Investing Archives | Page 24 of 191

Nov

2024

The 5498 Tax Form Explained

By Rebecca Lake | invest, Investing, Preparing for Retirement | Comments Off

IRS Form 5498 is used to report IRA contributions to the IRS. The financial institution (often referred to as the trustee or custodian) that manages your IRA should send a 5498 tax form to the IRS on your behalf each year that you make contributions. They’ll send a copy of the form to you as well.

This form is designed to be informational for taxpayers and you don’t need to file a copy of it with your tax return. However, it’s helpful to know how to read IRS Form 5498 if you’re using it to keep track of your annual IRA contributions.

Key Points

• IRS Form 5498 reports IRA contributions, rollovers, conversions, and recharacterizations to the IRS.

• IRA custodians or trustees must file Form 5498 with the IRS by May 31 following the contribution year.

• For taxpayers, the form is informational only, and does not need to be filed with their tax returns.

• Taxpayers should receive a copy of Form 5498 from their IRA custodian and keep it for their records.

• IRS contribution amounts listed on the 5498 form should be compared with the contribution amounts the taxpayer reported on their tax return, and if there are any mistakes, a corrected form should be requested.

What Is IRS Form 5498?

IRS Form 5498, IRA Contribution Information is an official tax form that’s used to report individual retirement account contributions to the IRS. This form is issued by your IRA trustee or custodian and is sent directly to the IRS each year that you make contributions to your account.

You’ll also receive a copy of your Form 5498 in the mail, but the form is purely informational. You won’t need to file it with your federal or state tax returns. However, it’s a good idea to keep a copy of it with your tax records for the year.

💡 Need a refresher? Check out our guide: What Is an IRA?

What Does Form 5498 Cover?

A 5498 tax form is used to report information about the annual contributions you make to your IRAs, including traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs. You should get one form from each IRA custodian that you have accounts with. You may also be issued a Form 5498 for certain other transactions that are IRA-related, such as rollovers and required minimum distributions (RMDs).

Your IRA custodian or trustee must file Form 5498 with the IRS by May 31 following the year in which the contributions were made.

IRA Contributions

The 5498 tax form is used to report IRA contributions. The information is recorded in different boxes on the form, depending on the type of contribution it is.

• Box 1: IRA contributions

• Box 8: SEP IRA contributions

• Box 9: SIMPLE IRA contributions

• Box 10: Roth IRA contributions

When you receive your 5498 tax form, it’s a good idea to compare the contribution amounts listed there to the amounts you reported on your tax return. If you spot any errors, you can reach out to your IRA custodian to request a corrected form.

Form 5498 records both deductible and non-deductible IRA contributions. If you’re using a Roth IRA to save for retirement, for example, tax deduction rules don’t allow you to write off those contributions. But you’ll still get a 5498 tax form showing what you contributed for the year.

¹Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

Type of IRA

As mentioned, Form 5498 reports contributions to different types of IRAs. So, you may receive this form if you make contributions to any of the following:

• Traditional IRA

• Roth IRA

• SEP IRA (Simplified Employee Pension)

• SIMPLE IRA

Box 7 of Form 5498 will identify the plan type that contributions are being reported for. You won’t see any contributions to other types of retirement plans, such as a 401(k) or 403(b), listed here.

Contributions to taxable accounts are not reported on Form 5498 either.

Conversions, Rollovers, and Recharacterizations

If you convert traditional IRA assets to a Roth account, roll over funds from one account to another, or recharacterize IRA contributions — which is the transfer of contributions plus any earnings from one IRA to another — you can expect to receive a Form 5498 reporting those transactions.

Here’s where those amounts will be listed on your form:

• Box 2: Rollover contributions

• Box 3: Roth IRA conversion amount

• Box 4: Recharacterized contributions

You’ll also see information about the fair market value (FMV) of the account listed in Box 5. If applicable, Box 6 notes any life insurance cost included in Box 1.

In terms of the difference between a rollover IRA vs. traditional IRA, a rollover is simply the movement of money from one retirement account to another. For instance, you might roll money from a 401(k) into a traditional IRA if you change jobs. Or you could roll assets from one traditional IRA to another if you switch to a new IRA custodian.

Withdrawal/Distribution Info

Form 5498 is primarily used for reporting contributions to IRAs, but it is also used for listing RMDs. If you have a traditional IRA, you must begin taking RMDs at age 73 (assuming you turn 72 after December 31, 2022). The amount you’re required to withdraw is determined by your age, life expectancy, and account value.

RMD information is included on in these boxes on Form 5498:

• Box 11: Only checked if an RMD is required

• Box 12a: RMD date

• Box 12b: RMD amount

Even if taking RMDs on an IRA is years away for you, it’s important to know what’s required. If you fail to take required minimum distributions on time each year, you may incur a tax penalty equivalent to 25% of the amount that you were supposed to withdraw. (The penalty might be reduced to 10% if you make a timely correction.)

