May
18
2024

What Is Private Credit?

By | Growing Wealth, invest, Investing | Comments Off on What Is Private Credit?

Private credit refers to lending from non-bank financial institutions. Also referred to as direct lending, private credit allows borrowers (typically smaller to mid-sized businesses) to seek financing through avenues other than a standard bank loan.

This type of arrangement can remove barriers to funding for businesses while creating opportunities for investors, as a type of alternative investment. Private credit funds allow institutional and individual investors to pool capital that is used to extend loans and generate returns through interest on those loans.

Key Points

•   Private credit refers to lending from non-bank financial institutions, providing financing options for businesses outside of traditional bank loans.

•   Private credit investments can include senior lending, junior debt, mezzanine debt, distressed credit, and specialty financing, each with different risk levels and repayment priorities.

•   Private credit offers potential benefits such as income and return potential, diversification, and supporting business growth.

•   However, investing in private credit carries risks, including borrower default, illiquidity, and potential challenges in underwriting and due diligence.

•   Retail investors can access private credit through private credit funds, but eligibility criteria, such as being an accredited investor, may apply.

What Are the Different Types of Private Credit?

Private credit investments can adhere to various investment strategies, each offering a different level of risk and rewards. Within a capital structure, certain types of private credit take precedence over others regarding the order in which they’re repaid.

Senior Lending

In a senior lending arrangement, secured loans are made directly to non-publicly traded, middle-market companies. These loans sit at the top of the capital structure or stack and assume priority status for repayment should the borrowing company file for bankruptcy protection.

Senior debt tends to have lower interest rates than other types of private credit arrangements since the loan is secured by business collateral. That means returns may also be lower, but the preferred repayment status reduces credit risk for investors.

Should the borrowing company fail, senior loans would hold an initial claim on the business’s assets. Those may include cash reserves, equipment and property, real estate, and inventory. That significantly reduces the risk of investors losing their entire investment in the event of bankruptcy.

Junior Debt

Junior or subordinated debt is debt that follows behind senior lending obligations in the capital stack. Loans are made directly to businesses with rates that are typically higher than those assigned to senior debt. Junior debt is most often unsecured though lenders can impose second lien requirements on business assets.

Investors may generate stronger returns from junior debt, but the risk is correspondingly higher. Should the borrowing business go bankrupt, junior debts would only be repaid once senior financing obligations have been satisfied.

Mezzanine Debt

Mezzanine debt is a private credit term that’s often used interchangeably with junior debt, but it has a slightly different meaning. In mezzanine lending, the lender may have the option to convert debt to equity if the company defaults on repayment. There may be some collateral offered but lenders also consider current and future cash flows when making credit decisions.

Compared to junior or senior debt, mezzanine debt is riskier but it has the potential to produce higher yields for investors as the interest rates are usually higher. The risk to borrowers is that if the company defaults, they’ll be forced to give up an ownership share in the business.

Distressed Credit

Distressed credit is extended to companies that are experiencing financial or operational stress and may be unable to obtain financing elsewhere. The obvious benefit to investors is the possibility of earning much higher returns since this type of private credit generally carries higher rates. However, that’s balanced by a greater degree of risk.

Risk may be mitigated if the company can effectively utilize private credit capital to restructure and stabilize cash flow. Should the company eventually file for bankruptcy protection, distressed debt investors would take precedence over equity holders for repayment.

Special Financing

Specialty financing refers to lending that serves a specific purpose and doesn’t fit within the confines of traditional bank lending. This type of private credit is also referred to as asset-based financing since lending arrangements typically involve the acquisition of an asset that is used as collateral for the loan.

Equipment financing is one example. Say that a construction business needs to purchase a new backhoe. They could get an equipment loan to buy what they need, using the backhoe they’re purchasing to secure it.

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Start trading funds that include commodities, private credit, real estate, venture capital, and more.

Potential Benefits of Investing in Private Credit

Private credit investing can be an attractive option for investors who are interested in diversifying their portfolios with alternative investments. Here are some of the primary reasons to consider private credit as an asset class.

Income Potential

Private credit can provide investors with current income if they’re collecting interest payments and fees on an ongoing basis. The more private credit investments someone holds in their portfolio, the more opportunities they have to generate regular cash flow.

Return Potential

Investing in private credit may deliver returns at a level well above what you might get with a standard portfolio of stocks, bonds, and mutual funds. The nature of private credit is such that borrowers may expect to pay higher interest rates than they would for a traditional bank loan. That, in part, is a trade-off since private credit offers lower levels of liquidity than other investments.

Investors benefit as long as borrowers repay their debt obligations on time. The exact return profile of any private credit investment depends on the interest rate the lender requires the borrower to pay, which can directly correspond to their risk profile and where the debt is situated in the capital stack.

Diversification

Like other alternative investments, private credit can introduce a new dimension into a portfolio, allowing for greater diversification of that portfolio. Private credit tends to have a lower correlation with market movements than stocks or bonds, which may help insulate investors against market volatility, to a degree.

Additionally, investors have an opportunity to diversify within the private credit segment of their portfolios. For example, an investor may choose to invest in a mix of senior lending, mezzanine debt, and specialty financing to spread out risk and generate varying levels of returns.

What Are the Risks of Investing in Private Credit?

