You may feel proud of yourself for paying off a debt early, but doing so could trigger prepayment fees (ouch). The best way to avoid those charges is to read the fine print before you take out a loan that involves this kind of fee.
If you neglected to do that, however, it doesn’t necessarily mean you’re stuck with a prepayment penalty. Read on to learn ways to avoid paying loan prepayment penalties.
• Prepayment penalties charge fees for early loan repayment, often to recoup lost interest income.
• Reviewing loan terms and conditions helps identify and avoid prepayment penalties.
• Early repayment might incur penalties based on interest, balance percentage, or flat fees.
• Prepayment penalties are more common in mortgages than in personal loans.
• Loan documents should be reviewed for prepayment clauses, and negotiation or partial payments can help.
What Is a Prepayment Penalty?
A prepayment penalty is when a lender charges you a fee for paying off your loan before the end of the loan term. It can be frustrating that a lender would charge you for paying off a loan too early. After all, many people may think a lender would appreciate being repaid as quickly as possible.
While that’s true in theory, in reality, it’s not that simple. Lenders make most of their profit from interest, so if you pay off your loan early, the lender is possibly losing out on the interest payments that they were anticipating. Charging a prepayment penalty is one way a lender may recoup their financial loss if you pay off your loan early.
Lenders might calculate the prepayment fee based on the loan’s principal or how much interest remains when you pay off the loan. The penalty could also be a fixed amount as stated in the loan agreement.
Can You Pay Off a Loan Early?
Say you took out a $5,000 personal loan three years ago. You’ve been paying it off for three years, and you have two more years before the loan term ends. Recently you received a financial windfall and you want to use that money to pay off your personal loan early.
Can you pay off a personal loan early without paying a prepayment penalty? It depends on your lender. Some lenders offer personal loans without prepayment penalties, but some don’t. A mortgage prepayment penalty is more common than a personal loan prepayment penalty.
The best way to figure out how much a prepayment penalty would be is to check a loan’s terms before you accept them. Lenders have to be upfront about how much the prepayment penalty will be, and they’re required by law to disclose that information before you take on the loan.
Personal Loan Prepayment Penalty
If you take out a $6,000 personal loan to turn your guest room into a pet portrait studio and agree to pay your lender back $125 per month for five years, the term of that loan is five years. Although your loan term says it can’t take you more than five years to pay it off, some lenders also require that you don’t pay it off in less than five years.
The lender makes money off the monthly interest you pay on your loan, and if you pay off your loan early, the lender doesn’t make as much money. Loan prepayment penalties allow the lender to recoup the money they lose when you pay your loan off early.
Mortgage Prepayment Penalty
When it comes to different types of mortgages, things get a little trickier. For loans that originated after 2014, there are restrictions on when a lender can impose prepayment penalties. If you took out a mortgage before 2014, however, you may be subject to a mortgage prepayment penalty. If you’re not sure if your mortgage has a prepayment penalty, check your origination paperwork or call your lender.
Checking for a Prepayment Clause
Lenders disclose whether or not they charge a prepayment penalty in the loan documents. It might be in the fine print, but the prepayment clause is there. If you’re considering paying off any type of loan early, check your loan’s terms and conditions to determine whether or not you’ll have to pay a prepayment penalty.
How Are Prepayment Penalties Calculated?
The cost of a prepayment penalty can vary widely depending on the amount of the loan and how your lender calculates the penalty. Lenders have different ways to determine how much of a prepayment penalty to charge.
If your loan has a prepayment penalty, figuring out exactly what the fee will be can help you determine whether paying the penalty will outweigh the benefits of paying your loan off early. Here are three different ways the prepayment penalty fee might be calculated:
1. Interest costs. If your loan charges a prepayment penalty based on interest, the lender is basing the fee on the interest you would have paid over the full term of the loan. Using the previous example, if you have a $6,000 loan with a five-year term and want to pay the remaining balance of the loan after only four years, the lender may charge you 12 months’ worth of interest as a penalty.
2. Percentage of balance. Some lenders use a percentage of the amount left on the loan to determine the penalty fee. This is a common way to calculate a mortgage prepayment penalty fee. For example, if you bought a house for $500,000 and have already paid down half the mortgage, you might want to pay off the remaining balance in a lump sum before the full term of your loan is up. In this case, your lender might require that you pay a percentage of the remaining $250,000 as a penalty.
3. Flat fee. Some lenders simply have a flat fee as a prepayment penalty. This means that no matter how early you pay back your loan, the amount you’ll have to pay will always be the prepayment penalty amount that’s disclosed in the loan agreement.
Trying to avoid prepayment penalties can seem like an exercise in futility, but it is possible. The easiest way to avoid them is to take out a loan or mortgage without prepayment penalties. If that’s not possible, you may still have options.
• If you already have a personal loan that has a prepayment penalty, and you want to pay your loan off early, talk to your lender. You may be offered an opportunity to pay off your loan closer to the final due date and sidestep the penalty. Or you might find that even if you pay off the loan early and incur a penalty, it might be less than the interest you would have paid over the remaining term of the loan.
• You can also take a look at your loan origination paperwork to see if it allows for a partial payoff without penalty. If it does, you might be able to prepay a portion of your loan each year, which allows you to get out of debt sooner without requiring you to pay a penalty fee.
For example, some mortgages allow payments of up to 25% of the purchase price once a year, without charging a prepayment penalty. This means that while you might not be able to pay off your full mortgage, you could pay up to 25% of the purchase price each year without triggering a penalty.
Some lenders shift their prepayment penalty terms over the life of your loan. This means that as you get closer to the end of your original loan term, you might face lower prepayment penalty fees or no fees at all. If that’s the case, it might make sense to wait a year or two until the prepayment penalties are less or no longer apply.
When it comes to your money, you don’t want to make any assumptions. You still need to do your due diligence by asking potential lenders if they have a prepayment penalty. The Truth in Lending Act (TILA) requires lenders to provide documentation of any loan fees they charge, including a prepayment penalty. Also, under the TILA, consumers have the right to cancel a loan agreement within three days of closing on the loan without the lender taking any adverse action against them.
