Opening a brokerage account is exciting. If you are a new investor, you might get overwhelmed by the paperwork and technical jargon. It’s tempting to rush through account opening to start trading. However, sometimes the impatience leads to costly mistakes. To give your investing journey a smooth start, we will show you the three common mistakes that you should avoid when opening a brokerage account.

Mistake one: failing to use IRAs

Typically, there are two types of investment accounts to choose from when you speak to a broker. The first type is a regular investment account. The second one is an Individual Retirement Arrangement (IRA) account. While a little more complex, IRAs offer savers and investors tax benefits to grow their investments faster with tax deferrals or tax-free growth. This means your investment can continue to grow and you only need to pay taxes later. If the goal of your investment is to prepare for retirement, using an IRA can help you save thousands of dollars.

What is an IRA?

An IRA is a retirement savings account that helps people meet their retirement goals. Once you reach the retirement age (59 and ½), you can start withdrawing money from your IRAs. Like other retirement accounts such as a 401k, IRAs offer investors tax benefits to help them grow their savings faster and more substantially. There are two types of IRAs you can choose from – traditional IRA and Roth IRA.

Traditional IRA

A traditional IRA allows you to make contributions to your account with your pre-tax income. This means there is no tax due on the income you put into your IRA. Moreover, the investments in your traditional IRA account will grow tax-deferred, with no tax obligation each year. The income is only taxed when you withdraw from your IRA.

The tax deferral allows you to delay your tax duties and keep the money in your portfolio to snowball to its maximum potential.

To illustrate the benefits of a traditional IRA, let’s look at an example. Mike has an annual income of $60,000 and wants to start investing. His goal is to save $250 for his retirement each month. The money he saves can have very different growths depending on the account he chooses. Let’s have a look at the two types of accounts Mike can choose from.

	Traditional IRA	Regular Investment Account
Monthly Contribution	$321	$250
Tax on Portfolio Growth	Tax-deferred	Taxed each year

While Mike can contribute $250 to a regular investment account, with a traditional IRA Mike can save $321 instead of $250. This is because IRA contributions are tax-deductible. With an annual income of $60,000, Mike has an income tax rate of 22%. The $250 post-tax income Mike contributes to his investment account is worth $321 in an IRA, because he can make the contribution without paying income taxes. Contributing $321 to a traditional IRA or $250 to an investment account have the same impact on his post-tax income. This tax benefit from IRAs gives Mike more money in his account to save and invest.

Additionally, the taxes on gains and incomes from an IRA are deferred to retirement. There is no annual tax obligation for your earnings in an IRA. On the other hand, your capital gains and incomes from an investment account will be taxed yearly. Tax deferral is a powerful advantage that allows you to keep all your money invested and growing until retirement.

Roth IRA

There is another type of IRA account with a different tax benefit, the Roth IRA. In a Roth IRA, you pay income tax on your contributions to the account. However, when you start withdrawing from your Roth IRA at retirement, all the contributions, gains, and incomes are completely tax-free! Additionally, there are more differences between a traditional IRA and a Roth IRA. You can learn more about them here.

Consequently, if your purpose is to save for retirement and you don’t need access to this money in the near future. You should first check if you are eligible for an IRA before putting money into a regular investment account. This will help you fully utilize the tax advantages to grow your money faster.

Mistake Two: investing on margin

If you are a new investor, you might be curious about what buying on margin means. Buying margin is an investment tool to buy stocks or bonds with money borrowed from your brokers. The borrowed money is called a margin loan. While buying on margin is not always a bad idea, new investors should avoid it. Here is why.

Why is buying in margin bad for new investors

Buying on margin helps people get access to a large amount of capital quickly. However, it can be a terrible choice for new investors. With margin loans, investors essentially invest with money they don’t have. Borrowing allows them to invest in larger quantities to amplify investment gains.

But it is important to remember, buying on margin also increases the potential losses.

Increased risk

Margin loans increase your investment exposure drastically. Most brokers allow investors to borrow 2-4 times of their cash investment. If you invest $1,000, you can borrow enough money to buy securities up to $4,000. Although your initial investment stays the same, your profits and losses are quadrupled. When the stock price drops by 10%, your return will drop by 40%. Margin loans significantly increase your investment risk, making bad investments extra costly.

Margin calls and liquidation

Each margin loan comes with a required maintenance margin. The maintenance margin dictates the ratio between your own money and borrowed money. For example, a 20% maintenance margin means that your own investment must be at least 20% of the total investment. When your stocks decline in value, the losses reduce your investment. If your investment falls below the maintenance margin, you will be required to give the broker additional funds.

If you don’t have more money to put in the account, your securities will be sold at market price to pay the broker. This is called liquidation. Liquidation tends to hurt investors because it often happens after a sharp decline in the market which is often the worst time for selling. Additionally, unexpected liquidation can trigger taxable events and disrupt tax planning.

High interest rates

Margin loan borrowers have to pay regular interests for the money they borrow. The interest rate charged by the brokers are high and will reduce your investment return. A high interest rate could also force investors to take on more risks than they normally would. 

To make a profit on margin, your return needs to exceed the interest rate on your margin loans. However, given the high interest rate on margin loans, most fixed income and equity investments will not be able to even cover the interest cost. Based on the information collected from online brokers, we calculated the average margin loan interests for different levels of borrowings. For a loan bellow $300k, the annual interest rate is 8.66%. That is almost five times the yield on the 10-year US treasury (1.88% December 16, 2019 ).

Amount Borrowed	$25K	$300K	$1.5M
Average Interest Rate	8.66%	7.49%	6.07%

Lose more than you put in

Although unlikely, margin investors can potentially lose more than their initial investment. Because your losses are magnified by the margin loans, you could lose all your original investment and still owe the broker money. Consequently, we highly recommend new investors to avoid investing on margin and focus on making good use of the money they have saved up.

Mistake Three: not setting up a beneficiary

For some investors, setting up a beneficiary doesn’t seem like a priority when opening a brokerage account. However, no matter how much money you have, you would want it to go to the right person just in case.

Normally when you open up a new account, your broker will ask you to set up a beneficiary. When they don’t, you should contact them to ask for a beneficiary form which allows you to name a person who will inherit your account. Setting up a beneficiary has several advantages and can help your family save money and time at the most difficult time.

With a beneficiary on record, the brokerage firm often will allow the beneficiary to take control of the account without probate and unnecessary legal procedure.

Setting up a beneficiary can help save time and legal fees for your family.

For retirement accounts, naming a beneficiary can provide huge tax benefits. Without a named beneficiary, your retirement account will go through a complicated probate process. The distribution of your retirement account is then limited to either a lump-sum distribution or a five-year distribution. This effectively shortens the distribution of your retirement account and hence heavily limits the potential growth and tax benefits associated with a 401k or an IRA.

In comparison, named beneficiaries have more options to spread out the distribution and delay the taxable events till a later date. Spouses can rollover the retirement account into their own IRA and take distribution based on their age. Non-spouse beneficiaries can stretch out the distribution based on their own life expectancy if the deceased was older than 70½. This gives your beneficiaries more flexibility to spread out the taxes over time and benefit from the continued growth of your portfolio.

Conclusion

Opening a brokerage account is an exciting beginning. It is a great step that you are taking to help secure the financial future for you and your family. By avoiding these three common mistakes, you can save unnecessary headaches later on and really maximize the potentials of your investment.