Feb
27
2024
What Is Compliance Testing for 401k?

What Is Compliance Testing for 401(k)?

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on What Is Compliance Testing for 401(k)?

To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.

401(k) compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.

Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.

Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.

401(k) Compliance Testing Explained

Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. 401(k) compliance testing is the responsibility of the company that offers the plan.

How 401(k) Compliance Testing Works

Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.

There are three nondiscrimination testing standards employers must apply to qualified retirement plans.

•   The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan

•   The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees

•   Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees

The Actual Deferral Percentage (ADP) Test

The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance testing measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.

To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.

A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:

•   125% of the ADP for the group of non-highly compensated employees

OR

•   The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%

The Actual Contribution Percentage (ACP) Test

Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.

This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:

•   125% of the ACP for the group of non-highly compensated employees

OR

•   The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%

Companies may run both the ADP and ACP tests using prior year or current-year contributions.

Top-Heavy Test

The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:

•   An officer making over $215,000 for 2023 and over $220,000 for 2024

•   A 5% owner of the business OR

•   An employee owning more than 1% of the business and making over $150,000 for the plan year

Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.

Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.

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Why 401(k) Compliance Testing Is Necessary

401(k) compliance testing ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.

If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.

Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.

Highly Compensated Employees

The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:

•   Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received,

OR

•   Received compensation from the business of more than $150,000 in 2023 and $155,000 in 2024 or $135,000 (if the preceding is 2022) and was in the top 20% of employees when ranked by compensation

If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.

Non-Highly Compensated Employees

Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.

Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

How to Fix a Non-Compliant 401(k)

The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:

•   Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards

•   Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test

Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.

Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:

•   Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.

•   Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.

Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.

The Takeaway

A 401(k) is a key way for employees to help save for retirement and reach their retirement goals. It’s important for employers to conduct IRS-mandated 401(k) compliance testing in order to ensure that their 401(k) plans are administered in a fair and equal manner that benefits all employees.

If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings, you may want to consider opening an Individual Retirement Account (IRA) to help save for retirement. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions.

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FAQ

What is top-heavy testing for 401(k)?

Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.

What happens if you fail 401(k) testing?

If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.

What is a highly compensated employee for 401(k) purposes?

The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the year. Income limits are set by the IRS and updated periodically.

Photo credit: iStock/tumsasedgars

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.

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

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

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Feb
27
2024
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How Do You Cash Out Stocks? Guide to Selling Stocks

By | Growing Wealth, invest, Investing, Terminology | Comments Off on How Do You Cash Out Stocks? Guide to Selling Stocks

Buying stocks can be fairly straightforward, whether online or through a financial advisor. But, when it’s time to sell shares, some beginning investors struggle with how to turn their stocks back into cash. After all, money invested in stocks is not immediately cash.

Investors may want to sell stocks for a wide variety of reasons. They might wish to reinvest the cash into another asset with an eye toward long-term gains. Or they could choose to withdraw funds from the stock market to cover short-term, daily expenses with cash earned from the sale.

So, how might investors go about cashing out stocks? And, what factors might individuals curious about how to cash out stocks bear in mind? Here’s an overview of the how and when of selling stocks.

Key Points

•   Stocks can be cashed out by selling them through a broker on a stock exchange.

•   Selling stocks can provide cash for major expenses or to reinvest in other assets.

•   Steps to cash out stocks include determining investment goals, accessing a brokerage account, placing a sell order, waiting for the sale to be completed, and receiving the proceeds.

•   Motivations for selling stocks include accessing cash for expenses, cashing out profits, preventing significant losses, day trading, and offloading low-performing stocks.

•   Types of sell orders include market orders, limit orders, stop orders, and trailing sell stop orders.

Can You Cash Out Stocks?

Investors can cash out stocks by selling them on a stock exchange through a broker. Stocks are relatively liquid assets, meaning they can be converted into cash quickly, especially compared to investments like real estate or jewelry. However, until an investor sells a stock, their money stays tied up in the market.

What Happens When You Sell a Stock?

When you sell a stock for a higher price than you paid, the proceeds from the sale will include your original investment plus your gains and minus any fees. If you sold your stock at a lower price than you paid, the proceeds will include your original investment minus your losses and any fees.

How to Cash Out Your Stocks: 5 Steps

There are several steps involved in selling stocks, including the following:

1.    Determine your investment goals: Consider why you want to sell your stocks and whether it aligns with your overall investment goals.

2.    Access your brokerage account: You need to access or log in to your brokerage account to sell your stocks.

3.    Place an order to sell your stocks: Once you’re logged into your brokerage account, you can place a sell order (like the orders outlined below) to sell your stocks. You can choose to sell at a specific price or through a market order, which will sell the stocks at the current market price.

4.    Wait for the sale to be completed: After placing an order to sell your stocks, you will need to wait for the sale to be completed. This can take anywhere from a few seconds to several days, depending on market conditions and the type of order you have placed.

5.    Receive the proceeds from the sale: After the sale is completed, the proceeds from the sale will be deposited into your brokerage account or sent to you in the form of a check.

Motivations for Selling Stocks

Some investors watch their portfolios closely, selling stocks regularly to cash out profits or avoid significant losses.

However, one common reason investors decide to sell stocks is that they need the cash from the investments to pay for living expenses. While different investors might sell for various reasons, it can be helpful to understand the motivation that drives the desire to sell.

So, why might investors want to cash out stocks? Some common reasons could include the following:

Motivation for Selling Stocks

Accessing Cash for Life Expenses

If investors know they’ll need cash for a major life expense, such as buying a car or home, they may choose to cash out some stocks. Selling shares might ensure there’s enough cash around to cover big expenses.

One benefit to having cash on hand instead of having money invested in stocks is that cash is not subject to the ups and downs of the stock market. However, the value of cash is impacted over time by inflation.

Some investors might also opt to move money out of stocks into potentially more secure investments, such as bonds or a money market account, until they’re ready to pay for that large expense. This way, their money still earns interest while at a lower risk of losing value.

