What do you do with your stocks when the market drops? If you’re like most people, your first instinct is to sell. It’s human nature. But when they decline, selling everything can seem like the best way out of a bad situation. However, instinctively selling when stocks drop is often counterproductive, and it may make more sense to invest while the market is down.
Key Points
• Selling stocks during a market downturn can be counterproductive; investing for the long term is often more beneficial.
• Dollar-cost averaging allows investors to buy more shares when prices are low, potentially increasing returns.
• Tax-loss harvesting can offset gains by selling investments at a loss and reinvesting in similar assets.
• Avoid high-risk investments and rash decisions during downturns; maintain a diversified portfolio to manage risk.
• Market downturns offer opportunities to buy stocks at lower prices, but decisions should align with long-term goals.
Should You Invest When the Market Is Down?
It’s generally a good idea to invest when the stock market is down as long as you’re planning to invest for the long term. Seasoned investors know that investing in the market is a long-term prospect. Stock market dips, corrections, or even bear markets are usually temporary, and, given enough time, your portfolio may recover.
When the market is down, it provides an opportunity to buy shares of stock through your online investing account at a lower price, which means you can potentially earn a higher return on your investment when the market recovers.
For example, in late 2007, stocks began one of the most dramatic plunges in their history. From October 2007 to March 2009, the S&P 500 Index fell 57%. During that time, many investors panicked and sold their holdings for fear of further losses.
However, the market bottomed out on March 9, 2009, and started a recovery that would turn into the longest bull market in history. Four years later, in 2013, the S&P 500 surpassed the high it reached in 2007. While that historic plunge of over 50% was terrifying, if you panicked and sold, rather than employ bear market investing strategies, you would have locked in your losses — and missed the subsequent recovery.
If, on the other hand, you had kept your investments, you would have seen stock values fall at first, but as the market reversed course, you may have seen portfolio gains again.
Consider the recent example of how the markets performed during the early stages of the Covid-19 pandemic in 2020. The S&P 500 fell about 34% from February 19, 2020, to March 23, 2020, as the pandemic ravaged the globe. However, stocks rebounded and made up the losses by August. As of the end of 2024, markets are hovering around record highs.
These examples illustrate why timing the market is rarely successful, but holding stock over the long term tends to be a smart strategy. It’s still important to keep in mind that the stock market can be volatile and can fluctuate significantly in the short term. Therefore, you must be prepared for short-term losses and have a long-term investment horizon.
4 Things to Consider Doing During a Market Downturn
When the stock market is down, it can be a worrying time for investors. But it’s important to remember that market downturns are a normal part of the investing process and that the market may eventually recover. Here are a few things to consider doing during a market downturn.
1. Stay Calm and Avoid Making Impulsive Decisions
It’s natural to feel worried or concerned when the stock market is down, but it’s essential to maintain a long-term perspective and not make rash decisions based on short-term market movements.
Buying and selling stocks based on gut reactions to temporary volatility can derail your investment plan, potentially setting you back.
You likely built your investment plan with specific goals in mind, and your diversified portfolio was probably based on your time horizon and risk tolerance preferences. Impulsive selling (or buying) can throw off this balance.
Instead of letting emotions rule the day, consider having a plan that includes investing more when the market is down (aka buying the dip). These strategies involve buying stocks on sale, and the hope is that the downturn is temporary and you’ll be able to ride any upturn to potential earnings.
So, when markets take a tumble, your best move is often to stay calm and stick to your predetermined strategy.
That said, any investment decisions you make should be based on your own needs. Just because the market is down doesn’t mean you have to buy anything. Buying stocks on impulse just because they’re cheaper might throw a wrench in your plan, just like rushing to sell. Taking time to consider your long-term needs and doing research typically pays off.
2. Evaluate Your Portfolio
Review your portfolio and make sure it’s properly diversified. Portfolio diversification may reduce the overall risk of your portfolio by spreading your investments across different asset classes, like stocks, bonds, real estate, and cash. Investing in various assets and industries can protect your portfolio during a market downturn.
However, even if you have a well-diversified portfolio, you may also need to pay attention to your portfolio’s asset allocation during volatile markets. For example, during a down stock market, your stock holdings may become a lower percentage of your portfolio than desired, while bonds or cash become a more significant part of your overall holdings. If your portfolio has become heavily weighted in a particular asset class or sector, it could be strategic to sell some of those holdings and use the proceeds to buy securities to rebalance your portfolio at your desired asset allocation.
3. Take Advantage of Low Prices With Dollar-Cost Averaging
To help curb your impulse to pull out of the market when it is low — and continue investing instead — you may want to consider dollar cost averaging.
Here’s how it works: On a regular schedule — say every month — you invest a set amount of money in the stock market. While the amount you invest each month will remain the same, the number of shares you’ll be able to purchase will vary based on the current cost of each share.
For example, let’s say you invest $100 a month. In January, that $100 might buy ten shares of a mutual fund at $10 a share. Suppose the market dips in April, and the fund’s shares are now worth $5. Instead of panicking and selling, you continue to invest your $100. That month, your $100 buys 20 shares.
In June, when the market rises again, the fund costs $25 a share, and your $100 buys four shares. In this way, dollar cost averaging helps you buy more shares when the markets are down, essentially allowing you to buy low and limiting the number of shares you can buy when markets are up. This helps protect from “buying high.”
After ten years of investing $100 a month, the value of each share is $50. Even if some shares you bought cost more than that, your average cost per share is likely lower than the fund’s current price.
Steady investments over time are more likely to give you a favorable return than dumping a large amount of money into the market and hoping you timed it right.
4. Consider Tax-Loss Harvesting
If you’ve already experienced losses, you may want to consider tax-loss harvesting — the practice of selling investments that experienced a loss to offset your gains from other investments.
Imagine that you invest $10,000 in a stock in January. Over the year, the stock decreases in value, and at the end of the year, it is only worth $7,500. Instead of wishing you’d had better luck, you can sell that position and reinvest the money in a similar (but not identical) stock or mutual fund.
You get the benefit of maintaining a similar investment profile that will hopefully increase in value over time, and you can write off the $2,500 loss for tax purposes. You can write off the total amount against any capital gains you may have in this year or any future year, helping to lower your tax bill. This is tax-loss harvesting.
You can also deduct up to $3,000 of capital losses each year from your ordinary income. However, you must deduct your losses against capital gains first before using the excess to offset income. Losses beyond $3,000 can be rolled over into subsequent years, known as tax loss carryforward.
During major market downturns, this technique can ease the pain of capital losses — but it’s important to consider reinvesting the money you raise when you sell, or you’ll risk missing the recovery. But remember that with investing comes risk, so there’s no assurance that a recovery will occur.
4 Things to Avoid When the Market Is Down
Feeling anxious when the stock market is down is natural, but it’s important to remain calm and not let fear drive your investment decisions. Here are a few things to avoid when the stock market is down.
1. Trying to Time the Market
Timing the market is the idea that you will somehow beat the market by attempting to predict future market movements and buying and selling accordingly. However, it’s difficult to predict with certainty when the stock market will go up or down, so trying to time the market is generally a futile endeavor.
However, it’s difficult to predict with certainty when the stock market will go up or down, so trying to time the market is generally a futile endeavor. As they say: No one has a crystal ball in this business.
As a result, timing the market is not a strategy that works for most investors. Even during a down market, you should not wait until the market hits bottom to start investing in stocks again.
2. Selling All Your Stocks
You should resist the temptation to sell all of your stocks or make other rash decisions when the market is down. While it may be tempting to sell all of your stocks during a down market, it’s important to remember that the stock market usually recovers. If you sell all of your stocks when the market is down, you may miss out on the opportunity to participate in the market’s recovery.
3. Chasing After High-Risk Investments
When stocks are down, you may be inclined to try to earn quick profits by investing in high-risk assets — like commodities or cryptocurrencies — but these investments can be particularly volatile and are not suitable for everyone.
Moreover, riskier investment strategies like options and margin trading may be an appealing way to amplify returns in down markets. But if you are not comfortable using these strategies, you could end up with even bigger losses.
