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Sep

2023

What Investors Should Know About Spread

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

A spread represents the difference between any two financial metrics. The type of spread depends on the type of security that’s being traded. For example, when trading bonds, the spread can refer to a difference in yields between bonds of varying maturity lengths or quality.

Further, while there are many differences between bonds and stocks — spread is just one of them. With stocks, though, spreadgenerally refers to differences in price. Specifically, it measures the gap between the bid price and the ask price. Understanding what is spread and how it works can help you more effectively shape your investment strategy.

What Is Spread in Finance?

As noted, spread is the difference between two financial measurements. When talking specifically about a stock spread, it is the difference between the bid and ask price.

The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.

A good way to visualize spread may be to think of buying a home. As a home buyer, you may have a set price that you’re willing to pay for a property, based on what you can afford and what you’ve been pre-approved for by your mortgage lender.

You search for homes and eventually find one that has everything on your wishlist. When you check the listing price, you see that the seller has it priced $10,000 above your budget. In terms of spread, the maximum amount you’re willing to offer for the home represents the bid price, while the seller’s listing price represents the ask.

What Does Spread Mean?

Aside from stock spread, spread can have a variety of applications and meanings in the financial world.

As mentioned earlier, bond spread typically refers to differences in yield. But if you’re trading futures, the spread can measure the gap between buy and sell positions for a particular commodity. With options trading, it can refer to differences in strike prices when placing call or put options.

Spread can also be used in foreign currency markets or forex (foreign exchange market) trades to represent the difference between the costs for traders and the profits realized by dealers.

With lending, spread is tied to a difference in interest rates. Specifically, it means the difference between a benchmark rate, such as the prime rate, and the rate that’s actually charged to a borrower. So for example, if you’re getting a mortgage there might be a 2% spread, meaning your rate is 2% higher than the benchmark rate.

Bid-Ask Price and Stocks Spread

If you trade stocks online, it’s important to understand how the bid-ask price spread works and how it can affect your investment outcomes. Since spread can help gauge supply and demand for a particular stock, investors can use that information to make informed decisions about trades and increase the odds of getting the best possible price.

Normally, a stock’s ask price is higher than the bid price. How far apart the ask price and bid price are can give you a sense of how the market views a particular security’s worth.

If the bid price and ask price are fairly close together, that suggests that buyers and sellers are more or less in agreement on what a stock is worth. On the other hand, if there’s a wider spread between the bid and ask price, that might signal that buyers and sellers don’t necessarily agree on a stock’s value.

What Influences Stock Spreads?

There are different factors that can affect a stock’s spread, including:

• Supply and demand. Spread can be impacted by the total number of outstanding shares of a particular stock and the amount of interest investors show in that stock.

• Liquidity. Generally, liquidity is a measure of how easily a stock or any other security can be bought and sold or converted to cash. The more liquid an investment is, the closer the bid and ask price may be, since it can be easier to gauge an asset’s worth.

• Trading volume. Trading volume means how many shares of a stock or security are traded on a given day. As with liquidity, the more trading volume a security has, the closer together the bid and ask price are likely to be.

• Volatility. Measuring volatility is a way of gauging price changes and how rapidly a stock’s price moves up or down. When there are wider swings in a stock’s price, i.e. more volatility, the bid-ask price spread can also be wider.

Why Pay Attention to a Stock’s Spread?

Learning to pay attention to a stock’s spread can be helpful for investors in that they may be able to use what they glean from the spread to make better decisions related to their portfolios.

In other words, when you understand how spread works for stocks, you can use that to invest strategically and manage the potential for risk. This means different things whether you are planning to buy, sell, or hold a stock. If you’re selling stocks, that means getting the best bid price; when you’re buying, it means paying the best ask price.

Essentially, the goal is the same as with any other investing strategy: to buy low and sell high.

Difference Between a Tight Spread and a Wide Spread

As discussed, a tight spread could be a signal to investors that buyers and sellers are more or less in agreement that a stock is valued correctly. A wide spread, on the other hand, may signal that there isn’t necessarily a consensus on what the stock’s value should be.

