Feb
27
2024

Asset Allocation by Age, Explained

By | Growing Wealth, invest, Investing | Comments Off on Asset Allocation by Age, Explained

Asset allocation is an investment strategy that helps you decide the ratio of different asset classes in your portfolio to ensure that your investments align with your risk tolerance, time horizon, and goals.

In other words, the way you allocate, or divide up the assets in your portfolio helps to balance risk, while aiming for the highest return within the time period you have to achieve your investment goals.

How do you set your portfolio to get the best asset allocation by age? Here’s what you need to know about asset-based asset allocation.

Key Points

•   Asset allocation is the process of dividing investments among different asset classes based on factors like age, risk tolerance, and financial goals.

•   Younger investors can typically afford to take more risks and allocate a higher percentage of their portfolio to stocks.

•   As investors approach retirement, they may shift towards a more conservative asset allocation, with a higher percentage allocated to bonds and cash.

•   Regularly reviewing and rebalancing your asset allocation is important to ensure it aligns with your changing financial circumstances and goals.

•   Asset allocation is a personal decision and should be based on individual factors such as risk tolerance, time horizon, and investment objectives.

What Is Age-Based Asset Allocation?

The mix of assets you hold will likely shift with age. When you’re younger and have a longer time horizon, you might want to hold more stocks, which offer the most growth potential. Also, that longer time horizon gives you plenty of years to help ride out volatility in the market.

You will likely want to shift your asset allocation as you get older, though. As retirement age approaches, and the point at which you’ll need to tap your savings draws near, you may want to shift your retirement asset allocation into less risky assets like bonds and cash equivalents to help protect your money from downturns.

In the past, investment advisors recommended a rule of thumb whereby an investor would subtract their age from 100 to know how much of their portfolio to hold in stocks. What is an asset allocation that follows that rule? A 30-year-old might allocate 70% of their portfolio to stocks, while a 60-year-old would allocate 40%.

However, as life expectancy continues to increase — especially for women — and people rely on their retirement savings to cover the cost of longer lifespans (and potential healthcare expenses), some industry experts and advisors now recommend that investors keep a more aggressive asset allocation for a longer period.

The new thinking has shifted the formula to subtracting your age from 110 or 120 to maintain a more aggressive allocation to stocks.

In that case, a 30-year-old might allocate 80% of their portfolio to stocks (110 – 30 = 80), and a 60-year-old might have a portfolio allocation that’s 50% stocks (110 – 60 = 50) — which is a bit more aggressive than the previous 40% allocation.

These are not hard-and-fast rules, but general guidelines for thinking about your own asset allocation strategy. Each person’s financial situation is different, so each portfolio allocation will vary.

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Asset Allocation Models by Age

As stated, age is a very important consideration when it comes to strategic asset allocation. Here are some asset allocation examples for different age groups.

Asset Allocation in Your 20s and 30s

For younger investors, the conventional wisdom suggests they may want to hold most of their portfolio in stocks to help save for long-term financial goals like retirement.

That said, when you’re young, your financial footing may not be very secure. You probably haven’t built much of a nest egg, you may change jobs relatively frequently, and you may have debt, such as student loans, to worry about. Setting up a potentially volatile, stock-focused allocation might feel nerve-wracking.

If you have a 401(k) at work, this might be your primary investment vehicle — or you may have set up an IRA. In either account you can invest in mutual funds or exchange-traded funds (ETFs) that hold a mix of stocks, providing some low-cost diversification without sacrificing the potential for long-term growth.

You could also invest in a target date fund, which is designed to help to manage your asset allocation over time (more on these funds below).

When choosing funds, it’s important to consider both potential performance and fees. Index funds, which simply mirror the performance of a certain market index, may carry lower expense ratios but they may generate lower returns compared to, say, a growth fund that’s more expensive.

Remember that the younger you are, the longer you have to recover from market downturns or losses. So allocating a bigger chunk of your investments to growth funds or funds that use an active management strategy could make sense if you feel their fees are justified by the potential for higher returns — and the higher risk that comes along with it.

And of course, you can counterbalance higher-risk/higher-reward investments with bonds or bond funds (as a cushion against volatility), index funds (to help manage costs) or target date funds (which can do a bit of both). Just be aware that the holdings within some funds can overlap, which could hamper your diversification strategy and require you to choose investment carefully.

Asset Allocation in Your 40s and 50s

As you enter middle age you are potentially entering your peak earning years. You may also have more financial obligations, such as mortgage payments, and bigger savings goals, such as sending your kids to college, than you did when you were younger. On the upside, you may also have 20 years or more before you’re thinking about retiring.

In the early part of these decades, one approach is to consider keeping a hefty portion of your portfolio still allocated to stocks. This may be useful if you haven’t yet been able to save much for your retirement because you’d be able to add potential growth to your portfolio, and still have some years to ride out any volatility.

Depending on when you plan to retire, adding stability to your portfolio with bonds as you approach the latter part of these decades might be a wise choice. For example, you may want to begin by shifting more of your IRA assets to bonds or bond funds at this stage. These investments may produce lower returns in the short term compared to mutual funds or ETFs. But they can be useful for generating income once you’re ready to begin making withdrawals from your accounts in retirement.

Asset Allocation in Your 60s

Once you hit your 60s and you’re nearing retirement age, your allocation will likely shift toward fixed-income assets like bonds, and maybe even cash. A shift like this can help prepare you for the possibility that markets may be down when you retire.

If that’s the case, you might be able to use these fixed-income investments to provide income during the downturn, so you can avoid selling stocks while the markets are down since doing so would lock in losses and might curtail future growth in your portfolio. Thus, leaning on the fixed-income portion of your portfolio allows time for the market to recover before you need to tap into stocks.

If you haven’t retired yet, you can continue making contributions to your 401(k) to grow your nest egg and take advantage of any employer match.

If you chose to invest in a target date fund within your retirement account when you were younger, it’s likely that fund’s allocation would now be tilting toward fixed-income assets as well.

Retirement Asset Allocation

Once you’ve retired it may seem like you can kick back and relax with all of your asset allocation worries behind you. Yet, your portfolio allocation is as important to consider now as it was in your 20s.

When you retire, you’ll likely be on a fixed income — and you won’t be adding to your savings with earned wages. Your retirement could last 20 to 30 years or more, so consider holding a mix of assets that includes stocks that might provide some growth. Keeping a modest stock allocation might help you avoid outliving your savings and preserve your spending power.

While that may sound contrary to the suggestion above for pre-retirees to keep more of their assets allocated to fixed-income, the difference is the level of protection you might want just prior to retirement. Now as an official retiree, and thinking about the potential decades ahead, you may want to inject a little growth potential into your portfolio.

It might also make sense to hold assets that grow faster than the rate of inflation or are inflation-protected, such as Treasury Inflation-Protected Securities, or TIPS, which can help your nest egg hold its value.