Like any other investment, private credit can present certain risks to investors. Weighing those risks against the potential upsides can help determine whether private credit is the right investment for you.

Borrower Default

Perhaps the most significant risk factor associated with private credit investments is borrower default. Should the borrower fail to repay their debt obligations, that can put the value of your investment in question. In a worst-case scenario, you may be forced to wait out the resolution of a bankruptcy filing to determine how much of your investment you’ll be able to recover.

Again, it’s important to remember that borrowers who seek private credit may have been turned down for traditional bank financing elsewhere. So, your credit risk has already increased. If you have a lower risk tolerance overall, private credit may not be the best fit for your portfolio.

Illiquidity

Private credit investments are less liquid than other types of investments since they operate on a fixed term. It can be difficult to exit these investments ahead of schedule without facing the possibility of a sizable loss if you’re forced to sell at a discount.

In that sense, private credit investments are similar to bonds which also lock investors in for a preset period. For that reason, it’s important to consider what type of time frame you’re looking for when making these investments.

Recommended: Short-Term vs Long-Term Investments

Underwriting

While banks often have strict underwriting requirements that borrowers are expected to meet, private credit allows for more flexibility. Lenders can decide who to extend credit to, what collateral to require if any, and what terms a borrower must agree to as a condition of getting a loan.

That’s good for borrowers who may have run into trouble getting loans elsewhere, but it ups the risk level for investors. If you’re investing in private credit funds that are less transparent when it comes to sharing their underwriting processes or detailed information about the borrower, that can make it more difficult to make an informed decision about your investments.

Ways to Invest in Private Credit

Private credit has traditionally been the domain of institutional investors, though retail investors may be able to unlock opportunities through private credit funds.

These funds allow investors to pool their capital together to make investments in private credit, similar to the way a traditional mutual fund or hedge fund might work. You’ll need to find an investment company or bank that offers access to private credit investments, including private credit funds, funds if you’re interested in adding them to your portfolio.

One caveat is that private credit investments may only be open to selected retail investors, specifically, those who meet the SEC’s definition of an accredited investor, who is someone that fits the following criteria:

•   Has a net worth of $1 million or more, excluding their primary residence

•   Reported income over $200,000 individually or $300,000 with a spouse or partner for the previous two years and expects to have income at the same level or higher going forward

Investment professionals who hold a Series 7, Series 65, or Series 82 securities license also qualify as accredited.

💡 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.

Who Should Invest in Private Credit?

Given its risk profile, private credit may not be an appropriate investment choice for everyone. In terms of who might consider private credit investments, the list can include people who:

•   Are interested in diversifying their portfolios with alternative investments.

•   Can comfortably assume a higher level of risk for an opportunity to generate higher returns.

•   Understand the time commitment and the risks involved.

•   Would like to support business growth through their investments.

•   Meet the requirements for a private credit investment (i.e., accredited status, minimum buy-in, etc.)

Private credit investments may be less suitable for someone who’s hoping to create some quick returns or is more risk-averse.

How Does Private Credit Fit in Your Portfolio?

If you’re able to invest in private credit, it’s important to consider how much of your portfolio you’d like to allocate to it. While you might be tempted to devote a larger share of your investment dollars to private credit, it’s wise to consider how doing so might affect your overall risk exposure.

Choosing a smaller allocation initially can allow you to test the waters and determine whether private credit investments make sense for you. That can also minimize the amount of risk you’re taking on as you explore new territory with your investments.

When evaluating private credit funds, it’s helpful to consider the fund manager’s track record and preferred investment strategy. A more aggressive strategy may yield better returns but it may mean accepting more risk, which you might be uncomfortable with. Also, take a look at what you might pay in management fees as those can directly impact your net return on investment.

The Takeaway

Private credit is a form of financing sought outside of traditional bank loans. For investors, it may be classified as an alternative investment, and it has its pros and cons in an investor’s portfolio.

Private credit can benefit investors and businesses alike, though in different ways. If you’re an accredited investor, you may consider private credit along with other alternative investments to round out your portfolio. Evaluating the risks and the expected rewards from private credit investing can help you decide if it’s worth exploring further.

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).

Invest in alts to take your portfolio beyond stocks and bonds.

FAQ

Is Investing in Private Credit Worth It?

Investing in private credit could be worth it if you’re comfortable with the degree of risk that’s involved and the expected holding period of your investments. Private credit investing can deliver above-average returns while allowing you to diversify beyond stocks and bonds with an alternative asset class.

What’s the Difference Between Private Credit and Public Credit?

Public credit refers to debt that is issued or traded in public markets. Corporate bonds and municipal bonds are two examples of public credit. Private credit, on the other hand, originates with private, non-bank lenders and is extended to privately-owned businesses.

Why is Private Credit Popular?

Private credit is popular among businesses that need financing because it can offer fewer barriers to entry than traditional bank lending. Among investors, private credit has gained attention because of its return potential and its use as a diversification tool.

What Is the Average Return on Private Credit?

Returns on private credit investments can vary based on the nature of the loan agreement. When considering private credit investments it’s important to remember that the higher the return potential, the greater the risk you may be taking on.

Is Private Credit a Loan?

Private credit arrangements are loans made between a non-bank entity and a privately owned business. These types of loans allow companies to raise the capital they need without having to meet the requirements that traditional bank lenders set for loans.

