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Q: What are common student loan terms?

Student loan terms include Direct Loans — which are any loans in the Federal Direct Loan program. These include Direct Subsidized and Unsubsidized loans in addition to Direct PLUS Loans.

Sep

2024

Student Loan Terminology Cheat Sheet

By Kayla McCormack | Debt Payoff, Fresh Out of School, Student Loans, student_loan | No Comments

There are so many upsides to investing in your education — the personal enrichment and possibility of a bright and fruitful future being the most obvious. But, there are also some potential downsides that are hard to ignore, one of the main ones being the debt you may accrue.

If you’re a student loan borrower, you’ve probably noticed that your loans have a language all their own. Getting a grasp on terms like interest rate vs. APR, subsidized vs. unsubsidized loans, and fixed vs. variable interest rates can help you make more informed, confident decisions.

Instead of enrolling in Student Loan Language 101, you can use our quick reference guide to find some answers without information overload. Borrowing money can have long-term financial consequences, so it’s important to fully understand the fees and interest rates that will affect the amount of money you owe.

Here are a few of the most important terms to understand before you take out a student loan:

Common Student Loan Terminology

Academic Year

An academic year is one complete school year at the same school. If you transfer, it is considered two half-years at different schools.

Accrued Interest

Accrued interest is the amount of interest that has accumulated on a loan since your last payment. You can keep student loan accrued interest in check by making your payments on time each month. However, after a period of missed or reduced payments, accrued interest may be “capitalized,” which essentially means you have to pay interest on the interest!

Adjusted Gross Income (AGI)

AGI is an individual’s gross income, less any payroll deductions or adjustments. Income includes things like wages, salary, any interest or dividends you may earn, and any other sources of income. You can find your AGI on your federal income tax returns.

Aggregate Loan Limit

The aggregate loan limit is the maximum amount of federal student loan debt a borrower can have when graduating from school. The aggregate loan limits vary depending on whether you are a dependent or independent student.

Amortization

Amortization refers to the amount of loan principal and interest you pay off incrementally over your loan term. Each student loan payment is a fixed amount that contributes to both interest and principal. Early in the life of the loan, the majority of each payment goes toward interest. But over time as you pay down your loan balance, the ratio shifts and most of the payment goes toward the principal.

Annual Percentage Rate (APR)

APR is the annual rate that is charged for borrowing, expressed as an annual a percentage. APR is a standardized calculation that allows you to make a more fair comparison of different loans. Consider the difference between interest vs. APR — APR reflects the cost of any fees charged on the loan, in addition to the basic interest rate. Generally speaking, the lower your APR, the less you’ll spend on interest over the life of the loan.

Annual Loan Limit

The yearly borrowing limit set for federal student loans.

Automated Clearing House (ACH)

An electronic funds transfer is sent through the Automated Clearing House system. The ACH is an electronic funds transfer system that helps your loan payment transfer directly from your bank account to your lender or loan servicer each month.

The benefits of ACH are two-fold — not only can automatic payments keep you from forgetting to pay your bill, but many lenders also offer interest rate discounts for enrolling in an ACH program.

Award Letter

An award letter is sent from your school and details the types and amounts of financial aid you are eligible to receive. This will include information on grants, scholarships, federal student loans, and work-study. You will receive an award letter for each year you are in school and apply for financial aid.

Award Year

The academic year that financial aid is applied to.

Borrower

The borrower is the person who took out a loan. In doing so, they agreed to repay the loan.

Campus-Based Aid

Some financial aid programs are administered by specific financial institutions, such as the federal work-study program. Generally, schools receive a certain amount of campus-based aid annually from the federal government. The schools are then able to award these funds to students who demonstrate financial need.

Recommended: Am I Eligible for Work-Study?

Cancellation

This refers to the cancellation of a borrower’s requirement to repay all or a portion of their student loans. Loan forgiveness and discharge are two other types of loan cancellation.

Capitalization

Capitalization is when unpaid interest is added to the principal value of the student loan. This generally occurs after a period of non-payment such as forbearance. Moving forward, the interest will be calculated based on this new amount.

Capitalized Interest

Accrued interest is added to your loan’s principal balance, typically after a period of non-payment such as forbearance. When the interest is tacked onto your principal balance, your interest is now calculated on that new amount.

Most student loans begin accruing interest as soon as you borrow them. While you are often not responsible for repaying your student loans while you are in school or during a grace period or forbearance, interest will still accrue during these periods. At the end of said period, the interest is then capitalized, or added to the principal of the loan.

When interest is capitalized, it increases your loan’s principal. Since interest is charged as a percent of principal, the more often interest is capitalized, the more total interest you’ll pay. This is a good reason to use forbearance only in emergency situations, and end the forbearance period as quickly as possible.

Cosigner

A cosigner is a third party, such as a parent, who contractually agrees to accept equal responsibility in repaying your loan(s). A student loan cosigner, also known as an endorser, can be valuable if your credit score or financial history are not sufficient enough to allow you to borrow on your own.

With a cosigner, you are still responsible for paying back the loan, but the cosigner must step in if you are unable to make payments. A co-borrower applies for the loan with you and is equally responsible for paying back the loan according to the loan terms on a month-to-month basis

Consolidation (through the Direct Loan Consolidation Program)

Student loan consolidation is the act of combining two or more loans into one loan with a single interest rate and term. The resulting interest rate is a weighted average of the original loan rates — rounded up to the nearest one-eighth of a percentage point.

Only certain federal loans are eligible for the Direct Consolidation Program. Consolidating can make your life simpler with one monthly bill, but it may not actually save you any money. You may be able to reduce your monthly payments by increasing the loan term, but this means you’ll pay more interest over the life of the loan.

Consolidation (through a Private Lender)

Consolidation is the act of combining two or more loans into one single loan with a single interest rate and term. When you consolidate loans with a private lender, you do so through the act of refinancing, so you’re given a new (hopefully lower) interest rate or lower payments with a longer term.

By refinancing, you may be able to lower your monthly payments or shorten your payment term. (Note: You may pay more interest over the life of the loan if you refinance with an extended term.)

Recommended: What Is a Direct Consolidation Loan?

Cost of Attendance

Cost of attendance is the estimated total cost for attending a college based on the cost of tuition, room and board, books, supplies, transportation, loan fees, and miscellaneous expenses. Schools are required to publish the cost of attendance.

Credit Report

Credit reports detail an individual’s bill payment history, loans, and other financial information. These reports are used by lenders to evaluate your creditworthiness.