These are highly personal decisions that, again, go back to the three intersecting factors that drive asset allocation: your goals, risk tolerance, and time horizon. There’s no right answer; the task is arriving at the right answer for you.

Understanding Assets and Asset Classes

At its heart, a financial asset is anything of value that you own, whether that’s a piece of property or a single stock. When you invest, you’re typically looking to buy an asset that will increase in value.

The three broad groups, or asset classes, that are generally held in investment accounts are stocks, bonds, and cash. When you invest, you will likely hold different proportions of these asset classes.

Asset Allocation Examples

What are some asset allocation examples? Well, your portfolio might hold 60% stocks, 40% bonds, and no cash — or 70% stocks, 20% bonds, and 10% in cash or cash equivalents. But how you decide that ratio gets into the nuts and bolts of your actual asset allocation strategy, because each of these asset types behaves differently over time and has a different level of risk and return associated with it.

•   Stocks. Stocks typically offer the highest rates of return. However, with the potential for greater reward comes higher risk. Typically, stocks are the most volatile of these three categories, especially in the short term. But over the long term, the return on equities (aka stocks) has generally been positive. In fact, the S&P 500 index, a proxy for the U.S. stock market, has historically returned an average of 10% annually.

•   Bonds. Bonds are traditionally less risky than stocks and offer steadier returns. A general rule of thumb is that bond prices move in the opposite direction of stocks.

When you buy a bond, you are essentially loaning money to a company or a government. You receive regular interest on the money you loan, and the principal you paid for the bond is returned to you when the bond’s term is up. When buying bonds, investors generally accept smaller returns in exchange for the security they offer.

•   Cash. Cash, or cash equivalents, such as certificates of deposit (CDs) or money market accounts, are the least volatile investments. But they typically offer very low returns.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

How Do Diversification and Rebalancing Fit In?

The old adage, “Don’t put all your eggs in one basket,” is apt for a number of concepts in investing.

Putting all of your money in one investment may expose you to too much risk. When it comes to asset allocation, you can help manage risk by spreading money out over different asset classes that are then weighted differently within a portfolio.

Here is a possible asset allocation example: If your stock allocation was 100%, and the stock market hit a speed bump, your entire portfolio could lose value. But if your allocation were divided among stocks, bonds, and cash, a drop in the value of your stock allocation wouldn’t have the same impact. It would be mitigated to a degree, because the bonds and cash allocation of your portfolio likely wouldn’t suffer similar losses (remember: bond prices generally move in the opposite direction of stocks, and cash/cash equivalents rarely react to market turmoil).

Diversification

Portfolio diversification is a separate, yet related, concept. Simple diversification can be achieved with the broader asset classes of stocks, bonds, and cash. But within each asset class you could also consider holding many different assets for additional diversification and risk protection.

For example, allocating the stock portion of your portfolio to a single stock may not be a great idea, as noted above. Instead, you might invest in a basket of stocks. If you hold a single stock and it drops, your whole stock portfolio falls with it. But if you hold 25 different stocks — when one stock falls, the effect on your overall portfolio is relatively small.

On an even deeper level, you may want to diversify across many types of stock — for example, varying by company size, geography, or sector. One way some investors choose to diversify is by holding mutual funds, index funds, or ETFs that themselves hold a diverse basket of stocks.

Rebalancing

What is rebalancing? As assets gain and lose value, the proportion of your portfolio they represent also changes. For example, say you have a portfolio allocation that includes 60% stocks and the stock market ticks upward. The stocks you hold might have appreciated and now represent 70% or even 80% of your overall portfolio.

In order to realign your portfolio to your desired 60% allocation, you might rebalance it by selling some stocks and buying bonds. Why sell securities that are gaining value? Again, it’s with an eye toward managing the potential risk of future losses.

If your equity allocation was 60%, but has grown to 70% or 80% in a bull market, you’re exposed to more volatility. Rebalancing back to 60% helps to mitigate that risk.

The idea of rebalancing works on the level of asset allocation and on the level of asset classes. For example, if your domestic stocks do really well, you may sell a portion to rebalance your dometic allocation and buy international stocks.

You can rebalance your portfolio at any time, but you may want to set regular check-ins, whether quarterly or annually. There may be no need to rebalance if your asset allocation hasn’t really shifted. One general rule to consider is the suggestion that you rebalance your portfolio whenever an asset allocation changes by 5% or more.

What’s the Deal with Target Date Funds?

One tool that some investors find useful to help them set appropriate allocations is a target date fund. These funds, which were described briefly above, are primarily for retirement, and they are typically geared toward a specific retirement year (such as 2030, 2045, 2050, and so on).

Target funds hold a diverse mix of stocks and fixed-income investments. As the fund’s target date approaches, the mix of stocks and bonds the fund automatically adjusts to a more conservative allocation — aka the fund’s “glide path.”

For example, if you’re 35 and plan to retire at 65, you could purchase shares in a target-date fund with a target date 30 years in the future. While the fund’s stock allocation may be fairly substantial at the outset, as you approach retirement the fund will gradually increase the proportion of fixed-income assets that it holds.

Target-date funds theoretically offer investors a way to set it and forget it. However, they also present some limitations. For one, you don’t have control over the assets in the fund, nor do you control how the fund’s allocation adjusts over time.

Target funds are typically one-size-fits-all, and that doesn’t always work with an individual’s unique retirement goals. For example, someone aggressively trying to save may want to hold more stocks for longer than a particular target date fund offers. Also, as actively managed funds, they often come with fees that can take a bite out of how much you are ultimately able to save.

The Takeaway

While many investors spend time researching complex issues like bond yields and options trading, understanding and executing a successful asset allocation strategy — one that works for you now, and that you can adjust over the long term — can be more challenging than it seems.

Although asset allocation is a fairly simple idea — it’s basically how you divide up different asset classes in your portfolio to help manage risk — it has enormous strategic implications for your investments as a whole. The three main factors that influence your asset allocation (goals, risk tolerance, and time horizon) seem straightforward enough as separate ideas, yet there is an art and a science to combining them into an asset allocation that makes sense for you. Like so many other things, arriving at the right asset allocation is a learning process.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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About the author

Rebecca Lake

Rebecca Lake

Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Feb
27
2024
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How to Analyze Stocks: 4 Ways

By | Growing Wealth, invest, Investing | Comments Off on How to Analyze Stocks: 4 Ways

When it comes to investing in stocks, there’s no single way to analyze stocks to find a sure winner. That being said, there are many methods that ordinary investors can use to find stocks that are trading at a discount to their underlying value.

The first step in how to analyze a stock before buying is reviewing financial statements. From there, investors can use various methods of analysis to assess investment opportunities and potentially identify worthwhile investments.

