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Mar

2023

Guide to Writing Call Options: What You Should Know

By Dan Miller | Growing Wealth, invest, Investing | Comments Off

Selling a call option is referred to as writing a call option. When writing a call option you will be initiating the option contract for sale, and will collect a premium from the buyer when the contract is initially sold.

There are two ways to write a call option — sell covered calls or sell naked calls.

• When you write a covered call, you are selling an option on an underlying stock that you own.

• Writing a naked call means you are selling an option on a stock you do not currently own.

The biggest difference between these two paths is the risk profile. Your risk with covered calls is that you may miss out on some of the upside gains if the stock’s price goes above the strike price of your call option.

When you sell a naked call, you have no risk protection and theoretically unlimited risk.

What Are Calls?

Remember the basics of put vs. call options: When you buy a call option at a specific strike price, you have the right (but not the obligation) to purchase the underlying stock at the strike price of the option over a given time period.

Buying put gives you the right, but not the obligation, to sell the underlying stock or asset before the expiration date.

If you are wanting to know how to trade options, it’s important to understand the differences between calls and puts, when you would buy or sell options, and how to arrange options trading strategies to minimize your risk. When you buy an option, your maximum risk is capped at the amount of premium that you initially paid for the option. But when you write a call option or put option, your risk is theoretically infinite.

Writing Call Options

Writing call options is similar to writing put options in that you are selling the option initially. When you write a call option, you are creating a new option contract that allows the buyer the right to buy the stock at the specified strike price at any time before the expiration date.

When you write a call option, you can be forced to buy the stock at the strike price at any time. In practice, this is unlikely to happen unless the stock is deep in-the-money before expiration or if it’s at or in-the-money at the date of expiration.

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Writing Call Option Strategies

There are several strategies when trading options, depending on whether you have a bullish or bearish outlook for a given stock. Here are two of the most common call writing option strategies:

Writing Covered Calls

One common options strategy is writing covered calls. A call is considered a “covered” call when you also own at least 100 shares of the underlying stock. Writing covered calls is a popular income strategy if you think that the stock you hold will move within a specific range. You then might write a covered call with a strike price a little above the expected price range.

When you write covered calls, since you are the seller of the option contract, you will collect an initial premium. Your best case scenario is that the underlying stock will close below the strike price of the call option at expiration. That means that the call will expire worthless, and you will keep the entire premium. If the stock closes above the strike price at expiration, you will be forced to sell your shares of stock at the strike price. This means that you may miss out on any additional gains for the stock.

Writing Naked Calls

If you are wondering what naked calls are, it is when you write a call when you don’t have a long position in the underlying stock. Unlike covered calls, writing naked calls comes with significant risk. Since a stock has no maximum price, you have unlimited exposure. The more a stock’s price rises above the strike price of the call option, the more money you will lose on the trade.

Because of this, writing naked calls is something that is recommended only for people with significant options experience and/or those who have a high tolerance for risk. You will want to make sure you understand your risk before writing naked calls, and have a plan for what you will do if the stock moves against you.

Writing Call Options Example

To understand the difference between writing covered calls and naked calls, here are two examples.

Covered Call Example

Say that you own 100 shares of stock XYZ with a cost basis of $65. You feel that the stock is trading in a range of $60-$70, so you write a covered call with a June expiration and a strike price of $70, collecting $1.25 in premium, or $125 ($1.25 x 100).

If the stock closes below $70 at June’s expiration, you keep your shares and the entire $125 premium. Because you still own shares in XYZ, you can write another covered call in July (and beyond) generating income as you collect the premiums.

If instead the stock rises to $75 by June, then you will be obligated to sell 100 shares of XYZ at the strike price of $70. Because you already own 100 shares of XYZ, your shares will be called away. Your broker will automatically sell your 100 shares at the price of $70/share. You will miss out on any additional gains above the $70 price.

Naked Call Example

Say that you are bearish about stock ABC, which currently is trading at $100/share. You sell the October $110 calls for a premium of $4.25. You collect $425 upfront ($4.25 * 100 shares per option contract). As long as stock ABC closes below $110/share, you will keep the entire $425.

However if stock ABC closes above $110 at October options expiration you will be forced to buy 100 shares of ABC at whatever the prevailing market price is for stock ABC.

When you wrote (sold) the call option, you gave your buyer the right to buy 100 shares of stock ABC at $110/share. If ABC has risen to $250/share, for example, you will have to pay $25,000 to buy 100 shares, and then sell those 100 shares for $11,000 ($110/share), taking a $14,000 loss on your trade offset slightly by the $425 premium you collected.