There’s no guarantee, of course, that that inclination is correct, but when looking at tight or wide spreads, it can be yet another useful piece of information to help inform decisions.

Executing Stock Trades Using Spread

If you’re using the bid-ask spread to trade stocks, there are different types of stock orders you might place. Those include:

• Market orders. This is an order to buy or sell a security that’s executed immediately.

• Limit orders. This is an order to buy or sell a security at a certain price or better.

• Stop orders. A stop order, also called a stop-loss order, is an order to buy or sell a security once it hits a certain price. This is called the stop price and once that price is reached, the order is executed.

• Buy stop orders. Buy stop orders are used to execute buy orders only when the market reaches a certain stop price.

• Sell stop orders. A sell stop order is the opposite of a buy stop order. Sell stop orders are executed when the stop price falls below the current market price of a security.

Stop orders can help with limiting losses in your investment portfolio if you’re trading based on bid-ask price spreads. Knowing how to coordinate various types of orders together with stock spreads can help with getting the best possible price as you make trades.

Other Types of Spreads

While we’ve mostly discussed spread as it relates to stocks, there are other types of spreads, too.

Options spreads, for instance, involve buying multiple options contracts with the same underlying asset, but different strike prices or expiration dates.

Under the options spread umbrella are several spreads as well. Box spreads are one example, and they are a type of arbitrage options trading strategy in which traders use some tricks of the trade to reduce their risk as much as possible.

There’s also the debit spread, which is an options trading strategy in which a trader buys and sells an option at the same time — it’s a high-level strategy, and one that may not be suited to investors who are mostly investing in stocks or bonds.

Note, too, that there is something called a credit spread (similar to a debit spread, but its inverse) and that there are some differences traders will need to learn about before deciding to utilize a credit spread vs. debit spread as a part of their strategy. Again, options trading requires a whole new level of market knowledge and know-how, and may not be for all investors.

Investing With SoFi

The more investing terms an investor is familiar with, the better able they’ll be to invest with confidence. Spread is a term that means different things in different situations, but when it comes to stocks, spread is the difference between the bid price and ask price of a given stock. Being able to assess what a spread might mean can help inform individual trading decisions.

As you learn more about stocks, including what is spread and how it works, you can use that knowledge to create a portfolio that reflects your financial needs and goals.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How do you read a stock spread?

A stock spread is the difference between the bid and ask price, so calculating it is a matter of subtracting the bid from the ask price. It’s typically expressed as a percentage.

What is the average spread of a stock?

The average spread of a stock ranges between 13% and 18%, but can vary wildly depending on what types of stocks or market segments are being looked at.

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Sep

2023

What Is a Shell Company and Why Do They Exist?

Guide to Shell Companies

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

A shell company, also called a shell corporation, refers to any legally structured corporation that has no meaningful assets or business operations. In popular culture, they’re often used to conceal illegal businesses, or to conceal the owners of a business from law enforcement, the public, or both. However, shell companies themselves are not illegal, and they do have some legitimate uses.

As business entities, shell companies exist to protect, and sometimes to conceal (or at least misrepresent) the assets of the shell company’s owner. But there’s nothing necessarily illegal about shell corporations themselves. It’s important to not only understand the definition of a shell company, but also to recognize how and why they’re used by businesses and people.

How Are Shell Companies Created?

There is more than one way to create a shell company. Most often, the people or corporations that launch new shell corporations use a registered agent in the country where the company will have its legal headquarters. So, in the United States, shell companies would need to register with the Securities and Exchange Commission.

In most countries, the agent must register his or her name, and the name of an owner or a shareholder director. The cost of creating and legally registering a corporation will vary from country to country, from as little as a few thousand dollars to as much as several hundred thousand dollars.

Being “hollow,” by definition, shell companies can do many things. They can open bank and brokerage accounts. They can transfer funds in and out of their home country. They can buy and sell real estate or other companies. And own copyrights and earn royalties on those copyrights.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you open an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

3 Uses of Shell Companies

People and corporations use shell companies in a wide range of legitimate businesses for legitimate reasons. Those might be used as a vehicle to raise funds, as a legal entity to attempt to take over another business via a reverse merger, or as a legal entity to give form to a company that intends to go public.

