Dec
06
2024
Financial Charts

Understanding Stock Dilution

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Understanding Stock Dilution

Stock dilution is when a company action increases the number of outstanding shares of its stock, typically reducing the ownership stake of current shareholders. There are a number of ways share dilution can occur. Sometimes companies issue new stock as part of a secondary or follow-on offering in addition to the shares issued as part of its initial public offering (or IPO). A company may create more shares through stock options for employees or board members as part of a compensation or retirement plan.

Whichever way the stock dilution happens, the increase in the number of shares means that each individual stockholder ends up owning a smaller, or diluted, portion of the company. This isn’t necessarily bad news for investors, however, as the issuance of these additional shares may be put toward the company’s debt or into research and development, potentially enhancing the company’s long-term value.

Key Points

•   Stock dilution occurs when a company increases its outstanding shares, reducing the ownership stake of current shareholders.

•   Dilution can be facilitated through secondary offerings, stock options, or conversion of bonds and warrants.

•   While dilution decreases earnings per share and voting power, it can provide capital for growth or debt reduction.

•   The impact of dilution depends on how the raised funds are used; productive use can enhance long-term value.

•   Frequent dilution without good reason can signal poor performance and negatively affect stock prices.

What Is Stock Dilution?

Stock dilution occurs when a publicly-traded company increases the number of shares of stock on the market. Stocks are shares of ownership in a company. Owning even one share of stock is like owning a tiny piece of the operations of a business.

When a company’s board of directors first makes the decision to take a company public, the IPO process allows a set number of shares of that company’s stock to trade on public stock exchanges. This initial number of shares is often called the “float.”

Any further issuance of stock (often referred to as a secondary offering) will result in the outstanding shares being diluted. (The same applies if the secondary offering occurs after a backdoor listing.) While this may or may not affect the price, it does impact current investors’ ownership stake.

Example of Stock Dilution

Here’s an example of stock dilution: Let’s say a company has 10,000 shares of stock as part of its initial offering, and decides to issue 10,000 more shares as a secondary offering to raise more capital. In that case, existing investors could see a dilution factor of 50%. So if they previously owned 5% of the company, they would now own 2.5%.

Owing to a decrease in their percentage of ownership, stock dilution can also reduce the voting power of some shareholders. That may be something to keep in mind if voting power is important to you as you dig deeper into the world of online investing.

How Does Stock Dilution Work?

There are any number of reasons that companies choose to issue secondary shares of stock. A company might want to give rewards to its employees or raise new capital.

Issuing new shares as a method of raising money can be a particularly desirable option because it allows a business to receive an infusion of cash without going into debt or having to sell any assets that belong to the company.

It should be noted that stock splits are separate events that do not result in dilution. And a stock buyback, which reduces the number of outstanding shares, can be a way of enhancing the value of the stock.

When a business has a standard split of its stock, investors who already hold that stock receive additional shares, so their ownership in the company stays the same. Dilution of stock only occurs when new shares are issued and sold to additional investors who hadn’t purchased shares before the secondary offering.

Reasons Why Stock Dilution Occurs

When share dilution occurs, a company usually has its reasons for issuing the additional shares. Those reasons could include:

•   Additional shares may be sold to pay down debt or increase capital for R&D or other purposes.

•   Companies may offer stock options to employees as rewards or bonuses. When employees exercise these options, that increases the number of outstanding shares.

•   A company might issue stock warrants or bonds as another way of raising capital. But when or if these are converted to shares, they can be dilutive.

•   Some shareholders may push for an action that would end up diluting shares, as a way to reduce the power of smaller shareholders.

Is Stock Dilution Bad?

Stock dilution isn’t inherently bad or good, because the repercussions of diluting stock can affect all parties differently. While all shareholders may see their ownership stake decrease, that will affect some more than others.

Even if shareholders are unhappy in the short term, the resulting cash infusion from making more shares available on the market can benefit the company long-term — which in turn might increase the value of the stock.

Stock Dilutions and Stock Price

When a company increases the number of outstanding shares, that action of course has an impact on earnings per share (EPS) as well as dividends — because there are now more shares on the market, or in investors’ hands. And when EPS and dividends effectively become diluted (or reduced) as well, that can impact the price per share.

So instead of looking only at basic EPS, investors should take into consideration convertible securities that may be outstanding as well. By understanding the whole picture, investors can arrive at the diluted earnings per share, which captures a more accurate picture of company fundamentals.

How Does Stock Dilution Affect Investors?

When a company creates new shares of stock, the value of existing shares becomes diluted, meaning they decrease in value. If you’re thinking of cashing out stocks, this is something to consider.

Think of it like a birthday cake. At first, you and seven of your friends agree to each have one slice of cake. But then two of your other friends unexpectedly show up, also wanting cake. Now you have to slice the cake into 10 pieces rather than eight, so each piece will be smaller.

This scenario is similar to what happens when a company issues more shares of stock and stockholders see the value of their shares reduced. The difference is that each share not only becomes like a smaller piece of the cake, but usually (but not always) becomes less valuable and entitles its holder to less company ownership and voting rights.

Stock Dilution and Dividends

For dividend-yielding stocks, dilution can also lead to smaller dividend payouts unless earnings per share rise enough to make up the difference.

Because more shareholders now have to be paid, paying the same dividend yield takes a heavier toll on profits. If a company is only issuing new shares out of an attempt at raising new capital because their business is hurting, then they may have to cut dividends even deeper down the line or halt them altogether.

This will likely have consequences for investors who hold equities for income. Dividend investors will do well to keep an eye on the number of shares outstanding for any stock, as well as how previous dilutions (if any) have affected dividends.

To be clear, dilution doesn’t have to affect dividends. Dilution cuts down on earnings per share (EPS) but not necessarily on dividends per share (DPS), but it’s likely it would.

While EPS measures a company’s profitability per each share of stock outstanding, DPS measures the value of dividends paid out to investors per each share of stock outstanding. A company can choose to keep DPS the same after dilution, although doing so will cut into the profits of their business to a larger extent than before.

The more dividends per share a company pays out, and the more shares there are, the more unsustainable the dividend is likely to become, since a company can only afford to pay so much of its profits out to investors.

The only way for big dividend payments to be sustainable is when a company is either growing rapidly or taking on lots of debt to finance its operations.