Cashing Out Profits

If it appears as though a recession is coming or investors have seen significant gains in their portfolio, they might choose to cash out to lock in the profits.

However, attempting to time the stock market to avoid losses during unstable economic conditions is risky. What seems to be a trend in the market one day may or may not indicate how the markets may perform in the future.

Investors may want to ask themselves whether they’re interested in cashing out based on an emotional reaction (fear of recent market ups and downs, for instance) or a need for profits.

Preventing Significant Losses

The goal of investing in stocks is to earn profits, not take losses. Still, there are some instances in which it could make sense to sell at a loss.

For example, an investor may sell specific stock holdings to prevent the likelihood of deeper losses in the future. Another scenario that might drive an investor to want to sell stocks is an industry-wide hardship, where numerous companies in one sector of the economy experience financial calamity at the same time. Industry-wide hardships may negatively impact the value of specific stock holdings.

In other instances, a company might reduce or eliminate shareholder dividends. Earning dividends may be a prime reason an investor bought the stock in the first place, so they decide to sell the stock because it’s no longer part of their investment strategy.

Day Trading

Day trading is one way of selling stocks, but it can carry significant risks. Day trades are the purchasing and selling (or vice versa) of the same stock on the same day. Here, traders are attempting to gain profit through short-term trades — typically through the use of technical or market analyses, which can require an in-depth knowledge of the intricacies of trading.

If it were possible to clearly predict future stock movements, everyone might want in on the stock market. But, stocks are volatile. Rather than guessing based on company news and technical indicators, traders who wish to make shorter term trades might choose to set a price goal. For instance, if they buy shares at $10 each, they could set a goal to sell them when they reach $18 per share.

Offloading Low Performing Stocks

Even if investors conduct thorough research on a company before buying a stock, they may later realize it wasn’t a boon for their portfolio. If a purchased stock continues to decline in value over time, investors may opt to offload the low-performing stock.

Also, some investors sell low-performing stocks at the end of the year for tax-loss harvesting, where investors sell investments at a loss to reduce their overall tax burden.

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Understanding Types of Sell Orders

Once an investor has decided to cash out a stock, there are several options for how to sell. Each comes with different amounts of control over the sale. Here’s an overview of the most common types of sell orders:

Understanding Types of Sell Orders

Market Orders

When placing a market order, an investor agrees to sell their shares at the current market price per share. The sell order will be placed immediately or when the market reopens if the order is placed after hours.

One upside of market orders is that the trade can usually be executed quickly. A downside is that the investor has no control over the selling price.

Limit Orders

With a limit order, however, an investor can set the minimum price they are willing to sell their shares for. The sell order only gets executed if and when the stock reaches that price or higher.

For example, if you want to sell a stock currently trading at $50 per share and place a sell limit order at $55, the order will only be filled if the stock price rises to $55 or above.

The upside of limit orders is that investors can control the selling price (and potentially get a higher price than the current market rate). But, one possible downside is that their order won’t go through instantly and, potentially, might never go through (if the stock doesn’t reach the selected price).

Stop Orders or Stop-Loss Orders

A stop-loss order is placed with a brokerage to automatically sell a security when it reaches a specific price, known as the stop price. The reason investors set stop orders is to prevent incurring significant losses if a stock plummets in value.

For example, if you own a stock currently trading at $50 per share and place a stop-loss order at $40, the order will be triggered, and the stock will be sold if the price falls to $40 or below.

The upside of stop orders is that they can help protect against significant losses if the stock price drops unexpectedly. However, stop-loss orders do not guarantee a specific price, and the actual sale price may differ from the stop price due to market fluctuations.

Trailing Sell Stop Orders

Investors may also choose to place a trailing sell stop order, which allows you to set a stop price for a security that adjusts automatically as the price of the security moves in your favor.

With a trailing sell stop order, you can set the initial stop price at a certain percentage or dollar amount below the market price. The stop price will then adjust automatically as the market price of the security increases so that the stop price remains a fixed percentage or dollar amount below the market price. If the market price of the security then falls and reaches the stop price, the order will be triggered, and the security will be sold.

Trailing sell stop orders may allow traders to benefit from gains when a stock’s price rises while still protecting themselves from potential losses.

Factors to Assess When Cashing Out Stocks

There are several factors that you should consider when cashing out stocks:

•   Capital gains taxes: Cashing out stocks may result in capital gains, which are subject to taxes. It is important to consider the tax implications of cashing out stocks. Not all stock holdings are taxed similarly, which could impact an investor’s decision to sell or not to sell.

•   Investment goals: Consider why you are cashing out stocks and whether it aligns with your overall investment goals. If you are cashing out stocks to meet a short-term financial need, selling may be necessary even if the stock price is not optimal. However, if you are cashing out stocks as part of a long-term investment strategy, it may be worth holding onto the stocks, even if they’ve declined in price, because they may still appreciate over time.

•   Fees and commissions: Brokerage firms generally charge investment fees and commissions for executing trades, which can impact the overall profit or loss on the sale of your stocks. Considering these fees and commissions is important when deciding whether to cash out stocks.

Pros and Cons of Reinvesting Profits

Investors may choose to sell stocks to gain or spend cash. But, individuals may want to reinvest earnings from the stocks sold into other assets. If investors decide to reinvest their profits, they need to consider the advantages and disadvantages of doing so.

Pros

 Cons
Benefit from compound growth Lose out on opportunity to use profits for other financial needs
Diversify your portfolio Capital gains taxes
Hedge against inflation Exposure to market risk

Pros

•   Compound growth: Reinvesting stock profits allows you to compound your returns on your investments, which can significantly increase your overall returns over time.

•   Diversification: Reinvesting stock profits can help you diversify your portfolio and reduce risk by investing in various stocks rather than holding a lot of cash.