Distributions from other types of retirement accounts such as pension plans are reported on Form 1099-R. Similar to the Form 5498, the IRS gets a copy so it’s important to make sure the withdrawals you’re reporting on your taxes match up.

Who Needs to File a 5498 Tax Form?

Your IRA custodian or trustee is required to submit a Form 5498 to the IRS on your behalf if you have a qualifying IRA transaction for the year. Again, that includes IRA contributions, IRA rollovers, recharacterizations, conversions, and required minimum distributions.

You don’t need to file this form with your tax return. However, you will need to report the appropriate information relating to IRA contributions you made, rollovers, RMDs, conversions, or recharacterizations on your tax return.

Different Kinds of 5498 Tax Forms

There’s more than one version of Form 5498 that you might receive, depending on what kind of accounts you’re funding during the year. In addition to the 5498 tax form for IRA contributions, you may also be issued either of the following:

• Form 5498-ESA: This form is issued if you make contributions to a Coverdell Education Savings Account (ESA) on behalf of an eligible student. Distributions from a Coverdell ESA are reported on Form 1099-Q.

• Form 5498-SA: This form 5498-SA is used to report contributions to Health Savings Accounts (HSAs), Archer Medical Savings Accounts (MSAs), and Medicare Advantage MSAs.

Form 5498 Due Date

The Form 5498 due date is generally May 31 of each year. So, for IRA contributions made in 2023, for instance, IRA trustees or custodians had until May 31, 2024 to send 5498 tax forms to the IRS.

You should also get a copy of the form, but if you don’t and you believe you should have, contact your IRA custodian or trustee to ask where it is. Remember, if you didn’t make any IRA contributions for the year or complete any other qualifying transactions, such as a recharacterization or rollover, you won’t get a Form 5498.

Entering a 5498 on a Tax Return

You don’t need to enter information from Form 5498 on your tax return. In fact, because of the timing when these forms are sent out, you should have already filed your return by the time you receive the 5498.

You will, however, need to enter your IRA contributions on your tax return. If you contributed to a traditional IRA, some or all of those contributions may be tax-deductible. Contributions to both traditional and Roth IRAs may qualify you for the Retirement Saver’s Credit, assuming that you’re within the accepted income threshold for your filing status.

You’ll also need to report contributions to SIMPLE IRAs and SEP IRAs on your tax return.

The Takeaway

Starting an IRA online can help you build wealth for retirement and potentially enjoy some tax breaks. A traditional IRA allows for tax-deductible contributions, while a Roth IRA allows you to take tax-free distributions in retirement. If you contribute to either type of IRA, or if you contribute to a SEP IRA or a SIMPLE IRA, you should get a Form 5498 each year. The form is informational only, and you are not required to file it with your taxes. Your IRA custodian will send a copy of the form to the IRS.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Help build your nest egg with a SoFi IRA.

FAQ

Do I have to report Form 5498 on my tax return?

No, you do not have to include or report Form 5498 on your tax return. The 5498 tax form you receive from your IRA trustee or custodian is informational only. The IRA custodian is required to send the form to the IRS.

What is the purpose of Form 5498?

Form 5498 is used to report IRA contributions to the IRS. IRA custodians are required to send this information to the IRS on behalf of each account owner who makes IRA contributions. The form is purely informational for taxpayers.

Who must file Form 5498?

IRA custodians, not individual taxpayers, are required to file a 5498 tax form with the IRS. If you get a Form 5498 in the mail, that means a copy of the form has also been sent to the IRS on your behalf.

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Nov

2024

What Is ESG Reporting?

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

Key Points

• ESG reporting is separate from financial reporting, but formal ESG disclosures are more common owing to the relevance of ESG standards to business outcomes.

• Over time, many organizations have sought to establish ESG criteria and metrics that would enable companies to be evaluated in terms of their progress toward ESG goals.

• Although a single set of ESG standards doesn’t exist, there are over a dozen frameworks that companies use for ESG reporting worldwide.

• ESG reporting is important because it helps companies to be accountable for their progress, and can enable investors to compare companies in terms of how well they meet ESG standards.

When a company decides to embrace certain environmental, social, and governance (ESG) standards, ideally the company will adhere to a set of ESG criteria and metrics that help the organization report its progress toward these ESG goals.

ESG reporting is considered separate from standard financial reporting. But investors are increasingly interested in understanding a company’s progress and risk mitigation efforts in light of ESG factors.

Investors can use a company’s ESG reporting to gauge whether it is indeed making positive changes in these areas. Unfortunately, while there are more than a dozen ESG frameworks that can be used for corporate ESG reporting, no one system has been universally adopted.

However, there are a handful of ESG frameworks that are commonly used for ESG reporting. By understanding the current state of ESG reporting and how it works, investors can be in a better position to decide which investments reflect their own values.

ESG Basics

Like many types of sustainable investing, ESG may be referred to in different ways, including green investing, socially responsible investing (SRI), and impact investing.