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The Takeaway
A prepayment penalty is one fee that can be avoided by asking questions of the lender and looking at the loan documents with a discerning eye. This may hold true both when you are shopping for a loan and when you are paying your loan off.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.
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Maybe you’ve already tried to apply for a regular personal loan — only to be turned down. If so, a guarantor loan might be an option worth looking into. With this type of loan, the guarantor (often a close friend or family member) agrees to repay the loan if the borrower can’t. Since this reduces risk to the lender, guarantor loans can make it possible for those with poor or limited credit to qualify for an unsecured personal loan.
However, guarantor loans come with risks and costs — for both the borrower and the guarantor. Here are some things to consider before you apply for a guarantor loan.
• A guarantor loan can allow individuals with poor credit to qualify for an unsecured personal loan by having a guarantor agree to repay the loan if the borrower defaults.
• The guarantor’s role is to reduce the lender’s risk, which can result in better loan terms for the borrower.
• Guarantor loans often come with higher interest rates than traditional personal loans, and the guarantor does not have access to the loan funds.
• Choosing a guarantor loan can help borrowers avoid expensive subprime loans and potentially build credit.
• Alternatives to guarantor loans include secured credit cards, flex loans, or borrowing directly from friends or family.
What Is a Loan With a Guarantor
A guarantor loan is typically an unsecured personal loan that requires the primary borrower to have a financial backer, or guarantor. A guarantor may be required because the borrower has not yet established credit or has had credit issues in the past (such as a history of late or missed debt payments). It’s still considered the borrower’s loan, but the guarantor is legally obligated to cover payments and any other fees if the borrower defaults on the agreement.
This guarantee reduces the lender’s risk and enables them to advance the money at a reasonable annual percentage rate (APR). However, APRs for guarantor loans are generally higher than APRs for regular personal loans.
How Do Guarantor Loans Work?
Guarantor loans work in the same way as other types of personal loans — you borrow a lump sum of money from a lender, which you are able to use for virtually any purpose. You then pay it back (plus interest) in monthly installments over a set period of time, which may be anywhere from one and seven years.
The only difference is that a third party (your guarantor) is part of the loan agreement. The guarantor is legally bound to make payments on the loan in the event that you default. A loan default is generally defined as missing payments for several months in a row but the exact meaning will depend on the lender.
While the guarantor bears responsibility for repaying the debt, this individual doesn’t have any legal right to the loaned money or anything purchased with the loan proceeds.
Are You Guaranteed to Get a Loan With a Guarantor?
Although it can certainly help your case, there’s no guarantee that you’ll qualify to take out a loan with a guarantor. Approval depends on the financial profiles of you and your guarantor and the eligibility requirements of the lender.
Who Can Be a Guarantor for Loans?
A guarantor doesn’t need to be anyone specific — it could be a parent, sibling, friend, or even a colleague. You generally want to choose someone you trust and feel comfortable openly discussing your finances with. That’s most likely going to be a family member or a close friend.
Guarantors also need to have a good credit history and typically be at least age 18 (though some lenders require a higher minimum age). Some lenders also require the guarantor to be a homeowner. As part of the application process, guarantors will need to undergo a credit check and provide proof of identification and income, as well as bank details and statements.
What Should I Look for in a Guarantor Loan?
Like any other loan, it’s generally a good idea to look for a guarantor loan with a competitive personal loan interest rates and low or no fees. You’ll also want to carefully consider the monthly payments and be sure you can comfortably afford to make them. While this is crucial with any loan, it’s particularly important with a guarantor loan, since your guarantor will be on the hook for repayment if you fall behind. This could impact your credit as well as put a significant strain on your relationship with your guarantor.
How Much Can I Borrow for a Guarantor Loan?
Many lenders offer personal loan amounts ranging anywhere from $500 to $50,000 (and sometimes up to $100,000 for borrowers with excellent credit). Loan amounts for guarantor loans will depend on which lender you choose as well as your financial situation and your guarantor’s credentials (such as their credit score and income).
Guarantor Loan Requirements
Guarantor loans have eligibility requirements such as minimum credit scores and income thresholds that the guarantor will have to meet. Here’s a closer look.
Credit Score
While the borrower’s credit score might be poor or fair, the guarantor’s credit score should be considerably higher in order to secure the loan.
Proof of Residency
A guarantor will need to provide proof of residency. This can be done by showing documents such as a utility bill, a mortgage or rental agreement, or bank statements.
Income
The guarantor will need to verify a consistent income that’s sufficient to make payments on the loan if the primary borrower cannot. They will need to be able to show proof of income through bank account statements, pay stubs, invoices, and/or tax returns.
Age Requirements
The guarantor must be at least 18 years old, though some lenders have an age requirement of 21 or 22. They will need to show proof of age (and identity) with a government-issued photo ID.
Guarantors aren’t just for personal loans, and they don’t always take on the full financial responsibility of the agreement they’re entering into. Here’s a look at some different types of guarantors.
Guarantors as Certifiers
A guarantor may act as a certifier for someone looking to land a job or get a passport. These guarantors pledge that they know the applicant and they are who they say they are.
Limited vs Unlimited
Acting as a guarantor doesn’t always mean you’re responsible for the entire loan if the primary borrower fails to repay it. Limited guarantors are liable for only part of the loan or part of the loan’s timeline. Unlimited guarantors, however, are responsible for the full amount and full term of the loan.
Lease Guarantor
A guarantor may be required to cosign an apartment lease if the renter has limited credit and income history. In the event that the tenant is unable to pay the rent or prematurely breaks the lease agreement, the guarantor is responsible for paying any money owed to the landlord.
Guarantors vs Cosigners
Guarantors and cosigners play similar roles in a lending agreement — they pledge their financial responsibility for the debt to strengthen the primary borrower’s application. And, in both cases, these individuals may become responsible for repaying the debt.