•   Hedge against inflation: Cash is subject to inflation, which makes cash savings lose value over time. Over a long-term period, cash tends to lose value, whereas the stock market tends to grow. By reinvesting rather than holding on to cash, investors may be less likely to lose money due to inflation.

💡 Recommended: 5 Tips to Hedge Against Inflation

Cons

•   Opportunity cost: Reinvesting stock profits means that you are not using the proceeds from the sale of your stocks to meet other financial goals or needs, such as paying off debt or saving for a down payment on a house.

•   Taxes: Reinvesting stock profits may result in capital gains tax, which can reduce the overall returns on your investments.

•   Market risk: The value of your investments can fluctuate due to market conditions, and reinvesting stock profits means you are exposed to the risks of the stock market.

Platforms for Buying and Selling Stocks

People just getting started with building a portfolio of stocks have several options. Options might include online platforms or traditional phone-in and in-person traders, including:

Online Brokerage Accounts

There are numerous online brokerage accounts and digital apps where investors can buy and sell stocks to build a portfolio. Online brokerage accounts and apps can be a convenient investment method, allowing users to sell from anywhere. Unlike many traditional brokerage firms, many trading apps don’t charge a commission on trades.

Opening a brokerage account will require identity verification and connection with a bank account for deposits and withdrawals.

Financial Advisors

Investors can also make stock trades over the phone or in person by working with a financial advisor. Sell orders placed through these individuals generally get executed within 24 hours, so it can be a slower method to cash out stocks. Before the arrival of web-driven trading, most stocks were bought and sold through traditional investment brokers or financial advisors.

The Takeaway

Before selling any stocks, investors might opt to evaluate their short- and long-term financial goals. Then, they could devise a plan to pursue those objectives, which may lead to cashing out stock holdings. However, knowing when to sell a stock can take time and effort. Rather than trying to time the market and sell stocks to lock in immediate profits and avoid future losses, individuals may want to invest for the long term.

Understanding how to navigate the stock market and decide when to cash out your stocks can be complicated. But that doesn’t mean the investing process needs to be confusing. By opening a SoFi Invest® online brokerage account, you can buy and sell stocks, exchange-traded funds (ETFs), fractional shares, and more with a few clicks of a button with no commissions. You can track your favorite stocks, stay up to date on the latest market news, and access educational resources, all in the SoFi app.

Take a step toward reaching your financial goals with SoFi Invest.

FAQ

How long does it take to cash out stocks?

The time it takes to cash out stocks can vary depending on the type of order you place and market conditions. Generally, it can take anywhere from a few seconds to several days for a sale of stocks to be completed.

Do you get money when you sell stock?

Yes, you will receive money when you sell stock. The proceeds from the stock sale will be deposited into your brokerage account or sent to you in the form of a check. The amount of money you receive will depend on the price you sell the stock and any fees or commissions charged by the brokerage firm.

Can I withdraw money from stocks?

To access cash from stocks, you need to sell your holdings and use the proceeds from the sale to withdraw cash from your brokerage account.

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.

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

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Feb
27
2024

8 Ways to Make Your Money Work For You

By | Budgeting & Goals, Growing Wealth, money | Comments Off on 8 Ways to Make Your Money Work For You

If you want your money to grow more quickly and to feel confident that you’ll reach your financial goals, you’re in the right place. This guide will show you how to make your money work harder for you. There are smart ways to maximize every single dollar you earn. Yes, it will take some planning and focus, but it can have very real rewards.

A few tactics to make the most of your money involve leaning into your personal finances and recognizing the importance of financial literacy. Once you’re committed to doing that, you can take such steps and budgeting well, maximizing interest and rewards on your cash, spending smarter, and automating your savings.

Key Points

•   Effective budgeting is crucial for understanding your spending habits and making the most of your money.

•   Paying off debt should be a priority to free up funds and make your money work for you.

•   Opening a high-yield savings account can help you save money for short-term goals and earn more through higher interest rates.

•   Considering passive income streams, such as rental properties or investments, can provide additional income and financial stability.

•   Investing as part of your financial plan can help grow your wealth over the long term, but it comes with risks and requires careful consideration.

Making Your Money Work For you

These tips and ideas can help you put your money to work.

1. Learning How to Budget

An effective budget can help you make the most of your money, allowing you to understand where you are spending, so that you can feel empowered to save, and spend, on things that are most important to you. With the right tools on your side, you can learn how to make your money work for you.

These budgeting tips can help you get started:

Layout Your Finances

An effective budget is an accurate budget. If you are starting your budget from scratch, some recommendations suggest reviewing three months’ worth of receipts, bills, etc., before moving forward. This will give you insight into your current spending habits. Then, split those expenditures into needs and wants.

A budgeting tip: The information for making your budget should be accessible. Depending on your preferences that may be a physical copy, a spreadsheet, or using an app that can help you stay on top of your budget and expenses. SoFi, a money-tracking app, lets you see all of your accounts in one central location so that you can easily see where the money is coming, where it’s going, and where you can shift things around.

Figure Out Your Net Income

After you know how much you’ve been spending, you want to compare it to how much you earn. When making a budget, it can help to work with your take-home pay. This is the total income you earn from your job, after taking out all the required taxes, savings, and insurance payments from it. Those who are self-employed may work with different deductions than those who work a regular 9-to-5. In that case, subtract your self-employment tax (the sum of Social Security and Medicare taxes).

Using your after-tax pay can help you determine an accurate total for how much money you actually have available to spend. If you have any other income earners in your household, do factor in their income as well. Also include any investments or additional sources of income.

Plan Your Budget

Now comes the moment of truth. You have to create a step-by-step plan and put it into action. One method you may want to think about is the 50/20/30 budget. This budgeting method breaks your spending and savings into the following amounts: 50% for your needs, 30% for wants, and 20% for savings. If they need adjusting, shift the numbers to suit your plan.

Tracking multiple categories may not work for you, though. If you have trouble logging expenses in hyper-specific categories, simplify them. Overwhelming yourself will only make it harder for you to stay on target.