The three pillars of ESG are based on specific environmental, social, and governance factors. Environmental standards help assess the ways a company works to preserve and protect the physical environment. Social factors include the treatment of workers, communities, customers, suppliers, and vendors. Governance criteria track issues of leadership, fraud prevention, accounting practices, data privacy, and more.

Common ESG Criteria Companies Use

As a rule of thumb when learning about ESG frameworks and metrics, it’s important for those interested in green investing to consider how these may or may not apply to different companies across various industries. A retail company may commit to reporting certain metrics that are relevant to its products and manufacturing, whereas a biotech firm would likely embrace other standards.

Following are some ESG factors commonly used as standards in in ESG frameworks:

Environmental factors: These can help ESG investors assess a company’s energy use and carbon emissions; management of air, water, and ground pollutants; efforts to preserve biodiversity (e.g., limiting deforestation); environmental initiatives, and more.

Social factors: These reflect a company’s commitment to fair labor practices; safe working conditions; equitable hiring; engagement with local communities; product safety; sustainability throughout the supply chain (e.g., sustainable material sourcing, green shipping), and more.

Governance factors: These can include fair and transparent accounting methods; committing to a diverse board and management; avoiding conflicts of interest in leadership; being accountable to shareholders; upholding shareholder rights, and so forth.

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ESG Reporting Frameworks

As mentioned above, there are more than a dozen ESG reporting frameworks. These have been created by business organizations, nonprofits, and others. It’s not mandatory that companies use these frameworks when doing ESG reporting, although there are ongoing efforts by the Securities and Exchange Commission as well as the European Union to create required reporting standards.

Existing frameworks are generally voluntary guidelines for which metrics should be reported, how they should be disclosed, and how often.

Although the frameworks can be useful tools, the fact that there are so many of them means it’s hard to compare companies to one another and gauge which data and ESG metrics are most meaningful.

Nonetheless, a number of governmental and non-governmental organizations have worked to develop standards to help companies be more transparent about their commitment to meeting certain ESG criteria. Here is a summary of three of the most commonly used ESG frameworks:

Global Reporting Initiative (GRI)

GRI is an independent entity that helps businesses, and also governments, evaluate and report their progress in terms of certain ESG standards.

Although this is a voluntary framework, according to a 2022 report by global accounting firm KPMG, some 78% of the world’s biggest companies by revenue have adopted the GRI reporting standards, making it the most widely adopted framework.

International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards

The IFRS Foundation set up the International Sustainability Standards Board (ISSB) in 2021, largely because a growing number of companies were looking for a more efficient method for ESG reporting. The ISSB then built upon several existing sustainability standards, in order to create the voluntary IFRS Sustainability Disclosure Standards that many companies now follow.

Sustainability Accounting Standards Board (SASB) Standards

Related to the IFRS Sustainability Disclosure Standards are the SASB Standards, which were established in 2018 to provide a way for companies across 77 different industries to report key ESG metrics. Although the SASB Standards were absorbed by the IFRS Foundation, they are still maintained as a separate set of standards by the ISSB, for companies that prefer to use this method.

Benefits of ESG Metrics

There are several upsides of ESG reporting for both companies and investors. These include:

• Companies can track and report their progress towards ESG goals using a common set of standards.

• This layer of transparency incentivizes companies to be accountable for their progress (or lack thereof).

• Companies may save money by adhering to certain ESG standards, which may improve efficiency or reduce waste.

• Companies that abide by ESG standards may help mitigate certain risk factors.

• Adhering to an ESG framework helps build trust and a positive image with investors, communities, and other stakeholders.

Key ESG Metrics

Environmental, social, and governance standards encompass a large number of potential issues that companies can be responsible for. Here are a few:

Carbon Footprint

Measuring a company’s carbon footprint and their progress toward reducing it is one of the most common ESG metrics. Lowering carbon emissions can help companies become more efficient, compliant with emissions regulations, lower pollutants, and more.

Steps that a company might be taking to reduce their footprint include:

• Switching factories and offices to renewable energy

• Switching to electric transport or reducing the use of conventional transport

• Reducing waste

• Switching to raw materials that result in fewer emissions

• Reusing and recycling materials

• Purchasing carbon offsets and carbon removal to cancel out any emissions they aren’t able to eliminate.

Energy Efficiency

Another important ESG metric is energy efficiency. Energy efficient companies not only seek to minimize the use of fossil fuels and conventional forms of energy, but to shift to a meaningful use of renewable energy sources.

In addition to the environmental benefits, companies using less energy may save money, which may increase profits and benefit both the companies and investors.

Ways that companies can improve their energy efficiency include:

• Using energy-efficient bulbs; utilizing natural light when possible

• Turning off lights and appliances/equipment when not in use

• Increasing the reliance on electric or hybrid vehicles

• Minimizing air travel and shipments; investing in green shipping options

• Managing the use of heat, refrigeration, and air conditioning

Employee and Worker Health and Safety

The health and safety of workers is a key social metric in light of ESG standards. Companies that go beyond legal compliance with federal Occupational Health and Safety Standards (OSHA) may demonstrate a deeper commitment to protecting its workforce in terms of total worker health, physically, mentally, and environmentally.