Key Points

•   There are four common methods of analyzing stocks: technical analysis, qualitative analysis, quantitative analysis, and fundamental analysis.

•   Technical analysis focuses on supply and demand patterns in stock charts to make investment decisions.

•   Qualitative analysis examines factors like a company’s leadership, product, and industry to evaluate investment opportunities.

•   Quantitative analysis uses data and numerical figures to predict price movements in stocks.

•   Fundamental analysis looks at a company’s financial health and value to determine if its stock is underor overvalued.

Why Analyzing Stocks Is Important

The process of stock analysis can reveal important information about a company and its history, allowing investors to make more informed decisions about buying or selling stocks. Analyzing stocks can help investors identify which investment opportunities they believe will deliver strong returns. Further, stock analysis can assist investors in spotting potentially bad investments.

Whether you’re strategy involves short vs. long term investing, or day trading, analyzing stocks is going to be important.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Understanding Financial Statements

The first step in understanding stock analysis is knowing the basics of business reporting. There are three main types of financial statements that an investor may need to look at when doing analysis:

•   Income statement: This statement shows a company’s profits, which are calculated by subtracting expenses from revenue.

•   Balance sheet: The balance sheet compares a company’s assets, liabilities, and stockholder equity.

•   Statement of cash flows: This statement outlines how a company is spending and earning its money.

In addition to these statements, a company’s earnings report contains information that can be useful for doing qualitative analysis. The annual report includes the company’s plans for the future and stock value predictions.

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4 Ways to Analyze a Stock

The next step in stock evaluation is deciding which type of analysis to do. Here’s a look at some of the different methods for how to analyze a stock.

1. Technical Analysis

Technical analysis is a method for analyzing stocks that looks directly at a stock’s supply and demand in order to make investing decisions. This form of analysis takes the stance that all information needed is present within stock charts and the analysis of history and trends.

Some key focal points of technical analysis are:

•   Stock prices move in trends.

•   History repeats itself.

•   Stock price history can be used to make price predictions.

•   Stock price contains all relevant information for making investing decisions.

•   Technical analysis does not consider intrinsic value.

Trend indicators are one of the most important parts of technical analysis. These indicators attempt to show traders whether a stock will go up or down in value. Uptrends mean higher highs and higher lowers, whereas downtrends mean lower lows and lower highs. Some common trend tools include linear regression, parabolic SAR, MACD, and moving averages.

Technical analysis also uses leading indicators and lagging indicators. Leading indicators signal before new trends occur, while lagging indicators signal after a trend has ended. These indicators look at information such as volume, price, price movement, open, and close.

There can be some pros and cons to using technical analysis, however, which can be important to consider when factoring in your risk tolerance.

Day traders tend to focus on technical analysis to try to capitalize on short-term price fluctuations. But because technical analysis generally focuses on short-term fluctuations in price, it’s not as often used for finding long-term investment opportunities.

Further, while technical analysis relies on objective and consistent data, it can produce false signals, particularly during trading conditions that aren’t ideal. This method of analysis also fails to take into consideration key fundamentals about individual shares or the stock market.

2. Qualitative Stock Analysis

When considering how to analyze a stock, it’s also a good idea to look at whether the company behind the stock is really a good business. Qualitative analysis looks into factors like a company’s leadership team, product, and the overall industry it’s a part of.

A few key qualitative metrics to look at are:

•   Competitive advantage: Does the company have a unique edge that will help it be successful in the long term? If a company has patents, a unique manufacturing method, or broad distribution, these can be positive competitive advantages.

•   Business model: Analyzing a business model includes looking at products, services, brand identity, and customers to get a sense of what the company is offering.

•   Strong leadership: Even a great idea and product can fail with poor management. Looking into the credentials of the CEO and top executives of a company can help in evaluating whether it’s a good investment.

•   Industry trends: If an industry is struggling, or looks like it may in the future, an investor may decide not to invest in companies in that industry. On the other hand, new and growing industries may be better investments. This is not always the case, as there are strong companies in weak industries, and vice versa.

3. Quantitative Analysis

Similar to technical analysis, quantitative analysis looks at data and numbers in an attempt to predict future price movements. Specifically, quantitative analysis evaluates data, such as a company’s revenues, price-to-earnings ratio, and earnings-per-share ratio, and uses statistical modeling and mathematical techniques to predict a stock’s value.

The upside is that this financial data is publicly available, and it creates an objective, consistent starting point. It can help with identifying patterns, and it can be useful in assessing risk. However, it requires sifting through a lot of data. Further, there’s no certainty when it comes to patterns, which can change.

4. Fundamental Analysis

Fundamental analysis looks at a company from a basic financial standpoint. This gives investors a sense of the company’s financial health and whether its stock may be under- or overvalued. Fundamental analysis takes the stance that a company’s stock price doesn’t necessarily equate to its value.

There are a number of key tools for fundamental analysis that investors might want to familiarize themselves with and use to get a fuller picture of a stock.

Earnings Per Share (EPS)

One of the main goals for many investors is to buy into profitable companies. Earnings per share, or EPS, tells investors how much profit a company earns per each share of stock, and how much investors are benefiting from those earnings. Companies report EPS quarterly, and the figure is calculated by dividing a company’s net income, minus dividend payouts, by the number of outstanding shares.

Understanding earnings per share can give investors guidance on a stock’s potential movement. On a basic level, a high EPS is a good sign, but it’s especially important that a company shows a high or growing EPS over time. The reason for this is that a company might have a temporarily high EPS if they cut some expenses or sell off assets, but that wouldn’t be a good indicator of the actual profitability of their business.

Likewise, a negative EPS over time is an indicator that an investor may not want to buy a stock.

Revenue

While EPS relates directly to a company’s stock, revenue can show investors how well a company is doing outside the markets. Positive and increasing revenues are an indicator that a company is growing and expanding.

Some large companies, especially tech companies, have increasing revenues over time with a negative EPS because they continue to feed profits back into the growing business. These companies can see significant stock value increases despite their lack of profit.

One can also look at revenue growth, which tracks changes in revenue over time.

Price-to-earnings (P/E) Ratio

One of the most common methods of analyzing stocks is to look at the P/E ratio, which compares a company’s current stock price to its earnings per share. P/E is found by dividing the price of one share of a stock by its EPS. Generally, a lower P/E ratio is a good sign.

Using this ratio is a good way to compare different stocks. One can also compare an individual company’s P/E ratio with an index like the S&P 500 Index to get a sense of how the company is doing relative to the overall market.

The downside of P/E is that it doesn’t include growth.

Price-Earnings-Growth (PEG) Ratio

Since P/E doesn’t include growth, the PEG ratio is another popular tool for analyzing stocks and evaluating stock performance. To look at EPS and revenue together, investors can use the price-earnings-growth ratio, or PEG.