Review and Adjust

No matter how perfect the plan, things change. You might switch jobs, have a child, move somewhere else, or gain new needs. That’s why your budget can be flexible. When things change, change your budget to reflect those new priorities. If you have trouble fixing the plan, you may need to revisit some of the previous planning stages. Your budget and money should work for you, after all.

💡 Quick Tip: An online bank account with SoFi can help your money earn more — up to 4.20% APY, with no minimum balance required.

2. Getting Out of Debt

More than anything, getting out of debt means finding ways to make your money work for you. Whether it’s more robust savings tactics or new repayments strategies, there are options. So if you want to take the burden of debt off of your shoulders, here are some methods to try out.

It’s easy to say you need to pay off a debt. But it’s another thing actually to have the money for it. So before you cut down your expenses, you may need to save up first. A high-yield savings account is an available option that can help you build wealth to meet your financial goals.

Selecting a Debt Repayment Strategy

What do you think of when you hear the words “snowflake,” “snowball,” and “avalanche”? Perhaps you picture snow-capped mountains or blustery winter sports. But they’re the names for some of the most popular debt repayment strategies. While these strategies encourage individuals to make additional payments on some of their debts, making the minimum payments on all debt is important.

•  The snowflake method encourages individuals to put any extra cash earned toward debt repayment. Any time there’s excess to play with, you put it towards your debt. Since that helps you pay over your monthly minimum, you’ll eventually finish off the debt. You can earn additional money in any way that works for you. For example, some people start low-cost side hustles in their free time, or you can try selling items you don’t want anymore.

•  With the snowball strategy, you pay off your debts from smallest to largest, when evaluating the total amount owed. During this, you still make minimum payments on all your other debts. While it’s motivating to see some of your financial troubles disappear, this may not work for you. The snowball method ignores interest rates, which gives a chance for other debts to grow.

•  The avalanche method works on the debts with the highest interest rates first.

Unsecured debts, like credit card balances and personal loans, often come with unfavorable interest terms. Leaving them alone allows your debt to grow exponentially when you’re not looking. Focusing on debts with the highest interest rate first could help you escape debt quickly and potentially spend less in interest overall.

3. Opening a High-Yield Savings Account

A high-yield savings account is an available option that can help you build wealth to meet your financial goals. High-yield savings accounts work similarly to traditional savings accounts. However, they have a greater annual percentage yield (APY), which indicates how much money you can earn in interest. While you still have to pay income taxes on that interest, these accounts are a great way to save money for significant, short-term expenses.

Another critical feature high-yield savings accounts have is their limited accessibility. You can’t make withdrawals as frequently as you do with a checking account. In addition, they come with monthly limits on deposits and withdrawals. So, you won’t be as tempted to touch the funds.

Get up to $300 when you bank with SoFi.

No account or overdraft fees. No minimum balance.

Up to 4.20% APY on savings balances.

Up to 2-day-early paycheck.

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FDIC insurance.


4. Considering Passive Income Streams

America’s workforce is changing with the times. As the cost of living rises, many people want to find ways to increase their income. Many are turning to passive income to combat these financial hurdles, which may be the solution to your debt.

Essentially, passive income is money that you earn without active involvement, outside of what you earn as a regular wage and salary. Instead, you put something you own to work, such as a rental property. Other examples of passive income include dividends from stock investments, royalties, and product sales.

So, you still might put in some effort getting started, but not as much as your full-time job. Side hustles are one of the best ways to pad that income. You can put the extra cash flow directly towards your debt and interest, weekly necessities, or your savings.

5. Considering Investing as a Part of Your Financial Plan

Analyzing your situation and finding an acceptable amount of money to invest can help long-term. Investing can be an important part of a well-rounded financial portfolio for long-term goals such as retirement.

Investing has the potential for a higher return on investment vs. a savings account, but the reward isn’t guaranteed. Unlike cash-based interest accounts, your portfolio balance will fluctuate with the market and isn’t covered by, say, Federal Deposit Insurance Corporation (FDIC) insurance.

Because of the risk associated with putting money into the market, some people may be hesitant to jump in, especially if they don’t fully understand how investing works. Getting a headstart on saving and investing can help you get prepared for retirement.

6. Automating Bill Pay or Automatic Savings

To avoid missing bill payments, consider an automatic payment system. Alternatively known as “autopay,” this technology automatically withdraws funds from your bank account or credit card. Then it transfers to the necessary vendor. Once you set it up, you don’t have to deal with the pressure of juggling repayments. Instead, you just have to make sure there are enough funds in your account for the withdrawal.

Paying bills on time history makes up about 35% of your overall FICO® score, so enrolling in autopay could potentially have the added benefit of building your credit score.

It’s also possible to automate contributions to retirement accounts or savings accounts. This could help keep you on track for your savings goals. It allows you to pay yourself first, and getting money siphoned out of your checking account right around payday can help you steer clear of spending it.

💡 Quick Tip: Bank fees eat away at your hard-earned money. To protect your cash, open a checking account with no fees online — and earn up to 0.50% APY, too.

7. Ditching the Fees

Fees charged by financial institutions can add up. Here are a few to consider avoiding:

Bank Fees

The list can include account maintenance fees, returned deposits, foreign transactions, account minimum fees, replacing a lost or stolen card, ATM fees, making too many savings withdrawals, writing too many checks, closing an account, not using an account enough, speaking with a human, paying late, or even paying off a loan too early.

In fact, American households spent $133 billion in credit card interest and fees in the most recent year studied. That’s your money flying away…Ouch.

ATM Fees

At an average of $4.73 a pop, out–of-network ATM fees can add up quickly. One way to avoid paying ATM fees is to always make sure that you’re using one of your bank’s designated ATMs. However, if you’re on the road or your bank only has a few networked ATMs, that can be a challenge.

Just like bank fees, however, more and more financial institutions are offering fee-free ATM usage as part of their perks. Especially if you use an online checking account, this can add up to hundreds of dollars in savings.