Photo credit: iStock/Adene Sanchez

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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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.


An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
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May
18
2024
What Is The Difference Between a Pension and 401(k) Plan?

401(k) vs Pension Plan: Differences and Which is Better For You

By | Growing Wealth, invest, Preparing for Retirement | Comments Off on 401(k) vs Pension Plan: Differences and Which is Better For You

A 401(k) plan is a retirement savings plan in which employees contribute to a tax-deferred account via paycheck deductions (and often with an employer match). A pension plan is a different kind of retirement savings plan in which a company sets money aside to give to future retirees.

Over the past few decades, defined-contribution plans like the 401(k) have steadily replaced pension plans as the private-sector, employer-sponsored retirement plan of choice. While both a 401(k) plan and a pension plan are employer-sponsored retirement plans, there are some significant differences between the two.

Here’s what you need to know about a 401(k) vs. pension.

Key Points

•   A 401(k) is primarily funded by employee contributions, often matched by employers, whereas pensions are predominantly employer-funded.

•   Pensions guarantee a fixed income for life, unlike 401(k)s where the value depends on contributions and investment performance.

•   Employees can choose their 401(k) investments, but employers control pension fund investments.

•   Contribution limits for 401(k)s in 2024 are $23,000, or $30,500 for those 50 and older, with higher total limits including employer contributions.

•   Pensions offer a stable retirement income, but 401(k)s provide more control over investment choices and potential growth.

What Is the Difference Between a Pension and a 401(k)?

The main distinction between a 401(k) vs. a pension plan is that pension plans are largely employer driven, while 401(k)s are employee driven.

These are some of the key differences between the two plans.

Pension

 401(k)
Funding Typically funded by employers Funded mainly by the employee; employer may offer a partial matching contribution
Contributions No more than $275,000 in 2024 or 100% of employee’s average compensation for the highest 3 consecutive years $23,000 ($30,500 for those 50 and up) for 2024. Contributions from employee and employer cannot exceed $69,000 (or $76,500 for those 50 and up) in 2024
Investments Employers choose the investments for the plan Employees choose the investments from a list of options
Value of the Plan Set amount designed to be guaranteed for life Determined by how much the employee contributes, the investments they make, and the performance of the investments

Funding

Employees typically fund 401(k) plans through regular contributions from their paychecks to help save for retirement, while employers typically fund pension plans.

Investments

Employees can choose investments (from several options) in their 401(k). Employers choose the investments that fund a pension plan.

Value

The value of a 401(k) plan at retirement depends on how much the employee has saved, in addition to the performance of the investments over time. Pensions, on the other hand, are designed to guarantee an employee a set amount of income for life.


💡 Quick Tip: The advantage of opening an IRA and a tax-deferred account like a 401(k) or traditional IRA is that by the time you retire, you’ll have tax-free income from your Roth, and taxable income from the tax-deferred account. This can help with tax planning.

Pension Plan Overview

A pension plan is a type of retirement savings plan where an employer contributes funds to an investment account on behalf of their employees. The earnings are paid out to the employees once they retire.

Types of Pension Plans

There are two common types of pension plans:

•   Defined-benefit pension plans, also known as traditional pension plans, are the most common type of pension plans. These employer-sponsored retirement investment plans are designed to guarantee the employee will receive a set benefit amount upon retirement (usually calculated with set parameters, i.e. employee earnings and years of service). Regardless of how the investment pool performs, the employer guarantees pension payments to the retired employee. If the plan assets aren’t enough to pay out to the employee, the employer is typically on the hook for the rest of the money.

According to the IRS, contributions to a defined-benefit pension plan cannot exceed 100% of the employee’s average compensation for the highest three consecutive calendar years of their employment or $265,000 for tax year 2023 and $275,000 for 2024.

•   Defined-contribution pension plans are employer-sponsored retirement plans to which employers make plan contributions on their employee’s behalf and the benefit the employee receives is based solely on the performance of the investment pool. Meaning: There is no guarantee of a set monthly payout.

Like 401(k) plans, employees can contribute to these plans, and in some cases, employers match the contribution made by the employee. Unlike defined-benefit pension plans, however, the employee is not guaranteed a certain amount of money upon retirement. Instead, the employee receives a payout based on the performance of the investments in the fund.

Recommended: What Is a Money Purchase Pension Plan (MPPP)?

When it comes to pension plan withdrawals, employees who take out funds before the age of 59 ½ must pay a 10% early withdrawal penalty as well as standard income taxes. This is similar to the penalties and taxes associated with early withdrawal from a traditional 401(k) plan.

Pros and Cons

There are benefits to and drawbacks of pension plans. It’s important to understand both in order to maximize your participation in the plan.

Advantages of a pension plan include:

Funded by employers

For employees, a pension plan is retirement income from your employer. In most cases, an employee does not need to contribute to a defined-benefit pension plan in order to get consistent payouts upon retirement.

Higher contribution limits

When compared to 401(k)s, defined-contribution pension plans have significantly higher contribution limits and, as such, present an opportunity to set aside more money for retirement.

A set amount in retirement

A pension plan typically provides employees with regular fixed payments in retirement,usually for life.