Efforts may include providing:

• Proper equipment and training

• Fire protection and emergency procedures

• Abatement of safety hazards

• Psychological support systems

Evaluations of employee health and safety can indicate to investors how good a company is at managing risk and operational procedures that can impact the bottom line. But it also includes a holistic take on how the workforce is faring, in order to ensure low turnover and avoid burnishing a company’s reputation.

Product Manufacturing and Safety

The way products are made and their safety are also important ESG metrics. There is greater awareness of whether materials are sourced responsibly, as well as a focus on supply chain transparency. In addition to meeting standards for sourcing and supply chain transparency, reporting can include:

• Number of product recalls

• Product certifications

• Adherence to federal and state regulations

• Disclosing any fines or legal action related to product manufacturing

Product safety is also essential in a financial sense, because a commitment to reliable products builds consumer trust and fosters bottom line stability.

Composition of the Board of Directors

The structure, makeup, and practices of the board of directors are a vital ESG metric relating to governance. Having a diversity of voices and opinions on the board, and checks and balances in place to prevent corruption, is key to the success and sustainability of a business.

Companies that disclose their leadership practices may be more accountable than those that don’t. Either way, it’s incumbent on investors to consider a company’s governance structure within a meaningful context: i.e., the relevant industry, as well as the company’s mission and goals.

Diversity and Inclusion

In terms of meeting social standards, companies must foster diversity amongst employees, as well as leadership. Adhering to clear standards around equitable hiring and labor practices can support a stronger, potentially more effective workforce.

Establishing a positive and inclusive company can range from hiring to education to including multiple languages in the workplace.

The Takeaway

ESG standards and reporting frameworks, while far from perfect, can provide investors with metrics for evaluating companies’ ability to uphold certain environmental, social, and governance factors.
Although there isn’t one set of standards for ESG reporting as yet, thousands of companies worldwide use various ESG frameworks to support their disclosures. It’s important for investors to look into the metrics companies report, and make decisions for themselves about the criteria that are important to them.

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Nov

2024

What Is Sustainable Shipping?

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

Sustainable shipping refers to the practice of reducing carbon emissions and environmental pollutants that are typically the result of maritime shipping and transportation.

Although maritime shipping tends to have a lower carbon footprint than shipping via air, rail, or road, it still accounts for about 2.1% of global CO2 emissions because most vessels still rely on fossil fuels. In addition, shipping via the ocean is responsible for pollutants such as nitrogen oxides, sulfur oxides and particulate matter.

Sustainable shipping practices seek to reduce greenhouse gas emissions through fuel efficiency, use of renewable energy sources, and redesigning ocean-going vessels of all types. The use of sustainable packaging and containers also plays a role in sustainable shipping.

Key Points

• Sustainable shipping aims to lower carbon emissions and environmental pollutants that often result from maritime shipping and transportation.

• Maritime shipping tends to have a lower carbon footprint than other types of shipping, but it still accounts for about 2.1% of global CO2 emissions.

• Shipping via the ocean is also responsible for pollutants such as nitrogen oxides, sulfur oxides and particulate matter, in addition to disrupting species’ natural habitats.

• There is a growing interest from global shipping concerns and financial institutions in supporting sustainable shipping technologies, but there are also obstacles.

• Sustainable packaging can be a factor in green shipping: the use of renewable and biodegradable packaging options may support efficient and environmentally responsible shipping practices.

Why Does Green Shipping Matter?

In light of global warming trends, the need to reign in greenhouse gases from all sources has emerged as a priority across industries, and shipping is no exception.

Investors who take an interest in green investing goals are likely aware that shipping emits a small but significant amount of the world’s CO2, which contributes to global warming, ocean acidification, loss of biodiversity, and climate change.

In addition to these emissions, shipping can cause air and water pollution, harm wildlife and destroy habitats through dredging, collisions, oil spills, and vessel routes.

Green shipping practices matter because they may help mitigate some of these climate risk factors. Sustainable shipping may also help protect the oceans themselves, which have long been part of the earth’s natural system for absorbing excess carbon dioxide.

Also, making maritime vessels more energy efficient and sustainable overall has certain business implications. Green shipping practices may help shipping companies lower operational costs and become more competitive, perhaps generating some reputational benefits as well.

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Green Shipping Initiatives

Mirroring socially responsible investing (SRI) trends across many industries today, the maritime shipping sector has seen a steady interest in making shipping more environmentally responsible. Consumer demand for greenhouse gas emissions reduction and decarbonization has accelerated in recent years, which has put pressure on the shipping and transportation sector, and created some momentum.

New Technology, New Targets

For example, the International Maritime Organization (IMO) has set a target of reducing carbon emissions from global shipping by 50% by 2050 versus 2008 levels. Reaching this ambitious goal will require the development and implementation of zero-carbon vessels by 2030, according to the World Shipping Council (WSC).