Investment Fees

Paying a traditional financial advisor a percentage of your account balance to manage, monitor, and optimize your portfolio could be worth the expense, but it might not be an option that is available to everyone.

Financial advising is still a confidence-booster for the majority of investors who use it. But when advisors charge a typical fee of 1% a year based on your portfolio balance, your total return can be significantly impacted.

Fortunately, a growing number of competitors are offering the same types of advising service with little or no fees — and no humans. Robo-advisors are becoming more popular because they use algorithms to optimize portfolios, thus eliminating the overhead of live employees.

Still other products offer the best of both worlds, with human advisors willing to help at the cost of an automated system.

8. Getting Rewarded for Spending

You also can find several ways to get rewarded for spending, such as retailer loyalty programs, coupons, or rebate apps. Cashback or reward credit cards can also be an effective way to save at your favorite store, provided you pay your statement balance in full every time it comes due.

The Takeaway

Things like effective budgeting, opening a high-yield bank account, paying off debt, establishing a passive income stream, and investing can help you make the most of your money.

Everyone’s financial situation is different, and what works for one person may not work for another. A bit of experimenting can be helpful, as can finding the right banking partner.

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 4.20% APY on SoFi Checking and Savings.

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.

SoFi members with direct deposit activity can earn 4.20% 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 4.20% 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 4.20% 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 10/31/2024. 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.

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

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

SoFi Relay offers users the ability to connect both SoFi accounts and external accounts using Plaid, Inc.’s service. When you use the service to connect an account, you authorize SoFi to obtain account information from any external accounts as set forth in SoFi’s Terms of Use. Based on your consent SoFi will also automatically provide some financial data received from the credit bureau for your visibility, without the need of you connecting additional accounts. SoFi assumes no responsibility for the timeliness, accuracy, deletion, non-delivery or failure to store any user data, loss of user data, communications, or personalization settings. You shall confirm the accuracy of Plaid data through sources independent of SoFi. The credit score is a VantageScore® based on TransUnion® (the “Processing Agent”) data.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

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27
2024
What Are the Different Types of Income?

What Are the Different Types of Income?

By | Financial Independence, Life & Career, money | Comments Off on What Are the Different Types of Income?

You may think of your income as being your paycheck or your freelance earnings, but there are actually many different types of income. If you have stocks that are generating dividends, that’s income, as is interest you earn on any savings accounts. Do you own a rental property that has rent payments flowing your way? That’s income, too.

Here, you’ll learn about seven common types of income and how they may affect your financial life.

Key Points

•   Income refers to money earned from labor, investments, or other sources, and can be categorized as earned, business, interest, dividend, rental, capital gains, or royalty income.

•   Earned income includes wages, salaries, tips, and bonuses, while business income is generated from products or services provided by a business.

•   Interest income is earned from interest-bearing financial vehicles like CDs or savings accounts, and dividend income comes from stock dividends.

•   Rental income is earned from property rentals, and capital gains are realized when selling assets for more than their purchase price.

•   Royalty income is earned from allowing others to use your property, such as patents or copyrighted work.

What Is Income?

Simply put, income is money that a person or business earns in return for labor, providing a product or service, or returns on investments. Individuals also often receive income from a pension, a government benefit, or a gift. Most income is taxable, but some is tax-exempt from federal or state taxes.

Another way to think about income types is whether it is active (or earned) or passive (or unearned).

•   Active or earned income is just what it sounds like: money that you work for, whether you are providing goods or a service.

•   Passive or unearned income is money you receive even though you are not actively doing anything to get it. For instance, if you have a certificate of deposit (CD) that earns you interest, that is passive income. Government benefits, capital gains, rental income, royalties, and more are also considered passive income. (We’ll go through these variations in more detail in a minute.)

People who are paid a salary may tend to think that their annual paycheck earnings are their income, but in truth, it’s common for many people to have multiple income streams. Granted, your salary may be by far the largest stream of income, but when considering your overall financial picture, don’t forget to think about the other ways that money comes to you.

💡 Quick Tip: Want to save more, spend smarter? Let your bank manage the basics. It’s surprisingly easy, and secure, when you open an online bank account.

Different Types of Income

Now that you know the answer to “What is income?” question, here’s a look at the various kinds of Income. These are usually categorized as seven different types of income (though these may also be called income streams).

1. Earned Income

Earned income is the money you earn for work you do, either in a job or self-employed. Earned income includes wages, salaries, tips, and bonuses.

Earnings are taxed at varying rates by the federal and state governments. Taxes may be withheld by your employer. Self-employed workers often pay quarterly and annual taxes directly to the government. Low-income workers may be eligible for the earned income tax credit.

2. Business Income

Next up: What is business income? This is a term often used in tax reporting; you may sometimes also hear it referred to as profit income. It basically means income received for any products or services your business provides. It is usually considered ordinary income for tax purposes.

Expenses and losses associated with the business can be used to offset business income. Business income can be taxed under different rules, depending on what type of business structure is used, such as sole proprietorship, partnership, corporation, etc.

3. Interest Income

When you invest in various types of interest-bearing financial vehicles, the return is considered interest income. Retirees often rely on interest income to fund their retirement. You can earn interest from a variety of sources including:

•   Certificates of deposit (CDs)

•   Government bonds

•   Treasury bonds and notes

•   Treasury bills (T-bills)

•   Corporate bonds

•   Interest-bearing checking accounts

•   Savings accounts.

In most cases, interest income is taxed as ordinary income. Some types of interest are fully taxable, while other forms (such as interest from Treasury bonds) are sometimes partially taxable.

Earn up to 4.20% APY with a high-yield savings account from SoFi.

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4. Dividend Income

Some companies pay stockholders dividends as a way of sharing profits. These are usually regular cash payments that investors can take as income or reinvest in the stock. Dividend income is one of the most common ways investors can make money from stocks. (Worth noting: Money-market funds distributions may seem like interest, but they are usually considered dividends.)