The Takeaway

Writing call options can be a viable and valuable options strategy with several different uses. Writing covered calls on a stock whose shares you also hold can be a way to earn additional income if the stock is not very volatile. You can also write naked calls, or calls on stocks that you don’t own. Writing or selling naked calls leaves you in a position where you have unlimited risk, so make sure that you have a risk mitigation plan in place.

If you’re ready to try your hand at options trading, SoFi can help. When you set up an Active Invest account and start investing online, you can trade options from the SoFi mobile app or through the web platform. SoFi doesn’t charge any commission, and also enables you to trade stocks, ETFs, and more. And if you have any questions, SoFi offers educational resources about options to learn more.

Trade options with low fees through SoFi.

FAQ

Is writing a call option the same thing as buying a put?

It is important to understand put vs. call options and how they are different. While writing a call option and buying a put option are both bearish options strategies, they are very different in terms of their risk/reward profile. When you write a call option, you collect the option premium upfront but have unlimited risk. Buying a put option has a defined risk of the initial premium that you paid to purchase the put option, which gives you the right but not the obligation to sell the underlying shares.

Does a writer of a call option make an unlimited profit?

No, the writer of a call option does not and cannot make an unlimited profit. When you write a call option, your maximum profit is defined by the initial premium that you collect when you first write the option. As a call option writer, you are hoping that the stock closes below the strike price of your option at expiration. In that scenario, it will expire worthless and you will receive your maximum profit.

How are call options written?

Writing a call option is another way to say that you are selling a call option. When you write a call option, you are giving the buyer the right (but not the obligation) to buy 100 shares of the underlying stock at a given strike price at any time before the options expiration. When you write a call option, you collect an initial premium from the buyer of the option.

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Mar

2023

What Is an ESG Index? 5 ESG Indexes to Know

By Kenny Zhu | Growing Wealth, invest, Investing, Terminology | Comments Off

An index is a group of companies that reflect the performance of a certain sector. Thus an ESG index includes companies that meet certain criteria for environmental, social, and governance standards and reflect that sector.

Just as a large-cap equity index like the S&P 500 can be used as a performance benchmark for the performance of large-cap U.S. stocks, different ESG indexes can be used as benchmarks for sectors focused on sustainable or socially responsible investing (sometimes called SRI) practices.

Some indexes may also include or exclude companies as a form of risk mitigation.

The challenge is that the criteria for what constitutes sustainable investing, in any form, is inconsistent throughout the industry.

Nonetheless, recent industry research suggests that ESG investing strategies perform similarly to, and sometimes better than conventional strategies. By knowing some of the top ESG indexes, then, it’s possible to invest in funds that capture the performance of that index, and put your money toward companies whose aim is to focus on positive environmental, social, and corporate governance outcomes.

What Are ESG Indexes?

There are a number of ESG indexes maintained by major data providers which track the performance of firms that embrace ESG or SRI criteria. Why are environmental, social, and governance factors considered important enough to be the foundation of dozens of industry indexes?

Some investors believe in investing their money in the stocks of companies (or other securities) that reflect certain proactive values regarding the planet, society, and fair and ethical corporate structures. At the same time, adherence to ESG factors is increasingly considered by many stakeholders as a form of risk management. For example, investors might choose to assess a company’s ESG scores or ratings to gauge its risk exposure (as well as possible future financial performance). Consumers might want to know about a company’s environmental and social practices to inform their purchasing decisions.

While you cannot invest in an index, investors can gain exposure to ESG companies in an index by purchasing an index mutual fund or exchange-traded fund (ETF) that seeks to replicate the performance of that index (aka passive investing).

Just as there are many different flavors of equity indexes — from large cap to small cap, domestic to international, and so on — there are numerous ESG indexes. These exist in many forms, depending on the underlying metrics used to construct them, and there are hundreds of ESG index funds and ETFs that investors can access.

Recommended: How to Invest in ESG Stocks

New Growth in the ESG Sector

According to Deloitte, some 149 ESG-related funds were launched in 2021 alone, making up 22% of all funds launched by managers in that year.

The number of ESG-related funds on the market continues to grow, roughly a third of them passively managed index funds or ETFs. In 2021, socially responsible U.S. mutual funds saw record inflows of some $70 billion — a 36% increase over 2020. However, ESG funds saw substantial outflows through 2021 and most of 2022. But sustainable funds still managed to outperform non-sustainable funds through Q3 of 2022, despite challenging market conditions, according to Morningstar research as of September 30, 2022.

ESG vs Socially Responsible Investing: What’s the Difference?

There are various terms for investing according to a certain set of values — including impact investing and socially responsible investing (SRI) — and not all of them refer to green investing strategies. Some terms may be used interchangeably, but there are some key differences to understand.