PEG is calculated by dividing a stock’s P/E by its projected 12-month forward revenue growth rate. In general, a PEG lower than 1 is a good sign, and a PEG higher than 2 indicates that a stock may be overpriced.

PEG can also be used to make predictions about the future. By looking at PEG for different time periods in the past, investors can make a more informed guess about what the stock may do next.

Price-to-Sales Ratio (P/S)

The P/S ratio compares a company’s stock price to its revenues. It’s found by dividing stock price by revenues. This can be useful when comparing competitors — if the P/S is low, it might be more advantageous to buy.

Debt-Equity Ratio

Although profits and revenue are important to look at, so is a company’s debt and its ability to pay it back. If a company goes into more and more debt in order to continue growing, and they’re unable to pay it back, it’s not a good sign.

Debt-equity ratio is found by dividing a company’s total liabilities (debt) by its shareholder equity. In general, a debt-equity ratio under 0.1 is a good sign, while a debt-equity ratio higher than 0.5 can be a red flag for the future.

Debt-to-EBITDA

Similar to debt-to-equity, debt-to-EBITDA measures the ability a company has to pay off its debts. EBITDA stands for earnings before interest, tax, depreciation, and amortization.

A high debt-to-EBITDA ratio indicates that a company has a high amount of debt that it may not be able to pay off.

Dividend Yield

While a stock’s price can vary significantly from day to day, dividend payments are a way that investors can earn a consistent amount of money each quarter or year. Not every company pays out dividends, but large, established companies sometimes pay out some of their earnings to shareholders rather than reinvesting the money into their business.

Dividend yield is calculated by dividing a company’s annual dividend payment by its share price. The average dividend yield for S&P 500 companies is around 2%.

One thing to note is that dividends are not guaranteed — companies can change their dividend amounts at any time. So if a company has a particularly high dividend yield, it may not stay that way.

Price-to-Book Ratio (P/B)

Price-to-book ratio, or P/B, compares a company’s stock market value to its book value. This is a useful tool for finding companies that are currently undervalued, meaning those that have a significant amount of growth but still relatively low stock prices.

P/B ratio is found by dividing the market price of a stock by the company’s book value of equity. The book value of equity is found by subtracting the company’s total liabilities from its assets.

Company Reports and Projections

When companies release quarterly and annual earnings reports, many of them include projections for upcoming revenue and EPS. These reports are a useful tool for investors to get a sense of a stock’s future. They can also affect stock price as other shareholders and investors will react to the news in the report.

Professional Analysis

Wall Street analysts regularly release reports about the overall stock market as well as individual companies and stocks. These reports include information such as 12-month targets, stock ratings, company comparisons, and financial projections. By reading multiple reports, investors may start to see common trends.

While analysts aren’t always correct and can’t predict global events that affect the markets, these reports can be a useful tool for investors. They can keep them up-to-date on any key happenings that may be on the horizon for particular companies. The information in the reports also can result in stock prices going up or down, since investors will react to the predictions.

Quantitative vs Qualitative Analysis

Here’s a quick rundown looking at the key differences between quantitative and qualitative analysis. Again, this can be important when weighing your risk need to knows as an investor.

Quantitative vs. Qualitative Analysis
Quantitative Analysis

 Qualitative Analysis
Looks at data and numerical figures to predict price movements Looks at business factors such as leadership, product, and industry
May require sifting through a lot of data, and may be difficult for some investors Metrics include business models, competitive advantage, and industry trends
Concerned more with the “quantity” and hard data a business produces Concerned more with the “quality” of a business

Pros and Cons of Doing Your Own Stock Analysis

If you feel like you can do a little stock analysis on your own, there are some pros and cons to it.

Pros

Perhaps the most obvious pro to doing your own stock analysis is that you don’t need to pay someone else to do it, you can do it on your own schedule, and learn as you go. You can develop knowledge that’ll likely help you as you continue to invest in the future. There are also numerous tools out there that you can use to analyze stocks which may not have been around in years or decades past.

Cons

Stock analysis can be an involved process, which can require a lot of investment in and of itself — both monetarily (if you’re using paid tools) and in terms of time. Depending on how deep you want to go, too, it can be a complex process. You may get frustrated or burnt out, or even make a mistake that leads to a bad investment decision.

💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Buying Stocks With SoFi

There are a number of ways to analyze stocks, including technical, fundamental, quantitative, and qualitative analysis. The more an investor gets comfortable with terms like P/E ratio and earnings reports, the more informed they can be before making any decisions. Stock analysis is an involved process, however, and may be above the typical investors’ head and ability.

It is important to do your research and homework in relation to your investments, however. If you feel like you could use some guidance or a helping hand, speaking with a financial professional is never really a bad idea.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

What is the best way to analyze a stock?

There’s no “best” way to analyze stocks. The right option for an investor will depend on their personal preferences and investing objectives. And remember, there’s no need to just use one method to analyze a stock — often, analysts will combine different methods of analysis to generate a more robust stock analysis.

What are key indicators to look for when analyzing a stock?

There are a ton of potential indicators that investors can look at, but some broad indicators that investors can start with include stock price history, moving averages, a company’s competitive advantages, business models, and industry trends.

What is an example of stock analysis?

A very, very basic example of stock analysis would include looking at a stock’s share price, comparing it to its historical averages and moving averages, overall market conditions, and looking at the company’s financial statements to try and gauge where it might move next.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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27
2024

The History of US Recessions: 1797-2020

By | Growing Wealth, invest, Investing | Comments Off on The History of US Recessions: 1797-2020

“Recession” can be a scary word, but economic contractions are fairly common throughout the history of the United States. In fact, they’re perfectly normal parts of the overall business cycle, during which the economy expands, contracts, and then expands again.

It’s during certain contractions, which we usually refer to as recessions, that life can get difficult, as a brief walk through U.S. recession history shows.

While the U.S. most recently experienced a short recession in the wake of the COVID-19 pandemic, and no one knows when the next recession might occur, it’s important to understand that recessions are common — and so are the recoveries.

Key Points

•   Recessions are common in the history of the United States and are part of the overall business cycle.

•   A recession is a period when the economy contracts, with indicators such as stock market declines, business failures, and rising unemployment.

•   The National Bureau of Economic Research officially declares recessions based on various economic indicators.

•   U.S. recession history includes significant downturns like the Great Depression and the Great Recession.

•   There have been multiple recessions throughout U.S. history, caused by factors such as credit expansion, financial crises, and economic contractions.

What Exactly Is a Recession?

A recession is a period of time during which the economy contracts, or shrinks. There are some typical hallmarks of a recession: Stock markets fall, businesses fail or close, and unemployment goes up. Indicators, such as U.S. gross domestic product (GDP), also dips into the negative.

While recessions are often “called” following two-straight quarters of negative GDP growth, that’s more of a layman’s definition. Recessions are, in fact, officially declared by the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER).