It’s important to remember that the stock market is just one part of your overall financial plan. Keep your long-term financial goals in mind, and don’t let short-term market movements distract you from your larger financial objectives.
Risks to Investing During Down Markets
While the stock market generally recovers after a decline, there are exceptions to the idea that the market tends to snap back quickly or always trends upward.
Take the stock market crash of 1929. Share prices continued to slide until 1932, as the Great Depression ravaged the economy. The Dow Jones Industrial Average didn’t reach its pre-crash high until November 1954.
In addition, as of early 2023, the Nikkei 225 — the benchmark stock index in Japan — has yet to reach the peak of over 38,000 it hit at the end of 1989. Back then, the index went on to lose half its value in three years as an economic bubble in the country burst. However, the Nikkei did touch the 30,000 level at various points in 2021 for the first time since 1990.
So, investors need to remember that just because stock markets have recovered in the past doesn’t mean that it will always be that way. As the saying goes, past performance is not indicative of future results.
The Takeaway
Almost everyone feels a sense of worry (or fear) when the market is down. It’s only natural to find yourself swamped with doubts: What if the market keeps sliding? What if I lose everything? What if it’s one of those rare occurrences when the recovery takes ten years?
Rather than succumb to panic, perhaps the best course of action is to stay the course, and not to give in to your impulses to sell or scrap your entire investment strategy, but to stay the course. Using strategies like dollar-cost averaging, which allow you to invest in a down market sensibly, can be a part of a balanced investment strategy that helps build wealth over time.
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A pattern day trader is actually a designation created by the Financial Industry Regulatory Authority (FINRA), and it refers to traders who day trade a security four or more times within a five-day period.
Because of their status, there are certain rules and stipulations that apply only to pattern day traders, which brokerages and investing firms must adhere to. Read on to learn more about pattern day traders, what rules apply to them, and how they’re different from regular day traders.
Key Points
• A pattern day trader is classified as someone who executes four or more day trades within a five-day period, exceeding 6% of their total trading activity.
• Investors identified as pattern day traders must maintain a minimum balance of $25,000 in their margin accounts to meet regulatory requirements set by FINRA.
• Engaging in pattern day trading can yield profits, but it also carries significant risks, especially when utilizing margin accounts, which can amplify both gains and losses.
• The Pattern Day Trader Rule was established to limit excessive risk-taking among individual traders, requiring firms to impose stricter trading restrictions on active day traders.
• Being designated as a pattern day trader may lead to account restrictions, including a 90-day trading freeze if the minimum balance requirement is not met.
Pattern Day Trader, Definition
The FINRA definition of a pattern day trader is clear: A brokerage or investing platform must classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period in a margin account.
When investors are identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules.
How Does Pattern Day Trading Work?
Pattern day trading works as the rules stipulate: An investor or trader trades a single security at least four times within a five business day window, and those moves amount to more than 6% of their overall trading activity.
Effectively, this may not look like much more than engaging in typical day trading strategies for the investor. The important elements at play are that the investor is engaging in a flurry of activity, often trading a single security, and using a margin account to do so.
Remember: A margin account allows the trader to borrow money to buy investments, so the brokerage that’s lending the trader money has an interest in making sure they can repay what they owe.
Example of Pattern Day Trading
Here is how pattern day trading might look in practice:
On Monday, you purchase 10 shares of Stock A using a margin account. Later that day, you sell the 10 shares of Stock A. This is a day trade.
On Tuesday, you purchase 15 shares of stock A in the morning and then sell the 15 shares soon after lunch. Subsequently, you purchase 5 shares of stock A, which you hold only briefly before selling prior to the market close. You have completed two day trades during the day, bringing your running total — including Monday’s trades — to three.
On Thursday, you purchase 10 shares of stock A and 5 shares of stock B in the morning. That same afternoon, you sell the 10 shares of stock A and the 5 shares of stock B. This also constitutes two day trades, bringing your total day trades to five during the running four-day period. Because you have executed four or more day trades in a rolling five business day period, you may now be flagged as a pattern day trader.
Note: Depending on whether your firm uses an alternative method of calculating day trades, multiple trades where there is no change in direction might only count as one day trade. For example:
• Buy 20 shares of stock A
• Sell 15 shares of stock A
• Sell 5 shares of stock A
If done within a single day, this could still only count as one day trade.
Do Pattern Day Traders Make Money?
Yes, pattern day traders can and do make money — if they didn’t, nobody would engage in it, after all. But pattern day trading incurs much of the same risks of day trading. Day traders run the risk of getting in over their heads when using margin accounts, and finding themselves in debt.
This is why it’s important for aspiring day traders to make sure they have a clear and deep understanding of both margin and the use of leverage before they give serious thought to trading at a high level.
It’s the risks associated with it, too, that led to the development and implementation of the Pattern Day Trader Rule, which can have implications for investors.
What Is the Pattern Day Trader Rule?
The Pattern Day Trader Rule established by FINRA requires that an investor have at least $25,000 cash and other eligible securities in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000, the investor will need to bring the balance back up in order to day trade again.
Essentially, this is to help make sure that the trader actually has the funds to cover their trading activity if they were to experience losses.
Note that, according to FINRA, a day trade occurs when a security is bought and then sold within a single day. However, simply purchasing shares of a security would not be considered a day trade, as long as that security is not sold later on that same day, per FINRA rules. This also applies to shorting a stock and options trading.
The PDT Rule established by FINRA requires that an investor have at least $25,000 in their margin account in order to conduct four or more day trades within five days. But merely day trading isn’t enough to trigger the PDT Rule.
All brokerage and investing platforms are required by FINRA, a nongovernmental regulatory organization, to follow this rule. Most firms provide warnings to their clients if they are close to breaking the PDT rule or have already violated it. Breaking the rule may result in a trading platform placing a 90-day trading freeze on the client’s account. Brokers can allow for the $25,000 to be made up with cash, as well as eligible securities.
Some brokerages may have a broader definition for who is considered a “pattern day trader.” This means they could be stricter about which investors are classified as such, and they could place trading restrictions on those investors.
A broker can designate an investor a pattern day trader as long as the firm has a “reasonable basis” to do so, according to FINRA guidelines.
Why Did FINRA Create the Pattern Day Trader Rule?
FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule during the height of the dot-com bubble in the late 1990s and early 2000s in order to curb excessive risk-taking among individual traders.
FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule amidst the heyday of the dot-com bubble in order to curb excessive risk taking among individual traders.
FINRA set the minimum account requirement for pattern day traders at $25,000 after gathering input from a number of brokerage firms. The majority of these firms felt that a $25,000 “cushion” would alleviate the extra risks from day trading. Many firms felt that the $2,000 for regular margin accounts was insufficient as this minimum was set in 1974, before technology allowed for the electronic day trading that is popular today.
Investing platforms offering brokerage accounts are actually free to impose a higher minimum account requirement. Some investing platforms impose the $25,000 minimum balance requirement even on accounts that aren’t margin accounts.
Pattern Day Trader vs Day Trader
As discussed, there is a difference between a pattern day trader and a plain old day trader. The difference has to do with the details of their trading: Pattern day traders are more active and assume more risk than typical day traders, which is what catches the attention of their brokerages.
Essentially, a pattern day trader is someone who makes a habit of day trading. Any investor can engage in day trading — but it’s the repeated engagement of day trading that presents an identifiable pattern. That’s what presents more of a risk to a brokerage, especially if the trader is trading on margin, and which may earn the trader the PDT label, and subject them to stricter rules.
Does the Pattern Day Trader Rule Apply to Margin Accounts?
As a refresher: Margin trading is when investors are allowed to make trades with some of their own money and some money that is borrowed from their broker. It’s a way for investors to boost their purchasing power. However, the big risk is that investors end up losing more money than their initial investment.
Investors trading on margin are required to keep a certain cash minimum. That balance is used as collateral by the brokerage firm for the loan that was provided. The initial minimum for a regular margin account is $2,000 (or 50% of the initial margin purchase, whichever is greater). Again, that minimum moves up to $25,000 if the investor is classified as a “pattern day trader.”