Other Stock Dilution Effects

Stock dilution has an impact on more than just the price of a stock or potential dividend payouts.

When additional shares are created, this reduces the stock’s earnings per share (there will be fewer earnings per share with more shares on the market) as well as the voting rights of the shareholder (holders of stocks sometimes get to cast a vote for important company decisions, like the addition or removal of board members).

In fact, income statements issued by companies often show both “basic” and “diluted” earnings per share (EPS) numbers. This allows for shareholders and investors thinking about purchasing the stock to see the effect that dilution would have if the maximum number of potential shares were to come into existence (through the use of unexercised stock options, for example).

Dilution of a stock can also have a positive impact on the stock’s valuation, however. That’s because the issuing of new shares being bought increases the stock’s market cap, as people buy those shares. If this momentum outpaces any selling caused by negative market views of the secondary offering, then share prices could rise.

Beyond the short-term, news-based influence of dilution, the long-term effects of new stock shares coming into existence depends largely on how a company’s management decides to spend the funds they just received.

Pros and Cons of Stock Dilution

While it’s easy to interpret stock dilution as a negative thing from the perspective of those who hold shares before the dilution occurs, the concept isn’t so one-sided.

When done in the right way for purposes that contribute to company growth, dilution can benefit both a company and its shareholders over the long-term.

When done recklessly or in an attempt at covering up bad business performance, dilution can provide a temporary cash flow boost that doesn’t solve any real problems and puts shareholders in a precarious position.

It comes down to whether or not a management team has a good reason for diluting their stock and what they choose to do with the funds raised afterward.

Pros of Stock Dilution

In some ways, dilution of stock can be a good thing. When new shares are used to reward managers and employees, this can indicate a company is growing and performing well, and that it wants to share some of its good fortune.

When new shares are issued at a price higher than what the stock is currently selling for, this can also be a win-win scenario. It indicates demand for shares while minimizing the share dilution that existing shareholders must endure.

Ideally, companies should have a good reason to issue new shares and use the resulting cash infusion in a productive manner. Raising money for a new product, research and development, or bringing on new and valuable employees might be some good reasons for dilution of a stock.

When a company dilutes its stock without good reason, or doesn’t use the proceeds in a productive way, then the cons of stock dilution are all that’s left.

Cons of Stock Dilution

In general, investors don’t take kindly to the concept of new stock shares being issued to internal shareholders, as it usually decreases the value of the stock and the ownership stake of those who already hold shares. To the investing public that has some kind of awareness of this, stock dilution can be seen as negative news.

Some of the things mentioned previously can also be considered cons of stock dilution: a decrease in earnings per share, less voting power for shareholders, or declining share prices.

Recurring, new stock issuances can be perceived as a warning sign by investors. If a company needs to keep diluting its stock to raise money, perhaps their business operations haven’t been performing well.

This perception might lead people to sell shares, resulting in a decline in the stock price. Sometimes this happens when a company merely announces that they might be issuing new shares in the future. The perception can become reality before anything even happens.

Stock Dilution vs Stock Splits

While share dilution and stock splits both increase the number of outstanding shares, a stock split has a different motive and different results.

A company often conducts a stock split to bring down the price per share. For example, a company trading at $200 per share could do a 4-to-1 stock split, bringing down the PPS to $50. Shareholders still hold the same dollar amount, but the number of shares they own has increased, so their ownership percentage doesn’t change.

Stock Dilution

 Stock Split
Increases number of outstanding shares Increases number of outstanding shares
Used for capital infusion or for employee incentives/bonuses Used to reduce the stock price
Investors’ ownership stake is reduced Investors’ stake remains constant

Understanding Corporate Buyback

The opposite of a company creating more shares is when a company buys its own shares back. This is sometimes called a corporate buyback and reduces the number of shares outstanding, usually leading to a rise in the price of a stock (due to the law of supply and demand).

While this might be good for shareholders in the short-term, it can be a bad thing for a company overall, since the money used could have been spent to improve business operations instead.

Sometimes stock can become highly overvalued due to the practice of corporate share buybacks, leading to precipitous drops in prices later on.

Sometimes companies issue public statements detailing their exact plans for dilution as well as their reasons for doing so.

This way, both current and future investors can prepare accordingly. The news alone can sometimes lead to a stock selloff due to the fact that the concept of stock dilution is usually interpreted in a negative way by most investors.

Investors would do well to monitor the amount of shares a company has outstanding. If the number keeps increasing, earnings per share are likely to decline or stay flat while investor’s voting rights diminish in their influence.

And while a drop in share counts can be a good thing, they can cover up a lack of growth by boosting earnings per share without any real underlying growth happening.

The Takeaway

Stock dilution — when a company issues additional shares — is neither good nor bad, but it does have specific consequences for shareholders, who typically see their ownership stake decrease. In some cases, the additional capital raised by the shares in a secondary offering (one that occurs after the IPO) can benefit a company long term by paying down debt or adding to its assets or intellectual capital. But stock dilution can impact earnings per share, as well as dividend payouts, which in turn can impact the price.

But if the company sees a gain, growth, or expansion from the additional revenue, that could boost the stock price. It’s just important for investors to understand what a stock dilution might mean.

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Debt Avalanche Method: A Smart Strategy for Paying Off Debt

By | Debt Payoff, Financial Independence | No Comments

Debt is a slippery slope. You can be doing just fine when an unexpected bill starts a slide. Maybe you use a credit card or three to keep up for a while. But one setback — like major car repairs — throws you off balance again, and eventually debt begins to swallow you up.

But there’s good news. First, you’re not alone. Second, millions of people like you have dug themselves out of debt using the Debt Avalanche Method. This debt reduction strategy focuses your efforts on the debts with the highest interest rates. Keep reading to learn the advantages and disadvantages of this strategy, as well as some proven alternatives for paying off debt.

Key Points

•   The Debt Avalanche Method focuses on paying off high-interest debts first, and making minimum payments on others, to save on interest and reduce overall debt faster.

•   Ideal for disciplined, logical individuals who prioritize long-term savings over quick wins, the method isn’t suitable for all debts; mortgages are considered “good” debt and should be excluded.