1. Tax Benefits of Shell Companies

Many shell corporations operate in a legal gray area, and it’s possible that corporations and wealthy individuals may use them to avoid taxes.

Many companies have found ways to move their profits to offshore shell corporations to take advantage of less expensive, or more permissive tax regimes in other countries (similar to how some states may be more tax-friendly than others). American corporations might set up shell companies in countries with inexpensive labor, where they have already begun to outsource some of their operations.

Corporations aren’t the only ones that use shell companies to avoid paying taxes. Wealthy individuals around the world may also use shell corporations, domiciled all over the world, to hide their earnings and their wealth from the governments of the countries in which they prosper.

2. Less Risk, More Opportunity

Tax avoidance isn’t the only reason a corporation would set up a shell corporation. It might create a shell company to operate in a country, while protecting its other operations from the legal, political, and financial risks related to that country. That way, if something goes wrong in the country where it operates, the parent company can limit its exposure by existing — at least on paper — offshore.

A corporation may also set up a shell corporation in another country to gain a window into new regions. A business might set up a shell company in Panama or Switzerland to gain access to the local business community, in order to generate contacts and information that would lead it to business opportunities in Latin America or Western Europe.

3. SPACs

While shell companies come up in the news in relation to questionable tax-avoidance schemes, in recent years, they’ve also been mentioned alongside special purpose acquisition companies, or SPACs.

At any given time, there may be hundreds of shell companies that qualify as SPACs — which may be a reason that SPACS were so popular for a couple of years in 2020 and 2021. These are companies formed exclusively to raise capital via an initial public offering (IPO), which will then purchase a company already in operation. SPACs are a type of “blank check company.”

These companies issue an IPO, then hold the money in a trust, until the SPAC management team chooses a company and buys it. And if the SPAC doesn’t find a company to buy, or can’t buy the company or companies it likes within a pre-set deadline — often two years — then the managers promise to liquidate the SPAC and give investors their money back.

Recommended: What Is A Backdoor Listing?

Example Shell Companies

An example of a shell company could be as follows.

Say there’s an entrepreneur that’s looking to raise money before they officially launch a startup — maybe the next big emerging growth company. They may create an LLC, which is a business entity, that doesn’t have any assets or employees. It only exists on paper. But the business entity — a shell company — can be used to store the money being raised for the startup prior to its launch.

In effect, the company itself is merely a shell used to hold cash until it’s ready for use. It’s not really a functional business in the traditional sense.

Shell Companies and Shady Dealings

While there are many legitimate uses for shell companies, as outlined, bad actors also might use them to shield their operations and their assets from authorities. And as different jurisdictions compete for business, new loopholes emerge on a regular basis. In Panama, the British Virgin Islands, Nevada and Delaware, to name only a few, there are strong laws that prevent the government from revealing the beneficial owner of a given shell corporation.

And for creative financiers, there are always new ways to add layers of anonymity, such as phony company directors, who agree to sign their names for a few dollars. Among professionals who specialize in such things, there are ways to find would-be board members, and for countries and states with convenient tax and privacy laws.

Are Shell Companies Legal?

Yes, shell companies are legal, and are most often used for perfectly legal purposes. While they can be used for illegal purposes, a shell company is generally used for a more or less boring or run of the mill business purpose — as discussed in the previous example above.

Shell Companies vs Holding Companies

Though there may be some superficial similarities, shell companies and holding companies are not the same thing. As discussed, shell companies may be formed to serve as empty entities that may be used to take advantage of different taxation regulations, for example. A holding company, on the other hand, is a parent company — holding companies holds or owns other companies within it, like an umbrella. It allows its owners to control numerous businesses without necessarily actively managing any of them.

The Takeaway

Shell companies are legal business entities that are often used for perfectly legal reasons, and often to reduce tax liabilities or store funds. Shell companies can be used for illegal purposes, too, which is what they’re often associated with.

Most investors wouldn’t use shell companies in their day-to-day trading, but they might consider allocating part of their portfolios to a SPAC. It’s important to remember that these are speculative, risky investments, so they don’t make sense for every portfolio.

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 a shell company legal?

