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Margin Trading: How Borrowing Money to Buy Stock Can Be Risky

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Once you become more comfortable with investing, it’s natural to want to take it up a notch and try to get more out of each investing dollar. One way to get more bang for your investing buck is to use margin trading.

Buying on margin allows you to invest in more shares and can expand your trading choices. Before you open a margin account, though, it’s important to understand the risks as well as the potential rewards. Here’s what you need to know.

What is margin trading?

“Buying on margin is basically using debt to fund your trades,” said David Stein, a former registered investment advisor and a podcaster at “Money For the Rest of Us.” “You get what amounts to a line of credit from your broker, including online brokerages, and use that money to make trades.”

A cash account, on the other hand, allows you to trade based only on your available funds. You either need to transfer additional money into the account or sell some of the assets in your portfolio in order to have ready cash for your next market order.

The hope with margin, Stein said, is that you’ll be able to use the capital to make good investments that will return enough to beat the interest you pay and result in larger profits than you otherwise would have. According to the Federal Reserve’s Regulation T, you can borrow up to 50% of the value of your purchase.

For example, you might see a stock you think is poised to grow quickly. You want to take advantage of the fact that you think it’s undervalued at $50 per share. You can afford to buy 100 shares ($5,000), but you’d like to be able to purchase another 50 shares. In order to make it work, you borrow $2,500 from your broker and place the market order.

“If the price does go higher, like you expect, you could repay your loan with interest and see better profits than without it,” said Stein. “But if you’re wrong, you still have to repay the loan on top of eating the losses.”

Buying on margin: the advantages

“All of my accounts are on margin by default,” said Larry Ludwig, a successful investor and the founder of popular investing education website Investor Junkie. “I use margin to make sure I have liquidity in my account and because it has other advantages.”

Some of the advantages of margin trading with stocks include:

  • Leverage: This is the advantage most people think of, according to Ludwig. “You can magnify your gains by increasing your buying power,” he said.
  • Increased access to investing options: In some cases, you can’t execute more advanced trading strategies without access to the liquidity that comes with a margin account. “With regular market orders, you have to wait for the transaction to clear before making your next move,” said Ludwig. “Margin gives you more flexibility because the capital is available to you right now.”
  • Diversify your portfolio: If your portfolio is more concentrated right now, you can use margin to purchase securities that allow you to diversify without selling any of your current assets.
  • Flexible repayment: For the most part, you can repay the margin on your own time schedule as long as you remain within the maintenance requirements.

With the ability to do more with your investing dollar, it’s no surprise that margin trading is an attractive strategy. However, before you decide to risk your money, it’s important to understand the risks as well.

Buying on margin: the risks

While you could improve your investing performance with the help of margin, there are issues with using debt to finance your investment purchases, including the following:

  • Magnified losses: The biggest risk of margin trading is the fact that your losses could be magnified. Not only do you end up with your investment losses, Stein pointed out, but you also have to repay your loan.
  • Interest on your loan: “For many individuals, it’s hard to get a good rate on your loan,” said Stein. “You might pay as high as 9%, although some brokers have better rates in the 3% to 4% range.” In order to be successful, your return needs to be enough to at least cover your interest charges.
  • Potential for a margin call: “If your stock goes down enough and you have a deficit between your cash and the value of your assets, they do a margin call,” said Ludwig. “You have to immediately come up with the difference between what you have in your account and what you owe. If you can’t, they force a sale of your assets.”
  • Lose more money than your initial investment: If you keep needing to add more capital to your account to maintain requirements and your portfolio keeps losing, you could owe more than your initial investment.

With margin trading, you could see improved profits, but your losses also could be much greater than you can afford.

“I use margin for short-term trading,” said Ludwig. “That way, I don’t have to pay as much in interest, and I can move quickly.”

Stein agreed that margin trading can make sense for some investors if they use it carefully. “For many investors, though, it’s really just not worth it,” he said. “This is especially true if you’re not going to pay it back quickly or if you can’t get a good interest rate.”