To accelerate what is in effect a technological revolution in shipping, WSC itself has proposed a $5 billion research and development program that would be funded by key players in the industry.

The Role of Financial Institutions in Green Shipping

Financial institutions are likewise finding ways to get on board with green shipping. For instance, 35 financial institutions have adopted the Poseidon Principles, a framework designed to meet the decarbonization goals of the International Maritime Organization (IMO). Collectively the 35 signatories represent 80% of the global portfolio of ship financing.

Recommended: What Is ESG Investing?

Barriers to the Adoption of Green Shipping

Although there is considerable interest in reducing greenhouse gas emissions in the shipping industry, there are also barriers that make implementation difficult. There can be hurdles when it comes to investment and financing in green shipping options, as well as challenges around ESG reporting and sustainability targets.

Some examples:

• Maritime shipping vessels are expensive, making it hard for companies to build or switch to new ones with lower carbon emissions. Also, there are emissions associated with manufacturing new vessels, canceling out a certain amount of the emissions reduction.

• Shipping is a cyclical and volatile market, making it hard to have a stable cash flow available for investment into decarbonization.

• The cost of R&D and developing new technologies to make shipping more sustainable is often high, and there’s no guarantee of commercial adoption.

• There is an increased shipping demand in developing countries, but it’s more difficult to get financing for green shipping. Investments in green shipping in developing nations tend to come with currency risks, cash flow risks, and other potential risk factors.

• The shipping sector has traditionally kept its data private, but stakeholders are now demanding more data and sustainability disclosures. Given the inconsistencies of ESG disclosure frameworks, it remains difficult to assess progress in terms of sustainability factors, and thus instituting regulations for widespread adoption is challenging.

• There is a lot of focus on easy or short-term improvements, such as using renewable energy, but less focus on the harder areas to decarbonize, such as steel and concrete production, which are material to vessel manufacturing and port construction.

• Used vehicles and vessels are often sent to developing countries. So although developed nations may be adopting lower-emission vessels, those high-emission vehicles may still be in use.

What Is Sustainable Packaging?

Sustainable packaging refers to the shift away from materials that are considered toxic for the environment (e.g., traditional petroleum-based plastics, non-recyclable cardboard, styrofoam), toward recyclable, reusable, and biodegradable types of packaging.

Sustainable packaging can include:

• Recyclable packaging such as paper, glass, and recyclable cardboard.

• Packaging made from reusable materials like recyclable paper, bamboo, wood, and others.

• Biodegradable and compostable materials like polylactic acid (PLA)-based bioplastics, often made from corn, potato, and other organic substances that biodegrade.

Why Sustainable Packaging Matters

Reducing carbon emissions is challenging in any industry owing to the various channels, direct and indirect, that can contribute to emissions. For example, the use of packaging in the shipping sector is also responsible for various types of waste and pollution.

First, because traditional packaging materials are often not biodegradable or recyclable they can add to the environmental impact of maritime shipping and other industries. While it’s nice to imagine a container ship sailing from one port to another, loading and unloading goods without any mishaps, accidents can and do occur — putting plastics, styrofoam, and other toxic materials in waterways.

Also, some materials and packaging that are labeled as recyclable or compostable don’t really get recycled, and can only degrade under specific conditions.

Thus, sustainable packaging may offer additional benefits to the shipping industry, in that recyclable and biodegradable packaging options may support greater efficiency in shipping products overall.

Sustainable Packaging Initiatives

The good news is that there are proposals to increase transparency in packaging labels, as well as the development of new materials and packaging options that are more environmentally friendly. Some ways that packaging can become more sustainable are:

• Transparent labeling

• Eliminating single-use plastic from packaging

• Removing toxic chemicals such as dyes, fragrances, and solvents

• Shipping in bulk when possible

• Switching to refillable packaging options

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Opportunities in the Green Shipping Sector

Individuals interested in ESG investing strategies can explore various investment options in the green shipping sector. Categories of green stocks to look for within the shipping sector include:

• Low- or zero-emission fuels such as green hydrogen, biodiesel, ammonia, and methanol

• Renewable energy technologies such as solar energy and wind energy.

• Exchange-traded funds (ETFs) and index funds that are focused on sustainable or ESG investments.

• In addition to investing in stocks and ETFs, choosing consumer or commercial end products from companies that are embracing sustainable or ESG principles.

• Investing in companies that use sustainable packaging, such as recycled packaging and alternative materials to plastic.

• Investors looking for fixed-income options can consider green bonds.

The Takeaway

As one of the biggest sectors in the world, there are both significant challenges and opportunities for green shipping and decarbonization of transportation. As an individual, you can participate in green shipping by investing in companies working to embrace sustainable fuel, technology, infrastructure, and supply chain alternatives.

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Nov

2024

What Is a Synthetic CDO?

By Rebecca Lake | invest, Investing | Comments Off

A synthetic CDO is a type of collateralized debt obligation that invests in non-cash derivatives, such as credit swaps, options, and insurance contracts, without owning the underlying assets.