• Impact investing is a broad term that encompasses investors who seek measurable outcomes. Impact investing may or may not have anything to do with environmental or social factors.

• Socially responsible investing is also a broader label, typically used to reflect progressive values of protecting the planet and natural resources, treating people equitably, and emphasizing corporate responsibility.

• Securities that embrace ESG principles, though, may be required to adhere to specific standards for protecting aspects of the environment (e.g. clean energy, water, and air); supporting social good (e.g. human rights, safe working conditions, equal opportunities); and corporate accountability (e.g. fighting corruption, balancing executive pay, and so on).

ESG Investing Standards

That said, there isn’t one universally observed set of criteria that define an ESG investment or an ESG index. Rather, each ESG index and corresponding index fund is typically based on proprietary metrics of qualitative and quantitative factors relating to environmental, social, and governance factors.

These metrics may be formulated internally by investment managers/research teams, based on metrics established by popularly accepted ESG frameworks, or a combination of both.

While it’s clear where the money’s been trending with regards to ESG investments, prudent investors should still remain selective when it comes to picking an ESG fund, as how these indexes are constructed can sometimes be based on opaque methodologies.

5 Commonly Used ESG Indexes

Following is an overview of five ESG indexes commonly used as benchmarks for some of the largest ESG funds, and the manner in which they’re constructed.

1. S&P 500 ESG Index

The S&P 500 ESG Index consists of 307 domestic investments across the broader market. All firms included in the index must meet specified ESG criteria established by S&P Dow Jones Indices.

ESG Criteria: According to S&P, the index uses an exclusionary methodology to filter out firms within the S&P 500 that partake in undesirable business activities, defined as follows:

• Firms operating within the thermo coal, tobacco, and controversial weapons industries.

• Companies that score within the bottom 5% of the United Nations Global Compact (UNGC).

• Companies that score within the bottom 25% of ESG scores within each global GICs industry group.

2. Nasdaq-100 ESG Index

The Nasdaq-100 ESG Index consists of 96 separate securities that meet ESG criteria established by Nasdaq. The parent index includes 100 of the largest domestic and international non-financial firms that trade on the Nasdaq exchange.

ESG Criteria: Firms must meet the following requirements, at a minimum, to qualify under the index:

• “An issuer must not be involved in certain specific business activities, such as alcohol, cannabis, controversial weapons, gambling, military weapons, nuclear power, oil & gas, and tobacco.”

• “…an issuer must be deemed compliant with the United Nations Global Compact principles, meet business controversy level requirements.”

• “…have an ESG Risk Rating Score that meets the requirements for inclusion in the Index.”

3. MSCI KLD 400 Social Index

Established in 1990, the MSCI KLD 400 Social Index is one of the first and oldest socially responsible investing (SRI) indexes, making it a popular standard for evaluating long-term ESG performance.

The KLD 400 Social index comprises 402 U.S. securities that meet the ESG standards set by the MSCI ESG Research team.

ESG Criteria: MSCI uses the following methodology to determine eligibility and inclusion within the index.

• Companies involved in nuclear power, tobacco, alcohol, gambling, military weapons, civilian firearms, GMOs, and adult entertainment are excluded.

• Must have an MSCI ESG rating above “BB.”

• Must have an MSCI Controversies score above “2.”

4. MSCI USA Extended ESG Focus Index

The MSCI USA Extended ESG Focus Index includes securities across the U.S. equity markets, but selects constituents from the MSCI USA parent index using an optimization process that targets companies with high ESG ratings in each sector. Companies related to segments such as tobacco, controversial weapons, producers of or ties with civilian firearms, thermal coal and oil sands are excluded.

The MSCI USA Index has 628 constituents while the MSCI USA Extended ESG Focus Index has around 321, which means an exclusion close to 49%.

5. FTSE US All Cap Choice Index

The FTSE U.S. All Cap Choice Index is part of the FTSE Global Choice Index Series. It’s designed to help investors align their investment choices with their values, by selecting companies based on the impact of their products and conduct on society and the environment., but excludes companies involved in:

• Vice-related industries (e.g. alcohol, tobacco, gambling, adult entertainment)

• Non-renewable energy (e.g. fossil fuels, nuclear power)

• Weapons (conventional military weapons, controversial military weapons, civilian firearms)

• Companies are also excluded based on controversial conduct and diversity practices

Risks and Drawbacks of ESG Indexes

As with all investments, the risks of choosing ESG-linked investments is that they may not necessarily outperform over your target timeframe. There are also unique ESG-linked issues that come with evaluating these indexes.