•   Alternatives like the Snowball Method or debt consolidation loans may be better for those needing quick motivation or dealing with multiple high-interest debts.

•   Psychological factors such as discipline, motivation by long-term goals, and the ability to celebrate self-made milestones influence the method’s success.

•   Consider interest rates on your debt, your financial goals, and personal preferences when weighing your options.

Understanding the Debt Avalanche Method

The Avalanche Method is all about the interest rate. Essentially, you’ll make the minimum payments toward all of your debts but put anything extra you can (bonuses, tax refunds, that $20 your grandma stuck in your pocket) toward paying off the high-interest debt at the top of the list. When it’s paid off, move on to the debt with the second-highest interest rate and so on.

Fans of the Debt Avalanche Method laud its efficiency. The most expensive debt is ditched first, which can be a big money saver. And the amount of time it takes to get out of debt overall is cut too, because less interest accumulates every month.

Debt Avalanche Method vs. Other Payoff Strategies

The Avalanche is for rational thinkers. But when it comes to money — and life in general — humans tend to follow their gut. That’s why some people prefer the Avalanche’s more emotionally available cousin, the Snowball Method.

With the Snowball Method, the steps are much the same, but you start your list with the smallest balance and work your way toward the largest, disregarding the interest rate. The idea is that those first targets can be knocked down quickly, creating a sense of accomplishment that helps keep you on task until it becomes a habit.

There are pros and cons to each method. If you use the Avalanche, it may take longer to move from one debt to the next. Also, this method assumes paying off debt as quickly as possible is always the right thing to do. But there are other factors to consider, like your credit score. That said, if you have a larger balance with higher interest rates, you could save money over time.

If you plan to pay off debt with the Snowball Method, you’re more likely to experience quick wins, which could help you stay motivated. But you probably won’t save as much on overall interest as you would with the Avalanche.

If you have multiple high-interest balances, you may want to consider a debt consolidation loan. These personal loans roll several debts into a single loan, which ideally has a lower interest rate. This approach can be a smart move if you’re able to stay on top of monthly payments and have a strong credit score.

Implementing the Debt Avalanche Method

Interested in trying the Debt Avalanche Method? It helps to get your finances organized first.

First, make a budget. Find ways to trim the fat from anything you can — dinners out, streaming services — so you’ll have more cash to pay toward that smothering debt. If you need help, here’s a guide to the 70-20-10 rule of budgeting.

Then make a list of all your debts. Start with the loan or credit card that has the highest interest rate, and work your way down to the one with the lowest interest rate. Continue to make the minimum payments on all your debts, but put anything you can (bonuses, tax refunds, that $20 your grandma stuck in your pocket) toward paying off the high-interest debt at the top of the list.

When the first debt on your list is paid off, cross it off and move to the next debt on your list. Roll whatever payment you were making on the first debt into the second debt, adding it on to the minimum payment. When that debt is paid off, do the same with the third on the list. As you continue paying off outstanding debt, you should have more and more money to put toward the next target balance. Keep going until you’ve plowed through each debt on your list and can declare yourself debt-free.

Depending on how much you owe, it could take some time before you’re able to move from one debt to another. Adopting sound financial habits, like tracking spending and using a budget app, can help you stick to your payoff plan.

Is the Debt Avalanche Method Right for You?

Using the Avalanche Method to pay off debt isn’t necessarily a good fit for everyone. The method is great for disciplined, analytical thinkers who get excited by the knowledge that they’re playing the long game. To make this approach a success, it helps to be the type of person who is self-disciplined, self-motivated, self-aware, and capable of celebrating self-made milestones.

Alternative debt payoff strategies, like the Snowball Method or a personal loan, may make more sense for your lifestyle, financial situation, and personal preferences.

Here are some questions to ask yourself as you weigh your options:

•   What are my short- and long-term financial goals?

•   Do I have high-interest debt?

•   Do I need a series of quick wins to stay motivated?

Maximize the Benefits of the Debt Avalanche Method

Before you begin tackling debt with the Avalanche Method, consider some strategies to get the maximum benefits:

•  Accelerate debt repayment. Paying off your balance doesn’t just relieve stress — it can also save on interest. Kick in more than the minimum payment each month. And if your lender and budget allow, make extra payments.

•  Build an emergency fund. While whittling down debt is the priority, it’s also a good idea to sock away money into an emergency fund. Determine a target amount — a good rule of thumb is to have enough to cover three to six months of expenses. Then open a high-yield savings account and add to it regularly.

•  Seek the help of a professional. Looking for personalized guidance? Consider meeting with a financial advisor, who can examine your current finances, discuss your financial goals, and help you create a plan to achieve them.

The Takeaway

Using the Debt Avalanche Method is a great way to pay off debt for disciplined, logical personalities who want to maximize their savings on interest. The Avalanche works by paying down the highest-interest debt first, regardless of balance, while making minimum payments only on other debts. It’s not for everyone, though, especially if your highest-interest debt is also your biggest balance.

If quick wins help you stay motivated, consider paying off debt with the Snowball Method. Instead of focusing on interest rate, borrowers prioritize the lowest balance first. A debt consolidation loan is another potential avenue to explore, as you can roll multiple high-interest debts into a single loan with (hopefully) a better interest rate.

The key to any debt payoff strategy is to know yourself and choose the method that best fits your preferences and financial goals.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.


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FAQ

How long does it take to pay off debt using the Avalanche Method?

While the Avalanche Method tends to whittle down debt faster than making minimum payments each month, the time it takes for you to pay off your balance will depend on the amount you owe, your interest rate, and how much extra you’re able to pay each month.

Can the Debt Avalanche Method be used for all types of debt?

The Avalanche isn’t suited for every type of debt. Consider using it to pay off credit cards, personal loans, student loans, and car loans. Don’t include your mortgage, as financial experts consider this “good” debt. One day, you may decide to put extra money toward paying down your mortgage principal, but for now, focus on your other debts.

What should I do if I have multiple debts with
similar interest rates?

When faced with paying down multiple debts with similar interest rates, the Snowball Method may be your best approach. It involves paying off your lowest balance first, while making minimum payments on your other debts. If the interest rates are high, you may want to explore a debt consolidation loan. That’s where you take out one loan or line of credit (ideally with a lower interest rate) and use it to pay off other debts.