Synthetic CDOs are a type of collateralized debt obligation; both are considered alternative investments and are high-risk due to their complexity. Unlike regular CDOs, which are pooled investments in traditional types of debt, like loans, mortgages, and bonds, synthetic CDOs are invested in non-cash derivatives, which may have a higher risk of default.

Synthetic CDOs are typically not available to retail investors. They are often viewed as controversial, as many have cited them as a contributor to the 2008 financial crisis and subprime mortgage collapse. Here’s a closer look at how synthetic CDOs work and the risks associated with investing in them.

Key Points

• A synthetic CDO invests in credit derivatives, like credit swaps, without owning underlying assets.

• Synthetic CDOs have tranches reflecting different risk levels, with higher ratings indicating lower risk as well as lower returns.

• Due to their complexity and risk, synthetic CDOs are used mainly by institutional investors.

• Synthetic CDO instruments are considered high-risk, in part due to market risk and the potential for the underlying assets to default.

• Synthetic CDOs have been criticized for contributing to the subprime mortgage collapse that led to the 2008 financial crisis.

What Is a Collateralized Debt Obligation (CDO)?

CDO and synthetic CDO are two distinct products. A CDO or collateralized debt obligation is a type of derivative investment, meaning it derives its value from an underlying financial asset or pool of assets. Those assets can include loans, bonds, and other types of debt.

How Does a CDO Work?

Many borrowers may be familiar with the term “collateral”; in finance it refers to the security that lenders typically require in return for offering loan products. With CDOs, the collateral would be the payments from the underlying loans, bonds, and other types of debt.

Because debt payments tend to be predictable, the appeal of CDOs is the potential for cash flow. But the risk in these types of financial assets lies in the potential for default.

CDOs are considered derivatives as their value (and price) derives from the underlying bonds and loans. In essence, a CDO is a bundle of debt that’s sold to investors on the secondary market. Rather than individual investors, CDOs are typically sold to institutional investors, such as insurance companies or investment banks.

Different Categories of CDOs

Collateralized debt obligations are considered a type of alternative asset, in that they’re not part of the world of traditional securities like stocks and bonds.

CDO categories may include:

• Mortgage-backed securities, which are comprised of mortgage loans

• Asset-backed securities, which invest in non-mortgage debt, such as credit cards or car loans

• Collateralized bond obligations, which hold a mix of bonds1

CDOs are assigned a tranche or class which signifies the level of risk and reward. The highest rating is AAA, which signifies the lowest risk but correspondingly, the lowest yields.

CDOs and the Financial Crisis

CDOs contributed to the 2008 financial crisis because many of them concentrated holdings in high-risk assets, namely, subprime mortgages. Banks flocked to CDOs because they offered diversification and generated cash flow, which was used to make new loans.

When the housing bubble burst, however, declining home values led many borrowers to default on their subprime loans. That resulted in a rapid cooling of the CDO market and substantial losses for banks.

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Understanding Synthetic CDOs

Synthetic investments attempt to generate cash flow without ownership of the underlying assets. What is a synthetic CDO? It’s an investment vehicle that offers investors exposure to non-cash credit derivatives, such as credit swaps, insurance contracts, or options.

Like regular CDOs, synthetic CDOs are assigned tranches relative to the level of risk they present. The higher the credit rating, the lower the risk, but the return profile is also lower.

How a Synthetic CDO Works

How does a synthetic CDO work? It depends on the underlying investments but for simplicity’s sake, let’s consider a typical synthetic CDO that invests in credit default swaps. A credit default swap is a contract in which a buyer pays a premium to the seller, and the seller agrees to pay a lump sum to the buyer if the underlying credit instrument defaults.

In this type of arrangement, the seller of the synthetic CDO assumes a long position, betting that the underlying assets will perform as expected. The buyer assumes a short position, betting that the underlying assets will default. If the asset defaults, the buyer is entitled to a payout from the seller.

Recommended: Stock Market Basics

Investing in Synthetic CDOs

Synthetic CDOs are not designed for the everyday investor. If you’re opening a brokerage account, for example, you won’t find them offered alongside individual stocks or exchange-traded funds (ETFs).

More often, synthetic CDOs are the domain of institutional investors like banks or insurance companies. That’s appropriate, given how complex — and often confusing — these products are.

Individual investors who are interested in diversifying their asset allocation with alternative investments can gain exposure to credit default swaps outside of a synthetic CDO. For example, you might invest in an ETF or mutual fund that holds credit default swaps as an underlying asset.

There are, however, some stipulations. Venturing into this type of alternative investment is generally not recommended for investors who don’t fully understand how they work or the risks involved.

What Are Alternative Investments?

Alternative investments, sometimes called alts, refer to non-traditional assets that fall outside the realm of stocks, bonds, and cash. Alts may include commodities, real estate, private equity, hedge funds, and other instruments like CDOs.

Alts typically have little or no correlation with traditional asset classes. Thus they can be appealing to some investors because they may offer some portfolio diversification, and the potential for higher risk-adjusted returns.

