Once you get your financial house in order, and are consuming personal finance blogs and books at a rate that practically ensures that you are violating one of the seven deadly sins, it is only a matter of time before you decide that you are going to have to open a taxable brokerage account.
“Invest in passive index funds!”, they’ll say.
“Automatically transfer x% of your paycheck to a brokerage account every month”, they’ll advise.
“Read JL Collins’ most excellent stock series!”, they’ll yell, encouragingly.
All of this is very good advice. However, none of them will tell you exactly how to go about opening a taxable brokerage account and make your first investment. Until now.
This is step-by-step guide to opening a taxable brokerage account. Every step will include
- A cheat sheet. If you want to blaze through the process like the roadrunner, use the cheat sheet.
- A details section. This will contain the gnarly details of that particular step. This section is helpful for those of you disdainful of the cheat sheet, determined to make it on your own.
- The references section will point to resources you might find useful to complete the step. Reading these links and then randomly quoting from them is guaranteed to make you the life and soul of any party.
Without further ado, I present
Step 1: Pick a Home for your Investments
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” – Robert G. Allen
The cheat sheet
This is the investment firm at which you will be opening your taxable brokerage account. You want to pick a firm that has the following properties:
- Has good index fund offerings with minuscule expense ratios.
- Does not stiff you on various fees. Things to look for are account service fees, purchase/redemption fees, front/back end loads and sales commissions.
- Has a good online interface.
- Offers good over the phone support.
Vanguard and Fidelity are both excellent choices. I have heard it said, but have no personal experience in the area, that Fidelity has a better website, and that their customer service over the phone is better than Vanguard. On the other hand, Mr. BITA has actually enjoyed a phone call with Vanguard, which is rare and special.
- A comparison of online brokerages in the United States.
- What makes Vanguard unique? Find out why your interests and those of Vanguard are exactly the same.
Step 2: Pick Your Asset Allocation
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson
The cheat sheet
Your asset allocation will be based on the Two Fund Portfolio. 80% in stocks. 20% in bonds.
Wikipedia defines asset allocation as the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. Examples of some asset classes include U.S. domestic stocks, international stocks, bonds (of various varieties), Real Estate Investment Trusts (REITs).
The Lazy Portfolios link in the references section is a wonderful resource to read about all sorts of asset allocations, ranging from the most basic two fund portfolio to others that hold nine different asset classes.
This is going to be the hardest step in this guide. On the other hand, if you already have money stashed away in your tax-advantaged accounts (your 401k, IRAs etc.), you probably already have your asset allocation figured out. And if you’re not maxing out your tax-advantaged accounts, stop right here first.
The thing to remember is that your taxable brokerage account isn’t your only account, and your asset allocation is a property of all your accounts. You can maintain your asset allocation in two ways. Maintain your chosen asset allocation within each account or across all accounts. Here is an example:
- You have a 401k and a taxable brokerage account. Your chosen asset allocation is 80% stock and 20% bonds.
- You have $40,000 in your 401k and $20,000 in your taxable account.
- If you were maintaining asset allocation within each account, in your 401k you would have $32,000 in stocks and $8,000 in bonds. In your taxable brokerage account you would have $16,000 in stocks and $4,000 in bonds.
- If you were maintaining asset allocation across your accounts, you would have $12,000 in bonds in your 401k, $28,000 in stocks in your 401k and $20,000 in stocks in your taxable accounts.
While it might be easier to maintain asset allocation within each account than across them all, it is rarely advantageous. What are the advantages of maintaining asset allocation across all your accounts?
- You can use tax efficient placement of funds to reduce your taxable income. e.g. if you hold any REITs as part of your portfolio, it is much more efficient to hold them in a tax-advantaged account because most income generated by such an asset class is taxed at a pretty high rate. There is a link in the references section that talks about each asset class and its optimal placement.
- Not all accounts are created equal. If your taxable account is with Vanguard, you have the choice of some of the best-in-class funds the market has to offer. With a 401k though, you are at the mercy of the fund house that your employer has chosen and you may not have access to good or even reasonable funds in every one of your asset classes. Maintaining asset allocation across accounts allows you to choose the best-in-class that every account has to offer.
- Some funds offer lower expense ratios once you have a minimum of $X in that fund. If you maintain your asset allocation within each account you will have to earn that minimum multiple times to qualify for the lower rates.
The references section provides a resource that delves into how to maintain asset allocation across different accounts in detail (with flow charts!).
- Bogleheads wikipedia on asset allocation
- Lazy portfolios
- JL Collins’ asset allocation
- How to maintain asset allocation across accounts
- Bogleheads wikipedia on tax efficient fund placement
- The case for an asset allocation of 100% stocks
Step 3: Pick Your Funds
“Don’t look for the needle in the haystack. Just buy the haystack!” – John Bogle
The cheat sheet
Your two funds will be VTSMX (total stock market) and VBMFX (total bond market). Both require a minimum investment of $3000 dollars, so you will need to save at least that much before you proceed to step 4.