Disadvantages of a pension plan include:

Lack of control

Employees can’t choose how the money in a pension plan is invested. If the investments don’t pan out, the plan could struggle to pay out the funds.

Vesting

Employees may need to work for the employer for a set number of years to become fully vested in the plan. If you leave the company before then, you might end up forfeiting the pension funds. Find out what the vesting schedule is for your pension plan.

Earnings and years employed

How much an employee gets in retirement with a pension plan generally depends on their salary and how long they work for the employer.

401(k) Overview

A traditional 401(k) plan is a tax-advantaged defined-contribution plan where workers contribute pre-tax dollars to the investment account via automatic payroll deductions. These contributions are sometimes fully or partially matched by their employers, and withdrawals are taxed at the participant’s marginal tax rate.

With a 401(k), employees and employers may both make contributions to the account (up to a certain IRS-established limit), but employees are responsible for selecting the specific investments. They can typically choose from offerings from the employer, which may include a mixture of stocks and bonds that vary in levels of risk depending on when they plan to retire.

Recommended: 401(a) vs 401(k): What’s the Difference?

Contribution Limits and Withdrawals

To account for inflation, the IRS periodically adjusts the maximum amount an employer or employee can contribute to a 401(k) plan.

•   For 2024, annual employee contributions can’t exceed $23,000 for workers under 50, and $30,500 for workers 50 and older (this includes a $7,500 catch-up contribution). The total annual contribution by employer and employee in 2024 is capped at $69,000 for workers under 50, and $76,500 for workers 50 and over.

•   For 2023, annual employee contributions can’t exceed $22,500 for workers under 50, and $30,000 for workers 50 and older (this includes a $7,500 catch-up contribution). The total annual contribution paid by employer and employee in 2023 is capped at $66,000 for workers under 50, and $73,500 for workers 50 and over.

Some plans allow employees to make additional after-tax contributions to their 401(k) plan, within the contribution limits outlined above.

•   Money can be withdrawn from a 401(k) in retirement without penalties. But taxes will be owed on the funds withdrawn. The IRS considers the removal of 401(k) funds before the age of 59 ½ an “early withdrawal.” The penalty for removing funds before that time is an additional tax of 10% of the withdrawal amount (there are exceptions, notably a hardship distribution, where plan participants can withdraw funds early to cover “immediate and heavy financial need”).

Pros and Cons

While a 401(k) plan might not offer as clearly-defined a retirement savings picture as a pension plan, it still comes with a number of upsides for participants who want a more active role in their retirement investments.

Advantages of a 401(k) include:

Self-directed investment opportunities

Unlike employer-directed pension plans, in which the employee has no say in the investment strategy, 401(k) plans offer participants more control over how much they invest and where the money goes (within parameters set by their employer). Plans typically offer a selection of investment options, including mutual funds, individual stocks and bonds, exchange traded funds (ETFs).

Tax advantages

Contributions to a 401(k) come from pre-tax dollars through payroll deductions, reducing the gross income of the participant, which may allow them to pay less in income taxes. Also, 401(k) contributions and earnings in the plan may grow tax-deferred.

Employer matching

Many 401(k) plan participants are eligible for an employer match up to a certain amount, which essentially means free money.

Disadvantages of a 401(k) include:

No guaranteed amount in retirement

How much you have in your 401(k) by retirement depends on how much you contributed to the plan, whether your employer offered matching funds, and how the investments you chose fared.

Contributions are capped

The amount you can contribute to a 401(k) annually is capped by the IRS, as described above.

Less stability

How the market performs generally affects the performance of 401(k) investments. That could make it difficult to know how much money you’ll have for retirement, which could complicate retirement planning.


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

Which Is Better, a 401(k) or a Pension Plan?

When considering a 401(k) vs. pension, most people prefer the certainty that comes with a pension plan.

But for those who seek more control over their retirement savings and more investment vehicles to choose from, a 401(k) plan could be the more advantageous option.

In the case of the 401(k), it really depends on how well the investments perform over time. Without the safety net of guaranteed income that comes with a pension plan, a poorly performing 401(k) plan has a direct effect on a retiree’s nest egg.

Did 401(k)s Replace Pension Plans?

The percentage of private sector employees whose only retirement account is a defined benefit pension plan is just 4% today, versus 60% in the early 1980s. The majority of private sector companies stopped funding traditional pension plans in the last few decades, freezing the plans and shifting to defined-contribution plans like 401(k)s.

When a pension fund isn’t full enough to distribute promised payouts, the company still needs to distribute that money to plan participants. In several instances in recent decades, pension fund deficits for large enterprises like airlines and steel makers were so enormous they required government bailouts.

To avoid situations like this, many of today’s employers have shifted the burden of retirement funding to their workers.

What Happens to a 401(k) or Pension Plan If You Leave Your Job?

With a 401(k), if you leave your job, you can take your 401(k) with you by rolling it over to your new employer’s 401(k) plan or into an IRA. The process is fairly easy to do.

If you leave your job and you have a pension plan, however, the plan generally stays with your employer. You’ll need to keep track of it through the years and then apply in retirement to begin receiving your money.

The Takeaway

Pension plans are employer-sponsored, employer-funded retirement plans that are designed to guarantee a set income to participants for life. On the other hand, 401(k) accounts are employer-sponsored retirement plans through which employees make their own investment decisions and, in some cases, receive an employer match in funds. The post-retirement payout varies depending on market fluctuations.