That said, alts tend to be illiquid, not transparent, not well-regulated, and high risk.

Risks of Investing in Synthetic CDOs

Like most types of alternative investments, synthetic CDOs carry elevated levels of risk for investors.

Some of the most significant risks include:

• Lack of transparency and limited federal regulation

• Credit risk and the potential for default of underlying assets

• Liquidity risk and the difficulties in buying and selling synthetic CDO positions

• Modeling risk, which can result in incorrect assumptions about the value of underlying assets

• Market risk, or the risk of changes in the value of underlying assets

While the market has changed in the years since the financial crisis, and federal regulations now exist to protect investors from a repeat of those events, the risks of synthetic CDOs and CDOs in general can’t be discounted.

The Takeaway

Synthetic CDOs are a complicated way to build a portfolio. If you’re looking for a way to diversify, you can invest in stocks, ETFs, private credit, commodities, and even IPOs through an online brokerage account.

SoFi does not offer CDO investments at this time, but it does provide access to a range of alternative investment funds. You can choose what to invest in, based on your risk tolerance and goals.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.

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FAQ

What is the main purpose of a synthetic CDO?

The main purpose of a synthetic CDO is to allow investors to gain exposure to an underlying credit asset without owning it. Synthetic CDOs that invest in credit default swaps allow a buyer and seller to take short and long positions respectively to bet on the behavior and performance of an underlying asset.

How do synthetic CDOs differ from traditional CDOs?

Traditional CDOs invest in debt instruments or securities, such as mortgage loans, credit card debt, or auto loans. Synthetic CDOs primarily invest in credit instruments, such as credit default swaps or options.

What are the risks associated with investing in synthetic CDOs?

Synthetic CDOs are subject to credit risk, market risk, and liquidity risk. If the underlying asset doesn’t perform as expected, that can result in losses for the buyer or seller.

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SOIN-Q324-055

Nov

2024

What Is Carried Interest?

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Carried interest is a compensation arrangement commonly used in private equity, hedge funds, and venture capital investments. General partners or GPs may receive a percentage of investment profits in the form of carried interest. This is similar to the way that certain stocks pay out profits to shareholders as dividends.

If you’re considering an investment in private equity, a hedge fund, or venture capital, it’s important to understand how carried interest works and what it means for you.

Key Points

• Carried interest is a compensation arrangement where general partners receive a percentage of investment profits, typically around 20%, incentivizing them to achieve strong fund performance.

• Before general partners receive carried interest, limited partners must first get back their original capital, and the fund may need to meet a minimum hurdle rate.

• Carried interest is taxed at the long-term capital gains rate if held for more than three years, which can be controversial due to perceived tax advantages.

• Understanding carried interest is crucial for investors in private equity, hedge funds, or venture capital, as it affects expected returns and highlights the importance of fund performance.

• In venture capital, carried interest tends to involve longer investment periods, with returns realized through company exits like IPOs, mergers, or acquisitions.

Carried Interest Explained

Carried interest is one of several ways that a general partner may be compensated. General partners are individuals or entities that have a say in how investment funds are managed.

Private equity funds, hedge funds, real estate funds, and venture capital funds can have multiple general partners, each of whom is entitled to a share of the fund’s profits. These profits may be paid out in the form of royalties, capital gains, dividends, or carried interest.

There’s no universal carried interest definition; it’s simply a performance-based fee that’s used to incentivize the fund’s general partners or money managers. Generally, the higher the fund’s profits, the more carried interest the general partners collect.

How Carried Interest Works

Carried interest, often simply called “carry,” works by rewarding an investment fund’s general partners for strong performance.

A typical payout structure is 20% of a fund’s returns, though compensation can vary from one fund to another. Market trends can push payouts higher or lower at any given time. General partners can also collect an annual management fee. For instance, the fee may be 2% of the fund’s assets under management (AUM).

There are some rules to know about when and how carried interest is paid to GPs:

• For general partners to receive carried interest, fund investors must first receive back the amount of capital they put in. These investors are referred to as limited partners or LPs and how they’re paid depends on the fund’s structure.

• The fund may need to achieve a minimum rate of return called a “hurdle rate” before any carried interest is paid out to GPs.

• Carried interest may be withdrawn if a fund underperforms. This may happen if LPs do not receive back the amount of capital they put in.

Here’s what investors should know about carried interest, in a nutshell: When they invest in a private equity fund, hedge fund, or venture capital fund, they (altogether) typically get ~80% of the profits and the GPs get the rest. Knowing how to define carried interest matters if you plan to explore these types of alternative investments for your portfolio.

Tax Treatment of Carried Interest

Taxes on investments affect the level of returns you get to keep. Taxing carried interest is a controversial topic, thanks to a loophole in the Internal Revenue Code (IRC). Section 1061 allows for carried interest held for longer than three years to be taxed at the long-term capital gains rate.