Yes, shell companies are legal, and are generally used for perfectly legal purposes. A shell company is simply a business entity that has no assets or employers, or engages in much or any meaningful business operations.

What is an example of a shell company?

An example of a shell company could be an LLC formed by an entrepreneur planning to launch a startup. The entrepreneur files the paperwork to create the LLC, and then uses it simply to store funds until the startup launches, rather than have the LLC engage in any business itself.

What is the difference between a holding company and a shell company?

Holding companies are parent companies, or umbrella organizations, that often have multiple businesses running underneath or within them. Shell companies do not have assets or employees, or any meaningful business operations.

Photo credit: iStock/akinbostanci

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Sep

2023

What Is a Credit Default Swap (CDS)?

By Laurel Tincher | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Credit default swaps (CDS) are widely used financial derivatives, or contracts, that give investors the ability to “swap” their credit risk with another investor. They’re a popular type of investment, especially for institutional investors.

Investors use CDS for many types of credit investments, including mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds.

Credit Default Swaps, Explained

Credit default swaps are the most common type of credit derivative, and they help investors reduce the risk that borrowers on the securities they own will default on their loans. To reduce their risk, the investor purchases a CDS from another investor, who will pay the lender back if the borrower defaults on the loan. There is generally an ongoing payment as part of the contract, which serves as an insurance policy.

The investments used to create credit-default swaps include many types of credit, such as mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds. However, while the contract references a specific security or set of securities, it is not actually connected to it. Most CDS investors are institutional investors, such as hedge funds, due to the securities’ complex and risky nature.

The credit-default swap contract lays out the responsibilities of the seller in the event that the borrower experiences a credit event or defaults on their loan. Credit events can include failure to pay, bankruptcy, moratorium, repudiation, and obligation acceleration. If any of these events occur, the buyer of the CDS may terminate the contract and the seller will need to pay. The specifics of these credit events are outlined in the contract that both parties sign.

The agreement between the borrower and the lender is separate from the lender’s agreement with the CDS seller, in which the lender becomes the CDS buyer.

Here’s a credit default swap example: A company sells a $200 bond with a 20-year maturity term. An investor buys that bond from the company, who agrees to pay back the money to the investor plus interest within 20 years. However, the company can’t guarantee its ability to pay back that money and the interest. This is the risk involved in investing in a bond.

In order to mitigate the risk, the investor who bought the bond purchases a CDS, which guarantees they will get their investment back if the company defaults on the loan. Just as with other types of insurance, the CDS buyer makes regular payments, typically every quarter, on the contract. The CDS seller is usually a bank, insurance company, reporting dealer, or hedge fund.

These sellers protect themselves against risk by diversifying their sales into many different companies, industries, or sectors. If one of their sales falls through, they have income from all the others to carry on their business.

Riskier Credit Default Swaps

The higher the risk of default, the more expensive a CDS will be. Some investors use credit-default to speculate on the credit quality of a company. Essentially, people use the CDS system to place bets on the bond issuer through the CDS system.

Investors can also switch sides on CDS if they come to decide that a borrower might default. The CDS seller can buy its own CDS or sell it to another bank. This makes it extremely difficult to track the market and decide how to invest in it.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

The Benefits of Credit Default Swaps

The main reason that people choose to buy CDS is as an insurance policy against the risks of loans in their portfolio. Using a CDS allows the investor to transfer some of the risk to the seller of the CDS or an insurance company.

The credit risk does not disappear with a CDS, the seller simply takes on that risk. However, if the borrower defaults on their loan, the seller of the CDS will default on the contract, and the debt goes back to the buyer.

One benefit of CDS is that they enable bond investors to buy into riskier ventures than they otherwise would, since they know they have some protection. This helps funds go towards innovative and unexplored ideas, which help grow the economy and solve world problems.

Downsides of Credit Default Swaps

Although there are several benefits to credit default swaps, they have some significant downsides as well. CDS are an investment focused on managing risk, and it can be difficult to figure out which ones are safer investments due to the complexities of the market.