Default

Default is failure to repay a loan according to the terms agreed to in the promissory note. Defaulting on your student loans can have serious consequences, such as additional fees, wage garnishment, and a significant negative impact on your credit. It’s always better to talk to your lender about potential hardship repayment options, such as deferment or forbearance, before defaulting on a loan.

Deferment

Deferment is the temporary postponement of loan repayment, during which time you may not be responsible for paying interest that accrues (on certain types of loans). Student loan deferment can be useful if you think you’ll be in a better place to pay your loans at a later date. However, deferment is usually only available for certain federal loans. To potentially cut down on interest, it may be wise to weigh your deferment options.

Delinquency

When you miss a student loan payment, the loan becomes delinquent. The loan will be considered delinquent until a payment is made on the loan. If the loan remains in delinquency for a specified period of time (which varies for federal vs. private student loans), it may enter default.

Direct Loan

The Direct Loan program is administered via the U.S. Department of Education. There are four main types of direct loans including Direct Subsidized Loans, Direct Unsubsidized Loans, Direct PLUS Loans, and Direct Consolidation Loans.

Direct PLUS Loan

Direct PLUS Loans are types of federal loans that are made to graduate or professional student borrowers or to the parents of undergraduate students. Direct PLUS Loans made to parents may be referred to as Parent PLUS Loans.

Disbursement

When funds for a loan are paid out by the lender.

Discharge

Student loan discharge occurs when you are no longer required to make payments on your loans. Typically, student loan discharge occurs when there are extenuating circumstances, such as the borrower has experienced a total and permanent disability or the school at which you received your loans has closed.

Discretionary Income

Discretionary income is the money remaining after you pay for necessary expenses. An individual’s discretionary income is used to help determine their loan payments on an income-driven repayment plan.

Enrollment Status

Determined by the school you attend, your enrollment status is a reflection of where you stand with the school. It includes full-time, half-time, withdrawn, and graduated.

Expected Family Contribution (EFC)

Now known as the Student Aid Index (SAI), it’s an estimation of the amount of money a student and their family is expected to pay out of pocket toward tuition and other college expenses.

Federal Work-Study

A type of financial aid, students who demonstrate financial aid may qualify for the federal work-study program, where they work part-time to earn funds to help pay for college expenses.

Financial Aid

Financial aid is funds to help pay for college. Financial aid includes grants, scholarships, work-study, and federal student loans.

Financial Aid Package

An overview of the types of financial aid you are eligible to receive for college, financial aid packages provide information on all types of federal financial aid and college-specific aid such as scholarships, grants, work-study, and federal student loans.

Financial Need

Some types of financial aid are determined by financial need. Financial need is determined by the Free Application for Federal Student Aid (FAFSA®).

Fixed Interest Rate

Fixed interest rates remain the same for the life of the loan. The interest rate does not fluctuate.

Forbearance

Forbearance is the temporary postponement of loan repayment, during which time interest typically continues to accrue on all types of federal student loans. If your student loan is in forbearance, you can either pay off the interest as it accrues or you can allow the interest to accrue and it will be capitalized at the end of your forbearance.

Use forbearance wisely, because interest that accrues during the forbearance period is typically capitalized, making your loan more expensive. If you can afford to make even small payments during forbearance, it can help keep interest costs down.

You will usually have to apply for student loan forbearance with your loan holder and will sometimes be required to provide documentation proving you meet the criteria for forbearance. For a loan to be eligible for forbearance, there must be some unexpected temporary financial difficulty.

Forgiveness

Loan forgiveness is another situation in which you are no longer responsible for repaying all or a portion of your student loans. Public Service Loan Forgiveness and Teacher Loan Forgiveness are two types of loan forgiveness programs in which your loans are forgiven after meeting specific requirements, such as working in a qualifying job and making qualifying loan payments.

In August 2022, President Biden announced a loan forgiveness plan for borrowers with student loan debt. Under this plan, borrowers earning up to $125,000 (when filing taxes as single) may qualify for up to $10,000 in student loan forgiveness. He also announced that Pell Grant recipients may qualify to have up to $20,000 of their loans forgiven.

Free Application for Federal Student Aid (FAFSA)

This is the application students use to apply for all types of federal student aid, including federal loans, work-study, grants, and scholarships. The FAFSA must be completed for each year a student wishes to apply for financial aid.

Recommended: FAFSA Guide

Grace Period

The grace period is a period of time after you graduate, leave school, or drop below half-time during which you’re not required to make payments on certain loans. Some loans continue to accumulate interest during the grace period, and that interest is typically capitalized, making your loan more expensive.

Grad PLUS Loans

Another term to refer to a Direct PLUS loan, specifically one borrowed by a graduate or professional student.

Graduate or Professional Student

A student who is pursuing educational opportunities beyond a bachelor’s degree. Graduate and professional programs include master’s and doctoral programs.

Graduated Repayment Plan

A type of repayment plan available for federal student loan borrowers. On this repayment plan, loan payments begin low and increase every two years. This plan may make sense for borrowers who expect their income to increase over time.

Grant

Grants are a type of financial aid that does not need to be repaid. Grants are often awarded based on financial need or merit-based.

In-School Deferment

Students who are enrolled at least half-time in school are eligible to defer their federal student loans. This type of deferment is generally automatic for federal student loans. Note that unless you have a subsidized student loan, interest will continue to accrue during in-school deferment.

Interest

Interest is the cost of borrowing money. It is money paid to the lender and is calculated as a percentage of the unpaid principal.

Interest Deduction

A tax deduction that allows you to deduct the student loan interest you paid on a qualified student loan for the tax year. Interest paid on both private and federal student loans qualifies for the student loan interest deduction.

Lender

The financial institution that lends funds to an individual borrower.

Loan Period

A loan period is the academic year for which a student loan is requested.

Loan Servicer

A loan servicer is a company your lender may partner with to administer your loan and collect payments. For questions about your student loan payments or administrative details such as account information, you should contact your student loan servicer.

Origination Fee

Some lenders charge an origination fee for processing a loan application, or in lieu of upfront interest. To minimize incremental costs on your loan, look for lenders that offer no or low fees.

Part-Time Enrollment

Students who are enrolled in school less than full-time are generally considered part-time students. The number of credit hours required for part-time enrollment are determined by your school.

Pell Grant

Pell Grant is awarded by the federal government to undergraduate students who demonstrate exceptional financial need.