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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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Why you need to invest when the market is down

What You Need to Know When the Market Is Down

By | Growing Wealth, invest, Investing | No Comments

What do you do with your stocks when the market drops? If you’re like most people, your first instinct is to sell. It’s human nature. But when they decline, selling everything can seem like the best way out of a bad situation. However, instinctively selling when stocks drop is often counterproductive, and it may make more sense to invest while the market is down.

Key Points

•   Selling stocks during a market downturn can be counterproductive; investing for the long term is often more beneficial.

•   Dollar-cost averaging allows investors to buy more shares when prices are low, potentially increasing returns.

•   Tax-loss harvesting can offset gains by selling investments at a loss and reinvesting in similar assets.

•   Avoid high-risk investments and rash decisions during downturns; maintain a diversified portfolio to manage risk.

•   Market downturns offer opportunities to buy stocks at lower prices, but decisions should align with long-term goals.

Should You Invest When the Market Is Down?

It’s generally a good idea to invest when the stock market is down as long as you’re planning to invest for the long term. Seasoned investors know that investing in the market is a long-term prospect. Stock market dips, corrections, or even bear markets are usually temporary, and, given enough time, your portfolio may recover.

When the market is down, it provides an opportunity to buy shares of stock through your online investing account at a lower price, which means you can potentially earn a higher return on your investment when the market recovers.

For example, in late 2007, stocks began one of the most dramatic plunges in their history. From October 2007 to March 2009, the S&P 500 Index fell 57%. During that time, many investors panicked and sold their holdings for fear of further losses.

However, the market bottomed out on March 9, 2009, and started a recovery that would turn into the longest bull market in history. Four years later, in 2013, the S&P 500 surpassed the high it reached in 2007. While that historic plunge of over 50% was terrifying, if you panicked and sold, rather than employ bear market investing strategies, you would have locked in your losses — and missed the subsequent recovery.

If, on the other hand, you had kept your investments, you would have seen stock values fall at first, but as the market reversed course, you may have seen portfolio gains again.

Consider the recent example of how the markets performed during the early stages of the Covid-19 pandemic in 2020. The S&P 500 fell about 34% from February 19, 2020, to March 23, 2020, as the pandemic ravaged the globe. However, stocks rebounded and made up the losses by August. As of the end of 2024, markets are hovering around record highs.

These examples illustrate why timing the market is rarely successful, but holding stock over the long term tends to be a smart strategy. It’s still important to keep in mind that the stock market can be volatile and can fluctuate significantly in the short term. Therefore, you must be prepared for short-term losses and have a long-term investment horizon.

Recommended: Bull vs. Bear Market: What’s the Difference?

4 Things to Consider Doing During a Market Downturn

When the stock market is down, it can be a worrying time for investors. But it’s important to remember that market downturns are a normal part of the investing process and that the market may eventually recover. Here are a few things to consider doing during a market downturn.

1. Stay Calm and Avoid Making Impulsive Decisions

It’s natural to feel worried or concerned when the stock market is down, but it’s essential to maintain a long-term perspective and not make rash decisions based on short-term market movements.

Buying and selling stocks based on gut reactions to temporary volatility can derail your investment plan, potentially setting you back.

You likely built your investment plan with specific goals in mind, and your diversified portfolio was probably based on your time horizon and risk tolerance preferences. Impulsive selling (or buying) can throw off this balance.

Instead of letting emotions rule the day, consider having a plan that includes investing more when the market is down (aka buying the dip). These strategies involve buying stocks on sale, and the hope is that the downturn is temporary and you’ll be able to ride any upturn to potential earnings.

So, when markets take a tumble, your best move is often to stay calm and stick to your predetermined strategy.

That said, any investment decisions you make should be based on your own needs. Just because the market is down doesn’t mean you have to buy anything. Buying stocks on impulse just because they’re cheaper might throw a wrench in your plan, just like rushing to sell. Taking time to consider your long-term needs and doing research typically pays off.

2. Evaluate Your Portfolio

Review your portfolio and make sure it’s properly diversified. Portfolio diversification may reduce the overall risk of your portfolio by spreading your investments across different asset classes, like stocks, bonds, real estate, and cash. Investing in various assets and industries can protect your portfolio during a market downturn.

However, even if you have a well-diversified portfolio, you may also need to pay attention to your portfolio’s asset allocation during volatile markets. For example, during a down stock market, your stock holdings may become a lower percentage of your portfolio than desired, while bonds or cash become a more significant part of your overall holdings. If your portfolio has become heavily weighted in a particular asset class or sector, it could be strategic to sell some of those holdings and use the proceeds to buy securities to rebalance your portfolio at your desired asset allocation.

Recommended: How Often Should You Rebalance Your Portfolio?

3. Take Advantage of Low Prices With Dollar-Cost Averaging

To help curb your impulse to pull out of the market when it is low — and continue investing instead — you may want to consider dollar cost averaging.

Here’s how it works: On a regular schedule — say every month — you invest a set amount of money in the stock market. While the amount you invest each month will remain the same, the number of shares you’ll be able to purchase will vary based on the current cost of each share.

For example, let’s say you invest $100 a month. In January, that $100 might buy ten shares of a mutual fund at $10 a share. Suppose the market dips in April, and the fund’s shares are now worth $5. Instead of panicking and selling, you continue to invest your $100. That month, your $100 buys 20 shares.

In June, when the market rises again, the fund costs $25 a share, and your $100 buys four shares. In this way, dollar cost averaging helps you buy more shares when the markets are down, essentially allowing you to buy low and limiting the number of shares you can buy when markets are up. This helps protect from “buying high.”

After ten years of investing $100 a month, the value of each share is $50. Even if some shares you bought cost more than that, your average cost per share is likely lower than the fund’s current price.

Steady investments over time are more likely to give you a favorable return than dumping a large amount of money into the market and hoping you timed it right.

4. Consider Tax-Loss Harvesting

If you’ve already experienced losses, you may want to consider tax-loss harvesting — the practice of selling investments that experienced a loss to offset your gains from other investments.

Imagine that you invest $10,000 in a stock in January. Over the year, the stock decreases in value, and at the end of the year, it is only worth $7,500. Instead of wishing you’d had better luck, you can sell that position and reinvest the money in a similar (but not identical) stock or mutual fund.