However, there are some key differences between a guarantor and a cosigner. The main one is that a cosigner is responsible for repayment of the debt as soon as the agreement is final and will need to cover any missed payments. A guarantor, on the other hand, is only responsible for repayment of the debt if the primary borrower defaults on the loan.
There are also differences in terms of credit impacts. A cosigner will have the loan added to their credit report and any positive or negative payment information that the lender shares with the consumer credit bureaus can have a positive or negative impact on their credit. Becoming a guarantor, on the other hand, will typically not have an impact on an individual’s credit unless the primary borrower defaults on the loan. At that point, the loan will appear as part of the guarantor’s credit report.
Pros and Cons of Guarantor Loans
Pros of Guarantor Loans
Cons of Guarantor Loans
Offers a lending option for people who cannot qualify for a loan on their own
Can be more expensive when compared to a standard personal loan
Helps borrowers avoid expensive and risky predatory loan products
Less choice of lenders compared with the wider personal loan market
Can help borrowers build their credit
Defaulting on the loan could strain your relationship with the guarantor
A guarantor loan can allow you to borrow money even if you have limited or less-than-ideal credit. It can also help you avoid expensive and risky subprime loans that are marketed to borrowers with bad credit. In addition, the proceeds of a guarantor loan can be used for virtually any purpose, including emergency expenses (such as a car repair or medical bill) and lifestyle expenses (like a wedding or home improvement project).
As with all forms of credit, getting a guarantor loan can help you establish or build your credit, provided you manage the debt responsibly and keep up with your payments. Stronger credit can give you access to loans with better rates and terms in the future, without the need for a guarantor.
But these loans also come with some downsides. For one, guarantor loans can be expensive, often with higher APRs than other types of personal loans. Also, you’ll want to make sure you can keep up with the payments. Should you default, you’ll not only be hurting yourself but also the person who signed on as your guarantor.
Another downside is that there are fewer guarantor loans on the market than traditional personal loans. This can lead to less choice of lenders, making it harder to shop around and find a good deal.
What Happens if a Guarantor Cannot Pay?
A guarantor is legally obligated to repay the loan if the primary borrower defaults. If the borrower defaults and the loan is a secured loan, then the guarantor’s home could be at risk if the borrower defaults on the repayments and the guarantor is also unable to pay. This is not the case for unsecured guarantor loans, but the lender will still pursue the guarantor for the repayment of the debt, possibly through the courts.
Alternative Options to a Guarantor Loan
What if you don’t have a trusted person to ask to be your guarantor or you don’t want to ask anyone to take on this responsibility? Here are some alternatives to a guarantor loan that you could consider.
• Secured credit card: If you have some cash, you could pledge that as collateral on a secured credit card. Responsible use of this type of credit card could help you build your credit history so you can improve your chances of future loan approval. Interest rates on secured credit cards can be higher than regular credit cards, and there may be fees associated with their use.
• Flex loan: A line of credit that is similar to a credit card, a flex loan can also be used to build credit. Borrowers can use funds up to their credit limit, repay those funds, and borrow them again. Interest rates on flex loans tend to be high, and there may be fees assessed daily or monthly or each time the loan is used.
• Loan from a friend or family member: Perhaps the person you ask to be a guarantor doesn’t want to take on that responsibility, but they are willing to directly loan you the money. A loan from family or a friend can be an option to consider, but you’ll want to be sure to have a written agreement outlining the expectations and responsibilities of both parties. This will go a long way to minimizing miscommunication and hurt feelings. Keep in mind that this is not an option that will help you build your credit history.
The Takeaway
Getting approved for an unsecured personal loan is more likely if you have a solid credit history, an above-average credit score, and sufficient income to satisfy a lender’s qualification requirements. If you’re lacking one or more of these things, you might consider other types of loans, which might include a guarantor loan. SoFi does not currently offer guarantor loans.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.
SoFi’s Personal Loan was named NerdWallet’s 2024 winner for Best Personal Loan overall.
FAQ
What are guarantor loans?
A guarantor loan is typically a type of personal loan that requires the primary borrower to have a financial backer, or guarantor. The guarantor agrees to pay the debt if the primary borrower defaults on the loan agreement.
How do I get a guarantor for a loan?
You might consider asking a trusted friend or family member to be a guarantor. This person should be someone who has solid credit and sufficient income to cover the loan payments should you default on the loan.
Are you guaranteed to get a loan with a guarantor?
No. Having a guarantor may strengthen a loan application, but it’s up to each individual lender to assess the qualifications of both parties.
Photo credit: iStock/fizkes
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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
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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.
Financial literacy is a way of saying that you have a good working knowledge of the basics of managing money and using it to reach your goals. It typically means you understand budgeting; you know how different financial products can help you protect and grow your cash; and you are aware of how the financial climate (from inflation to interest rates) can impact your personal situation.
Building financial literacy is a valuable move because it helps you achieve goals like saving for the down payment on a house, affording your kid’s college costs, and being prepared for retirement.
Read on to take a financial literacy quiz, learn more about financial literacy, and find out how to build it.
Key Points
• Financial literacy involves understanding fundamental money concepts to achieve personal financial goals.
• Being financially literate helps in avoiding debt, planning finances, and earning higher interest rates.
• Budgeting, interest, saving, credit, and investing are essential components of financial literacy.
• Government resources provide educational tools for financial literacy.
• Enhancing financial literacy can reduce stress, build wealth, and increase confidence in managing money.
Why Financial Literacy Is Important
Higher levels of financial literacy have been consistently linked to responsible money management. This can help consumers:
Boosting your financial literacy can be a great way to be confident that you have the information and insight you need to manage your finances well, today and tomorrow.
Are You Financially Literate?
If you feel as if you are not fully financially literate, it might be a case of not having focused on this aspect of your life. After all, financial literacy isn’t usually a part of the curriculum in high school or college.