FINRA rules allow pattern day traders to get a boost in their buying power to four times the maintenance margin excess — any extra money besides the minimum required in a margin account. However, most brokerages don’t provide 4:1 leverage for positions held overnight, meaning investors may have to close positions before the trading day ends or face borrowing costs.
If an investor exceeds their buying power limitation, they can receive a margin call from their broker. The investor would have five days to meet this margin call, during which their buying power will be restricted to two times their maintenance margin. If the investor doesn’t meet the margin call in five days, their trading account can be restricted for 90 days.
Does the Pattern Day Trader Rule Apply to Cash Accounts?
Whether the Pattern Day Trader Rule applies to other types of investing accounts, like cash accounts, is up to the specific brokerage or investing firm. The primary difference between a cash account vs. a margin account is that with cash accounts, all trades are done with money investors have on hand. Some trading platforms only apply the PDT rule to margin accounts and don’t apply it to cash accounts.
However, some platforms may adhere to FINRA rules that govern margin accounts even if they don’t offer margin trading. This means that a $25,000 minimum balance of cash and other securities must be kept in order for an investor to do more than four day trades in a five-business-day window.
Investors with cash accounts also need to be careful of free riding violations. This is when an investor buys securities and then pays for the purchase by using proceeds from a sale of the same securities. Such a practice would be in violation of the Federal Reserve Board’s Regulation T and result in a 90-day trading freeze.
Pros of Being a Pattern Day Trader
The pros to being a pattern day trader are somewhat obvious: High-risk trading goes along with the potential for bigger rewards and higher profits. Traders also have a short-term time horizon, and aren’t necessarily locking up their resources in longer-term investments, either, which can be a positive for some investors.
Also, the use of leverage and margin allows them to potentially earn bigger returns while using a smaller amount of capital.
Cons of Being a Pattern Day Trader
The biggest and most obvious downside to being a pattern day trader is that you’re contending with a significant amount of risk. Using leverage and margin to trade compounds that risk, too, so day trading does require thick skin and the ability to handle a lot of risk. (Make sure to consider your risk tolerance and investment objectives before engaging in day trading.) Given the intricacies of day trading, it can also be more time and research intensive.
Tips to Avoid Becoming a Pattern Day Trader
Here are some steps investors can take to avoid getting a PDT designation:
1. Investors can call their brokerage or trading platform or carefully read the official rules on what kind of trading leads to a “Pattern Day Trader” designation, what restrictions can potentially be placed, and what types of accounts are affected.
2. Investors can keep a close count of how many day trades they do in a rolling five-day period. It’s important to note that buying and selling during premarket and after-market trading hours can cause a trade to be considered a day trade. In addition, a large order that a broker could only execute by breaking up into many smaller orders may constitute multiple day trades.
3. Investors can consider holding onto securities overnight. This will help them avoid making a trade count as a day trade, although with margin accounts, they may not have the 4:1 leverage afforded to them overnight.
4. If an investor wants to make their fourth day trade in a five-day window, they can make sure they have $25,000 in cash and other securities in their brokerage account the night before to prevent the account from being frozen.
5. Investors can open a brokerage account with another firm if they’ve already hit three day trades over five days with one trading platform. However, it’s good to keep in mind that the PDT rule is meant to protect investors from excessive risk taking.
It’s also important to know that taking time to make wise or careful investment decisions could be in the investor’s favor.
The Takeaway
Pattern day traders, as spelled out by FINRA guidelines, are traders who trade a security four or more times within five business days, and their day trades amount to more than 6% of their total trading activity using a margin account.
Being labeled a pattern day trader by a brokerage can trigger the PDT Rule, which means that the trader needs to keep at least $25,000 in their margin account. While day trading can reap big rewards, it also has big risks — and that’s something that brokerages are keenly aware of, and why they may choose to have stricter requirements for pattern day traders.
If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.
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FAQ
What happens if you get flagged as a pattern day trader?
If you’re labeled as a pattern day trader, your brokerage may require you to keep at least $25,000 in cash or other assets in your margin account as a sort of collateral.
Do pattern day traders make money?
Yes, some pattern day traders make money, which is why some people choose to do it professionally. But many, perhaps most, lose money, as there is a significant amount of risk that goes along with day trading.
What is the pattern day trader rule?
The Pattern Day Trader Rule was established by FINRA, and requires traders to have at least $25,000 in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000 the trader needs to deposit additional funds.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information. Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.
It’s not uncommon for publicly-traded companies to restructure based on changing market conditions or their stock price. When companies merge, acquire competitors, or split their stock, it can raise the question of how to consolidate or restructure the company’s outstanding shares.
If such a corporate action generates fractional shares for investors, the company’s leadership has a few options for how to proceed: They could distribute the fractional shares to shareholders, round up to the nearest whole share, or pay cash in lieu of fractional shares. Investors need to be aware of cash in lieu because it can affect a portfolio and taxes.
Key Points
• Cash in lieu of fractional shares is a payment method where investors receive cash instead of fractional shares due to corporate actions like stock splits or mergers.
• Companies may opt for cash in lieu to simplify management and avoid dealing with fractional shares after events such as stock splits or acquisitions.
• Receiving cash in lieu is taxable, and investors must report it as capital gains, calculating their cost basis accurately to determine tax obligations.
• Corporate actions like stock splits, mergers, and spinoffs can lead to fractional shares, prompting the need for cash in lieu payments to investors.
• Understanding how cash in lieu of fractional shares works helps investors navigate the complexities of corporate actions and their financial implications.
What Is Cash in Lieu?
Cash in lieu is a type of payment where the recipient receives money instead of goods, services, or an asset.
In investing, cash in lieu refers to funds received by investors following structural company changes that unevenly disrupt existing stock prices and quantities. Instead of receiving fractional shares after a stock split or a merger, investors receive cash.
Following corporate actions like a stock split or a merger, the newly-adjusted stock supply can be uneven and often results in fractional shares. Rather than holding or converting fractional shares to whole shares, some companies opt to aggregate and sell all of the partial shares in the open market – where investors can buy stocks. After the sale of these shares, the company will pay cash to the investors who did not get fractional shares.
The company’s board ultimately determines how the company will maintain or return value to investors. Opting to distribute cash in lieu is a company’s method of disposing of fractional shares and returning the cash balance to investors that’s proportionate to prior holdings.
Investors can receive cash in lieu for various reasons involving company restructuring that affects the number of outstanding shares, stock price, or both.
The following events can lead to investors receiving cash in lieu of fractional shares.
Stock Split
A stock split occurs when a company’s board of directors determines that the company’s high share price may be too high for new investors. The company will then execute a stock split to lower the stock’s price by issuing more shares at a fixed ratio while maintaining the company’s unchanged value. Companies will often approve a stock split so its share price looks more attractive to more investors and gains more liquidity and marketability.
Depending on the predetermined ratio, a stock split could generate fractional shares. For example, a 3-to-2 stock split would create three shares for every two shares each investor holds. If you own five shares of the stock, you would have 7.5 shares after the split. Thus, a stock split would cause any investor with an odd number of shares to receive a fractional share.
However, suppose the company’s board isn’t keen to hold or deal with fractional shares. In that case, they will distribute investors’ whole shares and liquidate the uneven remainders, thus paying investors cash in lieu of fractional shares.
Conversely, a company may execute a reverse stock split because its stock price is too low, and they want to raise it. If stock prices get too low, investors may become fearful of buying the stock, and it may risk being delisted from exchanges.
When a stock undergoes a reverse stock split, investors usually receive one share for a specific number of shares they own, depending on the reverse split ratio. For example, a stock valued at $3.50 may undergo a reverse 1-for-10 stock split. Every ten shares are converted into one new share valued at $35.00. Investors who own 33 shares, or any number not divisible by ten, would receive fractional shares unless the company decides to issue cash in lieu of fractional shares.
Companies may notify their shareholders of an impending stock split or reverse split on Forms 8-K, 10-Q, or 10-K, as well as any settlement details if necessary.