The NBER, and the economists comprising it, look at a number of economic indicators when deciding whether to label a period of economic contraction a recession or not. Those might include employment numbers, production, personal income, and more. As such, it’s not an exact science.

Also, as noted, a recession in the U.S. economy isn’t exactly uncommon. The NBER’s measures show that, prior to the COVID-19 pandemic, U.S. recession history comprises as many as 33 recessions.

The last time the U.S. experienced a recession was in 2020. But that was a relatively short recession. The biggest recession in U.S. history sparked the Great Depression, between 1929 and 1933, though the Great Recession (2007-2009) was the worst in modern times.

But U.S. recession history stretches way back nearly to the founding of the country itself.

💡 Dive deeper: Understanding Recessions and What Causes Them

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Earliest Known Recessions

1797-1798

Strikingly familiar to the Great Recession of 2008 to 2009, the recession of 1797 is believed to have been caused by a credit expansion and an investment bubble that included real estate, manufacturing, and infrastructure projects.

Problems ensued, bringing about a recession that affected nearly everyone from investors to shopkeepers to laborers.

1857

The Panic of 1857 wasn’t the first financial crisis in the United States, but thanks to the invention of the telegraph, news about the crisis spread quickly across the country.

Most historians attribute the panic to a confidence crisis that involved the failure of the Ohio Life Insurance and Trust Company, but other events have also been cited, including the end of the Crimean War overseas (which affected grain prices), excessive speculative investing in various markets, and questions about the overall stability of the U.S. economy.

1873-1879

Often referred to as the “Long Depression,” the Depression of 1873–1879 started with a stock market crash in Europe. Investors there began selling their investments in American projects, including bonds that funded railroads.

Without that funding, the banking firm Jay Cooke and Company, which was heavily invested in railroad construction, realized it was overextended and closed its doors. Other banks and businesses followed; and from 1873 to 1879, 18,000 U.S. businesses went bankrupt, including 89 railroads and at least 100 banks.

At the same time, the Coinage Act of 1873 demonetized silver as the legal tender of the United States, in favor of fully adopting the gold standard. The withdrawal of silver coins further contributed to the recession, as miners, farmers, and others in the working class had few ways to pay their debts.

1893-1897

Like many other financial downturns, this depression was preceded by a series of events that undermined public confidence and weakened the economy, including disputes over monetary policy (particularly gold vs. silver), underconsumption that led to a cutback in production, and government overspending.

Two of the country’s largest employers, the Philadelphia and Reading Railroad and the National Cordage Company, collapsed, and the stock market panic that followed turned into a larger financial crisis.

Banks and other financial firms began calling in loans, causing hundreds of businesses to go bankrupt and fail, and as a result, unemployment rates and homelessness soared.

Recessions Between 1900-2000

1907-1908

The recession that occurred between May 1907 and June 1908 was preceded by the San Francisco Earthquake, which took a toll on the insurance industry, and was also influenced by the Bankers Panic of 1907 which caused a huge stock market drop.

Those events spread fear across the country and a lack of confidence in the financial industry, causing more banking failures. As a result, the banking industry experienced major changes, including the creation of the Federal Reserve System in 1913, which was designed to provide a more stable monetary and financial system.

1929-1938

Most recessions last months. The Great Depression lasted years, and is generally regarded as the most devastating economic crisis in U.S. history. It had many causes, including reckless speculation, volatile economic conditions in Europe, and overvaluation that ended in a stock market crash in 1929.

Consumer confidence crashed as well, and a downturn in spending and investment led businesses to slow down production and lay off workers.

By early 1933, after a series of panics caused investors to demand the return of their funds, thousands of banks closed their doors. Immediately upon taking office, President Franklin D. Roosevelt began implementing a recovery plan, including reforms known as the New Deal.

He also moved to protect depositors’ accounts with the new Federal Deposit Insurance Corporation (FDIC). And he created the Securities and Exchange Commission (SEC) to regulate the stock market.

America’s entry into World War II further solidified the recovery, as production expanded and unemployment continued to drop from a high of 24.9% in 1933 to 4.7% by 1942.

1945

The result of demobilization and a shift to a peacetime economy after World War II ended, this eight-month recession (February to October 1945) is mostly known for a precipitous 12.7% drop in the gross domestic product, or GDP.

1948-1949

Economists generally blame this 11-month downturn (November 1948 to October 1949) on the “Fair Deal” social reforms of President Harry Truman, as well as a period of monetary tightening by the Federal Reserve in response to rampant inflation. Although it is generally considered a minor downturn, the unemployment rate did reach a 7.9% peak in October 1949.

1953-1954

A combination of events led to this 10-month recession (July 1953 to May 1954), including a post-Korean War economic contraction, as well as the tightening of monetary policy due to inflation and the separation of the Federal Reserve from the U.S. Treasury in 1951.

Unemployment peaked at 6.1% in September 1954, four months after the recession was officially over.

1957-1958

The Federal Reserve’s contractionary monetary policy — restricting the supply of money in an overheated economy — is often cited as the cause of this economic downturn. GDP fell 4.1% in the last quarter of 1957, then dropped another 10% at the start of 1958. Unemployment peaked at 7.5% in July 1958.

1960-1961

This recession lasted 10 months (from April 1960 to February 1961) and spanned two presidencies. When it began, Dwight D. Eisenhower was in office, but John F. Kennedy inherited the problem (after using the downturn to defeat then-vice president Richard Nixon in the 1960 presidential election.)

Although the recession caused serious problems for many sectors of the economy (a drop in manufacturer’s sales — and, therefore, manufacturing employment — was one of the first signs of trouble), its overall effects were mostly mild.

Personal income continued to rise through much of 1960, and declined less than 1% from October 1960 to February 1961. Unemployment was high, however, peaking at 7.1% in May 1961.

1969-1970

Though it lasted almost a year (from December 1969 to November 1970), this recession is considered to have been relatively mild, because it brought about only a 0.6% decline in the GDP. However, the unemployment rate was high, reaching a peak of 6.1% in December 1970.

The downturn’s causes include a rising inflation rate resulting from increased deficits, heavy spending on the Vietnam War, and the Federal Reserve’s policy of increasing interest rates.

1973-1975

This recession, which lasted from November 1973 to March 1975, is usually blamed on rocketing gas prices caused by OPEC (the Organization of Petroleum Exporting Countries), which raised oil prices and embargoed oil exports to the United States.

Other major factors in this 1970s recession included a stock market crash that caused a bear market from 1973 to 1974, and several monetary moves made by President Richard Nixon, including implementing wage-price controls and ending the gold standard in the U.S. The result was “stagflation,” a slowing economy with high unemployment and high inflation.