Also, age plays a factor in financial literacy. The younger you are, the less money know-how you are likely to have. One recent study found that Gen Z (born between 1997 and 2012) had less financial savvy than Millennials, Gen X, and Boomers. Which could be understandable: The younger a person is, the less likely it can be that they’ve gone mortgage shopping, waded deeply into retirement planning, or researched health insurance.
Typically, financial literacy based on such key components of this type of knowledge as:
• Knowing how to create a budget so that you’re aware of and accountable for where your money is going
• Understanding how interest works when you save and invest, as well as how it works when you borrow, including the concept of compound interest
• Saving, whether that means for emergencies (perhaps stashed in a high-yield savings account) or for a specific goal, such as a big-ticket item or even a house
• Knowing the facts about credit card debt, managing your debt well, and avoiding the credit card debt roller-coaster
• Protecting your identity and otherwise using practices to safeguard your funds
If you’ve taken our quiz, the financial literacy questions will likely have helped you to pinpoint if you need to bolster your understanding of money matters.
Financial topics can be challenging, but fortunately, there are plenty of resources to help you increase your knowledge. Your bank may have a library of information as well as tools and calculators to help you do some number crunching and give you a better picture of your finances.
Your local library and book retailers, as well as financial magazines and websites, probably have plenty of information too. It can be a smart move to veer towards those publications that are well-regarded vs. following, say, an influencer without credentials but a lot of lofty promises on social media.
Podcasts, newsletters, and continuing-ed classes are other options. It can also make good sense to find a financial planner, who can walk you through your own unique challenges and opportunities.
Government Resources for Building Financial Literacy
There are also government resources, including those available at the Financial Literacy and Education Commission (FLEC), connected to the Treasury Department. This commission was founded to boost literacy.
Another government site, one created by FLEC, is dedicated to financial education: MyMoney.gov . This site provides practical information about each of what they call the five building blocks for money management (MyMoney Five), which are:
• Earn: Understand your pay and benefits to make the most out of what you earn.
• Save and Invest: Start as soon as you can to save for future goals, even if you need to begin by saving small amounts.
• Protect: Create an emergency savings fund, choose the right insurance for your needs, and otherwise take precautions to protect your finances.
• Spend: Shop around and compare prices and products to get a good value on purchases, especially with larger ones.
• Borrow: Borrowing allows you to make essential purchases and also helps you to build credit, so it makes sense to understand how to borrow in the smartest way possible for your situation.
You can also access the government resource known as Federal Reserve Education , which provides resources for educators and students alike, while also empowering consumers to boost their understanding of banking. Topics include central banking and monetary policy, economics/macroeconomics, our government’s role in money regulation, personal finances, and more.
Here’s one more financial literacy resource from the federal government: FDIC’s Money Smart . This program provides resources to help people learn how to improve their financial management skills, from computer-based educational games to podcasts that focus on saving and borrowing.
The Takeaway
Building financial literacy can be done in a number of ways. Accessing government educational websites and diving into books, magazines, and podcasts from trusted sources can help build your money know-how. Also, look for a banking partner that provides educational resources.
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FAQ
What is financial literacy?
Financial literacy means having the knowledge and the skills to manage your personal finances effectively.
Why is financial literacy important?
Financial literacy can play an important role in your money management. It can reduce financial stress and help you build wealth, avoid debt, navigate emergencies, and encourage greater confidence in money matters.
How can I improve financial literacy?
There are several ways to improve financial literacy. You might review government websites on the topic, listen to podcasts or read books from well–regarded experts, and see what resources your bank provides. Budgeting well, avoiding debt, and understanding investing can be important components of your financial savvy.
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The biggest difference between an IRA vs. a 401(k) is the amount you can save. You can save over three times as much in a 401(k) vs. an IRA — $23,500 versus $7,000 for tax year 2025, and $24,500 versus $7,500 for tax year 2026. But not everyone has access to a 401(k), because these are sponsored by an employer, typically for full-time employees.
“A 401(k) is probably one of the most common retirement vehicles,” says Brian Walsh, a CFP® at SoFi. “A 401(k) will be available through work. Your employer is going to choose whether or not to make a 401(k) available to all the employees. Generally speaking, 401(k)s are the most popular retirement plan employers provide.”
Other than that, a traditional IRA and a 401(k) are similar in terms of their basic provisions and tax implications. Both accounts are considered tax deferred, which means you can deduct the amount you contribute each year — unless you have a Roth account, which has a different tax benefit.
Before you decide whether one or all three types of retirement accounts might make sense for you, it helps to know all the similarities and differences between a 401(k) and a traditional IRA and Roth IRA.
Key Points
• An IRA (Individual Retirement Account) and a 401(k) are both retirement savings accounts, but they have different features and eligibility requirements.
• IRAs are typically opened by individuals, while 401(k)s are offered by employers to their employees.
• IRAs offer more investment options and flexibility, while 401(k)s may have employer matching contributions and higher contribution limits.
• Both accounts offer tax advantages, but the timing of tax benefits differs: IRAs provide tax benefits during retirement, while 401(k)s offer tax benefits upfront.
• Choosing between an IRA and a 401(k) depends on factors like employment status, employer contributions, investment options, and personal financial goals.
How Are IRAs and 401(k)s Different?
The government wants you to prioritize saving for retirement. As a result, they provide tax incentives for IRAs vs. 401(k)s.
In that respect, a traditional IRA and a 401(k) are somewhat similar; both offer tax-deferred contributions, which may lower your taxable income, and tax-deferred investment growth. Also, you owe taxes on the money you withdraw from these accounts in retirement (or beforehand, if you take an early withdrawal).
There is a bigger difference between a Roth IRA and a 401(k). Roth accounts are funded with after-tax contributions — so they aren’t tax deductible. But they provide tax-free withdrawals in retirement.
And while you can’t withdraw the contributions you make to a traditional IRA until age 59 ½ (or incur a penalty), you can withdraw Roth contributions at any time (just not the earning or growth on your principal).