Perkins Loan

Perkins Loans were a type of federal loan available to undergraduate and graduate students who demonstrated exceptional financial need. The Perkins Loan program ended in 2017.

PLUS Loans

Another way to describe Direct PLUS Loans, PLUS Loans are federal loans available for graduate and professional students or the parents of undergraduate students.

Prepayment

Prepayment is paying off the loan early or making more than the minimum payment. All education loans, including private and federal loans, allow for penalty-free prepayment, which means you can pay more than the monthly minimum or make extra payments without incurring a fee. The faster you pay off your loan, the less you’ll spend on interest.

Prime Rate

Prime rate is the interest rate that commercial banks charge their most creditworthy customers. The basis of the prime rate is the federal funds overnight rate. The federal funds overnight rate is the interest rate that banks use when lending to each other. The prime rate can be used as a benchmark for interest rates on other types of lending.

Principal

Principal is the original loan amount you borrowed. For example, if you take out one $100,000 loan for grad school, that loan’s principal is $100,000.

Private Student Loan

A private student loan is lent by a private financial institution such as a bank, credit union, or online lender. These loans can be used to pay for college and educational expenses, but are not a part of the Federal Direct Loan Program. These loans don’t offer the same borrower protections available to federal student loans — like income-driven repayment plans or deferment options.

Promissory Note

A promissory note is a contract that says you’ll repay a loan under certain agreed-upon terms. This document legally controls your borrowing arrangement, so read it carefully. If you don’t fully understand the agreement, contact your lender before you sign.

Repayment

Repayment is repaying a loan plus interest.

Repayment Period

The agreed upon term in which loan repayment will take place.

Scholarship

A scholarship is a type of financial aid which typically doesn’t need to be repaid. Scholarships can be awarded based on merit.

Secured Overnight Financing Rate (SOFR)

The Secured Overnight Financing Rate is an interest rate benchmark that is commonly used by banks and other lenders to set interest rates for loans. The SOFR is the cost of borrowing money overnight collateralized by Treasury securities. Starting in June 2023, the SOFR will begin replacing the LIBOR as a benchmark interest rate.

Stafford Loans

Stafford loans were a type of federal student loan made under the Federal Family Education Loan Program. Beginning in 2010, all federal student loans were loaned directly through the William D. Ford Federal Direct Loan Program.

Standard Repayment Plan

The Standard Repayment Plan is one of the repayment plans available for federal student loan borrowers. This repayment plan consists of fixed payments made over a 10 year period.

Student Aid Report

After submitting the FAFSA, you will receive a student aid report (SAR). The SAR is a summary of the information you provided when filling out the FAFSA.

Student Loan Refinancing

Student loan refinancing is using a new loan from a private lender to pay off existing student loans. This allows you to secure a new (ideally lower) interest rate or adjust your loan terms.

Subsidized Loan

A Direct Subsidized Loan is a type of federal loan available to undergraduate students where the government covers the interest that accrues while the student is enrolled at least half-time, during the grace period, and other qualifying periods of deferment.

Term

Term is the expected amount of time the loan will be in repayment. Generally speaking, a longer term will mean lower monthly payments but higher interest over the life of the loan, while a shorter term will mean the opposite. Loan terms vary by lender, and if you have a federal loan, you are usually able to select your student loan repayment plan.

Tuition

The cost of classes and instruction.

Undergraduate Student

A college student who is enrolled in a course of study, typically lasting four years, with the goal of receiving a bachelor’s degree.

Unsubsidized Loan

A Direct Unsubsidized Loan is a type of federal loan available to undergraduate or graduate students. The major difference between subsidized vs. unsubsidized loans is that the interest on unsubsidized loans is not paid for by the federal government.

Variable Interest Rate

Unlike a fixed interest rate, a variable interest rate fluctuates over the life of a loan. Changes in interest rates are tied to a prevailing interest rate.

The Takeaway

Understanding key terms is essential for navigating student borrowing. Prioritizing sources of financial aid that don’t need to be repaid like scholarships and grants can be helpful. But these don’t always meet a student’s financial needs.

Federal student loans have low-interest rates and, for the most part, don’t require a credit check. Plus they have borrower protections in place, like income-driven repayment plans and deferment options, that make them the first choice for most students looking to borrow money to pay for college.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.

Cover up to 100% of school-certified costs including tuition, books, supplies, room and board, and transportation with a private student loan from SoFi.

FAQ

What are common student loan terms?

Common student loan terms include the principal (the original borrowed amount), interest rate (the cost of borrowing), and repayment term (the length of time to repay the loan). Other terms involve grace periods (time before payments start after graduation), deferment, forbearance (temporary relief from payments), and fixed or variable interest rates.

What are the most important loan terms to understand?

It’s important to understand terms associated with borrowing because you’ll be required to repay the loan. Understand the interest rate and any fees associated with the loan.

What does APR mean in relation to student loans?

APR stands for annual percentage rate. It’s a reflection of the interest rate on the loan in addition to any other fees associated with borrowing. APR helps make it easier to compare loans from different lenders.

SoFi Private Student Loans
Please borrow responsibly. SoFi Private Student Loans are not a substitute for federal loans, grants, and work-study programs. You should exhaust all your federal student aid options before you consider any private loans, including ours. Read our FAQs. SoFi Private Student Loans are subject to program terms and restrictions, and applicants must meet SoFi’s eligibility and underwriting requirements. See SoFi.com/eligibility-criteria for more information. To view payment examples, click here. SoFi reserves the right to modify eligibility criteria at any time. This information is subject to change.

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Sep

2024

ESG, SRI, and Impact Investing Strategies: How Are They Different?

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

Impact investing is a broad category that includes a wide range of strategies; among them are two that are focused on the environment as well as social and governance issues: ESG (for environmental, social, and governance issues) and SRI (for socially responsible investing).

Investors who are interested in making an impact with their investing dollars may want to consider funds that embrace ESG or SRI strategies, but impact investing can include other goals as well (e.g., investing in or avoiding certain industries or sectors, or goals).

While there are ways in which these three strategies overlap, it’s important to understand the distinctions as they pertain to your own investing goals.

Key Points

• Impact investing refers to strategies that focus on having a measurable impact on certain companies, industries, or sectors.

• Impact investing is a broad category that can include a range of strategies, including ESG (environmental, social, and governance) and SRI (socially responsible investing), as well as others.