1980-1982

There were actually two recessions during the early 1980s, according to the NBER. A brief recession occurred during the first six months of 1980, and then, after a short period of growth, a second, more sustained recession, lasted from July 1981 to November 1982.

That second recession, known as a double-dip recession, is largely blamed on monetary policy, as high-interest rates — in place to fight inflation — put pressure on sectors of the economy that depended on borrowing, such as manufacturing and construction.

Unemployment grew from 7.4% at the start of the recession to a peak of 10.8% in December 1982, the highest level of any modern recession (with the exception of 2020).

1990-1991

The “Reagan Boom ” of the early and mid-1980s came to an ugly end at the beginning of the 1990s, as stock markets around the world crashed, and the U.S. savings and loan industry collapsed.

When Iraq invaded Kuwait in 1990, driving up the price of oil, consumer confidence took another hit.

The recession lasted from July 1990 to March 1991, according to the NBER, but it took the economy a while longer to fully rebound. Unemployment peaked at 7.8% in June 1992, and then-presidential candidate Bill Clinton’s focus on the struggling economy helped him unseat President George H.W. Bush later that year.

Recessions Between 2000-2022

2001

The 2001 recession lasted just eight months, from March to November, according to the NBER. And yet, the story behind the dot-com bubble trouble that triggered it remains a cautionary tale.

Investors looking for the next big thing cast aside fundamental analysis, and a frenzy grew over tech companies in the late 1990s. Many became overvalued, and the Y2K scare at the start of 2000 made investors jittery and took things up another notch.

When the tech bubble burst in 2001, equities crashed, and the 9/11 terrorist attacks only made matters worse. The Nasdaq index — one of several different stock exchanges — tumbled from a peak of 5,048.62 on March 10, 2000, to 1,139.90 on Oct 4, 2002, totaling a 76.81% fall.

On June 7, 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which used tax rebates and tax cuts to help stimulate the economy. And by 2003, the Federal Reserve had lowered its federal funds rate to a range of between 0.75% and 1.0% in an effort to further lift economic activity.

2008 to 2009

The Great Recession — also known as the financial crisis of 2008-2009 — is as notable for its severity as for its length. U.S. GDP fell 4.3% from its highest level at the end of 2007 to its lowest point in mid-2009. Meanwhile, the unemployment rate kept rising, from 5% at the end of 2007 to 10% in October 2009.

The average home price fell about 30% between mid-2006 and mid-2009. The S&P 500 fell 57% from October 2007 to March 2009. And the net worth of U.S. households and nonprofit organizations also took a hit, dropping from approximately $69 trillion in 2007 to $55 trillion in 2009.

Though the recession was especially devastating in the U.S., where it was triggered by the subprime mortgage crisis, it was an international crisis as well. A global economic downturn resulted in an unprecedented number of stimulus packages being introduced around the world.

In the U.S., the Federal Reserve reduced the federal funds rate from 5.25% in September 2007 to a range of zero to 0.25% by December 2008. And a $787-billion stimulus package, the American Recovery and Reinvestment Act of 2009, included tax breaks and spending projects credited with helping revive the sagging economy.

As for the three main causes of the recession of 2008? It’s complicated, but regulatory changes to how banks were allowed to invest customers’ money (specifically, into derivatives) was a main cause.

From there, derivative products were created from subprime mortgages, and as demand for homes increased (and interest rates rose) many borrowers could no longer afford to pay their mortgages. Finally, a collision of security fraud and predatory lending practices nearly overwhelmed the financial sector, as banks stopped lending to each other, and a game of derivative hot-potato ended with notable bank failures.

Will the US Enter a Recession in 2023?

First and foremost: there’s no way to predict a recession, just as there’s no way to accurately, 100% predict what the stock market will do on any given day. But there are indicators that investors can keep an eye on.

As of early 2023, the U.S. was facing a unique series of issues: High inflation, rising interest rates, and cultural and demographic shifts that forced countless businesses to figure out a “new normal.” Millions of workers retired (and many died due to the pandemic), leaving a glut of unfilled jobs. Wages needed to rise, too, as goods and services became more expensive.

And yet employment remained high, businesses, in many cases, reported record profits, and though the stock market took a tumble in 2022, it largely remained at levels above the pre-pandemic period.

Taken all together, there are signs that the economy could contract in 2023, but others that don’t indicate a recession is close. Again, this is something of an unprecedented set of factors, and as such, many economists don’t quite know what to make of it yet.

It’s wholly possible that the economy could go into recession in 2023, but it’s far from guaranteed.

The Takeaway

U.S. recession history is a long, complicated topic. But if there’s one thing you should take away from it, it’s that recessions happen, they happen fairly frequently, and they’re not the end of the world. There are many reasons that a recession could or might happen, too, and there’s often no way to accurately predict a recession.

With that in mind, you can and should keep an eye on the news, the markets, and on economic indicators to try and get a sense of what might happen in the economy. As discussed above, recessions may spell bad news, but typically only for a period of time, after which markets tend to recover.

That’s why some investors may find opportunities regardless of market conditions. You can start investing online today using SoFi Invest. You can select from a number of stocks and exchange-traded funds. SoFi doesn’t charge commissions, you can read the full fee schedule here, and you have access to complimentary financial advice.

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SoFi Invest®

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SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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2024
What Are Collateralized Debt Obligations (CDO)?

What Are Collateralized Debt Obligations (CDO)?

By | Growing Wealth, invest, Investing | Comments Off on What Are Collateralized Debt Obligations (CDO)?

Collateralized debt obligations are complex financial products that bundle multiple bonds and loans into single securities.

These packaged securities are then sold in the market, typically to institutional investors. CDOs became more widely known to the general public due to their role in the 2008-2009 financial crisis.

Individual investors cannot easily buy CDOs. However, the 2008 financial crisis and subsequent recession revealed the interconnected nature of markets, as well as how losses on Wall Street can have ripple effects on the broader economy.

Therefore, it can be important for everyday individuals to grasp the role that complex financial instruments like collateralized debt obligations have in markets.

Key Points

•   Collateralized debt obligations (CDOs) are complex financial products that bundle multiple bonds and loans into single securities.

•   CDOs are sold in the market to institutional investors and became more widely known due to their role in the 2008-2009 financial crisis.

•   CDOs work by using the payments from underlying loans, bonds, and other types of debt as collateral.

•   CDOs are typically sliced into tranches that hold varying degrees of risk and are sold to investors.

•   Synthetic CDOs invest in derivatives, while regular CDOs invest in bonds, mortgages, and loans. CLOs are a subset of CDOs that gather debt from different companies.

How Do CDOs Work?

“Collateral” in finance is a term that refers to the security that lenders may require in return for lending money. In collateralized debt obligations, the collateral are the payments from the underlying loans, bonds, and other types of debt.

CDOs are considered derivatives since their prices are derived from the performance of the underlying bonds and loans. The institutional investors who tend to hold CDOs may collect the repayments from the original borrowers in the securities.