These days, you may be able to fund a Roth 401(k), if your company offers it.
Other Key Differences Between IRAs and 401(k)s
As with anything that involves finance and the tax code, these accounts can be complicated. Because there can be stiff penalties when you don’t follow the rules, it’s wise to know what you’re doing.
Who Can Set Up a 401(k)?
As noted above, a key difference between an IRA and a 401(k) is that 401(k)s are qualified employer-sponsored retirement plans. You typically only have access to these plans through an employer who offers them as part of a full-time compensation package.
In addition, your employer may choose to provide matching 401(k) funds as part of your compensation, which is typically a percentage of the amount you contribute (e.g. an employer might match 3%, dollar for dollar).
Not everyone is a full-time employee. You may be self-employed or work part-time, leaving you without access to a traditional 401(k). Fortunately, there are other options available to you, including solo 401(k) plans and opening an IRA online (individual retirement accounts).
Who Can Set Up an IRA?
Anyone can set up an individual retirement account (IRA) as long as they’re earning income. (And if you’re a non-working spouse of someone with earned income, they can set up a spousal IRA on your behalf.)
If you already have a 401(k), you can still open an IRA and contribute to both accounts. But if you or your spouse (if you’re married) are covered by a retirement plan at work, you may not be able to deduct the full amount of your IRA contributions.
Understanding RMDs
Starting at age 73 (for those who turn 72 after December 31, 2022), you must take required minimum distributions (RMDs) from your tax-deferred accounts, including: traditional IRAs, SEP and SIMPLE IRAs, and 401(k)s. Be sure to determine your minimum distribution amount, and the proper timing, so that you’re not hit with a penalty for skipping it.
It’s worth noting, though, that RMD rules don’t apply to Roth IRAs. If you have a Roth IRA, or inherit one from your spouse, the money is yours to withdraw whenever you choose. The rules change if you inherit a Roth from someone who isn’t your spouse, so consult with a professional as needed.
However, RMD rules do apply when it comes to a Roth 401(k), similar to a traditional 401(k). The main difference here, of course, is that the Roth structure still applies and withdrawals are tax free.
A Closer Look at IRAs
An IRA is an individual retirement account that has a much lower contribution limit than a 401(k) (see chart below). Anyone with earned income can open an IRA, and there are two main types of IRAs to choose from: traditional and Roth accounts.
Self-employed people can also consider opening a SEP-IRA or a SIMPLE IRA, which are tax-deferred accounts that have higher contribution limits.
Traditional IRA
Like a 401(k), contributions to a traditional IRA are tax deductible and may help lower your tax bill. In 2025, IRA contribution limits are $7,000, or $8,000 for those ages 50 or older. In 2026, IRA contribution limits are $7,500, or $8,600 for those 50 or older.
With a traditional IRA, investments inside the account grow tax-deferred. And unlike 401(k)s where an employer might offer limited options, IRAs are more flexible because they are classified as self-directed and you typically set up an IRA through a brokerage firm of your choice.
Thus it’s possible to invest in a wider range of investments in your IRA, including stocks, bonds, mutual funds, exchange-traded funds, and even real estate.
When making withdrawals at age 59 ½, you will owe income tax. As with 401(k)s, any withdrawals before then may be subject to both income tax and the 10% early withdrawal penalty.
What Are Roth Accounts?
So far, we’ve discussed traditional 401(k) and IRA accounts. But each type of retirement account also comes in a different flavor — known as a Roth.
The main difference between traditional and Roth IRAs lies in when your contributions are taxed.
• Traditional accounts are funded with pre-tax dollars. The contributions are tax deductible and may provide an immediate tax benefit by lowering your taxable income and, as a result, your tax bill.
• Money inside these accounts grows tax-deferred, and you owe income tax when you make withdrawals, typically when you’ve reached the age of 59 ½.
Roth accounts, on the other hand, are funded with after-tax dollars, so your deposits aren’t tax deductible. However, investments inside Roth accounts also grow tax-free, and they are not subject to income tax when withdrawals are made at or after age 59 ½.
As noted above, Roths have an additional advantage in that you can withdraw your principal at any time (but you cannot withdraw principal + earnings until you’ve had the account for at least five years, and/or you’re 59 ½ or older — often called the five-year rule).
Roth accounts may be beneficial if you anticipate being in a higher tax bracket when you retire versus the one you’re in currently. Then tax-free withdrawals may be even more valuable.
It’s possible to hold both traditional and Roth IRAs at the same time, though combined contribution limits are the same as those for traditional accounts. And those limits can’t be exceeded.
Additionally, the ability to fund a Roth IRA is subject to certain income limits: above a certain limit you can’t contribute to a Roth. There are no income limits for a designated Roth 401(k), however.
A Closer Look at a 401(k)
Contributions to your 401(k) are made with pre-tax dollars. This makes them tax-deductible, meaning the amount you save each year can lower your taxable income in the year you contribute, possibly resulting in a smaller tax bill.
In 2025, you can contribute up to $23,500 to your 401(k). If you’re 50 or older, you can also make catch-up contributions of an extra $7,500, for a total of $31,000. For 2025, those aged 60 to 63 may contribute an additional $11,250 instead of $7,500, thanks to SECURE 2.0, for a total of $34,750.
In 2026, you can contribute up to $24,500 to your 401(k), or up to $32,500 (including $8,000 extra in catch-up contributions). And again in 2026, individuals aged 60 to 63 can contribute an additional $11,250 instead of $8,000, for a total of $35,750.
401(k) catch-up contributions allow people nearing retirement to boost their savings. In addition to the contributions made, an employer can also match their employee’s contribution, up to a combined employer and employee limit of $70,000 in 2025 and $72,000 in 2026.
An employer may offer a handful of investment options to choose from, such as exchange-traded funds (ETFs), mutual funds, and target date mutual funds. Money invested in these options grows tax-deferred, which can help retirement investments grow faster.