Once you pick your funds based on what your investment house has available, what matches your desired asset allocation, and what has the lowest expense ratios, turn your attention to the following aspect of the fund:
What is the minimum required investment amount? For most vanguard funds it is $3000. Vanguard offers what they call admiral versions of some funds if you have $10,000 in that fund. E.g. VTSMX has an expense ratio of .16%. The admiral version of the same fund is called VTSAX, and the expense ratio drops down to 0.05%. You can always start with VTSMX and when your account accumulates the required amount Vanguard will automatically upgrade you to the admiral version of the fund.
Step 4: Open the account
“The four most dangerous words in investing are: ‘this time it’s different.'” – Sir John Templeton
The cheat sheet
You will next be asked if you already have an online account with Vanguard. Let’s assume that you do not.
This screenshot shows you all the steps you’re going to go through to open your account. Look over the first two columns carefully and keep this information on hand before you actually get started.
When you complete this step you will have a Vanguard taxable brokerage account set up. This account will be linked to your bank account (checking or savings, whatever you chose) so that you can transfer money from your bank account to your Vanguard account. At the end of this step you should also have set up online access to your Vanguard account. Choose a secure password (long, random, peppered with numbers and special characters).
If you use a smartphone now is also a good time to install the Vanguard app on your phone.
You don’t have to open an account online. You can call the investment house of your choice and they will help you do it over the phone. Use the screenshots above as a guide for the information you will need to have handy when you call.
Once you have a bank account linked to your brokerage account, you can transfer money into your brokerage account. Transferring the money doesn’t mean that you have made an investment. You then have to execute a buy order and we will cover that next.
Step 5: Execute your first buy order
“If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.” – Warren Buffet
The cheat sheet
Start with the option to buy Vanguard funds.
Next, type in the name of the fund you want to purchase.
Then enter the amount of your purchase.
Repeat this for every fund you want to buy based on your asset allocation in your taxable brokerage account.
And the last step, choose the source of your funds.
The choices are pretty self-evident. If, when creating your account in step 4 you linked your bank account to your Vanguard account, this would be the easiest source of money to buy your funds.
Always check the capital gains and dividend distribution dates before buying mutual funds. Avoid buying a fund just before these dates as you will end up paying tax on the gains, without actually having benefitted from the gains. An example to illustrate this point: imagine an index fund with a purchase price of $19. A dividend is declared for some stocks held by this fund. The fund collects the dividends (say totalling $1), and will eventually pass these dividends on to you, the owner of the index funds, on certain pre-defined dates. The dividend will now be priced into the fund. So the Net Asset Value (NAV a.k.a. price per share) of the fund will now be $20. Eventually, the dividend payout date will roll around, $1 will be given to you and the NAV of the fund will drop back down to $19 and you will owe tax on the $1 (even if you reinvest it). So you typically don’t make money on the day of the dividend payout – the value of your account remains the same before and after (i.e. price of fund + dividend remains constant). So, if you have $1000 to invest, and you invest it on the day before the dividend payout, you will be buying into the fund at a NAV of $20, so you will get 50 shares. The next day you will get a dividend payout of $50, and the value of your fund will drop to $19 * 50 = $950. You will reinvest the $50, but after you pay the taxes you owe on that $50, you’ve actually only reinvested $34 (assuming a 28% tax rate). So now instead of having $1000 in the fund, you have $984. If you had waited until after the payout to invest your $1000, you would have the entire amount invested.
- Why you should not buy the dividend
Step 6: Set up an automatic investing schedule
“Time is your friend; impulse is your enemy.” – Jack Bogle
The cheat sheet
Log in to your Vanguard account and choose the ‘Account maintenance’ option.
Within account maintenance, choose Automatic Investment.
You will now choose the source of funds, how often you want to invest, etc. Vanguard shows you a list of all the funds you are invested in and their current balances. You can choose how much you want to invest in each of those funds automatically.
Setting up an automatic investment schedule is important if you need to get into the habit of paying yourself first. This is especially useful if you are new to saving and your spending muscle is still significantly stronger than your savings muscle. You can’t spend what you don’t have, so pay yourself first. Periodic investing also ensures that you make the most of your money. Your money goes to work for you as soon as you have it and doesn’t spend months lying idly around, accomplishing nothing at all.
One topic worth investigating further, now that you have everything all set up to invest automatically, is how you will deal with a sudden influx of money. This could be because of a giant bonus, an inheritance, any number of things really. Commonly held wisdom is that Dollar Cost Averaging (DCA) is the way to approach a large chunk of money. Simply stated DCA dictates that you gradually invest a windfall over a period of months and therefore hedge against losing all your money if the market dips immediately after you invest. Not everyone believes in DCA though. I’ve included some interesting links on the subject in the references section – so read up and be prepared for a windfall should one occur.
Congratulations! You are the proud owner of a shiny new brokerage account. Your dollars are hard at work and you can sit back and enjoy the ride to the two comma club.
Disclaimer: Ugh. Do I have to really say this? I am a random person on the internet with no special expertise in investing, taxation, or anything else I may have mentioned in this post. Don’t be lazy. Do your own research. And no, you don’t get to blame me if things go horribly wrong.