• As investor interest in ESG and SRI strategies has grown, so have inflows to funds that adhere to certain standards.

• Despite investor interest, standards and metrics vary widely when it comes to ESG, SRI, or any other type of impact investing.

Understanding ESG, SRI, and Impact Investing

These days, numerous companies seek to meet certain ethical, social, environmental, or other standards. While some criteria have been inspired by the United Nations’ Principles for Responsible Investment, or the U.N.’s 17 Sustainable Development Goals, investors need to bear in mind that the definition of ESG, SRI, and impact investing can vary from company to company, from country to country.

Nonetheless, investor interest in these strategies continues to grow. In fact, 67% of asset owners (e.g. institutional investors) say that over the last five years ESG standards have become even more critical to the investment process, according to a 2023 survey by Morningstar, the fund research and rating company.

As a result a number of companies have developed proprietary screening tools and scoring methods to help investors assess different investments, including stocks, bonds, ETFs, and more.

Defining ESG, SRI, and Impact Investing

That being said, the lack of clearcut ESG and SRI standards dates back to the very beginnings of these strategies.

As early as the 18th century, religious groups like the Methodists would take a financial stand against certain societal problems (e.g., the slave trade or alcohol and tobacco manufacturing) by not investing in related organizations. This values-based approach became known over time as impact investing.

Today, ESG and SRI investing can be considered modern offshoots of that philosophy — but typically with a focus on investing proactively in certain companies or sectors with the goal of supporting specific changes or outcomes.

It’s still possible to invest in ESG and SRI strategies that explicitly avoid certain industries, companies, or types of products (e.g., avoiding companies known to use child labor).

Impact investing tends to be used interchangeably with the term values investing, as well as ESG and SRI investing, but again these strategies have different aims and standards.

Impact Investing

The goal of impact investing is for investments to have a positive, measurable impact in a given area. That might mean avoiding industries (e.g. alcohol or weapons), or investing directly in social, environmental, political, or other concerns.

Some mutual funds or exchange-traded funds (ETFs) may utilize impact investing strategies, but impact investing may also involve private funds, such as closed-end private equity and venture capital funds. This is partly because some public companies have to prioritize financial goals to meet shareholder expectations or earnings forecasts, and impact goals alone may not suffice (more on profitability below).

Following are some examples of impact investing categories:

Impact Category	Metrics
Environmental	• Trees planted • Solar panels installed • Greenhouse gas emissions limited or reduced
Women’s Empowerment	• Female founders supported • Number of female employees
Jobs and Education	• Jobs created • Income creation • Access and enrollment targets
Affordable Housing	• People housed • Number of units built
Essential Services	• Individuals in need of bank accounts • Patients served in medical facilities

ESG Investing

ESG stands for environmental, social, and governance factors. It’s a set of criteria that can help investors evaluate companies according to how well they uphold or meet relevant criteria, in addition to financial concerns.

ESG investing is considered a form of sustainable or impact investing, but companies that embrace this term theoretically must focus on positive results in those three areas.

When ESG strategies started gaining more attention in the 1960s, some investors assumed ESG investing was primarily about values and ethics. Over time investors come to realize that ESG strategies may also impact a company’s financials. For example, ESG reporting can help illuminate potential risks to company performance, not only progress toward sustainability goals.

Still, adoption of ESG reporting and analysis has been slow owing to a lack of consistency around standards and metrics for meeting these criteria. While the SEC adopted new rules in early 2024 to help “standardize climate-related disclosures by public companies and in public offerings,” it soon stayed those rules when a number of groups filed petitions for review in multiple courts of appeals.

Overall, there is still quite a bit of variance in these standards.

However, the table below shows some common ways to assess a company’s adherence to ESG standards:

Environmental	Social	Governance
Energy consumption	Community engagement and support	Diversity in the board of directors
Waste and pollution	Human and labor rights	Management performance
Climate change mitigation and adaptation	Health and safety impacts on products, local areas, etc.	Executive compensation
Conservation and protection of biodiversity	Shareholder relations	Corruption
Resource management, such as water usage and sanitation	Employee relations	Disclosures and transparency

SRI

Socially responsible investing, or SRI, is another impact investing category that focuses on social and ethical issues. SRI mutual funds were among the first values-based investment products on the market.

While SRI is similar to ESG, it’s more broadly defined. Unlike ESG investing, which revolves around a set of standards, SRI doesn’t have clearly defined criteria, and investment strategies vary depending on the company.

SRI-focused investors might choose to avoid certain investments or industries, or choose companies that specifically work on or donate to certain causes. Investors may need to evaluate companies and funds based on their own criteria.
SRI investing strategies can include a focus on one or more of the following:

• Alternatives to fossil fuels (e.g., clean energy like wind or solar technologies)

• Avoiding so-called vice industries like alcohol, tobacco, cannabis, gambling

• Investing in female or minority-led companies, or companies with a social justice mission

• Avoiding companies relating to arms manufacturing and the military

• Investing in companies that adhere to human rights standards

• Supporting specific environmental outcomes, e.g. mitigating air and water pollution, safer agricultural practices, and so on

Is Sustainable Investing Different from ESG, SRI, and Impact Strategies?

Sustainable investing strategies can encompass SRI as well as ESG strategies. And while some investors use sustainable investing and impact investing interchangeably, it’s important to remember that not all impact investing is sustainable in nature.

Can SRI or ESG Investing Be Profitable?

The performance of SRI and ESG strategies versus their conventional peers have long been subject to debate. Nonetheless, the value of assets allocated to ETFs with an ESG focus has grown steadily in the last two decades. As of November 2023, according to data from Statista, the value of global assets in ESG funds was $480 billion — a substantial jump from $5 billion in 2006.

Investors interested in SRI and ESG strategies may want to examine the FTSE4Good Index Series: a compilation of stock indexes that track companies that seek to meet certain criteria or achieve certain environmental, social, or corporate governance goals. Morningstar has also developed a sustainability rating system, in use since 2016.

The Takeaway

Investors may want to bear in mind that, with the steady growth of ESG and SRI strategies in the last couple of decades, investment opportunities that focus on having an impact on the world are likely to expand.

In addition, the underlying goal of these strategies is to make a difference and potentially see a profit as well. That said, impact strategies overall don’t reduce investment risk factors; all types of impact investing, including ESG and SRI strategies, are subject to the same economic and market risk factors as conventional strategies.

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Sep

2024

What Is the Reverse Budgeting Method?