When someone begins taking withdrawals from their 401(k) account at age 59 ½ (the earliest age at which you can start taking penalty-free withdrawals), those funds are subject to income tax. Any withdrawals made before 59 ½ may be subject to a 10% early withdrawal penalty, on top of the tax you owe.
When Should You Use a 401(k)?
If your employer offers a 401(k), it may be worth taking advantage of the opportunity to start contributing to your retirement savings. After all, 401(k)s have some of the highest contribution limits of any retirement plans, which means you might end up saving a lot. Here are some other instances when it may be a good idea:
1. If your employer matches your contributions
If your company matches any part of your contribution, you may want to consider at least contributing enough to get the maximum employer match. After all, this match is tantamount to free money, and it can add up over time.
2. You can afford to contribute more than you can to an IRA
For tax year 2025, you can put up to $7,000 in an IRA, but up to $23,500 in a 401(k) — if you’re 50 or over, those amounts increase to $8,000 for an IRA and $31,000 for a 401(k). And those aged 60 to 63 can contribute up to $34,750 to a 401(k), thanks to SECURE 2.0.
For tax year 2026, you can put up to $7,500 in an IRA, but up to $24,500 in a 401(k) — if you’re 50 or older, those amounts increase to $8,600 for an IRA and $32,500 for a 401(k). And again, if you’re aged 60 to 63, you can contribute up to $35,750 to a 401(k). If you’re in a position to save more than the IRA limit, that’s a good reason to take advantage of the higher limits offered by a 401(k).
3. When your income is too high
Above certain income levels, you can’t contribute to a Roth IRA. How much income is that? That’s a complicated question that is best answered by our Roth IRA calculator.
And if you or your spouse are covered by a workplace retirement plan, you may not be able to deduct IRA contributions.
If you can no longer fund a Roth, and can’t get tax deductions from a traditional IRA, it might be worth throwing your full savings power behind your 401(k).
When Should You Use an IRA?
If you can swing it, it may not hurt to fund an IRA. This is especially true if you don’t have access to a 401(k). But even if you do, IRAs can be important tools. For example:
1. When you leave your company
When you leave a job, you can rollover an old 401(k) into an IRA — and it’s generally wise to do so. It’s easy to lose track of old plans, and companies can merge or even go out of business. Then it can become a real hassle to find your money and get it out.
You can also roll the funds into your new company’s retirement plan (or stick with an IRA rollover, which may give you more control over your investment choices).
If you have a good mix of mutual funds in your 401(k), or even some target date funds and low-fee index funds, your plan is probably fine. But, some plans have very limited investment options, or are so confusing that people can’t make a decision and end up in the default investment — a low interest money market fund.
If this is the case, you might want to limit your contributions to the amount needed to get your full employer match and put the rest in an IRA.
3. When you’re between jobs
Not every company has a 401(k), and people are not always employed. There may be times in your life when your IRA is the only option. If you have self-employment income, you can make higher contributions to a SEP IRA or a Solo 401(k) you set up for yourself.
4. If you can “double dip.”
If you have a 401(k), are eligible for a Roth IRA, or can deduct contributions to a traditional IRA, and you can afford it — it may be worth investing in both. After all, saving more now means more money — and financial security — down the line. Once again, you can check our IRA calculator to see if you can double dip. Just remember that the IRA contribution limit is for the total contributed to both a Roth and traditional IRA.
The real question is not: IRA vs. 401(k), but rather — which of these is the best place to put each year’s contributions? Both are powerful tools to help you save, and many people will use different types of accounts over their working lives.
When Should You Use Both an IRA and 401(k)?
Using an IRA and a 401(k) at the same time may be a good way to save for your retirement goals. Funding a traditional or Roth IRA and 401(k) at once can allow you to save more than you would otherwise be able to in just one account.
Bear in mind that if you or your spouse participate in a workplace retirement plan, you may not be able to deduct all of your traditional IRA contributions, depending on how high your income is.
Having both types of accounts can also provide you some flexibility in terms of drawing income when you retire. For example, you might find a 401(k) as a source of pre-tax retirement income. At the same time you might fund a Roth IRA to provide a source of after-tax income when you retire.
That way, depending on your financial and tax situation each year, you may be able to strategically make withdrawals from each account to help minimize your tax liability.
The Takeaway
Roth accounts — whether a Roth IRA or a Roth 401(k) — have a different tax treatment. You deposit after-tax funds in these types of accounts. And then you don’t pay any tax on your withdrawals in retirement.
Another difference is that a 401(k) is generally sponsored by your employer, so you’re beholden to the investment choices of the firm managing the company’s plan, and the fees they charge. By contrast, you set up an IRA yourself, so the investment options are greater — and the fees can be lower.
Generally, you can have an IRA as well as a 401(k). The rules around contribution limits, and how much you can deduct may come into play, however.
If you’re ready to open an IRA, it’s easy when you set up an Active Invest account with SoFi Invest.
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FAQ
Is a 401(k) considered an IRA for tax purposes?
No. A 401(k) is a completely separate account than an IRA because it’s sponsored by your employer.
Is it better to have a 401(k) or an IRA?
You can save more in a 401(k), and your employer may also offer matching contributions. But an IRA often has a much wider range of investment options. It’s wise to weigh the differences, and decide which suits your situation best.
Can you roll a 401(k) Into an IRA penalty-free?
Yes. If you leave your job and want to roll over your 401(k) account into an IRA, you can do so penalty free within 60 days. If you transfer the funds and hold onto them for longer than 60 days, you will owe taxes and a penalty if you’re under 59 ½.
Can you lose money in an IRA?
Yes. You invest all the money you deposit in an IRA in different securities (i.e. stocks, bonds, mutual funds, ETFs). Ideally you’ll see some growth, but you could also see losses. There are no guarantees.
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A Roth IRA is an individual retirement account that allows you to contribute after-tax dollars and then withdraw your money tax-free in retirement. A Roth IRA is different from a traditional IRA in which you contribute pre-tax dollars but owe tax on the money you withdraw in retirement.