While pension plans are far more rare today than they were in the past, if you have worked at a company that offers one, that money will still come to you after retirement even if you change jobs, as long as you stayed with the company long enough for your benefits to vest.

Some people have both pensions and 401(k) plans, but there are also other ways to take an active role in saving for retirement. An IRA is an alternative to 401(k) and pension plans that allows anyone to open a retirement savings account. IRAs have lower contribution limits but a larger selection of investments to choose from. And it’s possible to have an IRA in addition to a 401(k) or pension plan.

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

Can you have both a 401(k) and a pension plan?

Yes. An individual can have both a pension plan and a 401(k) plan, though the two plans may not be from the same employer. If an employee leaves a company after becoming eligible for a pension and opens a 401(k) with a new employer, their previous employer will still typically maintain their pension. An employee can access the pension funds by applying for them in retirement.

How much should I put in my 401k if I have a pension?

If you have both a pension and a 401(k), it’s wise to contribute as much as you can to your 401(k) up to the annual contribution limit. While a pension can help supplement your retirement income, it may not be enough to cover all your retirement expenses, so contributing to your 401(k) can help fill the gap. One rule of thumb says to contribute at least 10% of your salary to a 401(k) if possible to help ensure that you’ll have enough savings for retirement.

Photo credit: iStock/Sam Edwards

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

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

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

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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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May
18
2024

Mega Backdoor Roths, Explained

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Mega Backdoor Roths, Explained

For those who earn an income that makes them ineligible to contribute to a Roth IRA, a mega backdoor Roth IRA may be an effective tool to help them save for retirement, and also get a potential tax break in their golden years.

Only a certain type of individual will likely choose to employ a mega backdoor Roth IRA as a part of their financial plans. And there are a number of conditions that have to be met for mega backdoor Roth to be possible.

Read on to learn what mega backdoor Roth IRAs are, how they work, and the important details that investors need to know about them.

Key Points

•   A mega backdoor Roth IRA allows high earners to save for retirement with potential tax benefits, despite income limits on traditional Roth IRAs.

•   This strategy involves making after-tax contributions to a 401(k) and then transferring these to a Roth IRA.

•   Eligibility for a mega backdoor Roth depends on specific 401(k) plan features, including the allowance of after-tax contributions and in-service distributions.

•   Contribution limits for 401(k) plans in 2023 allow for significant after-tax contributions, enhancing the potential retirement savings.

•   The process, while beneficial, can be complex and may require consultation with a financial professional to navigate potential hurdles.

What Is a Mega Backdoor Roth IRA?

The mega backdoor Roth IRA is a retirement savings strategy in which people who have 401(k) plans through their employer — along with the ability to make after-tax contributions to that plan — can roll over the after-tax contributions into a Roth IRA.

But first, it’s important to understand the basics of regular Roth IRAs. A Roth IRA is a retirement account for individuals. For tax year 2023, Roth account holders can contribute up to $6,500 per year (or $7,500 for those 50 and older) of their post-tax earnings. That is, income tax is being paid upfront on those earnings — the opposite of a traditional IRA. For 2024, they can contribute up to $7,000 (or $8,000 for those 50 and older).

Individuals can withdraw their contributions at any time, without paying taxes or penalties. For that reason, Roth IRAs are attractive and useful savings vehicles for many people.

But Roth IRAs have their limits — and one of them is that people can only contribute to one if their income is below a certain threshold.

In 2023 the limit is $138,000 for single people (people earning more than $138,000 but less than $153,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $218,000 (or between $218,000 to $228,000 to contribute a reduced amount).

In 2024 the limit is $146,000 for single people (people earning more than $146,000 but less than $161,000 can contribute a reduced amount); for married people who file taxes jointly, the limit is $230,000 (or between $230,000 to $240,000 to contribute a reduced amount).

💡 Quick Tip: Did you know that you must choose the investments in your IRA? Once you open a new IRA and start saving, you get to decide which mutual funds, ETFs, or other investments you want — it’s totally up to you.

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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.

How Does a Mega Backdoor Roth Work?

When discussing a mega backdoor Roth, it’s helpful to understand how a regular backdoor Roth IRA works. Generally, individuals with income levels above the thresholds mentioned who wish to contribute to a Roth IRA are out of luck. However, there is a workaround: the backdoor Roth IRA, a strategy that allows high-earners to fund a Roth IRA account by converting funds in a traditional IRA (which has no limits on a contributors’ earnings) into a Roth IRA. This could be useful if an individual expects to be in a higher income bracket at retirement than they are currently.

Mega backdoor Roth IRAs involve 401(k) plans. People who have 401(k) plans through their employer — along with the ability to make after-tax contributions to that plan — can potentially roll over up to $46,000 in 2024, and $43,500 in 2023, in after-tax contributions into a Roth IRA. That mega Roth transfer limit has the potential to boost an individual’s retirement savings.

Example Scenario: How to Pull Off a Mega Backdoor Roth IRA

The mega backdoor Roth IRA process is pretty much the same as that of a backdoor Roth IRA. The key difference is that while the regular backdoor involves converting funds from a traditional IRA into a Roth IRA, the mega backdoor involves converting after-tax funds from a 401(k) into a Roth IRA.