You get the benefit of maintaining a similar investment profile that will hopefully increase in value over time, and you can write off the $2,500 loss for tax purposes. You can write off the total amount against any capital gains you may have in this year or any future year, helping to lower your tax bill. This is tax-loss harvesting.

You can also deduct up to $3,000 of capital losses each year from your ordinary income. However, you must deduct your losses against capital gains first before using the excess to offset income. Losses beyond $3,000 can be rolled over into subsequent years, known as tax loss carryforward.

During major market downturns, this technique can ease the pain of capital losses — but it’s important to consider reinvesting the money you raise when you sell, or you’ll risk missing the recovery. But remember that with investing comes risk, so there’s no assurance that a recovery will occur.

4 Things to Avoid When the Market Is Down

Feeling anxious when the stock market is down is natural, but it’s important to remain calm and not let fear drive your investment decisions. Here are a few things to avoid when the stock market is down.

1. Trying to Time the Market

Timing the market is the idea that you will somehow beat the market by attempting to predict future market movements and buying and selling accordingly. However, it’s difficult to predict with certainty when the stock market will go up or down, so trying to time the market is generally a futile endeavor.

However, it’s difficult to predict with certainty when the stock market will go up or down, so trying to time the market is generally a futile endeavor. As they say: No one has a crystal ball in this business.

As a result, timing the market is not a strategy that works for most investors. Even during a down market, you should not wait until the market hits bottom to start investing in stocks again.

2. Selling All Your Stocks

You should resist the temptation to sell all of your stocks or make other rash decisions when the market is down. While it may be tempting to sell all of your stocks during a down market, it’s important to remember that the stock market usually recovers. If you sell all of your stocks when the market is down, you may miss out on the opportunity to participate in the market’s recovery.

3. Chasing After High-Risk Investments

When stocks are down, you may be inclined to try to earn quick profits by investing in high-risk assets — like commodities or cryptocurrencies — but these investments can be particularly volatile and are not suitable for everyone.

Moreover, riskier investment strategies like options and margin trading may be an appealing way to amplify returns in down markets. But if you are not comfortable using these strategies, you could end up with even bigger losses.

Recommended: Options Trading 101: An Introduction to Stock Options

4. Abandoning Your Long-Term Financial Plan

It’s important to remember that the stock market is just one part of your overall financial plan. Keep your long-term financial goals in mind, and don’t let short-term market movements distract you from your larger financial objectives.

Risks to Investing During Down Markets

While the stock market generally recovers after a decline, there are exceptions to the idea that the market tends to snap back quickly or always trends upward.

Take the stock market crash of 1929. Share prices continued to slide until 1932, as the Great Depression ravaged the economy. The Dow Jones Industrial Average didn’t reach its pre-crash high until November 1954.

In addition, as of early 2023, the Nikkei 225 — the benchmark stock index in Japan — has yet to reach the peak of over 38,000 it hit at the end of 1989. Back then, the index went on to lose half its value in three years as an economic bubble in the country burst. However, the Nikkei did touch the 30,000 level at various points in 2021 for the first time since 1990.

So, investors need to remember that just because stock markets have recovered in the past doesn’t mean that it will always be that way. As the saying goes, past performance is not indicative of future results.

The Takeaway

Almost everyone feels a sense of worry (or fear) when the market is down. It’s only natural to find yourself swamped with doubts: What if the market keeps sliding? What if I lose everything? What if it’s one of those rare occurrences when the recovery takes ten years?

Rather than succumb to panic, perhaps the best course of action is to stay the course, and not to give in to your impulses to sell or scrap your entire investment strategy, but to stay the course. Using strategies like dollar-cost averaging, which allow you to invest in a down market sensibly, can be a part of a balanced investment strategy that helps build wealth over time.

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.

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q424-036

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Dec
06
2024
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What Is a Pattern Day Trader?

By | Financial Independence, invest, Investing | Comments Off on What Is a Pattern Day Trader?

A pattern day trader is actually a designation created by the Financial Industry Regulatory Authority (FINRA), and it refers to traders who day trade a security four or more times within a five-day period.

Because of their status, there are certain rules and stipulations that apply only to pattern day traders, which brokerages and investing firms must adhere to. Read on to learn more about pattern day traders, what rules apply to them, and how they’re different from regular day traders.

Key Points

•   A pattern day trader is classified as someone who executes four or more day trades within a five-day period, exceeding 6% of their total trading activity.

•   Investors identified as pattern day traders must maintain a minimum balance of $25,000 in their margin accounts to meet regulatory requirements set by FINRA.

•   Engaging in pattern day trading can yield profits, but it also carries significant risks, especially when utilizing margin accounts, which can amplify both gains and losses.

•   The Pattern Day Trader Rule was established to limit excessive risk-taking among individual traders, requiring firms to impose stricter trading restrictions on active day traders.

•   Being designated as a pattern day trader may lead to account restrictions, including a 90-day trading freeze if the minimum balance requirement is not met.

Pattern Day Trader, Definition

The FINRA definition of a pattern day trader is clear: A brokerage or investing platform must classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period in a margin account.

When investors are identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules.

How Does Pattern Day Trading Work?

Pattern day trading works as the rules stipulate: An investor or trader trades a single security at least four times within a five business day window, and those moves amount to more than 6% of their overall trading activity.

Effectively, this may not look like much more than engaging in typical day trading strategies for the investor. The important elements at play are that the investor is engaging in a flurry of activity, often trading a single security, and using a margin account to do so.

Remember: A margin account allows the trader to borrow money to buy investments, so the brokerage that’s lending the trader money has an interest in making sure they can repay what they owe.

Example of Pattern Day Trading

Here is how pattern day trading might look in practice:

On Monday, you purchase 10 shares of Stock A using a margin account. Later that day, you sell the 10 shares of Stock A. This is a day trade.

On Tuesday, you purchase 15 shares of stock A in the morning and then sell the 15 shares soon after lunch. Subsequently, you purchase 5 shares of stock A, which you hold only briefly before selling prior to the market close. You have completed two day trades during the day, bringing your running total — including Monday’s trades — to three.