The returns of CDOs depend on the performance of the underlying debt. CDOs are popular because they allow lenders, usually banks, to turn a relatively illiquid security — like a bond or loan — into a more liquid asset.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Tranches in CDOs

CDOs are typically sliced into so-called tranches that hold varying degrees of risk and then these slices are sold to investors.

The most senior tranche is the highest rated by credit rating firms like S&P and Moody’s. The highest credit rating possible is AAA. Holders of the most senior or highest-rated tranche generally receive the lowest yield but are the last group to absorb losses in cases of default.

The most junior tranche in CDOs is sometimes unrated. Investors of this layer earn the highest yields but are the first to absorb credit losses. The middle tranche is usually rated between BB to AA.

Recommended: How Do Derivatives Work?

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What Are Synthetic CDOs?

Regular, plain-vanilla CDOs invest in bonds, mortgages, and loans. In contrast, synthetic collateralized debt obligations invest in derivatives.

So instead of bundling corporate bonds or home mortgages, synthetic CDOs bundle derivatives like credit default swaps, options contracts, or other types of contracts. Keep in mind, these derivatives are themselves tied to another asset, such as loans or bonds.

Investors of regular CDOs get returns from the payments made on corporate debt or mortgage loans. Holders of synthetic CDOs get returns from the premiums associated with the derivatives.

CDOs vs CLOs

Collateralized loan obligations are a subset of CDOs. Instead of bundling up an array of different types of debt, CLOs more specifically gather together debt from hundreds of different companies, often this debt is considered below investment grade.

CLOs are considered by some market observers to be safer than CDOs, but both are risky debt products. CLOs do however tend to be more diversified across firms and sectors, while CDOs run the risk of being concentrated in a single debt type, such as mortgage loans during the 2008 financial crisis.

According to S&P, no U.S. AAA-rated CLO has ever defaulted. Also, CDOs can have a higher percentage of lower-rated debt. According to the ratings firm Moody’s, CDOs are allowed to hold up to 17.5% of their portfolio in Caa-rated assets and below (e.g. very high credit risk). That compares to the 7.5% in CLOs.

Collateralized Debt Obligations and the 2008-09 Housing Crisis

CDOs of mortgage-backed securities became notorious during the subprime housing crisis of 2008 and 2009. A selloff in the CDO market was said to amplify broader economic weakness in the economy.

Banks had been weakening lending standards when it came to home mortgages, allowing individuals to buy home that may have been too expensive for them.

Meanwhile, Wall Street banks were packaging home loans — some risky and subprime — into CDOs in the years leading up to the financial crisis. Ratings firms labeled these mortgage-backed CDOs as safe, on the premise that homeowners were a group of creditors less likely to default.

A mortgage-backed CDO holds many individual mortgage bonds. The mortgage bonds, in turn, packaged thousands of individual mortgages. These mortgage CDOs were considered to be of limited risk because of how they were diversified across many mortgage bonds.

But homeowners started to become unable to make their monthly payments, and defaults and foreclosures started piling up, leading to a domino effect of losses spread across the financial system.

Recommended: What Is Active Investing?

CDO Comeback

Around 2020, CDOs had a resurgence, with primarily corporate loans rather than home loans being packaged into securities.

A world of ultralow yields in the bond market pushed investors to seek higher-yielding markets. The average yield stands at just 2%, while trillions of dollars in debt trades at negative rates. In contrast, CDOs can yield up to 10%.

This time around hedge funds and private-equity firms, rather than banks, became the big players in the CDO market. Hedge funds are the new buyers–accounting for 70% of volume in the market. Banks were responsible for 10% of volumes in 2019, compared with 50% in the past.


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The Takeaway

Collateralized debt obligations or CDOs are financial structures that bundle together different types of debt and sell shares of these bundled securities to investors.

The return investors might see from these debt-based, derivative securities depends on the ongoing payments from the debt holders. CDOs are typically purchased by institutional investors, not retail investors, but it can be useful to know about this market sector.

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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.

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SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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2024
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Are 401(k) Contributions Tax Deductible? Limits Explained

By | Growing Wealth, invest, Investing | Comments Off on Are 401(k) Contributions Tax Deductible? Limits Explained

As you’ve been planning and saving for retirement, you may have heard that there’s a “401(k) tax deduction.” And while there are definitely tax benefits associated with contributing to a 401(k) account, the term 401(k) tax deduction isn’t accurate.

You cannot deduct your 401(k) contributions on your income tax return, per se — but the money you save in your 401(k) is deducted from your gross income, which can potentially lower how much tax you owe.

This is not the case for a Roth 401(k), a relative newcomer in terms of retirement accounts. These accounts are funded with after-tax contributions, and so tax deductions don’t enter the picture.

Key Points

•   401(k) contributions are not tax deductible, but they lower your taxable income.

•   Roth 401(k) contributions are made with after-tax money and do not provide tax deductions.

•   Contributions to employer-sponsored plans like 401(k) or 403(b) are taken out of your salary and reduce your taxable income.

•   401(k) withdrawals are taxed as income, and early withdrawals may incur additional penalties.

•   Making eligible contributions to a 401(k) or IRA can potentially qualify you for a Retirement Savings Contributions Credit.

How Do 401(k) Contributions Affect Your Taxable Income?

The benefits of putting pre-tax dollars toward your 401(k) plan are similar to a tax deduction, but are technically different.

•   An actual tax deduction (similar to a tax credit) is something you document on your actual tax return, where it reduces your gross income.

•   Contributions to an employer-sponsored plan like a 401(k) or 403(b) are actually taken out of your salary, so that money is not taxed, and thus your taxable income is effectively reduced. But this isn’t technically a tax deduction.

People will often say your 401(k) contributions are tax deductible, or you get a tax deduction for saving in a 401(k), but it’s really that your 401(k) savings are deducted from your salary, and not taxed.

The money in the account also grows tax free over time, and you would pay taxes when you withdraw the money.

Example of a 401(k) Contribution

Let’s say you earn $75,000 per year. And let’s imagine you’re contributing 10% of your salary to your 401(k), or $7,500 per year.

Your salary is then reduced by $7,500, an amount that is noted on your W2. As a result, your taxable income would drop to $67,500.

Would that alone put you in a lower tax bracket? It’s possible, but your marginal tax rate is determined by several things, including deductions for Social Security and Medicare taxes, so it’s a good idea to take the full picture into account or consult with a professional.

Recommended: IRA vs 401(k): What’s the Difference?

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Do You Need to Report 401(k) Contributions on Your Tax Return?

The short answer is no. Because 401(k) contributions are taken out of your paycheck before being taxed, they are not included in taxable income and they don’t need to be reported on a tax return (e.g. Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors).