Dividends from stocks held in a taxable brokerage account are considered taxable income. These funds will be taxed at your regular income-tax rate or as a long-term capital gain. By contrast, dividends that are paid from a stock held inside a tax-advantaged savings account such as an IRA or 401(k) are not taxed.

5. Rental Income

Just as it sounds, rental income is income earned from rental payments on property you own. This could be as straightforward as renting a room in your house or as complicated as owning a multi-unit building with several tenants.

Rental income can provide a steady stream of passive vs. active income. It may enhance your livelihood or even be your main income. When your rental property increases in value, you may also gain from that appreciation and increase in equity. In addition, rental income qualifies for several tax advantages, including taking depreciation and some expense write-offs.

But there are downsides. Owning a rental property isn’t for the faint of heart. Unreliable tenants, decreasing property values, the cost of maintaining and repairing properties, as well as fees for rental property managers can all take a bite out of your rental income stream.

6. Capital Gains

Another important income stream can come from capital gains. You incur a capital gain when you sell an asset for more than what you originally paid for it. For the purposes of capital gains, an asset usually means an investment security such as a stock or bond. But it can also encompass possessions such as real estate, vehicles, or boats. You calculate a capital gain by subtracting the price you paid from the sale price.

There is another key point to know on this topic: Two types of capital gains are possible — short-term and long-term.

•   Short-term capital gains are realized on assets you’ve held for one year or less.

•   Long-term capital gains are earned on assets held for more than a year.

The tax consequences are different for each type of capital gain. Short-term gains are taxed as ordinary income, while long-term capital gains are taxed at a lower rate depending on income. Taxpayers could typically pay 0%, 15%, or 20% on long-term capital gains, depending on their income.

Keep in mind, however, that capital losses can happen too. That’s when a capital asset is sold for less than the purchase price. While it’s never pleasant to experience losses, there can be a small silver lining in this case. Many times capital losses can be taken as a tax deduction against current and/or future capital gains.

7. Royalty Income

Royalty income comes from an agreement allowing someone to use your property. These payments can come from the use of patents, copyrighted work, franchises, and more. An example or two:

Inventors who sell their creations to a third party may receive royalties on the revenue their inventions generate. Celebrities often allow their name to be used to promote a product for royalty payments. Oil and gas companies pay landowners royalties to extract natural resources from their property. The market for music royalties has been particularly lucrative in recent years with the proliferation of music streaming services.
Royalty payments are often a percentage of the revenues earned from the other party using the property. Many things impact how much royalty is paid, including exclusivity, the competition, and market demand. How royalty payments are taxed can also vary, depending on the type of agreement.

Now that you’ve reviewed the seven different types of income, you may be wondering, “What about residual income?” That’s a term that doesn’t actually describe money that’s heading your way. Instead, think of that as the amount of your income left over after you’ve paid your financial obligations. It’s similar to discretionary income. Unfortunately, it’s not another way to enrich your bank account.

Recommended: 10 Personal Finance Basics

The Takeaway

Understanding the seven general income streams (such as earned, dividend, and rental income) can help you make the most of your financial planning. Earning income from any of these sources can add stability and help achieve long-term goals, such as saving for retirement. Because some types of income have unique tax implications, it can be important to check with your tax advisor about any tax consequences that may exist.

Aside from earned income, it’s likely that interest is the kind of income most people receive. And seeking out the best possible interest rate can be a solid way to enhance your money; looking for a high-yield bank account may be a good place to start.

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 4.20% APY on SoFi Checking and Savings.

Photo credit: iStock/Selcuk1

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.

SoFi members with direct deposit activity can earn 4.20% 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 4.20% 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 4.20% 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 10/31/2024. 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.

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

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Feb
27
2024
man on smartphone

Safe Harbor 401(k) Plan: What Is It? Is It for You?

By | Growing Wealth, Investing, Preparing for Retirement | Comments Off on Safe Harbor 401(k) Plan: What Is It? Is It for You?

Safe harbor 401(k) plans enable companies to avoid the annual IRS testing that comes with traditional 401(k) plans. With a safe harbor 401(k), an employer makes mandatory contributions to all employees’ retirement accounts, and those funds vest immediately.

Often a perk used to attract top talent, safe harbor 401(k) plans are a way for highly compensated employees, like company executives and owners, to save more than a traditional 401(k) plan would normally allow.

Keep reading to learn more about safe harbor rules, why companies use these plans, along with the benefits, drawbacks, and relevant deadlines.

Key Points

•   Like a traditional 401(k), a safe harbor 401(k) lets employees deposit tax-deferred funds from their paychecks into a retirement savings account.

•   Employers are required to contribute to employees’ safe harbor 401(k) accounts.

•   Employer contributions in a safe harbor 401(k) vest immediately. There is no waiting period.

•   Highly-paid employees can contribute more to a safe harbor 401(k) than a traditional 40(k).

•   Safe harbor 401(k) plans allow companies to skip the annual nondiscrimination regulatory testing required by the IRS for traditional 401(k)s.

What Is a Safe Harbor 401(k) Plan?

A 401(k) safe harbor plan is similar to a traditional 401(k) plan — but with a twist. In both cases, eligible employees can use the plan to contribute pre-tax funds to a retirement account and employers may contribute matching funds.

But with a traditional 401(k) retirement plan, companies must submit to annual nondiscrimination regulatory testing by the IRS to ensure that the company plan doesn’t treat highly compensated employees (HCEs) — generally defined as earning at least $150,000 in the 2023 tax year and $155,000 in the 2024 tax year and being in the company’s top 20% in pay, or owning more than 5% of the business — more favorably than others. The testing process is complex and can be a burden for some companies.

An alternative is to set up a safe harbor 401(k) plan with a safe harbor match. This allows a company to skip the annual IRS testing — and avoid imposing restrictions on employee saving — by providing the same 401(k) contributions to all employees, regardless of title, salary, or even years spent at the company. And those funds must vest immediately.