Diversification Risk

The primary risk of using an ESG-based strategy is the risk of underperformance and the risk of reduced diversification relative to cheaper, broader-market index funds.

This isn’t a surprise, as many of the top ESG indexes are market capitalization (“cap”) weighted, which means that the largest firms in the index bear the greatest responsibility for changes in index values.

Given that some of most popular ESG investments also track the performance of the broader-market indexes, this makes these particular indexes less attractive as part of a diversifying strategy.

Higher Costs

Another issue of concern is that some ESG funds charge higher fees and expense ratios relative to conventional funds.

While these fees aren’t necessarily head and shoulders above broader-market index funds, they can get progressively more expensive depending on how nuanced the fund’s investing strategy is. This is because ESG is a factor-based investment strategy which entails more complexity than traditional broader-market indexing.

Typically, the longer the time frame for comparison, the greater the risk for underperformance becomes, net of fees.

Inconsistency of ESG Standards

Perhaps the biggest drawback of ESG-investing is the inconsistent reporting among industry firms, and the desire for more uniformity among which ESG frameworks are applied.

In other words, the ESG criteria established at one institution for their index or funds has little or no bearing on the ESG criteria employed by another firm.

Because sustainable investing has grown over the past decade, there has been an industry-wide movement towards greater consistency in ESG criteria and reporting. The Securities and Exchange Commission (SEC) has even recently undertaken efforts to codify aspects of financial reporting when it comes to ESG-related investments.

Nevertheless, these efforts remain in their early stages, and investors should continue to be discerning when it comes to picking ESG-linked investments.

Relevance of ESG Criteria

Existing ESG frameworks run the gamut when it comes to which metrics they choose to apply; whether these metrics are actually relevant to the underlying investments can be debated. For example, metrics related to carbon emissions may be relevant to heavy industry, but how relevant would those metrics be to the financial or technology sectors?

To address the issue of relevance, some ESG-linked funds have introduced an additional factor to correctly weight relevance of certain criteria. However, individual investors would do well to identify and assess when these solutions are applied.

Finally, expect to encounter data consistency issues when trying to quantify information that is naturally qualitative, particularly when management at each firm has wide discretion over how they choose to represent those metrics.

The Takeaway

There’s no doubt that enthusiasm for ESG investing has grown over the past decade, and continues to gain traction. Understanding ESG indexes and how they apply sustainability rules and criteria to the companies in the index can help investors understand the corresponding index mutual funds and ETFs they may want to invest in.

Due to the sheer number of ESG-centric investments available to date, it’s a good idea to be selective when reviewing the underlying strategy of each fund, and understanding the underlying methodology of how each index constructs its portfolio.

Exploring and incorporating sustainable strategies in your portfolio can be easy when you open an online brokerage account with SoFi Invest. The app allows you to buy and sell shares of stocks, ETFs, fractional shares, IPO shares, and more. Even better, SoFi members have complimentary access to advice from professionals, who can answer any questions you may have.

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.

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Mar

2023

Guide to Risk Neutral Probability

By Kenny Zhu | Growing Wealth, invest, Investing, Terminology | Comments Off

“Risk neutral,” in the context of investing, means that an investor focuses on the expected gains of a potential investment rather than its accompanying risks. This concept comes up frequently in options trading, as it’s one of the core tenets in how options are valued.

Risk neutrality is more of a conceptual focus for valuation than a strategy that’s applied on a daily basis. It’s often used as a conceptual framework for the valuation of options and other complex derivatives by sophisticated investment firms.

What Is Risk Neutral?

Risk-neutral investors are solely concerned with the expected returns of an investment, regardless of its underlying risks. When confronted with a gamble versus a sure thing, risk neutral investors are indifferent as long as the expected value of both options balance out.

Risk Neutral vs Risk Averse

Contrast risk neutrality with “risk aversion,” which does consider risk and strongly prefers certainty when comparing investment alternatives. While risk averse investors consider expected value, they will also demand a “risk premium,” or additional benefit, for taking on any additional risk in a transaction. This is what leads to their preference for the more “certain” option, even when the mathematical expected value of two alternative investments is the same.

Risk neutral investors are indifferent between investment options with the same expected values, regardless of the accompanying risk factors. The concept of risk does not play into a risk-neutral investor’s decision-making process, and no risk premium is demanded for uncertain outcomes with equal expected values.

In reality, most retail investors are risk averse, e.g. they have a low risk tolerance, rather than risk neutral. It’s easy to spot this investor preference, given the incessant focus of financial firms on mitigating risk. Terms like “risk-adjusted returns” are frequently used, and entire doctrines in behavioral economics and game theory are built around the cornerstones of loss or risk-aversion.