On Thursday, you purchase 10 shares of stock A and 5 shares of stock B in the morning. That same afternoon, you sell the 10 shares of stock A and the 5 shares of stock B. This also constitutes two day trades, bringing your total day trades to five during the running four-day period. Because you have executed four or more day trades in a rolling five business day period, you may now be flagged as a pattern day trader.

Note: Depending on whether your firm uses an alternative method of calculating day trades, multiple trades where there is no change in direction might only count as one day trade. For example:

•   Buy 20 shares of stock A

•   Sell 15 shares of stock A

•   Sell 5 shares of stock A

If done within a single day, this could still only count as one day trade.

Do Pattern Day Traders Make Money?

Yes, pattern day traders can and do make money — if they didn’t, nobody would engage in it, after all. But pattern day trading incurs much of the same risks of day trading. Day traders run the risk of getting in over their heads when using margin accounts, and finding themselves in debt.

This is why it’s important for aspiring day traders to make sure they have a clear and deep understanding of both margin and the use of leverage before they give serious thought to trading at a high level.

It’s the risks associated with it, too, that led to the development and implementation of the Pattern Day Trader Rule, which can have implications for investors.

What Is the Pattern Day Trader Rule?

The Pattern Day Trader Rule established by FINRA requires that an investor have at least $25,000 cash and other eligible securities in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000, the investor will need to bring the balance back up in order to day trade again.

Essentially, this is to help make sure that the trader actually has the funds to cover their trading activity if they were to experience losses.

Note that, according to FINRA, a day trade occurs when a security is bought and then sold within a single day. However, simply purchasing shares of a security would not be considered a day trade, as long as that security is not sold later on that same day, per FINRA rules. This also applies to shorting a stock and options trading.

The PDT Rule established by FINRA requires that an investor have at least $25,000 in their margin account in order to conduct four or more day trades within five days. But merely day trading isn’t enough to trigger the PDT Rule.

All brokerage and investing platforms are required by FINRA, a nongovernmental regulatory organization, to follow this rule. Most firms provide warnings to their clients if they are close to breaking the PDT rule or have already violated it. Breaking the rule may result in a trading platform placing a 90-day trading freeze on the client’s account. Brokers can allow for the $25,000 to be made up with cash, as well as eligible securities.

Some brokerages may have a broader definition for who is considered a “pattern day trader.” This means they could be stricter about which investors are classified as such, and they could place trading restrictions on those investors.

A broker can designate an investor a pattern day trader as long as the firm has a “reasonable basis” to do so, according to FINRA guidelines.

Why Did FINRA Create the Pattern Day Trader Rule?

FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule during the height of the dot-com bubble in the late 1990s and early 2000s in order to curb excessive risk-taking among individual traders.

FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule amidst the heyday of the dot-com bubble in order to curb excessive risk taking among individual traders.

FINRA set the minimum account requirement for pattern day traders at $25,000 after gathering input from a number of brokerage firms. The majority of these firms felt that a $25,000 “cushion” would alleviate the extra risks from day trading. Many firms felt that the $2,000 for regular margin accounts was insufficient as this minimum was set in 1974, before technology allowed for the electronic day trading that is popular today.

Investing platforms offering brokerage accounts are actually free to impose a higher minimum account requirement. Some investing platforms impose the $25,000 minimum balance requirement even on accounts that aren’t margin accounts.

Pattern Day Trader vs Day Trader

As discussed, there is a difference between a pattern day trader and a plain old day trader. The difference has to do with the details of their trading: Pattern day traders are more active and assume more risk than typical day traders, which is what catches the attention of their brokerages.

Essentially, a pattern day trader is someone who makes a habit of day trading. Any investor can engage in day trading — but it’s the repeated engagement of day trading that presents an identifiable pattern. That’s what presents more of a risk to a brokerage, especially if the trader is trading on margin, and which may earn the trader the PDT label, and subject them to stricter rules.

Does the Pattern Day Trader Rule Apply to Margin Accounts?

As a refresher: Margin trading is when investors are allowed to make trades with some of their own money and some money that is borrowed from their broker. It’s a way for investors to boost their purchasing power. However, the big risk is that investors end up losing more money than their initial investment.

Investors trading on margin are required to keep a certain cash minimum. That balance is used as collateral by the brokerage firm for the loan that was provided. The initial minimum for a regular margin account is $2,000 (or 50% of the initial margin purchase, whichever is greater). Again, that minimum moves up to $25,000 if the investor is classified as a “pattern day trader.”

FINRA rules allow pattern day traders to get a boost in their buying power to four times the maintenance margin excess — any extra money besides the minimum required in a margin account. However, most brokerages don’t provide 4:1 leverage for positions held overnight, meaning investors may have to close positions before the trading day ends or face borrowing costs.

If an investor exceeds their buying power limitation, they can receive a margin call from their broker. The investor would have five days to meet this margin call, during which their buying power will be restricted to two times their maintenance margin. If the investor doesn’t meet the margin call in five days, their trading account can be restricted for 90 days.

Does the Pattern Day Trader Rule Apply to Cash Accounts?

Whether the Pattern Day Trader Rule applies to other types of investing accounts, like cash accounts, is up to the specific brokerage or investing firm. The primary difference between a cash account vs. a margin account is that with cash accounts, all trades are done with money investors have on hand. Some trading platforms only apply the PDT rule to margin accounts and don’t apply it to cash accounts.

However, some platforms may adhere to FINRA rules that govern margin accounts even if they don’t offer margin trading. This means that a $25,000 minimum balance of cash and other securities must be kept in order for an investor to do more than four day trades in a five-business-day window.

Investors with cash accounts also need to be careful of free riding violations. This is when an investor buys securities and then pays for the purchase by using proceeds from a sale of the same securities. Such a practice would be in violation of the Federal Reserve Board’s Regulation T and result in a 90-day trading freeze.

Pros of Being a Pattern Day Trader

The pros to being a pattern day trader are somewhat obvious: High-risk trading goes along with the potential for bigger rewards and higher profits. Traders also have a short-term time horizon, and aren’t necessarily locking up their resources in longer-term investments, either, which can be a positive for some investors.

Also, the use of leverage and margin allows them to potentially earn bigger returns while using a smaller amount of capital.