How to set up a margin account

If you decide margin trading is right for you, setting up an account is fairly straightforward. Check with your current online broker to see if it has a margin option. Many brokers that allow you to trade individual stocks also provide the ability to borrow.

Depending on the broker requirements, you might be able to open a margin account with as little as $2,000 or that much in “marginable assets.” Each brokerage has its own definition of what is “marginable,” including stocks, bonds and funds.

You also need to be aware of the maintenance margin. For example, a TD Ameritrade account that is approved to trade on margin is required to have at least $2,000 in cash or securities and at least 30% of its total value as equity. If you don’t maintain the margin required by the broker, it can make a margin call to bring you in compliance.

Should you engage in margin trading?

In the end, whether you should buy on margin depends on your risk tolerance and your plan for the money. Ludwig uses his margin account for flexibility and liquidity, keeping trades short-term to avoid high interest costs. Stein, on the other hand, doesn’t see much benefit for most individual investors, even though it works well in some cases.

Carefully consider your own situation and make sure you risk only what you can afford to lose.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Miranda Marquit
Miranda Marquit |

Miranda Marquit is a writer at MagnifyMoney. You can email Miranda here

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Investing

How to Trade Stocks for Beginners

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

Learning to trade stocks can be an excellent way to build long-term wealth. There’s a reason why the news reports on the stock market all the time — after all, it’s one of the most important parts of the economy. But if you’ve never traded stocks before, all this information can seem confusing and overwhelming. How do you even get started?

This beginner’s guide provides the basics on how to trade stocks. Whether you’re investing for the very first time or just need a refresher of the key concepts, we’ve covered them here.

What is a share of stock?

A share of stock represents a small ownership stake in the business. When a company such as Amazon or Nike needs money but doesn’t want to take out a loan, they can sell stock to investors.

When you buy a share of stock, you become a shareholder of a company — a part owner, in other words — and are entitled to a cut of the company’s profits. Some companies send cash directly to their stockholders, called a dividend payment, giving them their share of the year’s earnings.

Investors also make money by buying stocks, waiting for them to become more valuable, and then selling them. While you can buy shares of stock from a company directly, the most common way to buy and sell stocks from other investors on a stock market — also called a secondary market — like the S&P 500 or Nasdaq. When investors buy and sell shares on the stock market, it’s called trading stocks.

The price of a stock changes every day based on how people think the company will do. If its future prospects look good, the price will likely go up. If a company gets bad news, its stock price could go down.

How do you trade stocks?

  • Brokerage account: A brokerage account lets you buy and sell stocks and other investments. You can open one with online stock brokers, transfer money to your brokerage account and figure out which trades you’d like to make. This is the most do-it-yourself approach to trade stocks.
  • Mutual funds/ETFs: Rather than buying individual stocks, you could also buy mutual funds and exchange traded funds (ETFs). These are portfolios of stocks managed by a professional investor. When you buy in, you automatically get a share of a large, diverse portfolio so you don’t have to plan it together yourself.

Peter Creedon, a CFP and the CEO of Crystal Brook Advisors in New York, thinks this is a solid approach for beginners or investors with limited funds. “A person can get exposure to the 500 largest companies on the NYSE with just one fund,” said Creedon. He also recommended that beginning investors build exposure to many companies and possible sectors of the market, before going after an individual stock.

  • Financial advisor: If you’d like more help, you can also hire a financial advisor to suggest stocks or even manage the portfolio on your behalf. You’d need to pay them an additional fee for this advice. Some charge by the hour while others could charge a percentage of your portfolio, like 1% of your account balance each year.
  • Robo-advisor: Combining aspects of conventional financial advisors and brokerages, robo-advisors use computer algorithms to recommend stock portfolios based on your goals and preferences. They charge management fees, but they’re usually less expensive than hiring a financial advisor.

How do you invest with stocks?