Merger or Acquisition
Company mergers and acquisitions (M&As) can also create fractional shares. When publicly-traded companies combine or are bought, investors will often receive stock as part of the deal using a predetermined ratio. These stock purchase deals often result in fractional shares for investors in all involved companies.
In these cases, it’s rare for the ratio of new shares received to be a whole number. Companies may opt to return full shares to investors, sell fractional shares, and disburse cash in lieu to investors.
Suppose an investor owns shares of a company that spins off part of the business as a new entity with a separately-traded stock. In that case, shareholders of the original company may receive a fixed amount of shares of the new company for every share of the existing company held. Depending on the structure of the spinoff, investors may receive cash in lieu of fractional shares of the new company.
How Is Cash in Lieu of Fractional Shares Taxed?
Like many other forms of investment profits, cash in lieu of fractional shares is taxable, even though the payment occurred without the investor’s endorsement or action. Investors will pay a capital gains tax on the payment.
However, if you have a tax-advantaged account, like a 401(k) or individual retirement account (IRA), you do not have to worry about reporting or paying taxes on the gains of cash in lieu payment.
Some investors may simply report the payment on the IRS Form 1040’s Schedule D as sales proceeds with zero cost and pay capital gains tax on the entire cash settlement. However, the more accurate and tax-advantageous method would apply the adjusted cost basis to the fractional shares and pay capital gains tax only on the net gain.
Own part of a stock with fractional share investing.
Invest with as little as $5.
How to Report Cash in Lieu of Fractional Shares
As noted above, if you receive cash in lieu of fractional shares, you’ll have to pay capital gains taxes on the windfall. To ensure you’re paying the right amount of tax, you’ll have to take a few extra steps to determine your cost basis and accurately report the cash in lieu payment.
Gather Your Documents
Investors may receive the cash through their investment broker and an IRS Form 1099-B at year-end with a “cash in lieu” or “CIL” notation. To accurately report your cash in lieu payment, you’ll need the Form 1099-B, your original cost basis, the date you purchased the stock, the date of the stock split or other corporate action, and the reason why you received the cash in lieu of fractional shares.
Calculate Your Cost Basis
Calculating the cost basis for cash in lieu of fractional shares is a little tricky due to the share price and quantity change. The new stock issued is not taxable, nor does the cost basis change, but the per-share basis does.
Consider the following example:
• An investor owns 15 shares of Company X worth $10.00 per share ($150 value)
• The investor’s 15 shares have a $7.00 per share cost basis ($105 total cost basis)
• Company X declares a 1.5-to-1 stock split
After the stock split, the investor is entitled to 22.5 shares (1.5 x 15 shares = 22.5 shares) valued at $6.67 each ($150 value / 22.5 shares = $6.67 per share), but the company states they will only issue whole shares. Therefore, the investor receives 22 shares plus a $3.34 cash in lieu payment for the half share ($6.67 x 0.5 = $3.34 per half share).
The investor’s total cost basis remains the same, less the cash in lieu of the fractional shares. However, the adjusted cost basis now factors in 22 shares instead of 15, equaling a $4.77 per share cost basis ($105 total cost basis / 22 shares = $4.77 cost basis) and a $2.39 fractional share cost basis.
Finally, the taxable “net gain” for the cash payment received in lieu of fractional shares equates to:
$3.34 cash in lieu payment – $2.39 fractional share cost basis = $0.95 net gain.
So, rather than paying capital gains taxes on the $3.34 payment, you pay taxes on the $0.95 gain. You report this figure on the IRS Form 1040’s Schedule D.
The Takeaway
It’s not always possible to anticipate a company’s actions, like a merger or stock split, and how it will affect shareholders’ stock. If the company doesn’t wish to deal with fractional shares, shareholders need to understand the alternative payments, such as cash in lieu of fractional shares, and how it affects them. While cash in lieu can be burdensome, knowing the nuances of the payment and how it is taxed may benefit your portfolio.
Though you may receive cash in lieu of fractional shares, investors may still consider fractional shares to add to their investment portfolio.
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For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.
FAQ
Is cash in lieu of fractional shares taxable?
If you receive cash in lieu of fractional shares, the cash is taxable. The payment can be taxed as a short-term or long-term capital gain, depending on how long you’ve held the stock.
Is cash in lieu a dividend?
Investors can receive cash in lieu of fractional shares for a dividend payment. However, cash in lieu is not a dividend and is not taxed like a dividend.
Is cash in lieu a capital gain?
Cash in lieu is treated as a capital gain because the IRS considers it a stock sale. When you receive cash in lieu of fractional shares, you may have to pay capital gains taxes on the payment.
What is a cash in lieu settlement?
A cash in lieu settlement is an agreement between two parties in which one party agrees to pay the other party an agreed-upon amount of cash instead of some other form of payment or consideration.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.
FUD stands for “fear, uncertainty, and doubt” and refers to a general mindset of pessimism about a particular asset or market, as well as the manipulation of investor or consumer emotions so that they succumb to FUD.
While the term “fear, uncertainty, and doubt” has been in circulation for a century or so, it became popular as the abbreviation FUD in the 1970s — and widely known more recently, thanks to the highly volatile crypto markets. FUD is also used throughout finance and can apply to any asset class.
Here’s what you need to know about FUD now.
Key Points
• FUD, which stands for “fear, uncertainty, and doubt,” describes negative investor sentiment that can lead to impulsive decision-making in financial markets.
• Distinguishing between FUD and FOMO (fear of missing out) is crucial, as FUD represents collective fear while FOMO reflects collective greed during market fluctuations.
• The history of FUD dates back to the 1920s and gained traction in the 1970s as a tactic to influence consumer behavior through misinformation.
• In the cryptocurrency arena, FUD can refer to both deliberate attempts to manipulate prices and general skepticism about the asset class stemming from negative news.
• The impact of FUD can lead to significant market reactions, as exaggerated or misleading information spreads rapidly, influencing investor behavior during volatile periods.
What Does FUD Mean in Investing?
Investment strategies based on fear, uncertainty, and doubt are not usually recommended. Sometimes FUD might be justified, but in general, the term is used to describe irrational, overwhelming negative sentiment in the market.
Many investors have concrete or pragmatic fears and doubts. Some investors worry that they’ve invested too little or too late (or both). Others might fear a total market meltdown. Some investors worry that an unforeseen factor could impact their investments. These are ordinary, common concerns.
FUD is different, and it’s important to understand what FUD is. When investors talk about FUD, they’re referring to rumors and hype that spread through media (and social media) that drive impulsive and often irrational investor decisions. Think about the meme stock craze.
Thus the term FUD can often have a demeaning edge, in the sense that it refers to these unpredictable waves of investor behavior.
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FUD vs FOMO: What Is the Difference?
What is FUD in stocks or the stock market? FUD can be thought of as the opposite of FOMO (fear of missing out). While FOMO tends to inspire people to do what others are doing — often in that they don’t want to miss out on a hot stock and potential gains — FUD can be described as a collective negative effect that spreads like wildfire, typically through social media.
When markets are going up, many people fall victim to FOMO trading, but when markets are going down, FUD can also spread swiftly. In the most basic sense, you could think of it like this: FUD equals fear and FOMO equals greed.
The two can sometimes be contrary indicators. In other words, when FUD seems to be everywhere, astute investors might actually be buying assets at reduced prices (aka buying the dip), and when many people are experiencing FOMO, seasoned traders might actually be selling at a premium.
Crypto traders offer a counter to FUD by using the term “hodl.” The hodl meaning is interpreted as “hold on for dear life.” Hodl comes from an old Reddit post where an investor posted a rant about having trouble timing the market, while misspelling the word “hold” several times.
While FUD is often associated with investor sentiment in the crypto markets, the phrase “fear, uncertainty, and doubt” actually has a much longer history than many people realize.
The History of FUD
The general term “fear, uncertainty, and doubt” has been around for decades, and the use of FUD gained traction in marketing, sales, and public relations, through the 1980s and 1990s.