Long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income and household size. Short-term capital gains, meanwhile, are taxed at ordinary income tax rates. For the 2024 tax year, the maximum income tax rate for the highest earners was 37%. Additionally, that will remain the same for the 2025 tax year.

Lawmakers have argued that the current tax rules regarding carried interest allow wealthier taxpayers to sidestep higher tax rates by holding carried interest for longer than three years. Proposed legislation, such as the Carried Interest Fairness Act of 2024, has been pieced together in an attempt to close the loophole and apply ordinary income tax rates on carried interest. But despite being introduced, that particular piece of legislation has (at the time of publication) not advanced.

Carried Interest in Different Contexts

How does carried interest work in different investment settings? How GPs and LPs receive payouts can depend on the type of investment involved.

Private Equity

Private equity refers to an investment in a company that is not publicly listed or traded on a stock exchange. Private equity funds can hold numerous investments in a single basket, offering investors exposure to a range of different companies, including ones that have been delisted from an exchange and ones that have yet to launch an initial public offering (IPO).

In a private equity arrangement, GPs can be compensated with carried interest. Limited partners receive the original capital they invested, along with a share of the profits as dividends, less any fees they pay to own the fund.

Hedge Funds

Hedge funds pool money from multiple investors to make investments. These funds can hold a range of different investments, including stocks, bonds, commodities, real estate, derivatives, land, and foreign currency. Risk is typically higher with a hedge fund, but investors may earn a higher rate of return.

Hedge fund payouts generally follow the same pattern as private equity funds. The GPs receive ~20% of the profits as carried interest, once the fund reaches the minimum hurdle rate. The remaining profits are paid to limited partners as dividends, along with the return of their original capital investment, which they receive first.

Venture Capital

Venture capital funds pool money from multiple investors to fund startups and early-stage companies. This is essentially a form of private equity investment, with some differences.

Investment holding periods may be longer compared to private equity funds and returns are not realized until a company within the fund exits. That can happen if the company decides to go public with an IPO, merges with another company, or is acquired.

Investors can receive the proceeds of an exit as compensation, along with the return of their original capital. General partners receive carried interest, which is again around 20%, but may be higher or lower based on the fund’s performance and its hurdle rate.

Future of Carried Interest

Carried interest has received significant attention from lawmakers and the executive office. Some policymakers have discussed taxing carried interest as ordinary income for those making $400,000 or more, while others would like the loophole closed altogether. Closing the loophole could cut down on tax avoidance among some taxpayers, allowing the federal government to recoup more tax dollars.

HOwever, whether any major changes will be implemented remains to be seen.

What is an alternative to carried interest? One option proposed in the UK is growth shares. Growth shares entitle the shareholder to returns based on future growth. However, this strategy seems on the surface to be very similar to carried interest in terms of the tax benefits it delivers to GPs.

The Takeaway

Carried interest, meaning how general partners get paid, is an important consideration when determining which alternative investments to include in your portfolio. Carried interest is a compensation arrangement under which general partners receive a portion of investment profits, and that’s typically around 20%. This can be a fairly high-level way to invest, of course, so it may be a good idea to get your toes wet with a simple brokerage account before worrying about carried interest. If you have yet to start investing, it’s easy to open a brokerage account online.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

Why is carried interest controversial?

Carried interest is controversial because some critics have argued that it allows wealthier taxpayers to benefit from a tax loophole.

How much is carried interest taxed?

In the U.S., carried interest is taxed at the capital gains tax rate. Short-term capital gains are taxed at ordinary income tax rates. Carried interest held for more than three years, however, is subject to the lower long-term capital gains tax rate.

What is the average carried interest?

A typical carried interest payout for general partners is 20% of the fund’s profits. This is paid in addition to a 2% annual management fee. Funds may need to achieve a minimum rate of return before carried interest can be paid out.

Photo credit: iStock/Andrii Yalanskyi

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SOIN-Q324-037

The 5498 Tax Form Explained

What Is IRS Form 5498?

What Does Form 5498 Cover?

IRA Contributions

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Barriers to the Adoption of Green Shipping

What Is Sustainable Packaging?

Why Sustainable Packaging Matters

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Opportunities in the Green Shipping Sector

The Takeaway

What Is a Synthetic CDO?

What Is a Collateralized Debt Obligation (CDO)?

How Does a CDO Work?

Different Categories of CDOs

CDOs and the Financial Crisis

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Understanding Synthetic CDOs

How a Synthetic CDO Works

Investing in Synthetic CDOs

What Are Alternative Investments?

Risks of Investing in Synthetic CDOs

The Takeaway

FAQ

What is the main purpose of a synthetic CDO?

How do synthetic CDOs differ from traditional CDOs?

What are the risks associated with investing in synthetic CDOs?

What Is Carried Interest?

Carried Interest Explained

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How Carried Interest Works

Tax Treatment of Carried Interest

Carried Interest in Different Contexts

Private Equity

Hedge Funds

Venture Capital

Future of Carried Interest

The Takeaway

FAQ

Why is carried interest controversial?

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