Cons of Being a Pattern Day Trader

The biggest and most obvious downside to being a pattern day trader is that you’re contending with a significant amount of risk. Using leverage and margin to trade compounds that risk, too, so day trading does require thick skin and the ability to handle a lot of risk. (Make sure to consider your risk tolerance and investment objectives before engaging in day trading.) Given the intricacies of day trading, it can also be more time and research intensive.

Tips to Avoid Becoming a Pattern Day Trader

Here are some steps investors can take to avoid getting a PDT designation:

1.    Investors can call their brokerage or trading platform or carefully read the official rules on what kind of trading leads to a “Pattern Day Trader” designation, what restrictions can potentially be placed, and what types of accounts are affected.

2.    Investors can keep a close count of how many day trades they do in a rolling five-day period. It’s important to note that buying and selling during premarket and after-market trading hours can cause a trade to be considered a day trade. In addition, a large order that a broker could only execute by breaking up into many smaller orders may constitute multiple day trades.

3.    Investors can consider holding onto securities overnight. This will help them avoid making a trade count as a day trade, although with margin accounts, they may not have the 4:1 leverage afforded to them overnight.

4.    If an investor wants to make their fourth day trade in a five-day window, they can make sure they have $25,000 in cash and other securities in their brokerage account the night before to prevent the account from being frozen.

5.    Investors can open a brokerage account with another firm if they’ve already hit three day trades over five days with one trading platform. However, it’s good to keep in mind that the PDT rule is meant to protect investors from excessive risk taking.

It’s also important to know that taking time to make wise or careful investment decisions could be in the investor’s favor.

The Takeaway

Pattern day traders, as spelled out by FINRA guidelines, are traders who trade a security four or more times within five business days, and their day trades amount to more than 6% of their total trading activity using a margin account.

Being labeled a pattern day trader by a brokerage can trigger the PDT Rule, which means that the trader needs to keep at least $25,000 in their margin account. While day trading can reap big rewards, it also has big risks — and that’s something that brokerages are keenly aware of, and why they may choose to have stricter requirements for pattern day traders.

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, 12%*

FAQ

What happens if you get flagged as a pattern day trader?

If you’re labeled as a pattern day trader, your brokerage may require you to keep at least $25,000 in cash or other assets in your margin account as a sort of collateral.

Do pattern day traders make money?

Yes, some pattern day traders make money, which is why some people choose to do it professionally. But many, perhaps most, lose money, as there is a significant amount of risk that goes along with day trading.

What is the pattern day trader rule?

The Pattern Day Trader Rule was established by FINRA, and requires traders to have at least $25,000 in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000 the trader needs to deposit additional funds.

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.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q424-035

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Dec
06
2024
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Understanding Cash in Lieu of Fractional Shares

By | Growing Wealth, invest, Investing | Comments Off on Understanding Cash in Lieu of Fractional Shares

It’s not uncommon for publicly-traded companies to restructure based on changing market conditions or their stock price. When companies merge, acquire competitors, or split their stock, it can raise the question of how to consolidate or restructure the company’s outstanding shares.

If such a corporate action generates fractional shares for investors, the company’s leadership has a few options for how to proceed: They could distribute the fractional shares to shareholders, round up to the nearest whole share, or pay cash in lieu of fractional shares. Investors need to be aware of cash in lieu because it can affect a portfolio and taxes.

Key Points

•   Cash in lieu of fractional shares is a payment method where investors receive cash instead of fractional shares due to corporate actions like stock splits or mergers.

•   Companies may opt for cash in lieu to simplify management and avoid dealing with fractional shares after events such as stock splits or acquisitions.

•   Receiving cash in lieu is taxable, and investors must report it as capital gains, calculating their cost basis accurately to determine tax obligations.

•   Corporate actions like stock splits, mergers, and spinoffs can lead to fractional shares, prompting the need for cash in lieu payments to investors.

•   Understanding how cash in lieu of fractional shares works helps investors navigate the complexities of corporate actions and their financial implications.

What Is Cash in Lieu?

Cash in lieu is a type of payment where the recipient receives money instead of goods, services, or an asset.

In investing, cash in lieu refers to funds received by investors following structural company changes that unevenly disrupt existing stock prices and quantities. Instead of receiving fractional shares after a stock split or a merger, investors receive cash.

Following corporate actions like a stock split or a merger, the newly-adjusted stock supply can be uneven and often results in fractional shares. Rather than holding or converting fractional shares to whole shares, some companies opt to aggregate and sell all of the partial shares in the open market – where investors can buy stocks. After the sale of these shares, the company will pay cash to the investors who did not get fractional shares.

The company’s board ultimately determines how the company will maintain or return value to investors. Opting to distribute cash in lieu is a company’s method of disposing of fractional shares and returning the cash balance to investors that’s proportionate to prior holdings.

💡 Recommended: What Are Fractional Shares and How Do They Work?

Why Investors Receive Cash in Lieu

Investors can receive cash in lieu for various reasons involving company restructuring that affects the number of outstanding shares, stock price, or both.

The following events can lead to investors receiving cash in lieu of fractional shares.

Stock Split

A stock split occurs when a company’s board of directors determines that the company’s high share price may be too high for new investors. The company will then execute a stock split to lower the stock’s price by issuing more shares at a fixed ratio while maintaining the company’s unchanged value. Companies will often approve a stock split so its share price looks more attractive to more investors and gains more liquidity and marketability.

Depending on the predetermined ratio, a stock split could generate fractional shares. For example, a 3-to-2 stock split would create three shares for every two shares each investor holds. If you own five shares of the stock, you would have 7.5 shares after the split. Thus, a stock split would cause any investor with an odd number of shares to receive a fractional share.

However, suppose the company’s board isn’t keen to hold or deal with fractional shares. In that case, they will distribute investors’ whole shares and liquidate the uneven remainders, thus paying investors cash in lieu of fractional shares.

Conversely, a company may execute a reverse stock split because its stock price is too low, and they want to raise it. If stock prices get too low, investors may become fearful of buying the stock, and it may risk being delisted from exchanges.

When a stock undergoes a reverse stock split, investors usually receive one share for a specific number of shares they own, depending on the reverse split ratio. For example, a stock valued at $3.50 may undergo a reverse 1-for-10 stock split. Every ten shares are converted into one new share valued at $35.00. Investors who own 33 shares, or any number not divisible by ten, would receive fractional shares unless the company decides to issue cash in lieu of fractional shares.