By Julia Califano | Budgeting & Goals, Family Finances, money | Comments Off

The reverse budgeting method is an approach that prioritizes savings. Budgets typically start by looking at monthly bills and expenses and allocating whatever is left over to saving. Reverse budgeting turns this approach on its head — it considers savings first and spending second.

Also known as the “pay yourself first” method, reverse budgeting starts by allocating a certain amount of your monthly income to your savings goals (such as retirement or an emergency fund). Whatever is left over after that is how much you have to spend. Essentially, it involves pretending that your paycheck is smaller than it actually is.

If your top goal is saving or you’ve tried budgeting in the past without complete success, the reverse budget might be for you. Here’s what reverse budgeting means and how it works.

Key Points

• Reverse budgeting prioritizes savings by allocating a portion of income to savings goals first, then spending the remainder on other expenses.

• Reverse budgeting simplifies budgeting since you can focus on saving a predetermined amount and then spend the rest as needed or desired.

• The reverse budgeting method can help achieve financial goals faster and allows guilt-free spending within remaining income limits.

• Reverse budgeting may not be ideal for those with high-interest debt or irregular income.

• Automating savings and periodically reassessing the budget are key steps to making reverse budgeting work effectively.

Reverse Budgeting Explained

The reverse budgeting method prioritizes setting money aside for your savings and investing goals. This might include building an emergency fund, saving for a new car or down payment on a house, or investing for retirement. Once that money has been set aside, the rest of your income can be used to cover your living expenses.

Reverse budgeting usually involves setting up automatic contributions to savings, typically on payday. As a result, the money leaves your bank account before you get a chance to spend it. That’s why this method is also known as the “pay yourself first” approach.

How Reverse Budgeting Differs from Traditional Budgeting

Making a budget typically involves listing all of your monthly expenses and assigning a portion of income to each category (e.g., housing, groceries, transportation). The goal is to ensure that expenses don’t exceed income, and any leftover funds can be saved or invested. This approach often requires meticulous tracking and discipline to avoid overspending in any category.

By contrast, reverse budgeting starts by looking at your financial goals and the things you want to save for. It helps you determine how much you need to put aside each month to accomplish them. You then subtract that sum from your monthly pay; what’s left is how much you have to spend on everything else.

Steps to Create a Reverse Budget

Creating a reverse budget tends to be less complicated than setting up other types of budgets. It doesn’t require establishing spending categories and totals for how much you will spend on each. That said, there are a few steps involved. Here’s a look at how to do a reverse budget.

1. Assess Your Spending

To know how to set your savings goals, you’ll need to get a general sense of your current cash flow. You can do this by pulling the last few months of financial statements, then adding up how much is coming in and going each month on average. You might also want to make a list of your essential monthly expenses, as well as how much you tend to spend each month on nonessentials.

This type of spending audit will give you a clear picture of your spending patterns. It can also help you identify any discretionary spending you may be able to reduce to accommodate your savings goals. There are also budgeting apps that can do a lot of this work for you. Start by seeing what your financial institution offers that could help with this process.

2. Identifying Your Savings Goals

Next, you’ll want to think about your savings goals. These might include building an emergency fund, saving for a down payment on a house, doing a home renovation, going on a vacation, paying for a wedding, contributing to retirement accounts, or any other financial objectives.

You’ll likely want to set your savings goals in terms of dollars as well as the timeframe within which you want to work.

3. Allocate Income to Savings

Once you’ve identified your savings goals, you might pick just a couple to start with. For each, as noted, you’ll have determined how much money you’ll need, along with a realistic timeline for reaching the goal. With that information in mind, you can then allocate a portion of your income to each goal.

For example, if you want to save $5,000 for an emergency fund over the next year, you would need to save approximately $417 per month.

As you go through this step, you’ll want to be realistic about how much you can afford to siphon off your paycheck for savings. It’s important to have enough spending money left over to cover your bills and also have some fun.

Recommended: 10 Most Common Budgeting Mistakes

4. Automate Your Saving

To ensure consistency and reduce the temptation to spend your savings, it’s a good idea to automate the saving process. If you have a 401(k) at work, you can do this by letting your employer know how much of your paycheck to put into your retirement account.

For shorter-term goals, consider setting up an automatic transfer from your checking account to a savings account for the same day each month, ideally right after you get paid. Some employers even allow you to split up your direct deposit into two different bank accounts.

5. Make Adjustments as Needed

Once you’re living on your reverse budget, you may find that you don’t have enough wiggle room to comfortably cover your bills and everyday spending. Or you might realize that you can afford to put more money towards savings and, in turn, reach your goals faster. Either way, it’s important to periodically reassess your reverse budget and, if necessary, make some adjustments in your savings rate.

This is especially important as your life circumstances and financial goals change. If you get a raise, for example, consider increasing your savings rate (this can help you avoid lifestyle creep). Conversely, if you encounter unexpected expenses, you may need to temporarily reduce your savings rate to accommodate these costs.

Pros and Cons of Reverse Budgeting

As with any financial strategy, reverse budgeting has its advantages and disadvantages. Understanding these pros and cons can help you determine if this method is right for you.

Pros of Reverse Budgeting

First, consider the upsides of reverse budgeting:

• It can help you reach your goals faster: One of the main advantages of reverse budgeting is that it takes savings right off the top of your paycheck. This can help you build an emergency fund, save for a major purchase, or invest for retirement more quickly than traditional budgeting methods.

• Low maintenance: Reverse budgeting simplifies the budgeting process. Instead of meticulously tracking every expense category, you focus on saving a predetermined amount and spend the remainder as you see fit. This low-maintenance approach can be particularly appealing for those who find traditional budgeting too time-consuming and/or restrictive.

• Spending without guilt: With reverse budgeting, you can enjoy spending within the limits of your remaining income. Since your savings goals are already met, you have the freedom to spend on discretionary items without worrying that you are derailing your future progress.

In these ways, the reverse budgeting method can help you prioritize savings and achieve financial security.

Cons of Reverse Budgeting

Next, keep these potential downsides of reverse budgeting in mind:

• It could lead to overspending: Since reverse budgeting doesn’t require setting up spending categories and strict spending limits for each one, you could end up overspending on certain things. Then, you might have to dip into savings to cover the shortfall.

• You might be better off focusing on debt: If you have high-interest debt, paying down those balances could provide a better return on investment than saving or investing. If this is the case, a more traditional budgeting approach that prioritizes debt repayment might be more effective.