Whether a mega backdoor Roth IRA is even an option will depend on an individual’s specific circumstances. These are the necessary conditions that need to be in place for someone to try a mega backdoor strategy:

•   You have a 401(k) plan. People hoping to enact the mega backdoor strategy will need to be enrolled in their employer-sponsored 401(k) plan.

•   You can make after-tax contributions to your 401(k). Determine whether an employer will allow for additional, after-tax contributions.

•   The 401(k) plan allows for in-service distributions. A final piece of the puzzle is to determine whether a 401(k) plan allows non-hardship distributions to either a Roth IRA or Roth 401(k). If not, that money will remain in the 401(k) account until the owner leaves the company, with no chance of a mega backdoor Roth IRA move.

If these conditions exist, a mega backdoor strategy should be possible. Here’s how the process would work:

Open a Roth IRA — so there’s an account to transfer those additional funds to.

From there, pulling off the mega backdoor Roth IRA strategy may sound deceptively straightforward — max out 401(k) contributions and after-tax 401(k) contributions, and then transfer those after-tax contributions to the Roth IRA.

But be warned: There may be many unforeseen hurdles or expenses that arise during the process, and for that reason, consulting with a financial professional to help navigate may be advisable.

Who Is Eligible for a Mega Backdoor Roth

Whether you might be eligible for a mega backdoor Roth depends on your workplace 401(k) retirement plan. First, the plan would need to allow for after-tax contributions. Then the 401(k) plan must also allow for in-service distributions to a Roth IRA or Roth 401(k). If your 401(k) plan meets both these criteria, you should generally be eligible for a mega backdoor Roth IRA.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Contribution Limits

If your employer allows for additional, after-tax contributions to your 401(k), you’ll need to figure out what your maximum after-tax contribution is. The standard 401(k) contribution limit for all types of contributions to a 401(k) (meaning employee, employer, and after-tax contributions) in 2023 is $22,500 (or $30,000 for those 50 and older). For 2024, the limit is $23,000 (or $30,500 for those 50 and older).

The IRS allows up to $66,000, or $73,500 including catch-up contributions for those 50 and up, in total contributions to a 401(k) in 2023. For 2024, the total limits are $69,000, or 76,500 including catch-up contributions for those 50 and up.

So how much can you contribute in after-tax funds? Here’s an example. Say you are under age 50 and you contributed the max of $22,500 to your 401(k) in 2023, and your employer contributed $8,000, for a total of $30,500. That means you can contribute up to $35,500 in after-tax contributions to reach the total contribution level of $66,000.

Is a Mega Backdoor Roth Right For Me?

Given that this Roth IRA workaround has so many moving parts, it’s worth thinking carefully about whether a mega backdoor Roth IRA makes sense for you. These are the advantages and disadvantages.

Benefits

The main upside of a mega backdoor Roth is that it allows those who are earning too much to contribute to a Roth IRA a way to potentially take advantage of tax-free growth.

Plus, with a mega backdoor Roth IRA an individual can effectively supercharge retirement savings because more money can be stashed away. It may also offer a way to further diversify retirement savings.

Downsides

The mega backdoor Roth IRA is a complicated process, and there are a lot of factors at play that an individual needs to understand and stay on top of.

In addition, when executing a mega backdoor Roth IRA and converting a traditional IRA to a Roth IRA, it could result in significant taxes, as the IRS will apply income tax to contributions that were previously deducted.

The Future of Mega Backdoor Roths

Mega backdoor Roths are currently permitted as long as you have a 401(k) plan that meets all the criteria to make you eligible.

However, it’s possible that the mega backdoor Roth IRA could go away at some point. In prior years, there was some legislation introduced that would have eliminated the strategy, but that legislation was not enacted.

The Takeaway

Strategies like the mega backdoor Roth IRA may be used by some investors to help achieve their retirement goals — as long as specific conditions are met, including having a 401(k) plan that accepts after-tax contributions.

While retirement may feel like far off, especially if you’re early in your career or still relatively young, it’s generally wise to start thinking about it sooner rather than later.

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

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FAQ

Are mega backdoor Roths still allowed in 2023?

Yes, mega backdoor Roths are still permissible in 2023.

Is a mega backdoor Roth worth it?

Whether a mega backdoor Roth is worth it depends on your specific situation. It may be worth it for you if you earn too much to otherwise be eligible for a Roth IRA and if you have a 401(k) plan that allows you to make after-tax contributions.

Is a mega backdoor Roth legal?

Yes, a mega backdoor Roth IRA is currently legal.

Are mega backdoor Roths popular among Fortune 500 companies?

A number of Fortune 500 companies allow the after-tax contributions to a 401(k) that are necessary for executing a mega backdoor Roth IRA.

What is a super backdoor Roth?

A super backdoor Roth IRA is the same thing as a mega backdoor Roth IRA. It is a strategy in which people who have 401(k) plans through their employer — along with the ability to make after-tax contributions to that plan — can roll over the after-tax contributions into a Roth IRA.