Introduced in 1994, the CDS market went largely unregulated until the financial crisis of 2008, and was a key contributor to the problems that led up to it. Since it wasn’t regulated, CDS sellers often did not have the money available to pay the buyer in the case of a default. Many sellers only held a fraction of what would be needed to pay back all their buyers.

As long as nobody defaulted, this system worked, but in 2008, this resulted in a massive financial meltdown. Large scale sellers of CDS, including some of the largest financial institutions in the United States were unable to make good on theirCDS contracts, creating a wave of economic effects around the world and requiring multiple bailouts by the Federal Reserve.

Dodd-Frank Reforms

After the 2008 financial crisis, regulators stepped in to try and prevent the same thing from happening again.

The Dodd-Frank Wall Street Reform Act of 2010 required the regulation of swaps by the Commodity Futures Trading Commission and the Securities and Exchange Commission. It also mandated reporting of all credit-default swaps and imposed capital requirements on CDS sellers.

The Takeaway

Credit-default swaps are complicated securities, but some institutional investors can use them to reduce the risk of other investments or to bet that another company might be close to default.

While credit-default swaps are complex investments, they may have a place in a diversified portfolio. However, due to their complexity, it may be a good idea to consult with a financial professional before diving in.

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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Sep

2023

What Is Scalp Trading?

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

Scalp trading, or scalping, is a style of short-term trading used with stocks, cryptocurrencies, and other assets. The goal of this trading style is to make profits off of small changes in asset prices. Generally this means buying a stock, waiting for it to increase in value by a small amount, then selling it.

The theory behind it is that many small gains can add up to a significant profit over time. Scalp trading is one of the most popular day trading strategies. Scalping requires a lot of focus, quick decision-making, the right trading tools, and a strategy — and even then, it’s no sure thing. Since traders make many small gains, one big loss could wipe out all their profits.

How Scalping Works in Trading

The goal of scalping is to make many small profits during a trading session. This is the opposite of a buy-and-hold or long term trading strategy, where one hopes to see their portfolio grow over time. Scalpers might make anywhere from 10 to more than 100 trades in a single day, taking a small profit on as many of them as possible. And they might only stay in each position for a few minutes.

With each trade they assess the risk-to-reward ratio with a goal of profiting on more than 50% of their trades. Each win may be small, but the profits can add up over time if they outnumber the losses. Often, scalpers make use of stop losses and leverage when making trades.

Scalp trading reduces risk exposure, since traders only have their money in the market for a short amount of time. It can also be an easier day trading strategy than some others because the goal is to capitalize on small price movements. Small moves happen constantly in the market, and it’s easier to make a profit of a few cents or dollars than a larger amount.

However, any type of day trading involves a significant amount of risk. Scalping is challenging and can result in large losses. This is just one reason why some traders use scalping along with other trading methods.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Scalp Trading Strategies

There are many different scalp trading strategies, some of which can be used together.

Systematic Planning

Technical analysis helps scalp traders spot trading opportunities and plan exits ahead of time. Traders use one-minute charts, Level II quotes, moving averages, exchange order books, and other tools while scalping. Since positions may be entered and exited within seconds or minutes, five- or 10-minute charts aren’t very useful.

On the Fly

Although fundamental analysis doesn’t play a large role in scalping, it can help to identify stocks that are currently in the news or of interest based on a current event, which may lead to more price movement and trading opportunities. Higher volatility is generally a good sign for scalpers.

Shorting Stocks

Some scalpers also short stocks and sell when they decrease in value. This can be done with the same asset repeatedly, or with different assets throughout a trading session.

Bid/Ask Profiting

Some scalpers prefer to earn profits off of the bid/ask spread rather than actual stock price movements. This takes a significant amount of experience and is a particular trading skill that takes time to learn. It entails looking for trades with a wide spread, meaning a large difference between the broker’s ask price and the price at which a trader buys the asset.

Range Trading

With this strategy, the trader waits for an asset to enter a specific price range before they start trading. Generally, the range is between a support and a resistance level.

Market Making

Market making is when traders post a bid and an offer on a stock at the same time. This only works with stocks that trade a large volume but have low volatility, and the profits are small.