Before you start putting money in the stock market, you need to figure out your investment goals. Some of the main factors to consider include:

  • Time horizon: How soon will you need your money back? If retirement is decades away, you can afford to take more risks with your stocks, perhaps buying stocks of smaller companies with more growth potential. But if you need money in a few years, you’d likely want to play it safer by purchasing stocks of more established companies, known as blue chips.
  • Risk tolerance: Imagine your stock portfolio lost a bunch of money today — 10%, 20%, even 50%. How would you feel? If losing money would really rattle you, it may be better to use safer stocks and even keep more money in cash or bonds. On the other hand, if you are OK dealing with short-term losses in exchange for higher future gains, you could be a better fit for riskier strategies like day trading.
  • Target return: How much do you hope to grow your money year after year? Investing is a trade-off between risk and return. If you want to earn more, you may need to take more risks and buy stocks with more growth potential, rather than proven blue chip companies. Just know that aiming for a higher return increases your chance of losing money.
  • Income needs: Do you need cash coming in from your stocks right away? Consider high-dividend stocks that pay out more now. In exchange, their price likely won’t gain value as quickly as growth stocks, which reinvest profits so the company hopefully earns even more in the future.
  • Amount to invest: What is your investment budget per year? Some brokerage accounts, funds and financial advisors require at least a minimum investment, for example, you may need at least $10,000. Your budget could determine your investment options.
  • Other investments: What are you doing with the rest of your savings? If it’s in safe places like cash or bonds, you could potentially afford to take more risk with your stock portfolio. On the other hand, if your money is in gold, real estate and other potentially riskier investments, you may want to be more conservative with your stocks.

How do you decide which stocks to buy?

With your goals in-mind, you can start reaching which stocks to buy. Now, without a crystal ball, it’s impossible to know ahead of-time which stocks will earn a great return. But there are strategies that can help you chances.

Bill Harris, a CFP® and financial advisor based in Massachusetts, recommends that you keep it simple. “Invest in companies that you know and that a third grader can understand.”

A different strategy would be to target sectors where you have specialized knowledge, because this can give you an edge versus the average investor. For example, if you have a science or medical background, you could focus on pharmaceutical stocks.

Research companies before you buy their stock

Putting in the proper research is also important as you figure out which companies will succeed in the long-haul. The internet and TV are full of financial news but Harris says don’t overlook your local library. “Most library systems have access to Valueline, CFRA and Morningstar. These companies do not make markets in securities, so their research is pure.”

Another useful strategy is to focus on diversification, also called asset allocation. This means you buy a mix of stocks and other assets so you don’t put all your eggs in one basket. For example, let’s say you buy both car and oil stocks. If the price of oil goes down, that might be bad for oil profits but could lead to customers buying more cars. As a result, your car stocks go up and balance off your oil stock losses.

Finally, you could use a stock market simulator to test your strategy without taking any risk. These tools let you virtually invest in stocks with play money, so you can see whether your ideas would be successful before you commit your actual savings.

What’s the difference between day trading and investing?

As you figure out your strategy, you need to decide whether you’d like to day trade or invest for the long-term. Day trading means you’re buying and selling stocks frequently throughout the day based on the most recent news. Investing in stocks takes a longer-term horizon and you’re buying stocks and holding them for months, even years.

While day trading may seem more interesting, it does have its downsides. Each time you buy or sell a stock, you need to pay trading fees. You could also owe higher income taxes on your stocks, as the IRS charges a higher tax rate on short-term gains, stocks that you sell within a year of buying. Not to mention, you’re also trying to outmaneuver all of Wall Street. As a result, making money with day trading can be stressful and challenging.

Investing may be a better strategy

The financial advisors we spoke with for this article all came out in favor of investing as a more profitable strategy. “Too many people hear a hot tip, jump in, and check the stock every five minutes. My mantra is ‘Become the owner of a company, not a trader’,” said Harris.

Harris also recommends patience with your picks and that you shouldn’t sell at the first hint of bad news. “I commit to staying invested in each position for at least one year. One year from now before I even look at the stock performance, I will make the decision if I still feel the same way about industry and that company.  At that point, I will either sell or buy more.”

Where can you get help buying stocks?