• Not ideal for people with variable income: Reverse budgeting generally depends on earning a set amount of money each month. For people with variable income, such as freelancers or those with seasonal work schedules, maintaining a fixed savings rate could be challenging.

The Takeaway

Reverse budgeting, also known as the “pay yourself first” method, prioritizes saving and simplifies the entire budgeting process. By automating saving, it also reduces the chance that you’ll spend money today that you were intending to set aside for the future. However, reverse budgeting may not be the best approach if you have a lot of high-interest debt or your income fluctuates. You might be better off with another budgeting technique.

Choosing the right banking partner can also help you budget more effectively.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.00% APY on SoFi Checking and Savings.

FAQ

How does reverse budgeting help with saving money?

Reverse budgeting helps with saving money by prioritizing savings over expenditures. With this approach, you allocate a set percentage or amount of your income to savings first and then use the remaining amount to cover your expenses. This ensures that you don’t spend money you were planning to use for future goals.

Can reverse budgeting work for irregular income?

Reverse budgeting can be challenging for those with irregular income, such as gig workers. Here’s why: It relies on setting aside a certain amount of money into savings each month — before other expenses are paid. If your income fluctuates significantly, it may be difficult to meet your savings goal monthly.

However, you may be able to make it work by taking a flexible approach. For example, you might set a minimum savings rate based on your lowest expected income and then, during higher-income months, increase your savings contributions. Building an emergency fund can also help smooth out the fluctuations.

Is reverse budgeting suitable for paying off debt?

Reverse budgeting isn’t ideal for paying off debt, since it focuses on saving first, which can divert funds from debt repayment. If you have significant high-interest debt, prioritizing debt repayment might provide better financial benefits in the long run compared to the returns from savings or investments.

However, you might consider a hybrid approach — allocating a portion of your income to debt repayment and another to savings, ensuring you address both goals.

Photo credit: iStock/Goodboy Picture Company

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

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SoFi members with direct deposit activity can earn 4.00% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.00% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.00% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 12/3/24. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

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.

SOBNK-Q324-035

Sep

2024

40-Year Mortgage: What You Need to Know

By Alene Laney | Financial Topics, Home Ownership | Comments Off

40-year mortgages aren’t exactly what you think they are, and we’re here to clear up the confusion. Yes, a 40-year mortgage is only 10 years longer than the traditional 30-year mortgage, but the increased time to amortize interest makes it significantly more expensive. Though it may seem more affordable on a month-to-month basis, the increased amount of interest you’ll pay over the entire loan makes it hard to pay off the principal and build equity.

Additionally, 40-year mortgages are not backed by the federal government, so it can be hard to find a lender that originates them.

Here’s a deep dive on exactly what they are, how to qualify for one, how much they cost, how they compare with other loan terms, and what factors you’ll want to consider if you’re thinking about a 40-year mortgage.

First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.

Questions? Call (844)-763-4466.

Understanding a 40-Year Mortgage

To understand a 40-year mortgage, it’s important to look at how the mortgage market works and where a 40-year mortgage fits. With a traditional 30-year mortgage, the loan is typically sold on the secondary mortgage market to be bundled into securities by government-sponsored enterprises Fannie Mae and Freddie Mac.

To be eligible for sale, the loan must meet certain criteria to be considered a “qualified” mortgage. One of these criteria is that the loan term must not be longer than 30 years (the average mortgage term length in the U.S. is three decades). So a 40-year loan isn’t considered a qualified mortgage. You might also see it referred to as a “nonconforming loan.”

Because a 40-year mortgage can’t be backed by the government, it’s harder and more expensive to originate. As a result, this type of mortgage often doesn’t make sense for borrowers or lenders.

Recommended: What Is Mortgage Curtailment?

How a 40-Year Mortgage Works

When lenders do offer 40-year mortgages, there are a number of different ways these loans can be structured.

• ARM: The 40-year mortgages can be adjustable-rate mortgages (ARMs) where the interest rate adjusts every five or ten years.

• Interest-only for 10 years + 30-year term: They can also operate like a 10-year interest-only loan tacked on to the front of a traditional 30-year mortgage.

• Fixed 40-year term: They can also work as a 40-year fixed loan, much like a 30-year fixed-rate loan.

Most 40-year loans require that the property be owner occupied. But the biggest hurdle you’ll encounter in the mortgage process is finding a lender that offers 40-year mortgages. Qualification works as it does with a 30-year loan, but because the lender has to keep the loan on its books, it will be extra judicious about lending when it comes to a 40-year mortgage.

40-year Loan Modification

If you’re reading up on 40-year mortgages, you may run across the term as it relates to home loan modifications. Borrowers with FHA loans (from the Federal Housing Administration) who got into financial trouble during the COVID-19 pandemic may have the opportunity to have their loans modified (or “recast”) into 40-year loans.

Advantages and Disadvantages

With a typical 40-year mortgage, it’s clear what the advantage is because there’s only one: a lower monthly payment. A lower monthly payment may make buying a home possible for some borrowers, so it’s tempting to look at a 40-year mortgage despite the drawbacks.

The lone pro, as well as the risks and drawbacks of a 40-year mortgage, can be summarized as follows:

Pros	Cons
Lower monthly payment	Pay more in interest over a 40-year term
	May have a higher interest rate
	Builds equity more slowly
	Hard to find a lender who offers this loan type

Qualifying for a 40-Year Mortgage

Qualifying for a 40-year mortgage is similar to qualifying for other types of mortgages. In addition to the loan type and interest rate the lender can offer you, other mortgage qualification factors may include:

• Credit score. There is no minimum score required specifically for 40-year mortgages but generally, the better the score, the better your rate.

• Income verification. The lender will examine your employment history and how reliable your source of income is.

• Debt-to-income ratio. How much debt you have affects how large a mortgage you can take on. Higher debt equals less borrowing power.

• Down payment. The down payment affects the loan-to-value ratio, which affects how much the lender is willing to lend and what rate it will offer.

Recommended: How to Get a Home Loan

Comparing 40-Year Mortgage to Other Loan Terms

When you look at the costs on a 40-year mortgage, it becomes very clear what the tradeoff is. Here is an example using interest rates available in August 2024. Note that the 40-year example has a rate that adjusts every five years, so the total interest paid is an estimate.