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

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

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

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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.
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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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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Dollar Cost Averaging: Definition, Formula, Examples

By | Growing Wealth, invest, Investing | No Comments

Dollar cost averaging is a way to manage volatility as you continue to save and build wealth. Volatility is a natural part of investing. Virtually every part of the market is impacted by volatility in one way or another — thus, nearly every investor must contend with inevitable price fluctuations, and one way to do this is by using dollar cost averaging.

With this strategy, you decide on the securities you want to purchase, and the dollar amount you want to invest each month (or the interval you choose), and then ideally automate that amount to be invested on a regular basis.

Key Points

•   Dollar cost averaging (DCA) is an investment strategy that helps manage volatility by investing a fixed dollar amount regularly.

•   DCA involves buying securities at regular intervals, regardless of market prices, to avoid trying to time the market.

•   Dollar cost averaging works by investing the same amount consistently, resulting in buying more shares when prices are low and fewer when prices are high.

•   The strategy can help investors stay the course and avoid emotional decision-making based on market fluctuations.

•   While dollar cost averaging has benefits like consistency and automation, it may not maximize returns compared to lump-sum investing and may not address the need for portfolio rebalancing.

What Is Dollar Cost Averaging (DCA)?

Dollar cost averaging is a basic investment strategy where you buy a fixed dollar amount of an investment on a regular basis (e.g. weekly or monthly). The goal is not to invest when prices are high or low, but rather to keep your investment steady and repeatable, and thereby avoid the temptation to time the market.

That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time, so that, effectively, when prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among investors).

How Dollar Cost Averaging Works

Dollar cost averaging works by making more or less the same investment over and over on a repeating basis. For an investor, it may be as simple as investing $5 in Stock A every Monday, or something similar, no matter what’s going on in the market.

That way, you’re investing the same amount whether the market goes up, down, or sideways. For example, if you invest $100 in Stock A at $20 per share, you get 5 shares. The following month, say, the price has dropped to $10 per share, but you stay the course and invest $100 in Stock A — and you get 10 shares.

Over time, the average cost of your investments – the dollar amount you’ve paid – may end up being a little lower, which can benefit the overall value of your portfolio.

Example of Dollar Cost Averaging

Here’s an example of how dollar cost averaging might look in practice.

Investor A might buy 20 shares of an exchange-traded fund (ETF) at $50 per share, for $1,000 total. This would be investing a lump-sum, rather than using a dollar cost averaging strategy.

Investor B, however, decides to use a dollar cost averaging strategy.

•   The first month, Investor B buys shares of the same ETF at $50/share, but spends $300 and gets six shares.

•   The next month the ETF price drops to $30 per share. So Investor B once again invests $300 and now gets 10 shares.

•   By the third month, the ETF is worth $50 per share again, and their regular $300 investment gets them six shares.

Investor B now owns 22 shares of the ETF, at an average price of $40.90 per share, compared with Investor A, who paid $1,000 ($50 per share for 20 shares) in one lump sum.

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Benefits and Disadvantages of DCA

Every strategy has its pros and cons, of course. Here are some of the advantages and disadvantages of DCA.

Dollar Cost Averaging Benefits

DCA forces you to stay the course, regardless of volatility. It keeps you from trying to “time the market.” By investing the same amount of money every month, you will buy more shares when the market is down and fewer shares when the market is up. You’re not investing with your emotions, which can lead to impulsive choices.

DCA allows you to “set it and forget it.” Investing the same dollar amount every month is a straightforward strategy, and technology makes it easy to automate. You don’t have to keep your eye on different investments or even market volatility. Just stick to the plan.

You also don’t have to be wealthy in order to use the dollar cost averaging method. You can start small, but all the while, you will be contributing to and growing an investment portfolio.

Dollar Cost Averaging Disadvantages

In some cases, investing a lump sum may net you a higher return over time. Although DCA works well in terms of helping to manage the impact of volatility, the reality is that over the course of many years, the market trends upward, as the average market return shows. Although there are many factors to consider when it comes to investing returns — including the impact of fees, of selling when the market is down and locking in losses, and so forth — the market’s upward trajectory is something to bear in mind.

When you use any kind of “set it and forget it” strategy, you run the risk of missing out on certain market opportunities — and red flags. Although the upside of dollar cost averaging is its consistency, the potential downside is that you may be less aware if there are new opportunities or the need to avoid losses.

Last, dollar cost averaging doesn’t solve the problem of rebalancing — another strategy that’s designed to mitigate volatility.

💡 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.

When to Use Dollar Cost Averaging

There are certain times when dollar cost averaging makes sense, and certain investments that are suited to this strategy.

•   For example, many people believe they need to invest large sums of money to invest successfully. In fact, DCA is evidence that you can invest small amounts, steadily over time, and reap the benefits of market growth.

•   Funds: Mutual funds allow you to purchase a share, which represents a very small allocation of the underlying investment portfolio. This means that you can diversify with much smaller dollar amounts than if you purchased the securities on your own.

•   ETFs (exchange-traded funds): Similar to mutual funds, ETFs provide an opportunity to diversify with smaller dollar amounts. Additionally, ETFs are available to trade throughout the day, generally have low expenses, no investment minimums, and may offer greater tax-efficiency.

The Takeaway

Dollar cost averaging is a fairly straightforward strategy that can help mitigate the impact of volatility on your portfolio, and also help you avoid giving into emotional impulses when it comes to buying or selling. Thus, dollar cost averaging can help you stay in the market, even when it’s fluctuating, with the result that you buy more when prices are low and less when prices are high — but overall, you may end up paying less on average.