Your employer does include the full amount of your annual contributions on your W2 form, which is reported to the government. So Uncle Sam does know how much you’ve contributed that year.

You won’t need to report any 401(k) income until you start taking distributions from your 401(k) account — typically after retiring. At that time, you’ll be required to report the withdrawals as income on your tax return, and pay the correct amount of taxes.

When you’re retired and withdrawing funds (aka taking distributions), the hope is that you’ll be in a lower tax bracket than while you were working. In turn, the amount you’re taxed will be relatively low.

How the Employer Match Works

When an individual receives a matching contribution to their 401(k) from their employer, this amount is also not taxed. A typical matching contribution might be 3% for every 6% the employee sets aside in their 401(k). In this case, the matching money would be added to the employee’s account, and the employee would not owe tax on that money until they withdrew funds in retirement.

How Do 401(k) Withdrawals Affect Taxes?

The tax rules for withdrawing funds from a 401(k) account differ depending on how old you are when you withdraw the money.

Generally, all traditional 401(k) retirement plan distributions are eligible for income tax upon withdrawal of the funds (note: that rule does not apply to Roth 401(k)s, since contributions to those plans are made with after-tax dollars, and withdrawals are generally tax free).

If you withdraw money before the age of 59 ½ it’s known as an “early” or “premature” distribution. For these early withdrawals, individuals have to pay an additional 10% tax as a part of an early withdrawal penalty, with some exceptions, including withdrawals that occur:

•   After the death of the plan participant

•   After the total and permanent disability of the plan participant

•   When distributed to an alternate payee under a Qualified Domestic Relations Order

•   During a series of substantially equal payments

•   Due to an IRS levy of the plan

•   For qualified medical expenses

•   Certain distributions for qualified military reservists called to active duty

For individuals looking to withdraw from their 401(k) plan before age 59 ½, a 401(k) loan may be a better option that will not result in withdrawal penalties, but these loans with their own potential consequences.

How Do Distributions From a 401(k) Work?

Once you turn 59 ½, you can withdraw 401(k) funds at any time, and you will owe income tax on the money you withdraw each year. That said, you cannot keep your retirement funds in the account for as long as you wish.

When you turn 72, the IRS requires you to start withdrawing money from your 401(k) each year. These withdrawals are called required minimum distributions (or RMDs), and it’s important to understand how they work because if you don’t withdraw the correct amount by Dec. 31 of each year, you could get hit with a big penalty.

Prior to 2019, the age at which 401(k) participants had to start taking RMDs was 70 ½. The rule changed in 2019 and the required age is now 72. When you turn 72 the IRS requires you to start taking withdrawals from your 401(k), or other tax-deferred accounts (like a traditional IRA or SEP IRA).

If you don’t take the required minimum amount each year, you could face another requirement: to pay a penalty of 50% of the withdrawal you didn’t take.

All RMDs from tax-deferred accounts like 401(k) plans are taxed as ordinary income. If you withdraw more than the required minimum, no penalty applies.

Recommended: Should You Open an IRA If You Have a 401(k)?

What Are Tax Saver’s Credits?

Making eligible contributions to an employer-sponsored retirement plan such as a 401(k) or an IRA can potentially lead to a tax credit known as a Retirement Savings Contributions Credit, or a Saver’s credit. There are three requirements that must be met to qualify for this credit.

1.    Individual must be age 18 or older.

2.    They cannot be claimed as a dependent on someone else’s return.

3.    They can not be a student (certain exclusions apply).

The amount of the credit received depends on the individual’s adjusted gross income.

The credit amount is typically 50%, 20%, or 10% of contributions made to qualified retirement accounts such as a 401(k), 4013(b), 457(b), traditional or Roth IRAs.

For tax year 2023, the maximum contribution amount that qualifies for this credit is $2,000 for individuals, and $4,000 for married couples filing jointly, bringing the maximum credit to $1,000 for individuals and $2,000 for those filing jointly. Rollover contributions don’t qualify for this credit.

Alternatives for Reducing Taxable Income

Aside from contributing to a traditional 401(k) account, there are other ways to reduce taxable income while putting money away for the future.

Traditional IRA: Traditional IRAs are one type of retirement plan that can lower taxable income. Individuals may be able to deduct their traditional IRA contributions on their federal income tax returns. The deduction is typically available in full if an individual (and their spouse, if married) doesn’t have retirement plan coverage offered by their work. Their deduction may be limited if they or their spouse are offered a retirement plan at work, and their income exceeds certain levels.

SEP IRA: SEP IRAs are a possible alternative investment account for individuals who are self-employed and don’t have access to an employee sponsored 401(k). Taxpayers who are self-employed and contribute to an SEP IRA can qualify for tax deductions.

403(b) Plans: A 403(b) plan applies to employees of public schools and tax-exempt organizations, and certain ministers. Employees with 403(b) plans can contribute some of their salary to the plan, as can their employer. As with a traditional 401(k) plan, the participant doesn’t need to pay income tax on any allowable contributions, earnings, or gains until they begin to withdraw from the plan.

Charitable donations: It’s possible to claim a deduction on federal taxes after donating to charities and non-profit organizations with 501(c)(3) status. To deduct charitable donations, an individual has to file a Schedule A with their tax form and provide proper documentation regarding cash or vehicle donations.

To deduct non-cash donations, they have to complete a Form 8283. For donated non-cash items, individuals can claim the fair market value of the items on their taxes. from the IRS explains how to determine vehicle deductions. For donations that involve receiving a gift or a ticket to an event, the donor can only deduct the amount of the donation that exceeds the worth of the gift or ticket received. Individuals are generally required to include receipts when they submit their return.

Earned Income Tax Credit: Individuals and married couples with low to moderate incomes may qualify for the Earned Income Tax Credit (EITC). This particular tax credit can help lower the amount of taxes owed if the individual meets certain requirements and files a tax return — whether or not the individual owes money. Filing a return in this case can be beneficial, because if EITC reduces the amount of taxes owed to less than $0, then the filer may actually get a refund.

The Takeaway

Individuals who expect a 401(k) deduction come tax time may be disappointed to learn that there is no such thing as a 401(k) tax deduction. But they may be pleased to learn the other tax benefits of contributing to a 401(k) retirement account.

Contributions are made with pre-tax dollars, which effectively lowers one’s amount of taxable income for the year — and that may in turn lower the amount of income taxes owed.

Once an individual reaches retirement age and starts withdrawing funds from their 401(k) account, that money will be considered income, and will be taxed accordingly.

Another way to maximize your retirement savings: Consider rolling over your old 401(k) accounts so you can manage your money in one place with a rollover IRA. SoFi makes the rollover process seamless and simple. There are no rollover fees. The process is automated so you’ll avoid the risk of a penalty, and you can complete your 401(k) rollover quickly and easily.

Help grow your nest egg with a SoFi IRA.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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