responds to the securities simply falling in value, which is the risk investors actually run.

Pros

• No contribution limit, no income eligibility test, no age rules and no penalty for taking money out, so the account fits any goal and any horizon.
• Long-term gains are taxed at preferential capital gains rates and losses can be used to offset gains.
• Full liquidity. The money is reachable without a hardship test or a plan document.
• Assets held at death may receive a step-up in basis, which is a genuine advantage a retirement account does not offer.
• A transfer-on-death designation can pass the account outside probate.

Cons

• Nothing shelters the income. Dividends and interest are taxable each year even if reinvested, and realised gains are taxed in the year of the sale.
• Trading creates tax consequences, so rebalancing inside a taxable account costs more than the same trade inside a retirement account.
• SIPC protects custody rather than value, so nothing in the account structure protects against markets falling.
• Margin borrowing changes the custody position of the securities pledged, and a margin call can force a sale at the worst possible time.
• Cost basis for older, noncovered holdings is the taxpayer's problem to document, and the records are frequently long gone.