The difference between risk-neutral vs. risk-averse investors can be illustrated using an example comparing separate sets of probabilities.

Example of Risk Neutrality

To illustrate risk neutrality, consider a hypothetical situation with two investment options: one which involves a guaranteed payoff of $100, while the other involves a gamble, with a 50% chance of a $200 payoff and a 50% chance you receive nothing.

In our hypothetical scenario, the risk neutral investor would be indifferent between the two options, as the expected value (EV) in both cases equals $100.

1. EV = 100% probability X $100 = $100

2. EV = (50% probability X $200) + (50% probability X $0) = $100 + 0 = $100

However, a risk averse investor would introduce the added variable of risk into their decision, thereby unbalancing the alternatives above. Given that the 2nd option involves uncertainty, and therefore risk, the risk averse investor would demand an added payoff to justify taking on any added risk.

Reframing the problem above, the risk averse investor would choose option 1, given a) both options return the same expected value, and b) option 1 involves the greatest certainty.

On the other hand, the risk neutral investor would remain indifferent, as risk does not factor into their decision-making process.

Finally, user-friendly options trading is here.^*

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Risk Neutral Pricing and Valuation

Conceptually, risk neutrality is used extensively in valuing derivative securities because it establishes a theoretical basis for finding the equilibrium price between buyers and sellers in any transaction. It’s therefore an important aspect of options trading strategies.

Given that risk-averse investors demand a premium for taking on additional risk, while each individual investor’s risk tolerance can differ. This risk premium can present a problem from an analytical perspective; it introduces “noise” and analytical complexity which can complicate the pricing of derivatives and other investments.

Conceptually, the value of an investment is calculated as the present value of all its current and future cash flows. Future cash flows are discounted using its expected rate of return, which factors in the risk-neutral rate of return along with any added risk premia.

While the risk-neutral rate of return can be assumed to be the same for a given set of investments, the risk premium can vary according to the risk tolerance of individual investors, which complicates the present value calculation, additionally it often skews the calculated value of a security below what the expected future benefit might imply.

To adjust for this complexity in derivatives trading, mathematicians and financial professionals often find it useful to apply risk-neutral measures when pricing derivatives.

Understanding Risk Neutral Probability

The concept of risk neutrality is used to find objective pricing for derivatives; risk neutral probability therefore removes the noisy risk factor from calculations when finding fair value.

This differs from real-world risk-based pricing, which introduces any number of security-specific or market-based factors back into the calculation. The downside of this “real-world probability” is that it makes calculating value an exceedingly complex exercise, as you would need to make fine-tuning adjustments for almost every unique factor that might affect your investment.

Ultimately, risk-neutral probabilities allow you to apply a consistent single rate towards the valuation of all assets for which the expected payoff is known. This allows for ease and simplicity when approaching the valuation process.

However, that’s not to say that risk-aversion and other costs are not factored into calculations, as risk-averse investors would never choose to accept trades that don’t offer risk premiums over the long run.

Instead, risk-neutral probabilities represent the basis on which to build your investment valuation thesis, allowing you to selectively layer on any number of other risk factors later in the process.

Investing Today

Identifying what type of investor you are is important before diving in. If you’re a risk-neutral investor, choosing between risky and non-risky investments will be based on expected values.

If you are risk averse, your investment opportunities will need to be assessed based on whether you are receiving a risk premium commensurate with the risk you perceive.

If you want to learn more about risk and investing, SoFi Invest is a great place to get started. When you set up an online stock trading account, you have access to a range of self-directed options for both brokerage and retirement investing.

Remember that options trading is complex and can entail significant risk for new investors. It’s important to establish a solid investing foundation before moving onto more advanced trading strategies like options trading.

With SoFi, user-friendly options trading is finally here.

FAQ

Is risk neutral the same as risk free?

Risk neutral does not imply risk free. Risk neutral is simply a conceptual approach for evaluating trade offs without the impact of risk-factors.

Risk continues to exist in the context of each investment when evaluating tradeoffs; risk neutral simply suspends risk as a factor in the evaluation process.

What makes some companies risk neutral?

From a theoretical perspective, companies behave in a risk-neutral manner because firms have the means to hedge their risks away. They can do this by purchasing insurance, buying financial derivatives, or transferring their risk to other parties. This allows them to focus on expected outcomes rather than the risk-related costs of those decisions.

Conceptually, shareholders also want firms to make decisions in a risk-neutral manner, as individual investors can hedge risk exposure themselves by buying the shares of any number of other firms to diversify and offset these risk factors.