More recently, FUD has taken on a broader connotation in investing circles — particularly in the crypto markets — referring to the potential many investors have to succumb to sudden anxiety or pessimism that changes their behavior.
1. To spread doubt about a particular token or project in an attempt to manipulate prices downward.
2. The general skepticism and cynicism about crypto as an asset class, and any related news/events. Even the rumor of a negative event possibly happening can generate FUD.
Again, FUD is not strictly relegated to the crypto space, but in recent years, it’s perhaps most commonly used when discussing crypto.
FUD Crypto and Memes
Crypto FUD also tends to involve the spreading of memes that can either amplify or lessen the FUD’s effect. Sometimes FUD being spread by the media is widely seen as trivial, in which case memes making fun of the idea might pop up. Or, if the FUD is perceived as more legitimate, memes making fun of those not taking the threat seriously might start circulating.
When Can FUD Occur?
FUD can occur whenever prices are falling or a big event happens that’s widely thought to be bearish. A company could miss earnings expectations or it could be revealed that an influential investor has taken a short position against a stock. Or the FUD could come from a larger source, like a pandemic, natural disaster, or the threat of a government defaulting on its debt.
The more catastrophic something could theoretically be, and the greater uncertainty surrounding its outcome, the more it becomes a suitable subject for people to spread FUD.
Sometimes markets react swiftly across the board to such news. Other times people take things out of context or exaggerate them, creating a sort of fake news buzz to scare others into selling.
In stocks and other regulated securities, it’s against the law to spread FUD with the intention of lowering prices. Doing so is considered to be a form of market manipulation and could subject individuals to legal action from regulatory agencies like the SEC, FINRA, or FINCEN.
As not all cryptocurrencies have been definitively classified as securities by all regulatory agencies, there is still some gray area. The idea that many altcoins could one day be deemed securities has itself become a big topic of FUD, because it would have a big impact on the regulatory landscape surrounding crypto
FUD Crypto Examples
Here are a few well-known examples of FUD in crypto. These examples show FUD at its finest. There are elements of truth to them, but the idea is that their detrimental impacts to asset prices are exaggerated to the point of hysteria.
China Banning Bitcoin
This might be one of the best examples of FUD in crypto, and perhaps the one that has been the subject of more memes and Twitter rants than any other.
At many points in recent years, officials in China have claimed to ban Bitcoin in one way or another. Of course, a real, comprehensive “ban” on Bitcoin would be a one-time event. What really happens is the Chinese government introduces some kind of restrictions for individuals or organizations involved in crypto markets, and media outlets report the event as a “ban on Bitcoin.”
In 2021, China really did make Bitcoin mining illegal in the country. Even so, markets shrugged off the event over time.
Government Regulation
Regulatory concerns coming from any national government can be a big source of fear, uncertainty, and doubt. Because crypto markets are still somewhat new, many countries have yet to adopt regulatory frameworks around crypto that provide specific rules around the use and taxation of cryptocurrencies.
Several countries have tried to make any use of crypto illegal, while others make public statements about harsh restrictions coming down the line. Whether the threat is real or perceived, the mere suggestion of governments cracking down on crypto transactions tends to spook investors.
The Fear of Lost Crypto
Nothing stokes investors’ fears like the idea of investment losses, but with crypto there’s the even greater dread of actually losing your coins. Unfortunately, there is some truth to that anxiety, in that there are notable cases of crypto being lost and never recovered, usually because someone loses the private keys that gave them access to their crypto.
Unfortunately, because crypto is decentralized, investors’ assets aren’t protected the same way they would be in traditional, centralized banking systems. (While it’s theoretically possible that all your cash money could vanish from your bank overnight, it’s highly improbable. And even if it did, you’d have the benefit of FDIC insurance.)
Influential Crypto Tweets
Another example of FUD includes some social media posts by famous people that had an immediate impact on a given type of crypto.
It’s important to remember that FUD moments don’t last, and the impact of a single power person on the price of a certain coin — even if it roiled markets for a period of time — was temporary.
Corporate Crypto Assets
In the last couple of years, several big corporations have launched, or announced plans to launch, a proprietary form of crypto. Unfortunately, it’s not that easy to get a new crypto off the ground — despite the many comparisons between the crypto markets and the frontiers of the Wild West — and the failure of at least one high-profile coin helped to sow FUD for some investors.
Solar Storms
Because crypto is digital, a great deal of FUD stems from technology-based fears that random events could take down electrical grids and effectively wipe out crypto holdings. One such FUD-inducing rumor is about the possibility of Earth being zapped by solar storms, but the scientific validity of this has yet to be confirmed.
The Takeaway
Crypto FUD is one of many crypto terms that have become popular, but the underlying concept — that fear, uncertainty, and doubt can influence investor behavior — is not new. In fact, FUD as an actual strategy exists in many spheres, including marketing, sales, public relations, politics (and of course crypto).
FUD can come from anywhere and be focused on just about anything, but crypto can be particularly vulnerable to FUD because this market is already quite volatile. It’s also a very new sector, and some investors don’t fully understand the technology involved, and they can be manipulated by alarmist rumors or even celebrity opinions.
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FAQ
Who uses FUD?
Some FUD arises naturally from market movements or economic conditions. Some FUD is deliberately cooked up to instill enough fear in the markets that investors make impulsive decisions, e.g. selling one type of crypto for another.
Why does FUD matter?
It’s important for investors to understand the concept of FUD so that they don’t get caught in the inevitable waves of negativity that can lead some people to panic and make poor choices.
What Counts as FUD?
Ordinary fears and concerns about market performance, or an investor’s personal long-term goals, don’t count as FUD. FUD refers to a broader market or crypto phenomenon, where highly negative information goes viral and causes investors to panic.
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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
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Retirement will likely be the most significant expense of your lifetime, which means saving for retirement is a big job. This is especially true if you envision a retirement that is rich with experiences such as traveling through Europe or spending time with your grown children and grandkids. A retirement savings plan may help you achieve these financial goals and stay on track.
There are all types of retirement plans you may consider to help you build your wealth, from 401(k)s to Individual Retirement Accounts (IRAs) to annuities. Understanding the nuances of these different retirement plans, like their tax benefits and various drawbacks, may help you choose the right mix of plans to achieve your financial goals.
Key Points
• There are various types of retirement plans, including traditional and non-traditional options, such as 401(k), IRA, Roth IRA, SEP IRA, and Cash-Balance Plan.
• Employers offer defined contribution plans (e.g., 401(k)) where employees contribute and have access to the funds, and defined benefit plans (e.g., Pension Plans) where employers invest for employees’ retirement.
• Different retirement plans have varying tax benefits, contribution limits, and employer matches, which should be considered when choosing a plan.
• Individual retirement plans like Traditional IRA and Roth IRA provide tax advantages but have contribution restrictions and penalties for early withdrawals.
• It’s possible to have multiple retirement plans, including different types and accounts of the same type, but there are limitations on tax benefits based on the IRS regulations.
🛈 SoFi does not offer employer-sponsored plans, such as 401(k) or 403(b) plans, but we do offer a range of individual retirement accounts (IRAs).
Types of Retirement Accounts
There are several different types of retirement plans, including some traditional plan types you may be familiar with as well as non-traditional options.
Traditional retirement plans can be IRA accounts or 401(k). These tax-deferred retirement plans allow you to contribute pre-tax dollars to an account. With a traditional IRA or 401(k), you only pay taxes on your investments when you withdraw from the account.
Non-traditional retirement accounts can include Roth 401(k)s and IRAs, for which you pay taxes on funds before contributing them to the account and withdraw money tax-free in retirement.
Here’s information about some of the most common retirement plan types:
There are typically two types of retirement plans offered by employers:
• Defined contribution plans (more common): The employee invests a portion of their paycheck into a retirement account. Sometimes, the employer will match up to a certain amount (e.g. up to 5%). In retirement, the employee has access to the funds they’ve invested. 401(k)s and Roth 401(k)s are examples of defined contribution plans.