If investing in the stock market for the first time seems intimidating, well that’s because it can be. There’s a ton of information to learn, especially if you try to do everything by yourself. As a beginner, consider getting some help with your first trades. Whether it’s working with a live financial advisor, a professionally mutual fund/ETF or even a robo-advisor, all these methods would get you started on the right foot.

“For beginners, I would recommend they hire a certified financial planner to prepare a financial plan, understand their risk profile and set up an overall target allocation,” suggests Clark Randall, CFP and founder of Financial Enlightenment based in Texas.  “After the planning phase, they can either invest themselves or hire the planner to implement the recommendations.”

Learning how to trade stocks takes some work, but the returns could be well worth it. Between the information in this guide and the support of a professional advisor, you can feel confident about investing in stocks, even as a beginner.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

David Rodeck
David Rodeck |

David Rodeck is a writer at MagnifyMoney. You can email David here

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Investing

Everything You Need to Know about Spousal IRAs

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

A spousal IRA is an investment strategy used by married couples to save for retirement. There is no separate type of individual retirement account called a “spousal IRA” — rather, it’s just a traditional IRA for a married person who isn’t earning an income. IRS rules allow spouses who aren’t earning income, for whatever reason, to still use the tax advantages of saving and investing money in an IRA to accumulate a nest egg for retirement.

What is a spousal IRA?

The IRS requires individuals to report annual income in order to fund an IRA — with the exception of a spouse who isn’t earning an income, but is married to someone who is. If both partners in the marriage file taxes jointly, the IRS lets each partner have their own IRA. Married couples who file taxes separately are not eligible for the spousal IRAs approach.

According to Janice M. Cackowski, a financial advisor with providence Wealth Partners in Ohio, the IRS looks at married couples who file jointly as one entity, and their combined income as one figure, so spousal IRAs allow them to put away twice as much.

“Spousal IRAs are terrific tools when one spouse is employed and the other is not,” said Cackowski. “It allows the spouse who is earning wages to deposit them an IRA for the benefit of the non-working spouse, essentially allowing each spouse to maximize their retirement savings.”

Basic spousal IRA rules

  • The tax filing status of the couple must be “married filing jointly”
  • The married couple does not co-own a spousal IRA — it is owned by and held in the name of the non-working spouse
  • Spousal IRA can be a Traditional IRA or a Roth IRA
  • There is no longer an age limit for making contributions to a Traditional IRA, so you may keep adding money after age 70 ½, as has always been the case with a Roth IRA

Like any other IRA, married people making use of a spousal IRA strategy contribute funds to their separate accounts and invest the funds in stocks, bonds, CDs and other assets. Interest accumulates over the years, and the account grows either tax-free or tax-deferred (more on this in a bit).

For example, if you contribute $6,000 a year to your IRA starting at age 30 until you retire at age 65, the sum would grow to more than $700,000, assuming a 6% annual rate of return. This figure doesn’t account for taxes (so it’s not entirely exact), but it does show how the power of compound interest can work in your favor over time.

What are your spousal IRAs options?

Your spousal IRA can be either a Traditional IRA or a Roth IRA. The rules and contribution limits for spousal IRAs are no different than conventional versions of either account. Remember, the difference between a Roth IRA and a Traditional IRA comes down to when you can reap the tax benefits of each option, and Traditional IRAs may provide tax deduction benefits.

  • Traditional IRA: Contributions to a Traditional IRA are made before you pay income tax. As such, you end up paying income taxes on all withdrawals — principal and interest earned — when you withdraw funds in retirement.
  • Roth IRA: Contributions to a Roth IRA are made after you pay income taxes. Since you’ve already paid taxes upfront, money you withdraw in retirement is tax free.

Which should you choose? In general, if you’re in a lower tax bracket now than you expect to be when you retire, then a Roth IRA may be more beneficial, as you may save money on taxes down the road. This decision is unique in each situation.

Spousal IRA contribution and income limits

For 2020, the annual contribution limits for both Traditional IRAs and Roth IRAs is $6,000, or $7,000 if you’re 50 or older. This is the core benefit of a spousal IRA: A married couple can potentially sock away a total of $12,000 into their IRAs.