	Mortgage amount	Interest rate	Monthly payment (principal and interest only)	Total interest paid over the term
40-year 5/5 adjustable rate mortgage	$450,000	6.625%	$2,674.73	$833,870.52
30-year fixed mortgage	$450,000	6.500%	$2,844.31	$573,950.20
15-year fixed mortgage	$450,000	6.250%	$3,858.40	$244,512.52

For a 40-year loan, you’ll pay $833,870.52 in interest for a $450,000 mortgage. In total, that’s $1,283,870.52 you’ll pay for the $450,000 loan.

The monthly payment on a 40-year mortgage is only about $200 less for a $450,000 mortgage. All told, you would save nearly $300,000 by choosing a mortgage term of 30 years vs. a 40-year mortgage. Borrowers who opt for the lowest payment with an idea that they would pay off the mortgage early would be wise to make sure they understand whether there are prepayment penalties before signing on the loan.

Factors to Consider with a 40-Year Mortgage

Because of how much more you’ll pay for a 40-year mortgage vs. 30-year mortgage, a 40-year loan comes with some serious considerations.

Long Repayment Period

A 40-year mortgage loan will take much longer to pay off. And because you’re paying a greater percentage of interest in the beginning of your loan, it will be hard to pay down the principal for quite some time.

Building Equity Is Difficult

As noted above, a 40-year mortgage loan makes building equity more difficult because of the increased interest costs. Difficulty building equity can make it harder to move because you may not have adequate profits from the home sale to make a down payment on your next home. It can also make refinancing challenging.

Interest Costs Are High

When you look at a mortgage calculator, you may be quite shocked at how much more interest you’ll pay on a 40-year mortgage when compared to a 30-year mortgage, as illustrated previously.

When a 40-Year Mortgage Makes Sense

A 40-year mortgage could make sense if:

• You plan to refinance to a different mortgage term in the future. If you need to keep monthly costs as low as possible and refinance at a later date, such as when you’re renovating your home, then you may want to consider a 40-year mortgage.

• It makes a difference in home affordability. If the difference between buying a home and not buying a home is a 40-year mortgage, you’re probably thinking about the 40-year mortgage. Hopefully, you could refinance down the line and save yourself a large chunk of money.

As mentioned previously, the high cost of a 40-year mortgage is a major drawback. The total amount of the mortgage works out to be hundreds of thousands more when compared with a traditional 30-year mortgage. Be sure you’re aware of the increased costs and risks before committing to a 40-year mortgage.

The Takeaway

The 40-year mortgage isn’t common and there are few scenarios where it makes sense. When you compare a 30-year mortgage with a 40-year mortgage, you’ll only pay a couple hundred dollars more per month on a 30-year mortgage, but you’ll save hundreds of thousands of dollars over the life of the loan. If you’re considering a 40-year mortgage, consult a lender you trust. They will have many tools at their disposal for helping you afford a home of your own.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

SoFi Mortgages: simple, smart, and so affordable.

FAQ

Are 40-year mortgages widely available?

No, 40-year mortgages are not common because they aren’t considered conforming, qualified mortgages. Qualified mortgages follow guidelines set by the government so they’re less risky and able to be bought by Fannie Mae and Freddie Mac. A 40-year mortgage falls outside the maximum allowable 30-year term for a qualified mortgage.

Can I refinance a 40-year mortgage later?

Yes, you can refinance a 40-year mortgage at a later date, provided you can qualify for the new loan you’re applying for.

Is a 40-year mortgage a good option for first-time homebuyers?

There are serious downsides to a 40-year mortgage. It may have a more affordable monthly payment than a 15- or 30-year mortgage, but you’ll have a hard time building equity (which is important for first-time homebuyers) and you’ll pay much more in interest over 40 years than you would 30 years.

Photo Credit: iStock/gradyreese

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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

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Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.

*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
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.
^¹FHA loans are subject to unique terms and conditions established by FHA and SoFi. Ask your SoFi loan officer for details about eligibility, documentation, and other requirements. FHA loans require an Upfront Mortgage Insurance Premium (UFMIP), which may be financed or paid at closing, in addition to monthly Mortgage Insurance Premiums (MIP). Maximum loan amounts vary by county. The minimum FHA mortgage down payment is 3.5% for those who qualify financially for a primary purchase. SoFi is not affiliated with any government agency.

SOHL-Q324-022

Sep

2024

Can You Name a Trust as a Beneficiary of an IRA?

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

Individual retirement accounts (IRAs) offer a tax-advantaged way to invest for retirement. When opening an IRA, one question you’ll need to answer is who should be the beneficiary. You could name your spouse or another relative, but it’s also possible to list a trust as beneficiary of IRA assets.

A trust is a legal arrangement used in estate planning that allows an individual called a
trustee to manage assets for one or more beneficiaries, according to the specific wishes of the person who creates the trust.

There are advantages and disadvantages to naming a trust as the beneficiary of an IRA. It’s helpful to understand the implications of this process when developing your estate plan.

Key Points

• Naming a trust as an IRA beneficiary allows the account holder to control when and how IRA assets are distributed after they’re gone.

• IRA assets can be left to a trust in order to provide financially for those dependent on care, such as minors or special needs individuals.

• When an IRA is left to a trust instead of a spouse, that spouse will not be able to claim or roll those assets into their own IRA, as they would if they were the beneficiary.

• IRA assets held in a trust must be distributed within five years if the IRA owner died before starting to take required minimum distributions (RMDs).

• A trust that qualifies as a see-through trust, which passes assets to beneficiaries through the trust, may be able to bypass certain distribution requirements.

How an IRA Is Inherited

The way IRAs work is that the account holder makes contributions to the IRA (up to $7,000 in 2024 for those under age 50, and up to $8,000 for those 50 and up) to help save for retirement. The account holder names one or more beneficiaries to inherit the IRA. After the account holder’s death, IRA beneficiaries must take distributions from the account — known as required minimum distributions (RMDs) — and pay any required taxes due on those distributions, in accordance with Internal Revenue Service (IRS) rules.

You can select one or more beneficiaries when you open an IRA and then update your beneficiaries at any time. For example, you could make a change to your beneficiary designation if you get married or divorced and wish to name or remove your spouse.

Types of Designated IRA Beneficiaries

A designated IRA beneficiary, similar to a 401(k) beneficiary, is the individual who will inherit the IRA account, as chosen by the account owner. A designated IRA beneficiary must be a person.