• Defined benefit plans (less common): The employer invests money for retirement on behalf of the employee. Upon retirement, the employee receives a regular payment, which is typically calculated based on factors like the employee’s final or average salary, age, and length of service. As long as they meet the plan’s eligibility requirements, they will receive this fixed benefit (e.g. $100 per month). Pension plans and cash balance accounts are common examples of defined benefit plans.
Let’s get into the specific types of plans employers usually offer.
401(k) Plans
A 401(k) plan is a type of work retirement plan offered to the employees of a company. Traditional 401(k)s allow employees to contribute pre-tax dollars, where Roth 401(k)s allow after-tax contributions.
• Income Taxes: If you choose to make a pre-tax contribution, your contributions may reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement. Some employers allow you to make after-tax or Roth contributions to a 401(k). You should check with your employer to see if those are options.
• Contribution Limit: $23,000 in 2024 and $23,500 in 2025 for the employee; people 50 and older can contribute an additional $7,500 in 2024 and 2025. However, in 2025, under the SECURE 2.0 Act, a higher catch-up limit of $11,250 applies to individuals ages 60 to 63.
• Pros: Money is deducted from your paycheck, automating the process of saving. Some companies offer a company match. There is a significantly higher limit than with Traditional IRA and Roth IRA accounts.
• Cons: With a 401(k) plan, you are largely at the mercy of your employer — there’s no guarantee they will pick plans that you feel are right for you or are cost effective for what they offer. Also, the value of a 401(k) comes from two things: the pre-tax contributions and the employer match, if your employer doesn’t match, a 401(k) may not be as valuable to an investor. There are also penalties for early withdrawals before age 59 ½, although there are some exceptions, including for certain public employees.
• Usually best for: Someone who works for a company that offers one, especially if the employer provides a matching contribution. A 401(k) retirement plan can also be especially useful for people who want to put retirement savings on autopilot.
• To consider: Sometimes 401(k) plans have account maintenance or other fees. Because a 401(k) plan is set up by your employer, investors only get to choose from the investment options they provide.
403(b) Plans
A 403(b) retirement plan is like a 401(k) for certain individuals employed by public schools, churches, and other tax-exempt organizations. Like a 401(k), there are both traditional and Roth 403(b) plans. However, not all employees may be able to access a Roth 403(b).
• Income Taxes: With a traditional 403(b) plan, you contribute pre-tax money into the account; the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement. Additionally, some employers allow you to make after-tax or Roth contributions to a 403(b); the money will grow tax-deferred and you will not have to pay taxes on withdrawals in retirement. You should check with your employer to see if those are options.
• Contribution Limit: $23,000 in 2024 and $23,500 in 2025 for the employee; people 50 and older can contribute an additional $7,500 in both of those years. In 2025, under the SECURE 2.0 Act, those ages 60 to 63 can contribute a higher catch-up amount of $11,250. The maximum combined amount both the employer and the employee can contribute annually to the plan (not including the catch-up amounts) is generally the lesser of $69,000 in 2024 and $70,000 in 2025 or the employee’s most recent annual salary.
• Pros: Money is deducted from your paycheck, automating the process of saving. Some companies offer a company match. Also, these plans often come with lower administrative costs because they aren’t subject to Employee Retirement Income Security Act (ERISA) oversight.
• Cons: A 403(b) account generally lacks the same protection from creditors as plans with ERISA compliance.
• To consider: 403(b) plans offer a narrow choice of investments compared to other retirement savings plans. The IRS states these plans can only offer annuities provided through an insurance company and a custodial account invested in mutual funds.
Solo 401(k) Plans
A Solo 401(k) plan is essentially a one-person 401(k) plan for self-employed individuals or business owners with no employees, in which you are the employer and the employee. Solo 401(k) plans may also be called a Solo-k, Uni-k, or One-participant k.
• Income Taxes: The contributions made to the plan are tax-deductible.
• Contribution Limit: $23,000 in 2024 and $23,500 in 2025, or 100% of your earned income, whichever is lower, plus “employer” contributions of up to 25% of your compensation from the business. The 2024 total cannot exceed $69,000, and the 2025 total cannot exceed $70,000. (On top of that, people 50 and older are allowed to contribute an additional $7,500 in 2024 and 2025. In 2025, those ages 60 to 63 can contribute a higher catch-up amount of $11,250 under the SECURE 2.0 Act .)
• Pros: A solo 401(k) retirement plan allows for large amounts of money to be invested with pre-tax dollars. It provides some of the benefits of a traditional 401(k) for those who don’t have access to a traditional employer-sponsored 401(k) retirement account.
• Cons: You can’t open a solo 401(k) if you have any employees (though you can hire your spouse so they can also contribute to the plan as an employee — and you can match their contributions as the employer).
• Usually best for: Self-employed people with enough income and a large enough business to fully use the plan.
SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
A SIMPLE IRA plan is set up by an employer, who is required to contribute on employees’ behalf, although employees are not required to contribute.
• Income Taxes: Employee contributions are made with pre-tax dollars. Additionally, the money will grow tax-deferred and employees will pay taxes on the withdrawals in retirement.
• Contribution Limit: $16,000 in 2024 and $16,500 in 2025. Employees aged 50 and over can contribute an extra $3,500 in 2024 and in 2025, bringing their total to $19,500 in 2024 and $20,000 in 2025. In 2025, under the SECURE 2.0 Act, people ages 60 to 63 can contribute a higher catch-up amount of $5,250.
• Pros: Employers contribute to eligible employees’ retirement accounts at 2% their salaries, whether or not the employees contribute themselves. For employees who do contribute, the company will match up to 3%.
• Cons: The contribution limits for employees are lower than in a 401(k) and the penalties for early withdrawals — up to 25% for withdrawals within two years of your first contribution to the plan — before age 59 ½ may be higher.
• To consider: Only employers with less than 100 employees are allowed to participate.
This is a retirement account established by a small business owner or self-employed person for themselves (and if applicable, any employees).
• Income Taxes: Your contributions will reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on withdrawals in retirement.
• Contribution Limit: For 2024, $69,000 or 25% of earned income, whichever is lower; for 2025, $70,000 or 25% of earned income, whichever is lower.
• Pros: Higher contribution limit than IRA and Roth IRAs, and contributions are tax deductible for the business owner.
• Cons: These plans are employer contribution only and greatly rely on the financial wherewithal and available cash of the business itself.
• Usually best for: Self-employed people and small business owners who wish to contribute to an IRA for themselves and/or their employees.
• To consider: Because you’re setting up a retirement plan for a business, there’s more paperwork and unique rules. When opening an employer-sponsored retirement plan, it generally helps to consult a tax advisor.
Profit-Sharing Plans (PSPs)
A Profit-Sharing Plan is a retirement plan funded by discretionary employer contributions that gives employees a share in the profits of a company.
• Income taxes: Deferred; assessed on distributions from the account in retirement.
• Contribution Limit: The lesser of 25% of the employee’s compensation or $69,000 in 2024. (On top of that, people 50 and older are allowed to contribute an additional $7,500 in 2024.) In 2025, the contribution limit is $70,000 or 25% of the employee’s compensation, whichever is less. Those 50 and up can contribute an extra $7,500 in 2024 and 2025. And people ages 60 to 63 can make a higher contribution of $11,250 in 2025 under SECURE 2.0.
• Pros: An employee receives a percentage of a company’s profits based on its earnings. Companies can set these up in addition to other qualified retirement plans, and make contributions on a completely voluntary basis.
• Cons: These plans put employees at the mercy of their employers’ profits, unlike retirement plans that allow employees to invest in securities issued by other companies.
• Usually best for: Companies who want the flexibility to contribute to a PSP on an ad hoc basis.
• To consider: Early withdrawal from the plan is subject to penalty.
Defined Benefit Plans (Pension Plans)
These plans, more commonly known as pension plans, are retirement plans provided by the employer where an employee’s retirement benefits are calculated using a formula that factors in age, salary, and length of employment.
• Income taxes: Deferred; assessed on distributions from the plan in retirement.
• Contribution limit: Determined by an enrolled actuary and the employer.