This is an important benefit, because in many cases, employer contributions to traditional 401(k) plans vest over time, requiring employees to stay with the company for some years in order to get the full value of the employer match. Often, if you leave before the employer contributions or match have vested, you may forfeit them.

For smaller companies, it may be worth making the extra safe harbor match contributions in order to avoid the time and expense of the IRS’s annual nondiscrimination testing. For larger companies, giving all employees the same percentage contribution could be expensive. But the upside is that highly paid employees can then make much larger 401(k) contributions without running afoul of IRS rules, a real perk for company leaders. In addition, 401(k) safe harbor plans are typically less expensive to set up than traditional plans.

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Traditional 401(k) vs Safe Harbor 401(k) Plans

While safe harbor 401(k)s and traditional 401(k) plans are similar in many ways, there are some important differences that employers should be aware of.

For instance, with traditional 401(k) plans, contributions from highly compensated employees can’t comprise more than 2% of the average of all other employee contributions, in addition to other restrictions. However, with safe harbor 401(k) plans, those limits don’t apply.

Comparing Plan Features and Benefits

Here is a side-by-side comparison of a safe harbor 401(k) vs. a traditional 401(k)

Safe Harbor 401(k) Traditional 401(k)
Employer contributions are required. Employer contributions are optional.
Employer contributions are vested immediately. Employer contributions may vest over time.
Highly-paid employees can contribute up to the $22,500 maximum in tax year 2023 and up to $23,000 in 2024. Highly-paid employees can be limited in how much they can contribute.
Companies do not have to do annual nondiscrimination testing. Companies must do annual nondiscrimination testing.

Choosing the Right Plan for Your Business

A safe harbor plan may be beneficial for some smaller companies that can’t afford the expense of nondiscrimination testing. In addition, the plan is simpler with less administrative tasks.

A company might also choose a safe harbor 401(k) if it has some key high-earning employees that make up a large share of the workforce.

However, if your company is able to easily manage the nondiscrimination testing process, you may want to opt for a traditional 401(k). A traditional 401(k) could also be a good option for business owners who want to try to retain employees over the long-term. They could set up a vesting schedule for employer contributions that requires employees to be with the company for three years before becoming fully vested, for instance.

Setting Up a Safe Harbor 401(k) Plan

For employers interested in using a safe harbor 401(k), there are some general rules and guidelines they will need to follow.

Requirements, Contribution Formulas, and Deadlines

To fulfill the safe harbor 401(k) requirements, the employer must make qualifying 401(k) contributions (a.k.a. the safe harbor match) that vest immediately. The company contributes to employees’ retirement accounts in one of three ways:

•   Non-elective: The company contributes the equivalent of 3% of each employee’s annual salary to a company 401(k) plan, regardless of whether the employee contributes.

•   Basic: The company offers 100% matching for the first 3% of an employee’s 401(k) plan contributions, plus a 50% match for up to 5% of an employee’s contributions.

•   Enhanced: The company offers a 100% company match for all employee 401(k) contributions, up to 4% of a staffer’s annual salary.

Companies that opt for a safe harbor 401(k) plan have to adhere to strict compliance filing deadlines. These are the dates worth knowing.

October 1: That’s the deadline for filing for a safe harbor 401(k) for the current calendar year. This deadline meets the government criteria of a company needing to have a safe harbor 401(k) in operation for at least three months in a 12 month period, for the first year operating a safe harbor plan.

December 1: By this date, all companies — whether they’re rolling out a brand new safe harbor plan or are administering an existing one — must issue a formal notice to employees that a safe harbor 401(k) will be offered to company staffers.

January 1: The date that all safe harbor 401(k) plans are activated. For companies that currently have no 401(k) plan at all, they can roll out either a traditional 401(k) plan or a safe harbor 401(k) plan at any point in the year, for that calendar year.

Advantages of Implementing a Safe Harbor 401(k) Plan

Safe harbor 401(k)s offer some distinct upsides for business owners and employees alike.

Benefits for Employers and Employees

By creating a safe harbor 401(k) plan, a business owner can potentially attract and maintain highly skilled employees. Employees are attracted to higher retirement plan contributions and the ability to optimize retirement plan contribution amounts, ensuring more money for long-term retirement savings.

Plus, a safe harbor 401(k) plan can also help business owners save money on the compliance end of the spectrum. For example, companies save on regulatory costs by avoiding the costs of preparing for a nondiscrimination test (and the staff hours and training that goes with it).

There are some additional upsides to offering a safe harbor 401(k) retirement plan, for higher paid employees and regular staff too.

•   Playing catch up. If a company owner, or high-level managers, historically haven’t stowed enough money away in a company retirement plan, a safe harbor 401(k) plan can help them catch up. The same may be true, although to a lesser degree, for regular employees.

•   The spread of profit. Suppose a company has a steady and robust revenue stream and is managed efficiently. In that case, company owners may feel comfortable “spreading the wealth” with not only high-profile talent but rank-and-file employees, too.

•   Encourage retirement savings. If a company is seeing weak contribution activity from its rank-and-file employees, it may feel more comfortable going the safe harbor route and at least guaranteeing minimum 401(k) contributions to employees while rewarding higher-value employees with more lucrative 401(k) plan contributions.

Disadvantages of Safe Harbor Plans

Safe harbor 401(k) plans have their downsides, too. Here are some drawbacks to consider.

Financial Implications for Employers

The matching contribution requirements for safe harbor 401(k)s can add up to a hefty expense, depending on employee salaries. And because employees are vested immediately, there’s no incentive to stay with the company for a certain period.

In addition, if a company introduces a safe harbor 401(k) plan, it must commit to it for one calendar year, no matter how the plan is performing internally. Even after a year, 401(k) plan providers (which administer and manage the retirement plans) may charge a termination fee if a company decides to pull the plug on its safe harbor plan after one year.