Companies may notify their shareholders of an impending stock split or reverse split on Forms 8-K, 10-Q, or 10-K, as well as any settlement details if necessary.

Merger or Acquisition

Company mergers and acquisitions (M&As) can also create fractional shares. When publicly-traded companies combine or are bought, investors will often receive stock as part of the deal using a predetermined ratio. These stock purchase deals often result in fractional shares for investors in all involved companies.

In these cases, it’s rare for the ratio of new shares received to be a whole number. Companies may opt to return full shares to investors, sell fractional shares, and disburse cash in lieu to investors.

💡 Recommended: What Happens to a Stock During a Merger?

Spinoff

Suppose an investor owns shares of a company that spins off part of the business as a new entity with a separately-traded stock. In that case, shareholders of the original company may receive a fixed amount of shares of the new company for every share of the existing company held. Depending on the structure of the spinoff, investors may receive cash in lieu of fractional shares of the new company.

How Is Cash in Lieu of Fractional Shares Taxed?

Like many other forms of investment profits, cash in lieu of fractional shares is taxable, even though the payment occurred without the investor’s endorsement or action. Investors will pay a capital gains tax on the payment.

However, if you have a tax-advantaged account, like a 401(k) or individual retirement account (IRA), you do not have to worry about reporting or paying taxes on the gains of cash in lieu payment.

Some investors may simply report the payment on the IRS Form 1040’s Schedule D as sales proceeds with zero cost and pay capital gains tax on the entire cash settlement. However, the more accurate and tax-advantageous method would apply the adjusted cost basis to the fractional shares and pay capital gains tax only on the net gain.

💡 Recommended: A Guide to Tax-Efficient Investing

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How to Report Cash in Lieu of Fractional Shares

As noted above, if you receive cash in lieu of fractional shares, you’ll have to pay capital gains taxes on the windfall. To ensure you’re paying the right amount of tax, you’ll have to take a few extra steps to determine your cost basis and accurately report the cash in lieu payment.

Gather Your Documents

Investors may receive the cash through their investment broker and an IRS Form 1099-B at year-end with a “cash in lieu” or “CIL” notation. To accurately report your cash in lieu payment, you’ll need the Form 1099-B, your original cost basis, the date you purchased the stock, the date of the stock split or other corporate action, and the reason why you received the cash in lieu of fractional shares.

Calculate Your Cost Basis

Calculating the cost basis for cash in lieu of fractional shares is a little tricky due to the share price and quantity change. The new stock issued is not taxable, nor does the cost basis change, but the per-share basis does.

Consider the following example:

•   An investor owns 15 shares of Company X worth $10.00 per share ($150 value)

•   The investor’s 15 shares have a $7.00 per share cost basis ($105 total cost basis)

•   Company X declares a 1.5-to-1 stock split

After the stock split, the investor is entitled to 22.5 shares (1.5 x 15 shares = 22.5 shares) valued at $6.67 each ($150 value / 22.5 shares = $6.67 per share), but the company states they will only issue whole shares. Therefore, the investor receives 22 shares plus a $3.34 cash in lieu payment for the half share ($6.67 x 0.5 = $3.34 per half share).

The investor’s total cost basis remains the same, less the cash in lieu of the fractional shares. However, the adjusted cost basis now factors in 22 shares instead of 15, equaling a $4.77 per share cost basis ($105 total cost basis / 22 shares = $4.77 cost basis) and a $2.39 fractional share cost basis.

Finally, the taxable “net gain” for the cash payment received in lieu of fractional shares equates to:

$3.34 cash in lieu payment – $2.39 fractional share cost basis = $0.95 net gain.

So, rather than paying capital gains taxes on the $3.34 payment, you pay taxes on the $0.95 gain. You report this figure on the IRS Form 1040’s Schedule D.

The Takeaway

It’s not always possible to anticipate a company’s actions, like a merger or stock split, and how it will affect shareholders’ stock. If the company doesn’t wish to deal with fractional shares, shareholders need to understand the alternative payments, such as cash in lieu of fractional shares, and how it affects them. While cash in lieu can be burdensome, knowing the nuances of the payment and how it is taxed may benefit your portfolio.

Though you may receive cash in lieu of fractional shares, investors may still consider fractional shares to add to their investment portfolio.

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

Is cash in lieu of fractional shares taxable?

If you receive cash in lieu of fractional shares, the cash is taxable. The payment can be taxed as a short-term or long-term capital gain, depending on how long you’ve held the stock.

Is cash in lieu a dividend?

Investors can receive cash in lieu of fractional shares for a dividend payment. However, cash in lieu is not a dividend and is not taxed like a dividend.

Is cash in lieu a capital gain?

Cash in lieu is treated as a capital gain because the IRS considers it a stock sale. When you receive cash in lieu of fractional shares, you may have to pay capital gains taxes on the payment.

What is a cash in lieu settlement?

A cash in lieu settlement is an agreement between two parties in which one party agrees to pay the other party an agreed-upon amount of cash instead of some other form of payment or consideration.

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q324-023

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Terms and conditions apply. SOFI RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE. To qualify, a borrower must be a U.S. citizen or other eligible status, be residing in the U.S., and meet SoFi's underwriting requirements. Not all borrowers receive the lowest rate. Lowest rates reserved for the most creditworthy borrowers. If approved, your actual rate will be within the range of rates at the time of application and will depend on a variety of factors, including term of loan, evaluation of your creditworthiness, income, and other factors. If SoFi is unable to offer you a loan but matches you for a loan with a participating bank, then your rate may be outside the range of rates listed above. Rates and Terms are subject to change at any time without notice. SoFi Personal Loans can be used for any lawful personal, family, or household purposes and may not be used for post-secondary education expenses. Minimum loan amount is $5,000. The average of SoFi Personal Loans funded in 2023 was around $33K. Information current as of 2/26/24. SoFi Personal Loans originated by SoFi Bank, N.A. Member FDIC. NMLS #696891 (www.nmlsconsumeraccess.org). See SoFi.com/legal for state-specific license details. See SoFi.com/eligibility for details and state restrictions.

✝ To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.

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