• Pros: Provides tax benefits to both the employer and employee and provides a fixed payout upon retirement that many retirees find desirable.
• Cons: These plans are increasingly rare, but for those who do have them, issues can include difficulty realizing or accessing benefits if you don’t work at a company for long enough.
• Usually best for: Companies that want to provide their employees with a “defined” or pre-determined benefit in their retirement years.
• To consider: These plans are becoming less popular because they cost an employer significantly more in upkeep than a defined contribution plan such as a 401(k) program.
Employee Stock Ownership Plans (ESOPs)
An Employee Stock Ownership Plan is a qualified defined contribution plan that invests in the stock of the sponsoring employer.
• Income taxes: Deferred. When an employee leaves a company or retires, they receive the fair market value for the stock they own. They can either take a taxable distribution or roll the money into an IRA.
• Contribution limits: Allocations are made by the employer, usually on the basis of relative pay. There is typically a vesting schedule where employees gain access to shares in one to six years.
• Pros: Could provide tax advantages to the employee. ESOP plans also align the interests of a company and its employees.
• Cons: These plans concentrate risk for employees: An employee already risks losing their job if an employer is doing poorly financially, by making some of their compensation employee stock, that risk is magnified. In contrast, other retirement plans allow an employee to invest in stocks in other securities that are not tied to the financial performance of their employer.
457(b) Plans
A 457(b) retirement plan is an employer-sponsored deferred compensation plan for employees of state and local government agencies and some tax-exempt organizations.
• Income taxes: If you choose to make a pre-tax contribution, your contributions will reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement. Some employers also allow you to make after-tax or Roth contributions to a 401(k).
• Contribution limits: The lesser of 100% of employee’s compensation or $23,000 in 2024 and $23,500 in 2025; some plans allow for “catch-up” contributions.
• Pros: Plan participants can withdraw as soon as they are retired at any age, they do not have to wait until age 59 ½ as with 401(k) and 403(b) plans.
• Cons: 457 plans do not have the same kind of employer match as a 401(k) plan. While employers can contribute to the plan, it’s only up to the combined limit for individual contributions.
• Usually best for: Employees of governmental agencies.
Federal Employees Retirement System (FERS)
The Federal Employees Retirement System (FERS) consists of three government-sponsored retirement plans: Social Security, the Basic Benefit Plan, and the Thrift Savings Plan.
The Basic Benefit Plan is an employer-provided pension plan, while the Thrift Savings Plan is most comparable to what private-sector employees can receive.
• Income Taxes: Contributions to the Thrift Savings Plan are made before taxes and grow tax-free until withdrawal in retirement.
• Contribution Limit: The contribution limit for employees is $23,000 in 2024, and the combined limit for all contributions, including from the employer, is $69,000. In 2025, the employee contribution limit is $23,500, and the combined limit for contributions, including those from the employer, is $70,000. Also, those 50 and over are eligible to make an additional $7,500 in “catch-up” contributions in both 2024 and 2025, and in 2025, those ages 60 to 63 can make a higher catch-up contribution of $11,250 under the SECURE 2.0 Act.
• Pros: These government-sponsored plans are renowned for their low administrative fees and employer matches.
• Cons: Only available for federal government employees.
• Usually best for: Federal government employees who will work at their agencies for a long period; it is comparable to 401(k) plans in the private sector.
Cash-Balance Plans
This is another type of pension plan that combines features of defined benefit and defined contribution plans. They are sometimes offered by employers that previously had defined benefit plans. The plans provide an employee an “employer contribution equal to a percent of each year’s earnings and a rate of return on that contribution.”
• Income Taxes: Contributions come out of pre-tax income, similar to 401(k).
• Contribution Limit: The plans combine a “pay credit” based on an employee’s salary and an “interest credit” that’s a certain percentage rate; the employee then gets an account balance worth of benefits upon retirement that can be paid out as an annuity (payments for life) or a lump sum. Limits depend on age, but for those over 60, they can be more than $250,000.
• Pros: Can reduce taxable income.
• Cons: Cash-balance plans have high administrative costs.
• Usually best for: High earners, business owners with consistent income.
Nonqualified Deferred Compensation Plans (NQDC)
These are plans typically designed for executives at companies who have maxed out other retirement plans. The plans defer payments — and the taxes — you would otherwise receive as salary to a later date.
• Income Taxes: Income taxes are deferred until you receive the payments at the agreed-upon date.
• Contribution Limit: None
• Pros: The plans don’t have to be entirely geared around retirement. While you can set dates with some flexibility, they are fixed.
• Cons: Employees are not usually able to take early withdrawals.
• Usually best for: Highly-paid employees for whom typical retirement plans would not provide enough savings compared to their income.
Multiple Employer Plans
A multiple employer plan (MEP) is a retirement savings plan offered to employees by two or more unrelated employers. It is designed to encourage smaller businesses to share the administrative burden of offering a tax-advantaged retirement savings plan to their employees. These employers pool their resources together to offer a defined benefit or defined contribution plan for their employees.
Administrative and fiduciary responsibilities of the MEP are performed by a third party (known as the MEP Sponsor), which may be a trade group or an organization that specializes in human resources management.
This article is part of SoFi’s Retirement Planning Guide, our coverage of all the steps you need to create a successful retirement plan.
Compare Types of Retirement Accounts Offered by Employers
To recap retirement plans offered by employers:
Retirement Plans Offered by Employers
Type of Retirement Plan
May be Funded By
Pro
Con
401(k)
Employee and Employer
Contributions are deducted from paycheck
Limited investment options
Solo 401(k)
Employee and Employer
Good for self-employed people
Not available for business owners that have employees
403(b)
Employee and Employer
Contributions are deducted from paycheck
Usually offer a narrow choice of investment options
SIMPLE IRA
Employer and Employee
Employer contributes to account
High penalties for early withdrawals
SEP Plan
Employer
High contribution limits
Employer decides whether and how much to contribute each year
Profit-Sharing Plan
Employer
Can be paired with other qualified retirement plans
Plan depends on an employer’s profits
Defined Benefit Plan
Employer
Fixed payout upon retirement
May be difficult to access benefits
Employee Stock Ownership Plan
Employer
Aligns interest of a company and its employees
May be risky for employees
457
Employee
You don’t have to wait until age 59 ½ to withdraw
Does not have same employer match possibility like a 401(k)
Federal Employees Retirement System
Employee and Employer
Low administrative fees
Only available for federal government employees
Cash-Balance Plan
Employer
Can reduce taxable income
High administrative costs
Nonqualified Deferred Compensation Plan
Employer
Don’t have to be retirement focused
Employees are not usually able to take early withdrawals
Get a 1% IRA match on rollovers and contributions.
Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1
1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.
With an IRA, you open and fund the IRA yourself. As the name suggestions, it is a retirement plan for individuals. This is not a plan you join through an employer.
• Income Taxes: You may receive an income tax deduction on contributions (depending on your income and access to another retirement plan through work). The balance in the IRA is tax-deferred, and withdrawals will be taxed (the amount will vary depending on whether contributions were deductible or non-deductible).
• Contribution Limit: In 2024 and 2025, the contribution limit is $7,000, or $8,000 for people 50 and older.
• Pros: You might be able to lower your tax bill if you’re eligible to make deductible contributions. Additionally, the money in the account is tax-deferred, which can make a difference over a long period of time. Finally, there are no income limits for contributing to a traditional IRA.
• Cons: Traditional IRAs come with a number of restrictions, including how much can be contributed and when you can start withdrawals without penalty. Traditional IRAs are also essentially a guess on the tax rate you will be paying when you begin withdrawals after age 59 ½, as the money in these accounts are tax-deferred but are taxed upon withdrawal. Also, traditional IRAs generally mandate withdrawals starting at age 73.
• Usually best for: People who can make deductible contributions and want to lower their tax bill, or individuals who earn too much money to contribute directly to a Roth IRA. Higher-income earners might not get to deduct contributions from their taxes now, but they can take advantage of tax-deferred growth between now and retirement. An IRA can also be used for consolidating and rolling over 401(k) accounts from previous jobs.