There is no income threshold for contributing to a traditional IRA, while the limit for contributing to Roth IRAs is $206,000 for married couples filing jointly. Also, In addition, for both Roth IRAs and Traditional IRAs, the married couple must have taxable income that is equal to or greater than the total amount contributed to their IRAs.

Spousal IRA tax deductions

Couples can deduct their contributions to a Traditional IRA from their taxes, depending on two factors. The income tax deduction is reduced or eliminated entirely depending on the couple’s total income, or the earning spouse’s participation in an employer-sponsored retirement plan.

If the spouse who works is covered by their employer’s retirement plan, the Traditional IRA income tax deduction is phased out when the couple’s income falls between $104,000 and $124,000. Incomes above $124,000 get no tax deduction.

However, if the spouse does not participate in an employer-sponsored retirement plan, the deduction phases out at an income level of $196,000, and is eliminated after income hits $206,000. There are also tax credits available — the Saver’s Credit — for married couples filing jointly who earn less than $65,000 a year.

Spousal IRA withdrawals

Because IRA funds are intended for use in retirement, withdrawing them before that time often comes with a penalty. For traditional IRAs, there’s a 10% penalty if you withdraw funds before age 59 ½, and you also must pay taxes on the money you withdraw. For Roth IRAs, you can withdraw the funds you contributed at any time penalty free, since you already paid taxes on them up front, but you’ll pay a 10% penalty on any earnings if you with withdraw them sooner than five years after the account was opened or before age 59 ½ (whichever is longer).

For both traditional and Roth IRAs, there are some exceptions to early withdrawal penalties for things including death, disabilities and a first-time home purchase.

Who should consider a spousal IRA?

Any family with a non-working spouse and disposal income for long-term savings that is looking to increase their retirement nest egg should consider a spousal IRA as a potential option.

According to Michelle Buonincontri, an Arizona-based certified financial planner and certified divorce financial analyst, spousal IRAs help protect the non-working spouse in the case their happily ever after doesn’t end quite so happily.

“Let’s face it, with 50% or more of first marriages ending in divorce, spousal IRAs are a great way to level the playing field by having retirement assets in the name of the spouse that does not have access to a retirement plan if a couple ever find themselves in a divorce situation,” she said.

Although retirement assets accumulated during the marriage are usually considered marital assets, Buonincontri suggested that “folks seem less emotional about letting the other spouse keep accounts titled in their own name and less tense during the marital settlement negotiation process.”

Spousal IRAs aren’t for all couples

This doesn’t mean contributing to a spousal IRA is right for every couple, however. While spousal IRAs are generally a positive investment, people need to take a hard look at their financial situation to make sure funds won’t be needed elsewhere.

Diane Pearson, a certified financial planner with Pearson Financial Planning in Pittsburgh, Penn., noted that a spousal IRA isn’t always the first move couples should make with disposable income.

She advised that couples should build their emergency fund and general savings before opting for a spousal IRA. Savers don’t want to set themselves up for additional taxes or early withdrawal tax penalties if they end up needing to pull funds out of an IRA to pay for near-term emergencies or a child’s education before age 59 1/2.

“Every situation is obviously different, but if an employer is offering the working spouse a match to a qualified retirement plan, and the individual instead decides to use their income to fund their non-working spouse’s IRA, they may be missing out on the employer’s matching contribution,” said Pearson.

How to open a spousal IRA

As we noted in the introduction, a spousal IRA is a strategy, not a distinct type of individual retirement account. Whether you choose to set up your spousal IRA as a Traditional IRA or a Roth IRA, you can do so through most banks, brokerage and wealth management firms, as well as robo-advisors.

For more help determining which might be best for your IRA needs, visit our list of the best IRA account providers, and the best robo-advisors.

How hands-on you want to be when it comes to managing your IRA will help you decide which route to go. While some providers will do all the work for you, you’ll pay for that help in the form of management fees, other brokers give you complete control over your portfolio and you save on fees.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Julie Ryan Evans
Julie Ryan Evans |

Julie Ryan Evans is a writer at MagnifyMoney. You can email Julie here