What is an example of risk neutral?

An example of risk neutral would be an individual who’s indifferent between 1) a 100% chance of receiving $1,000, versus 2) a 50% chance of receiving $2,000, and a 50% chance of receiving nothing.

In both cases, the expected value would be $1,000, after calculating for both probability and return. This expected value would be what risk-neutral investors would focus on. By contrast, a risk-averse individual would choose option 1, as the outcome has more certainty (and less risk).

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Mar

2023

401(k) Blackout Periods: All You Need to Know

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

A 401(k) blackout period is a hiatus during which plan participants may not make certain changes to their 401(k) accounts. Employers who offer 401(k) plans typically impose blackouts when they need to update or alter aspects of their plans. A blackout period may last anywhere from a few days to several weeks.

A blackout period doesn’t mean that the account is frozen. Employees in a payroll deduction plan can often continue making scheduled contributions to their 401(k) accounts during a blackout period, and assets held in 401(k) accounts remain invested in the market.

What Is a 401(k) Blackout Period?

As noted above, a 401(k) blackout period is a temporary suspension of employees’ ability to access their 401(k) accounts for actions such as withdrawals or portfolio adjustments. Companies use blackout periods to update or change their 401(k) retirement savings plans. Unfortunately, these blackout periods may sometimes be inconvenient for employees.

When Is a 401(k) Blackout Period Necessary?

There are several situations that might call for an employer to implement a 401(k) blackout period. Some common reasons include:

• Changes to the plan. Employers may need to implement a blackout period to allow for changes to their 401(k) plans, such as adding or eliminating investment alternatives or modifying the terms of the plan.

• New management. If an employer’s 401(k) plan is managed by a third party, the employer might decide to change sponsors or financial managers. A blackout period would give the employer time to transfer the assets and records.

• Mergers and acquisitions. Acquisition of a new firm or a merger with another company could require a blackout period while the two companies integrate their 401(k) plans.

• Issues with compliance. If an employer finds that the terms of their 401(k) plan violate federal laws, they may need to impose a blackout period while they conduct audits and bring the plan into compliance.

How Long Can a 401(k) Blackout Period Last?

A 401(k) blackout period can last for a few days or for a few weeks, but the typical duration is 10 days. The length often depends on the reason for the blackout and how much time it will take to implement the scheduled fixes. There is no legal maximum blackout period for 401(k) plans.

Will I Be Given a 401(k) Blackout Notice?

Employers are required to notify employees in advance of a blackout period. For blackout periods expected to last more than three days, employers must give at least 30 days’ (and not more than 60 days’) notice, according to the federal Employee Benefits Security Administration (EBSA). If the period’s beginning or ending date changes, employers are expected to provide an updated blackout notice as soon as reasonably possible.

Employers must provide this notice in writing, either by mail or email. The notice should include the reason for the blackout.

What Should I Do Before the Blackout Starts?

If a 401(k) blackout period is approaching, there are some steps you can take to prepare. Here are a few things to consider doing before the blackout starts:

• Review the account. Once you get your blackout notice, take some time to review your 401(k) plan, including your current contributions, investment options, and overall balance. This overview can help you zero in on anything that may need correction before the blackout begins.

• Make any appropriate changes. If you need to fine-tune how you’re investing in your 401(k), such as by adjusting contribution amounts or reallocating investments, try to do so before the blackout period. This will help ensure that your changes take effect as soon as possible.

• Communicate with your employer. For questions about the blackout period or requests for additional information, your employer is likely to be the best resource. They should be able to provide more details and address account-related concerns.

Starting Out With a New 401(k)

People starting a new job that offers a 401(k) plan have some decisions to make. Plan details to consider before committing to a new 401(k) account may include:

• Contribution limits. The Internal Revenue Service (IRS) sets limits on annual 401(k) contributions. In 2023, the contribution limit is $22,500 for those under age 50 and $30,000 for those 50 and older. If you want to max out your 401(k), knowing these limits can help you schedule your contributions appropriately.

• Investment options. Most 401(k) plans offer a range of investment vehicles, including mutual funds, exchange-traded funds (ETFs), and individual stocks. As you’re preparing for retirement, researching various asset types will help you see which ones align with your investment goals and risk tolerance.

• Fees. Some 401(k) plans charge fees for services such as plan administration or investment management. Understanding how the plan’s fees may impact your overall returns is crucial.

• Employer match. Many employers offer a matching contribution to employee 401(k) accounts. This means that the employer will kick in an additional percentage to augment an employee’s contributions. An employer match is a way of boosting your retirement savings, which may lead to bigger investment gains over time.