• To consider: You may be subject to a 10% penalty for withdrawing funds before age 59 ½. As a single filer, you cannot deduct IRA contributions if you’re already covered by a retirement account through your work and earn more (according to your modified gross adjusted income) than $87,000 in 2024, with a phase-out starting at $77,000, and more than $89,000 in 2025, with a phase-out starting at $79,000.
Roth IRAs
A Roth IRA is another retirement plan for individuals that is managed by the account holder, not an employer.
• Income Taxes: Roth IRA contributions are made with after-tax money, which means you won’t receive an income tax deduction for contributions. But your balance will grow tax-free and you’ll be able to withdraw the money tax-free in retirement.
• Contribution Limit: In 2024 and 2025, the contribution limit is $7,000, or $8,000 for those 50 and up.
• Pros: While contributing to a Roth IRA won’t lower your tax bill now, having the money grow tax-free and being able to withdraw the money tax-free down the road could provide value in the future.
• Cons: Like a traditional IRA, a Roth IRA has tight contribution restrictions. Unlike a traditional IRA, it does not offer tax deductions for contributions. As with a traditional IRA, there’s a penalty for taking some kinds of distributions before age 59 ½.
• Usually best for: Someone who wants to take advantage of the flexibility to withdraw from an account during retirement without paying taxes. Additionally, it can be especially beneficial for people who are currently in a low income-tax bracket and expect to be in a higher income tax bracket in the future.
• To consider: To contribute to a Roth IRA, you must have an earned income. Your ability to contribute begins to phase out when your income as a single filer (specifically, your modified adjusted gross income) reaches $146,000 in 2024 and $150,000 in 2025. As a joint filer, your ability to contribute to a Roth IRA phases out at $230,000 in 2024 and $236,000 in 2025.
Payroll Deduction IRAs
This is either a traditional or Roth IRA that is funded through payroll deductions.
• Income Taxes: For a Traditional IRA, you may receive an income tax deduction on contributions (depending on income and access to a retirement plan through work); the balance in the IRA will always grow tax-deferred, and withdrawals will be taxed (how much is taxed depends on if you made deductible or non-deductible contributions). For a Roth IRA, contributions are made with after-tax money, your balance will grow tax-free and you’ll be able to withdraw the money tax-free in retirement.
• Contribution Limit: In 2024 and 2025, the limit is $7,000, or $8,000 for those 50 and older.
• Pros: Automatically deposits money from your paycheck into a retirement account.
• Cons: The employee must do the work of setting up a plan, and employers can not contribute to it as with a 401(k). Participants cannot borrow against the retirement plan or use it as collateral for loans.
• Usually best for: People who do not have access to another retirement plan through their employer.
• To consider: These have the same rules as a Traditional IRA, such as a 10% penalty for withdrawing funds before age 59 ½. Only employees can contribute to a Payroll Deduction IRA.
Guaranteed Income Annuities (GIAs)
Guaranteed Income Annuities are products sold by insurance companies. They are similar to the increasingly rare defined benefit pensions in that they have a fixed payout that will last until the end of life. These products are generally available to people who are already eligible to receive payouts from their retirement plans.
• Income Taxes: If the annuity is funded by 401(k) benefits, then it is taxed like income. Annuities purchased with Roth IRAs, however, have a different tax structure. For “non-qualified annuities,” i.e. annuities purchased with after-tax income, a formula is used to determine the taxes so that the earnings and principal can be separated out.
• Contribution Limit: Annuities typically do not have contribution limits.
• Pros: These are designed to allow for payouts until the end of life and are fixed, meaning they’re not dependent on market performance.
• Cons: Annuities are expensive; to buy an annuity, you’ll likely pay a high commission to a financial advisor or insurance salesperson.
• Usually best for: People who have high levels of savings and can afford to make expensive initial payments on annuities.
Cash-Value Life Insurance Plan
Cash-value life insurance typically covers the policyholder’s entire life and has tax-deferred savings, making it comparable to other retirement plans. Some of the premium paid every month goes to this investment product, which grows over time.
• Income Taxes: Taxes are deferred until the policy is withdrawn from, at which point withdrawals are taxed at the policyholder’s current income tax rate.
• Contribution Limit: The plan is drawn up with an insurance company with set premiums.
• Pros: These plans have a tax-deferring feature and can be borrowed from.
• Cons: While you may be able to withdraw money from the plan, this will reduce your death benefit.
• Usually best for: High earners who have maxed out other retirement plans.
Compare Types of Retirement Accounts Not Offered by Employers
To recap retirement plans not offered by employers:
Retirement Plans Not Offered by Employers
Type of Retirement Plan
Pro
Con
IRA
Contributions may be tax deductible
Penalty for withdrawing funds before age 59 ½
Roth IRA
Distributions are not taxed
Not available for individuals with high incomes
Payroll Deduction IRA
Automatically deposits money from your paycheck into the account
Participants can’t borrow against the plan
Guaranteed Income Annuity
Not dependent on market performance
Expensive fees and commissions
Cash-Value Life Insurance Plan
Tax-deferred savings
May be able to withdraw money from the plan, but this will reduce death benefit
Specific Benefits to Consider
As you’re considering the different types of retirement plans, it’s important to look at some key benefits of each plan. These include:
• the tax advantage
• contribution limits
• whether an employer will add funds to the account
• any fees associated with the account
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
Determining Which Type of Retirement Plan Is Best for You
Depending on your employment circumstances, there are many possible retirement plans in which you can invest money for retirement. Some are offered by employers, while other retirement plans can be set up by an individual. Brian Walsh, a CFP® at SoFi, says “a mixture of different types of accounts help you best plan your retirement income strategy down the road.”
Likewise, the benefits for each of the available retirement plans differ. Here are some specific benefits and disadvantages of a few different plans to consider.
With employer-offered plans like a 401(k) and 403(b), you have the ability to:
Take them with you. If you leave your job, you can roll these plans over into a plan with a new employer or an IRA.
Possibly earn a higher return. With these plans, you typically have more investment choices, including stock funds.
With retirement plans not offered by employers, like a SEP IRA, you may get:
A wider variety of investment options. You could have even more options to choose from with these plans, including those that may offer higher returns.
You may be able to contribute more. The contribution limits for some of these plans tend to be higher.
Despite their differences, the many different types of retirement accounts all share one positive attribute: utilizing and investing in them is an important step in saving for retirement.
Because there are so many retirement plans to choose from, it may be wise to talk to a financial professional to help you decide your financial plan.
Can You Have Multiple Types of Retirement Plans?
You can have multiple retirement savings plans, whether employer-provided plans like a 401(k), IRAs, or annuities. Having various plans can let you take advantage of the specific benefits that different retirement savings plans offer, thus potentially increasing your total retirement savings.
Additionally, you can have multiple retirement accounts of the same type; you may have a 401(k) at your current job while also maintaining a 401(k) from your previous employer.
Nonetheless, there are limitations on the tax benefits you may be allowed to receive from these multiple retirement plans. For example, the IRS does not allow individuals to take a tax deduction for traditional IRA contributions if they also have an employer-sponsored 401(k).
Opening a Retirement Investment Account With SoFi
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).
Easily manage your retirement savings with a SoFi IRA.
FAQ
Why is it important to understand the different types of retirement plans?
Understanding the different types of retirement plans is important because of the nuances of taxation in these accounts. The various rules imposed by the Internal Revenue Service (IRS) can affect your contributions, earnings, and withdrawals. And not only does the IRS have rules around taxation, but also about contribution limits and when you can withdraw money without penalties.
Additionally, the various types of retirement plans differ regarding who establishes and uses each account and the other plan rules. Ultimately, understanding these differences will help you determine which combination of retirement plans is best for you.
How can you determine which type of retirement plan is best for you?
The best type of retirement plan for you is the one that best meets your needs. Many types of retirement plans are available, and each has its own benefits and drawbacks. When choosing a retirement plan, some factors to consider include your age, investing time horizon, financial goals, risk tolerance, and the fees associated with a retirement plan.
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