A Roth IRA can be a valuable way to help save for retirement over the long-term with the potential for tax-free growth. Read on to learn how Roth IRAs work, the rules about contributions and withdrawals, and how to determine whether a Roth IRA is right for you — just think of it as Roth IRA information for beginners and non-beginners alike.
Key Points
• A Roth IRA is a retirement savings account that offers tax-free growth and tax-free withdrawals in retirement.
• Contributions to a Roth IRA are made with after-tax dollars, and qualified withdrawals are not subject to income tax.
• Roth IRAs have income limits for eligibility, and contribution limits that vary based on age and income.
• Unlike traditional IRAs, Roth IRAs do not entail required minimum distributions (RMDs) during the account holder’s lifetime.
• Roth IRAs can be a valuable tool for long-term retirement savings, especially for individuals who expect to be in a higher tax bracket in the future.
What Is a Roth IRA?
A Roth IRA is a retirement account that provides individuals with a way to save on their own for their golden years.
You can open a Roth IRA at most banks, online banks, or brokerages. Once you’ve set up your Roth account, you can start making contributions to it. Then you can invest those contributions in the investment vehicles offered by the bank or brokerage where you have your account.
What differentiates a Roth IRA from a traditional IRA is that you make after-tax contributions to a Roth. Because you pay the taxes upfront, the earnings in a Roth grow tax free. When you retire, the withdrawals you take from your Roth will also be tax free, including the earnings in the account.
With a traditional IRA, you make pre-tax contributions to the account, which you can deduct from your income tax, but you pay taxes on the money, including the earnings, when you withdraw it in retirement.
Roth IRA Contributions
There are several rules regarding Roth IRA contributions, and it’s important to be aware of them. First, to contribute to a Roth IRA, you must have earned income. If you don’t earn income for a certain year, you can’t contribute to your Roth that year.
Second, Roth IRAs have annual contribution limits (see more on that below). If you earn less than the Roth IRA contribution limit for the year, you can only deposit up to the amount of money you made. For instance, if you earn $5,000 in 2025, that is the maximum amount you can contribute to your Roth IRA for that year.
In 2025, single filers with a modified adjusted gross income (MAGI) of:
• less than $150,000 can contribute the full amount to a Roth
• $150,000 to $165,000 to contribute a reduced amount
• $165,000 or more can’t contribute to a Roth
In 2025, married filers with a MAGI of:
• less than $236,000 can contribute the full amount to a Roth
• $236,000 to $246,000 can contribute a reduced amount
• $246,000 or more can’t contribute to a Roth
In 2026, single filers with a MAGI of:
• less than $153,000 can contribute the full amount to a Roth
• $153,000 to $168,000 can contribute a reduced amount
• $168,000 or more can’t contribute to a Roth
In 2026, married joint filers with a MAGI of:
• less than $242,000 can contribute the full amount
• $242,000 to $252,000 can contribute a reduced amount
• $252,000 or more can’t contribute to a Roth.
Tax Treatment
Contributions to a Roth IRA are made with after-tax dollars — meaning you pay taxes on the money before contributing it to your Roth. You can’t take your contributions as income tax deductions as you can with a traditional IRA, but you can withdraw your contributions at any time with no taxes or penalties. Once you reach age 59 ½ or older, you can withdraw your earnings, along with your contributions, tax-free.
If you expect to be in a higher tax bracket in retirement, or if you want to maximize your savings in retirement and not have to pay taxes on your withdrawals then, a Roth IRA may make sense for you.
Contribution Limits
As mentioned, Roth IRAs have annual contribution limits, which are the same as traditional IRA contribution limits.
For 2025, the annual IRA contribution limit is $7,000 for individuals under age 50, and $8,000 for those 50 and up. The extra $1,000 is called a catch-up contribution for those closer to retirement. For 2026, the contribution limit is $7,500 for those under age 50, and $8,600 for those 50 and up, including a $1,100 catch-up contribution.
Remember that you can only contribute earned income to a Roth IRA. If you earn less than the contribution limit, you can only deposit up to the amount of money you made that year.
As noted, you can make withdrawals, including earnings, tax-free from a Roth once you reach age 59 ½. And you can withdraw contributions tax-free at any time. However, there are some specific Roth IRA withdrawal rules to know about so that you can make the most of your IRA.
Qualified Distributions
Since you’ve already paid taxes on the money you contribute to your Roth IRA, you can withdraw contributions at any time without paying taxes or a 10% early withdrawal penalty. But you cannot withdraw earnings tax- and penalty-free until you reach age 59 ½.
For example, if you’re age 45 and you’ve contributed $25,000 to a Roth through your online brokerage over the last five years, and your investments have seen a 10% gain (or $2,500), you would have $27,500 in the account. But you could only withdraw up to $25,000 of your contributions tax-free, and not the $2,500 in earnings.
The 5-Year Rule
According to the 5-year rule, you can withdraw Roth IRA account earnings without owing tax or a penalty, as long as it has been five years or more since you first funded the account, and you are 59 ½ or older.
The 5-year rule applies to everyone, no matter how old they are when they want to withdraw earnings from a Roth. For example, even if you start funding a Roth when you’re 60, you still have to wait five years to take qualified withdrawals.
Non-Qualified Withdrawals
Non-qualified withdrawals of earnings from a Roth IRA depends on your age and how long you’ve been funding the account.
• If you meet the 5-year rule, but you’re under age 59 ½, you’ll owe taxes and a 10% penalty on any earnings you withdraw, except in certain cases, as noted below.
• If you don’t meet the 5-year rule, meaning you haven’t had the account for five years, and if you’re less than 59 ½ years old, in most cases you will also owe taxes and a 10% penalty.
Exceptions
You can take an early or non-qualified withdrawal prior to 59 ½ without paying a penalty or taxes in certain circumstances, including:
• For a first home. You can take out up to $10,000 to pay for buying, building, or rebuilding your first home.