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Safe Harbor 401(k) Contribution Limits and Match Types

There are some different rules for employer contribution limits and matching with a safe harbor 401(k) vs. a traditional 401(k).

Understanding Contribution Limits

Just like traditional 401(k) plans, the maximum employee contribution limit for a safe harbor plan is $22,500 in 2023 and $23,000 in 2024. If you are over 50, you would be eligible for an additional $7,500 catch-up contribution, if your plan allows it.

But in a safe harbor plan, a company owner can reserve the maximum $22,500 (in 2023) and $23,000 in 2024 for their plan contribution and also boost contribution payments to valued team members up to an individual profit-sharing maximum amount of 100% of their compensation, or $66,000 in 2023 ($73,500 for those over age 50) — whichever is less. In 2024, that number is $69,000 (76,500 for those over age 50).

Regular employees are allowed the standard maximum contribution limit of $22,500 in 2023 and $23,000 in 2024, plus anyone over age 50 can contribute an extra “catch-up” amount of $7,500. Those are the same maximum contribution ceilings as regular 401(k) plans.

Different Types of Employer Matching Contributions

As mentioned earlier, with a safe harbor 401(k), an employer must make qualifying 401(k) contributions that vest immediately in one of these ways:

•   Non-elective: The company contributes the equivalent of 3% of each employee’s annual salary to a company 401(k) plan.

•   Basic: The company matches 100% for the first 3% of an employee’s 401(k) plan contributions, plus a 50% match for the following 2% of their contributions.

•   Enhanced: The company provides a 100% company match for all employee 401(k) contributions, up to 4% of a staffer’s annual salary.

IRS Compliance Testing and Safe Harbor Provisions

To help understand the benefit of safe harbor plans, it helps to see what employers with traditional 401(k) plans face in terms of following IRS rules and submitting to the annual nondiscrimination tests.

Navigating Non-Discrimination Testing

Each year, a company must conduct Actual Deferral Percentage (ADP), Actual Contribution Percentage (ACP), and Top Heavy tests to confirm there is no compensation discrimination.

If the company fails one of the tests, it could mean considerable administrative hassle, plus the expense of making corrections, and potentially even refunding 401(k) contributions.

Before explaining the details of each test, here’s a refresher on how the IRS defines highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).

To be a HCE:

•   The employee must own more than 5% of the company at any time during the current or preceding year (directly or through family attribution).

•   The employee is paid over $150,000 in compensation from the employer for 2023 and $155,000 in 2024. The plan can limit these employees to the top 20% of employees who make the most money.

Employees who don’t fit these criteria are considered non-highly compensated. The nondiscrimination tests are designed to assess whether top employees are saving substantially more than the rank-and-file staffers.

•   The Actual Deferral Percentage (ADP) test measures how much income highly paid employees contribute to their 401(k), versus staff employees.

•   The Actual Contribution Percentage (ACP) test compares employer retirement contributions to HCEs versus the contributions to everyone else.

According to the IRS, the terms of the ADP test — which compares the amounts different employees are saving in their 401(k)s — are met if the ADP for highly compensated employees (HCE) doesn’t exceed the greater of:

•   125% of the deferral percentage for ordinary, i.e., non-highly compensated employees (NHCEs)

Or the lesser of:

•   200% of the deferral percentage for the NHCEs

•   or the deferral percentage for the NHCEs plus 2%.

The ACP test is met if the deferral percentage for highly compensated employees doesn’t exceed the greater of:

•   125% of the deferral percentage for the NHCEs,

Or the lesser of:

•   200% of the deferral percentage for the group of NHCEs

•   or the deferral percentage for the NHCEs plus 2%.

Last, the top-heavy test measures the value of the assets in all company 401(k) accounts, total. If the 401(k) balances of “key employees” account for more than 60% of total plan assets, the 401(k) would fail the top heavy test. The IRS defines key employees somewhat differently than highly compensated employees, although both groups are similar in that they earn more than ordinary staff.

As you can see, maintaining a traditional 401(k) plan, and meeting these requirements each year, can be a burden for some companies. Fortunately, by setting up a safe harbor 401(k) plan, a company can avoid the annual nondiscrimination tests and still provide a 401(k) savings plan for employees.

The Takeaway

Companies that don’t want the regulatory obligations of a traditional 401(k) plan, and would like to prioritize talent acquisition and employee retention may want to consider safe harbor 401(k) plans.

However, a business owner needs to weigh the pros and cons of a safe harbor 401(k) plan because, in some cases, it can be expensive for a company to maintain.

But no matter what type of 401(k) an employer decides to go with, having a retirement plan in place, with different savings and investment options, can help employees — and business owners themselves — save for the future.

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FAQ

Is a safe harbor 401(k) worth it?

Whether a safe harbor 401(k) is worth it depends on the goals of the business owner. A safe harbor 401(k) allows a company to skip the expense of nondiscrimination testing. And by creating a safe harbor 401(k) plan, a business owner may be able to attract and maintain highly skilled employees because of the higher contributions. However, the matching employer contribution requirements can add up to a high expense. A business owner needs to weigh the pros and cons of these plans.

Can I cash out my safe harbor 401(k)?

You can withdraw safe harbor 401(k) funds without penalty at age 59 ½ or if you leave your job. However, hardship withdrawals for immediate and heavy financial need may be allowed in certain circumstances. You can learn more at irs.gov.

Why would a company use a safe harbor 401(k)?

A company might use a safe harbor 401(k) to avoid the expense of nondiscrimination testing and to simplify the administration of a 401(k) plan. They might also use a safe harbor 401(k) to help attract and keep highly skilled employees.

What is an example of a safe harbor 401(k) match?

If an employer with a safe harbor 401(k) chooses to offer non-elective matching contributions, that means they contribute at least 3% of each employee’s annual salary. So if an employee makes $70,000 a year, for example, the employer would contribute $2,100 to their safe harbor 401(k) account.

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