There are two primary categories of designated beneficiaries: Spouse and non-spouse. Non-spouse designated beneficiaries to an IRA can include:

• Children

• Parents or other family members

The IRS recognizes a separate category of designated beneficiaries, referred to as eligible designated beneficiaries (EDBs). This term is used to describe beneficiaries who benefit from special treatment regarding inherited IRA distributions under the SECURE Act, which went into effect in 2020. The following individuals qualify for EDB status:

• Spouses and minor children of the deceased IRA owner

• Disabled or chronically ill individuals

• Individuals who are not more than 10 years younger than the IRA owner

Eligible designated beneficiaries can space out required minimum distributions from an inherited IRA over their lifetime. Ordinarily, non-spouse beneficiaries who inherit an IRA are required to withdraw all of the assets from the account within 10 years, under the rules of the SECURE ACT.

Non-Designated Beneficiaries

Non-designated beneficiaries are entities that inherit an IRA or another retirement account. Examples of non-designated beneficiaries include:

• Estates

• Charities

• Trusts

Non-designated beneficiaries must withdraw IRA assets within five years of the account owner’s death if the owner died before they were required to start taking RMDs at age 72 before 2023, and at age 73 beginning in 2023.

However, if the account owner died after they started taking out RMDs, the payout rule applies. According to this rule, the beneficiary (in this case, the trust) must take out the assets over what would have been the account owner’s life expectancy if they had not died.

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.

Benefits to Naming a Trust as an IRA Beneficiary

So, can a trust be the beneficiary of an IRA? Yes. But should a trust be the beneficiary of an IRA? That answer is largely determined by the specifics of your situation. Here are some of the advantages of naming a trust as beneficiary to an IRA.

Control

Assets held in a trust are managed by a trustee who is bound by a fiduciary duty, meaning that they must act in the best interest of their client. During your lifetime you may act as your own trustee, with someone else succeeding you at your death. Any trustee you name is required to adhere to your wishes, as specified in the trust document.

That means you can have a say in what happens to IRA assets after you’re gone. That’s one of the chief benefits to a trust. If you were to name an individual as IRA beneficiary, on the other hand, they could do whatever they like with the money.

Special Situations

Trusts can be used to manage assets on behalf of minor children or special needs children/adults. You may set up a trust for the purpose of providing financially for a family member or another individual who is dependent on you for their care.

Setting up an IRA financial trust ensures that their needs will continue to be met after you’re gone. You can leave specific instructions for your trustee and any successor trustees you name on how the trust assets should be used to fund the care for these individuals.

Disadvantages to a Trust IRA Beneficiary

Naming a trust as the beneficiary of an IRA doesn’t always make sense, however. You may lose more than you benefit by choosing a trust as beneficiary vs. an individual. Here are some of the drawbacks to carefully consider.

Distribution Rules

Non-person IRA beneficiaries, including trusts, must fully distribute assets within five years of the account owner’s death if the owner had not yet begun taking required minimum distributions, or if the account is a Roth IRA. If the account owner died after they started taking out RMDs, however, the beneficiary must take out the assets over what would have been the account owner’s life expectancy if they had not died.

The only exception to these rules is if a trust qualifies as a see-through trust (learn more about that below).

By comparison, designated non-spouse beneficiaries generally have a 10-year window in which to withdraw IRA assets. Spousal beneficiaries can treat the IRA as their own and roll it over to their retirement account, which may minimize their tax liability.

Loss of Spousal Benefits

Naming a trust as IRA beneficiary when you have a living spouse takes away some of the tax benefits that are typically afforded to spouses when inheriting retirement accounts.

Most importantly, they don’t have the option to treat the IRA as their own. That could increase their tax obligation when receiving trust assets, leaving them with less inherited wealth to fund their retirement.

Rules for Trusts Inheriting IRAs

The SECURE Act introduced rules for trusts that inherit IRAs, including the five-year requirement for distributions. The rules says that non-designated beneficiaries must withdraw IRA assets within five years of the account owner’s death if the owner died before they were required to start taking out RMDs at age 72 before 2023, and at age 73 beginning in 2023.

If the account owner died after they started taking out RMDs, the beneficiary must take out the assets over what would have been the account owner’s life expectancy if they had not died.

Trusts may be able to bypass these requirements if they qualify as see-through entities, meaning they pass retirement assets to beneficiaries. With see-through trusts, the RMDs that must be taken are calculated based on the age of the beneficiary.

Here are the rules for see-through trusts.

• Trusts must be valid according to the laws of the state in which they’re created.

• The trust must become irrevocable, meaning it can’t be changed, when the account owner passes away.

• Trust beneficiaries must be readily identifiable.

• A copy of the trust must be provided to the custodian by October 31 in the year following the account owner’s death.5

These are the most current rules as of 2024. New legislation or updates to existing legislation can change inherited IRA rules.

Process for Updating IRA Beneficiary

The process for updating IRA beneficiaries is usually determined by the brokerage or bank that holds your IRA. If you need to make an update, you’ll need to contact your IRA custodian for the next steps.

Typically, you’ll fill out a beneficiary change form and share some information about the new beneficiary. If you’re updating your IRA beneficiary to a trust you’ll likely need to share the trust’s tax identification number as well as the trustee’s name and contact information.

Keep in mind that if you have an irrevocable trust you may not be able to make the change. Talking to an estate planning attorney or financial advisor can help you better understand what changes you can or cannot make.

The Takeaway

If you’re considering a trust as part of your estate plan and you also have an IRA, think about your specific situation and objectives. Putting an IRA in a trust could make sense if you have a special family situation or you want some say in how the assets are to be used after your death. On the other hand, it’s important to weigh the tax consequences your heirs might face.

If you don’t yet have an IRA but you’d like to set one up and begin making IRA contributions, it’s easy to open a retirement account online.

Invest with as little as $5 with a SoFi Active Investing account.

FAQs

Who pays the taxes if a trust is the beneficiary of an IRA?

When a trust retains income from an inherited IRA, the trust pays tax on that income. If IRA assets are passed on to the trust beneficiaries, then the beneficiaries pay the tax.

Can a trust be the beneficiary of Roth IRAs and traditional IRAs?

A trust can be the beneficiary of a traditional or Roth IRA. It’s possible for someone to have both types of IRAs and name a trust as beneficiary to one or both of them.

Do IRAs with beneficiaries go through probate?

Probate is a legal process in which a deceased person’s assets are inventoried, outstanding debts are paid, and remaining assets are then passed on to their heirs. Generally speaking, retirement accounts with designated beneficiaries are not subject to probate.

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