The Takeaway

Employees with 401(k) retirement accounts occasionally experience blackout periods. People may not access or alter their accounts during these breaks, which occur when employers and 401(k) plan sponsors need time to update or retool their retirement benefit plan. Blackout periods typically last for a few days or weeks. By law, participants must be notified at least 30 days ahead of a scheduled blackout period. This enables them to make any desired investment changes beforehand.

One convenient way of investing for retirement is through SoFi individual retirement accounts. You can open an online IRA account from your phone and start saving right away. If you have questions, SoFi has a team of professional advisors available to help.

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FAQ

What is a retirement-fund blackout period?

A 401(k) blackout period is a multi-day pause during which the employer or the plan administrator typically update or maintain the plan. During this time, employees can’t alter their 401(k) retirement accounts. Making withdrawals or changing asset allocations may be prohibited. Though a blackout period is temporary, it can last several weeks or more.

Can you contribute to your 401(k) during the blackout period?

This depends on the specific terms of the employer’s 401(k) plan and the blackout period. Some plans may allow employees to keep setting aside money in their 401(k) accounts during a blackout; others may not. Your employer or plan administrator will have information on your plan’s rules for contributions.

How do I get my 401(k) out of the blackout period?

In most cases, there is nothing you can do to avoid or shorten your 401(k) blackout period. A blackout period generally comes to an end once the employer or plan administrator has completed the necessary plan updates. If you have additional questions about the duration of the blackout period or how to access your account again, your employer should be able to answer them.

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Mar

2023

Understanding Highly Compensated Employees (HCEs)

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

Internal Revenue Service (IRS) rules require companies with 401(k) retirement plans to identify highly compensated employees (HCEs). An HCE, according to the IRS, passes either an ownership test or a compensation test. Someone owning more than 5% of the company would qualify as an HCE, as would someone who was compensated more than $135,000 for the 2022 tax year.

The IRS uses this information to help all employees receive fair treatment when participating in their 401(k). As a result, your HCE status can affect the amount you can contribute to your 401(k).

What Does It Mean to Be an HCE?

A highly compensated employee’s 401(k) contributions will be subject to additional scrutiny by the IRS. Again, you’re identified as an HCE if you either:

• Owned more than 5% of the business this year or last year, regardless of how much compensation you earned or received, or

• Received at least $135,000 in compensation for the 2022 tax year ($150,000 for 2023) and, if your employer so chooses, you were in the top 20% of employees ranked by compensation.

If you meet either of these criteria, you’re considered an HCE, though that doesn’t necessarily mean that you earn a higher salary.

For example, someone could own 6% of a business while also drawing a salary of less than $100,000 a year. Because they meet the ownership test, they would still be classified as an HCE.

It’s also possible for you to be on the higher end of your company’s salary range and yet not qualify as an HCE. This can happen if your company chooses to rank employees by pay. If your income is above the IRS’s HCE threshold but you still earn less than the highest-paid 20% of employees (while not owning 5% of the company), you don’t meet the definition of an HCE.

Highly Compensated Employee vs Key Employee

Highly compensated employees may or may not also be key employees. Under IRS rules, a key employee meets one of the following criteria:

• An officer making over $200,000 for 2022 ($215,000 for 2023)

• Someone who owns more than 5% of the business

• A person who owns more than 1% of the business and also makes more than $150,000 a year

• Someone who meets none of these conditions is a non-key employee.

In order for a highly compensated employee to be a key employee, they must pass the ownership or officer tests. For IRS purposes, ownership is determined on an aggregate basis. For example, if you and your spouse work for the same company and each own a 2.51% share, then you’d collectively pass the ownership test.

Benefits of Being a Highly Compensated Employee

Being a highly compensated employee can offer certain advantages. Here are some of the chief benefits of being an HCE:

• Having an ownership stake in the company you work for may entail additional employee benefits or privileges, such as bonuses or the potential to purchase company stock at a discount.

• Even with a high salary, you can still contribute to your 401(k) retirement plan, possibly with matching contributions from your employer.

• You may be able to supplement 401(k) contributions with contributions to an individual retirement account (IRA) or health savings account (HSA).

There are, however, some downsides to consider if you’re under the HCE umbrella.

Disadvantages of Being a Highly Compensated Employee

Highly compensated employees are subject to additional oversight when making 401(k) contributions. If you’re an HCE, here are a few disadvantages to be aware of:

• You may not be able to max out your 401(k) contributions each year.

• Lower contribution rates could potentially result in a shortfall in your retirement savings goal.

• Earning a higher income could make you ineligible to contribute to a Roth IRA for retirement.

• Any excess contributions that get refunded to you will count as taxable income when you file your return.