• Disability. You can withdraw money if you qualify as disabled.
• Death. Your heirs or estate can withdraw money if you die.
Additionally you may be able to avoid the 10% penalty (although you’ll still generally have to pay income taxes) if you withdraw earnings for such things as:
• Medical expenses. Specifically, those that exceed 7.5% of your adjusted gross income.
• Medical insurance premiums. This applies to health insurance premiums you pay for yourself during a time in which you’re unemployed.
• Qualified higher education expenses. This includes expenses like college tuition and fees.
Advantages of a Roth IRA
Depending on an individual’s income and circumstances, a Roth IRA has a number of advantages.
• No age restriction on contributions. Roth IRA account holders can make contributions at any age as long as they have earned income for the year.
*You can fund a Roth and a 401(k). Funding a 401(k) and a traditional IRA can sometimes be tricky, because they’re both tax-deferred accounts. But a Roth IRA is after-tax, so you can contribute to a Roth and a 401(k) at the same time and stick to the contribution limits for each account.
• Early withdrawal option. With a Roth IRA, an individual can generally withdraw money they’ve contributed at any time without tax or penalties (but not earnings). In contrast, withdrawals from a traditional IRA before age 59 ½ may be subject to a 10% penalty.
• Qualified Roth withdrawals are tax-free. Investors who have had the Roth for five years or more, and are at least 59 ½, are eligible to take tax- and penalty-free withdrawals of contributions and earnings.
• No required minimum distributions (RMDs). Unlike traditional IRAs, which require account holders to start withdrawing money at age 73, Roth IRAs do not have RMDs. That means an individual can withdraw the money as needed without fear of triggering a penalty.
Disadvantages of a Roth IRA
Roth IRAs also have some disadvantages to consider. These include:
• No tax deduction for contributions. A primary disadvantage of a Roth IRA is that your contributions are not tax deductible, as they are with a traditional IRA and other tax-deferred accounts like a 401(k).
• Higher earners often can’t contribute to a Roth. Individuals with a higher MAGI are generally excluded from Roth IRA accounts, unless they do what’s known as a backdoor Roth or a Roth conversion.
• The 5-year rule applies. The 5-year rule can make withdrawals more complicated for investors who open a Roth later in life. If you open a Roth or do a Roth conversion at age 60, for example, you must generally wait five years to take qualified withdrawals of contributions and earnings or face a penalty.
• Low annual contribution limit. The maximum amount you can contribute to a Roth IRA each year is low compared to other retirement accounts like a SEP IRA or 401(k). But, as noted above, you can combine saving in a 401(k) with saving in a Roth IRA.
Roth IRA Investments
How does a Roth IRA make money? Once you contribute money to your IRA account you can invest those funds in different assets such as mutual funds, exchange-traded funds (ETFs), stocks, and bonds. Depending on how those investments perform, you may earn money on them (however, no investment is guaranteed to earn money). And if you leave your earnings in the account, you can potentially earn money on your earnings through a process called compounding returns, in which your money keeps earning money for you.
To choose investments for your Roth IRA, consider your financial circumstances, goals, timeframe (when you will need the money), and risk tolerance level. That way you can determine which investment options are best for your situation.
Is a Roth IRA Right for You?
How do you know whether you should contribute to a Roth IRA? This checklist may help you decide.
• You might want to open a Roth IRA if you don’t have access to an employer-sponsored 401(k) plan, or if you do have a 401(k) plan but you’ve already maxed out your contribution to it. You can fund both a Roth IRA and an employer-sponsored plan.
• Because Roth contributions are taxed immediately, rather than in retirement, using a Roth IRA can make sense if you are in a lower tax bracket currently. It may also make sense to open a Roth IRA if you expect your tax bracket to be higher in retirement than it is today.
• Individuals who are in the beginning of their careers and earning less might consider contributing to a Roth IRA now, since they might not qualify under the income limits later in life.
• A Roth IRA may be helpful if you think you’ll work past the traditional retirement age, as long as your income falls within the limits. Since there is no age limit for opening a Roth and RMDs are not required, your money can potentially grow tax-free for a long period of time.
The Takeaway
A Roth IRA can be a valuable tool to help save for retirement. With a Roth, your earnings grow tax-free, and you can make qualified withdrawals tax-free. Plus, you can withdraw your contributions at any time with no taxes or penalties and you don’t have to take required minimum distributions (RMDs).
That said, not everyone is eligible to fund a Roth IRA. You need to have earned income, and your modified adjusted gross income cannot exceed certain limits. You must fund your Roth for at least five years and be 59 ½ or older in order to make qualified withdrawals of earnings. Otherwise, you would likely owe taxes on any earnings you withdraw, and possibly a penalty.
Still, the primary advantage of a Roth IRA — being able to have an income stream in retirement that’s tax-free — may outweigh the restrictions.
Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
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FAQ
Are Roth IRAs insured?
If your Roth IRA is held at an FDIC-insured bank and is invested in bank products like certificates of deposit (CDs) or money market account, those deposits are insured up to $250,000 per depositor, per institution. On the other hand, if your Roth IRA is with a brokerage that’s a member of the Securities Investor Protection Corporation (SIPC), and the brokerage fails, the SIPC provides protection up to $500,000, which includes a $250,000 limit for cash. It’s very important to note that neither FDIC or SIPC insurance protects against market losses; they only cover losses due to institutional failures or insolvency.
How much can I put in my Roth IRA monthly?
For tax year 2025, the maximum you can deposit in a Roth or traditional IRA is $7,000, or $8,000 if you’re over 50. For tax year 2026, the maximum you can contribute is $7,500, or $8,600 if you’re age 50 or older. How you divide that per month is up to you. But you cannot contribute more than the annual limit.
I opened a Roth IRA — now what?
After you open a Roth IRA, you can make contributions up to the annual limit. Then you can invest those contributions in assets offered by your IRA provider. Typically you can choose from such investment vehicles as mutual funds, exchange-traded funds, stocks and bonds.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
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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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