How to Scalp Trade

While there is no one way to engage in scalp trading, these are the general guidelines that scalpers follow to make decisions:

• Create a watchlist each day based on fundamental analysis and news

• Trade stocks with enough liquidity that there will be price movement and more options for exit points

• Quickly sell a stock isn’t increasing in value

• Make a daily profit goal

• Set goals for each stock trade and stick to them

• Buy stocks at breakouts

• Keep trades short for more chance at a profitable exit

• Adjust exit points as stocks move.

Pros and Cons of Scalp Trading

Scalp trading is a particular day trading strategy which works well for some people, there are many risks associated with day trading.

Pros of Scalp Trading

• Small gains can add up to significant returns

• It reduces risk exposure to market due to short trade times

• It may be easier than some other day-trading strategies

• It can be easier to make profitable trades when the goal is to profit off of small movements rather than large price movements

• There are many trading opportunities, no matter what the market conditions are.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Cons of Scalping

• Even one large loss can cancel out any gains made during a trading session

• It requires a lot of focus to watch the charts for several hours and execute trades, and can be tedious

• It requires knowledge and experience with technical analysis

• Transaction and commission fees can add up quickly if making multiple trades per day—and potentially cancel out profits. It’s key to use a broker that doesn’t charge commissions or one that offers discounts to high volume traders.

• If traders experience a few losses it can be distressing, and it’s easy to let emotions get in the way of good trading habits. Scalping may be one of the most stressful trading strategies.

• Scalpers often use margin trading and leverage to increase their positions, which can be very risky.

The Takeaway

Scalp trading, or scalping, is a style of short-term trading used with stocks or other securities. Scalping is best suited for more experienced traders, since it requires an understanding of technical analysis, fast trades, and an understanding of how to set up and execute trades in specific ways.

But scalp trading is just one of many different strategies when it comes to trading stocks and other assets. While trading can seem complex, there are simple ways to get started building a portfolio.

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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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

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Sep

2023

Inherited 401(k): Rules and Tax Information

By Ashley Kilroy | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

When you inherit a 401(k) retirement account, there are tax rules and other guidelines that beneficiaries must follow in order to make the most of their inheritance.

Inheriting a 401(k) isn’t like getting a simple inheritance, e.g. cash, property, or jewelry. How you as the beneficiary must handle the account is determined by your relationship to the deceased, your age, and other factors.

Understanding the tax treatment of an inherited 401(k) is especially important, as 401(k) accounts are tax-deferred vehicles, so regardless of your status as a beneficiary you will owe taxes on the withdrawals from the account, now or later.

What Is an Inherited 401(k)?

As the name suggests, an inherited 401(k) is an employer-sponsored retirement plan that is bequeathed to an individual, either a spouse or a non-spouse.

When an individual sets up their 401(k) to begin with, they generally fill out a beneficiary form. This form may include their spouse (if the account holder was married), children, siblings, or others.

In most cases, when the account holder of a 401(k) dies, the account is automatically bequeathed to the surviving spouse, unless the will specifies otherwise. This is not the case if your partner dies and you weren’t married. In that case, the 401(k) does not pass to the surviving partner, unless they are officially designated as an account beneficiary.

What to Do If You’re Inheriting a 401(k)

The rules for inheriting a 401(k) are different when you inherit the account from a spouse versus someone who wasn’t your spouse. Depending on your relationship, you’ll have different options for what you can do with the money and how those options affect your tax situation.

Remember, a 401(k) is a tax-deferred retirement account, and the beneficiary will owe taxes on any withdrawals from that account, based on their marginal tax rate.

Inheriting a 401(k) From a Spouse

A spouse has a number of options when inheriting an IRA. But be careful; there are a number of wrinkles given that the rules have changed in the last few years.

• You could rollover the inherited 401(k) into your own 401(k) or into an inherited IRA: For most spouses, taking control of an inherited 401(k) by rolling over the funds is often the smartest choice. A rollover gives the money more time to grow, which could be useful as part of your own retirement strategy. Also, rollovers do not incur penalties or taxes. (But if you convert funds from a traditional 401(k) to a Roth 401(k) or a Roth IRA, you will likely owe taxes on the conversion to a Roth account.)