Benefits	Disadvantages
HCEs may get certain perks or bonuses.	401(k) contributions may be limited.
Can still contribute to a company retirement plan.	Limits may make it more difficult to reach retirement goals.
Can still contribute to an IRA.	High earnings may make you ineligible to contribute to a Roth IRA.
	Refunds of excess contributions could raise employee’s taxable income.

Nondiscrimination Regulatory Testing

The IRS requires employers to conduct 401(k) plan nondiscrimination compliance testing each year. The purpose of this testing is to ensure that highly compensated employees and non-highly compensated employees have a more level playing field when it comes to 401(k) contributions.

Employers calculate the average contributions of non-highly compensated employees when testing for nondiscrimination. Depending on the findings, highly compensated employees may have their contributions restricted in certain ways. If you aren’t sure, it’s best to ask someone in your HR department, or the plan sponsor.

If an employer reviews the plan and finds that it’s overweighted in favor of HCEs, the employer must take steps to correct the error. The IRS allows companies to do that by either making additional contributions to the plans of non-HCEs or refunding excess contributions back to HCEs.

401(k) Contribution Limits for HCEs

In theory, highly compensated employees’ 401(k) limits are the same as retirement contribution limits for other employees. For 2022, the limit is $20,500; it’s $22,500 for 2023. Employees age 50 and older can make an additional $6,500 in catch-up contributions for 2022, and $7,500 for 2023.

But, as noted above, these plans may be restricted for HCEs, so it’s wise to know the terms before you begin contributing.

Other Retirement Plan Considerations

For example, one thing to watch out for if you’re a highly compensated employee is the possibility of overfunding your 401(k). If your employer determines that you, as an HCE, have contributed more than the rules allow, the employer may need to refund some of that money back to you.

As mentioned earlier, refunded money would be treated as taxable income. Depending on the refunded amount, you could find yourself in a higher tax bracket and facing a larger tax bill. So it’s important to keep track of your contributions throughout the year so the money doesn’t have to be refunded to you.

Recommended: Should You Retire at 62?

401(k) vs IRAs for HCEs

A highly compensated employee might consider opening an IRA account, traditional or Roth IRA, to supplement their 401(k) savings. Either kind of IRA lets you contribute money up to the annual limit and make qualified withdrawals after age 59 ½ without penalty.

However, income-related rules could constrain highly compensated employees in terms of funding both a 401(k) and a traditional or Roth IRA.

• An HCE’s contributions to a traditional IRA may not be fully tax-deductible if they or their spouse are covered by a workplace retirement plan. Phaseouts depend on income and filing status.

• Highly compensated employees may be barred from contributing to a Roth IRA. Eligibility phases out as income rises. For the 2023 tax year, people become ineligible when their MAGI exceeds $153,000 (if single) or $228,000 (if married, filing jointly).

The Takeaway

A highly compensated employee is generally someone who owns more than 5% of the company that employs them, or who received compensation of more than $135,000 in 2022 ($150,000 in 2023).

Being an HCE can restrict how much you’re able to save in your company’s 401(k); under certain circumstances the IRS may require the employer to refund some of your contributions, with potential tax consequences for you. Even so, HCEs may still be able to save and invest through other retirement accounts.

SoFi offers traditional and Roth IRAs to help you grow your retirement savings. You can open an account online in minutes and build a diversified portfolio that suits your goals. It’s a hassle-free way to work toward a secure financial future.

Help grow your nest egg with a SoFi IRA.

FAQ

Does HCE income include bonuses?

The IRS treats bonuses as compensation for determining which employees are highly compensated. Overtime, commissions, and salary deferrals to a 401(k) account are also counted as compensation.

What is the difference between a key employee and a highly compensated employee?

A highly compensated employee is someone who passes the IRS’s ownership test or compensation test. A key employee is someone who is an officer or meets ownership criteria. Highly compensated employees can also be key employees.

Can you be a key employee and not an HCE?

It is possible to be a key employee and not a highly compensated employee in certain situations. For example, you might own 1.5% of the business and make between $150,000 and $200,000 per year, while not ranking in the top 20% of employees by compensation.

Photo credit: iStock/nensuria

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FAQ

What is a retirement-fund blackout period?

Can you contribute to your 401(k) during the blackout period?

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Understanding Highly Compensated Employees (HCEs)

What Does It Mean to Be an HCE?

Highly Compensated Employee vs Key Employee

Benefits of Being a Highly Compensated Employee

Disadvantages of Being a Highly Compensated Employee

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FAQ

Does HCE income include bonuses?

What is the difference between a key employee and a highly compensated employee?

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