Also remember that once the rollover is complete, traditional 401(k) or IRA rules apply, meaning you’ll face a 10% penalty for early withdrawals before age 59 ½.

And when you reach age 73, you must start taking required minimum distributions (RMDs). Because RMD rules have recently changed, owing to the SECURE Act 2.0, it may be wise to consult a financial professional to determine the strategy that’s best for you.

• Take a lump sum distribution: Withdrawing all the money at once will not incur a 10% early withdrawal penalty as long as you’re over 59 ½, but you’ll owe income tax on the money in the year you withdraw it — and the amount you withdraw could put you into a higher tax bracket.

• You can reject or disclaim the inherited account, passing it to the next beneficiary.

• Last, you could leave the inherited 401(k) where it is: If you don’t touch or transfer the inherited 401(k), you are required to take RMDs if you’re at least 73. If you’re not yet 73, other rules apply and you may want to consult a professional.

Inheriting a 401(k) from a Non-Spouse

The options for a non-spouse beneficiary (e.g. a child, sibling, etc.) are far more limited. For example, as a non-spouse beneficiary you cannot rollover an inherited 401(k) into your own retirement account.

• You can “disclaim” or basically reject the inherited account.

• If the account holder died in 2019 or earlier, you can take withdrawals for up to 5 years — as long as the account is empty after the 5-year period. If the account holder died in 2020 or after, you have 10 years to withdraw all the funds. You must start taking withdrawals starting no later than Dec. 31 of the year after the death of the account holder. These rules are known as the 5-year and 10-year rules.

• A positive point to remember: If you are a non-spouse beneficiary and younger than 59 ½ at the time the withdrawals begin, you won’t face a 10% penalty for early withdrawals.

The exception to this rule is if you’re a minor child, chronically ill or disabled, or not more than 10 years younger than the deceased, you can take distributions throughout your life.

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

How RMDs Impact Inherited 401(k)s

If the account holder died prior to Jan. 1, 2020, anyone can use the so-called “life expectancy method” to withdraw funds from an inherited IRA. That means taking required minimum distributions, or RMDs, based on your own life expectancy per the IRS Single Life Table (Publication 590-B).

But if the account holder died after Dec. 31, 2019, the SECURE Act (also known as the “Setting Every Community Up for Retirement Enhancement Act of 2019”) outlines different withdrawal rules for those who are defined as eligible designated beneficiaries.

What Is an Eligible Designated Beneficiary?

To be an eligible-designated beneficiary, and be allowed to take RMDs based on your own life expectancy, an individual must be one of the following:

• A surviving spouse

• No more than 10 years younger than the original account holder at the time of their death

• Chronically ill

• Disabled

• A minor child

Individuals who are not eligible-designated beneficiaries must distribute (i.e. withdraw) all the funds in the account by December 31st of the 10th year of the account owner’s death.

Eligible-designated beneficiaries are exempt from the 10-year rule: With the exception of minor children, they can take distributions over their life expectancy.

Minor children must take any remaining distributions within 10 years after their 18th birthday.

How to Handle Unclaimed Financial Assets

What if someone dies, leaving a 401(k) or other assets, but without a will or other legally binding document outlining the distribution of those assets?

That money, or the assets in question, may become “unclaimed” after a designated period of time. Unclaimed assets may include money, but can also refer to bank or retirement accounts, property (e.g. real estate or vehicles), physical assets such as jewelry.

Unclaimed assets are often turned over to the state where that person lived. However, it is possible for relatives to claim the assets through the appropriate channels. In most cases, it’s incumbent on the claimant to provide supporting evidence for their claim, since the deceased did not leave a will or other documentation officially bequeathing the money to that person.

The Takeaway

Inheriting a 401(k) can be a wonderful and sometimes unexpected financial gift. It’s also a complicated one. For anyone who inherits a 401(k) — spouse or otherwise — it can be helpful to review the options for what to do with the account, in addition to the rules that come with each choice.

In some cases, the beneficiary may have to take required distributions (withdrawals) based on their age. In some cases, those required withdrawals may be waived. In almost all cases, withdrawals from the inherited 401(k) will be taxed at the heir’s marginal tax rate.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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