But dollar cost averaging isn’t an excuse for literally “setting and forgetting” your portfolio. It’s still important to check on your investments in case there are any new opportunities or bona fide laggards. And once a year, it’s wise to rebalance your portfolio to restore your original asset allocation (unless of course your risk tolerance or goals have changed).

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

Is dollar cost averaging a good idea?

Dollar cost averaging may be a good strategy for many investors to employ, as it has certain advantages that beginner investors, in particular, may use to their benefits. But it’s important to consider the downsides or disadvantages, too.

When is the best time to do dollar cost averaging?

There isn’t really a bad time to use a dollar cost averaging strategy, as such, investors interested in implementing one could likely do it at nearly any time.

How often should you do dollar-cost averaging?

When using a dollar cost averaging strategy, investors can choose a cadence that is best suited to their overall financial goals. For some, it may involve weekly investments, while it may involve daily or monthly investments for others.

Where is dollar-cost averaging most commonly done?

Dollar cost averaging is a strategy commonly used in retirement plans, such as 401(k)s, although it can be used in various types of investment accounts.

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.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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Commodity ETF: What It Is and Examples

By | Growing Wealth, invest, Investing | Comments Off on Commodity ETF: What It Is and Examples

Commodity exchange-traded funds are ETFs that invest in hard and soft commodities. Commodities are raw materials — e.g. grain, precious metals, livestock, energy products — used for direct consumption or to produce other goods. Crude oil, corn, and copper are examples of commonly traded commodities.

Investing in a commodity ETF can offer exposure to one or more types of commodities within a single vehicle. There are different types of commodity ETFs to choose when building a diversified portfolio.

Key Points

•   Commodity ETFs are exchange-traded funds that invest in hard and soft commodities like grain, precious metals, livestock, and energy products.

•   They offer exposure to commodities within a single investment vehicle and can be bought and sold on a brokerage account.

•   Commodity ETFs can be physically backed, futures-based, or focused on commodity companies.

•   Pros of commodity ETFs include diversification, inflationary protection, and access to commodities, while cons include volatility and lack of dividends.

What Is a Commodity ETF?

A commodity ETF is an exchange-traded fund that specifically invests in commodities or companies involved in the extraction or production processing of commodities.

An ETF or exchange-traded fund combines features of mutual funds and stocks, in that they offer exposure to an underlying group of assets (e.g. stocks, bonds, derivatives). But unlike mutual funds, ETFs trade on an exchange.Whether you have broad or narrow exposure to commodities within a single ETF can depend on how it’s managed and its objectives.

Like other exchange-traded funds, commodity ETFs can be bought and sold inside a brokerage account. Each fund can have an expense ratio, which determines the cost of owning it annually, and brokerages may charge transaction fees when you buy or sell shares.

Commodity ETFs fall under the rubric of alternative investments, which also applies to private equity and hedge funds.

💡 Quick Tip: Alternative investments provide exposure to sectors outside traditional asset classes like stocks, bonds, and cash. Some of the most common types of alternative investments include commodities, real estate, foreign currency, private credit, private equity, collectibles, and hedge funds.

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Start trading funds that include commodities, private credit, real estate, venture capital, and more.

How Do Commodity ETFs Work?

Commodity ETFs are pooled investments, with multiple investors owning shares. The fund manager determines which commodities the fund will hold and when to buy or sell holdings within the fund. When you buy shares of a commodity ETF, you invest in everything that’s held within the fund.

In many cases, that includes commodities futures contracts. A commodity futures contract is an agreement to buy or sell a set amount of a commodity at a future date for a specified price. That’s an advantage for investors who may be interested in trading futures but lack the know-how to do so.

A commodity ETF may follow an active or passive management strategy. Many commodity ETFs are structured as index funds. An index fund aims to track and match the performance of an underlying benchmark. These types of commodity ETFs are passively managed.

Actively-managed funds, by comparison, typically aim to outstrip market returns but may entail more risk to investors.

Types of Commodity ETFs

Commodity ETFs aren’t all designed with the same objectives in mind. There are different types of commodity ETFs you might invest in, depending on your goals, diversification needs, and risk tolerance.

Here are some of the most common ETF options commodities investors may choose from.

Physically Backed ETFs

A physically backed ETF physically holds the commodity or commodities it trades. For example, a physically backed ETF that invests in precious metals may store gold, silver, platinum, or palladium bars in a secure vault at a bank.

It’s more common for physically backed ETFs to hold hard commodities like precious metals, since these are relatively easy to transport and don’t have a shelf life expiration date. It’s less likely to see physically backed ETFs that invest in agricultural goods like wheat or corn, as they cannot be stored for extended periods.

Futures-Based ETFs

Futures-based ETFs invest in commodities futures contracts, rather than holding or storing physical commodities. That can reduce the overall management costs, resulting in lower expense ratios for investors.

A futures-based ETF may hold commodities contracts that are close to expiration, then roll them into new contracts before the expiration date. Depending on the price of the new futures contract, this strategy may result in a cost or gain for investors.

Commodity Company ETFs

Commodity company ETFs invest in companies that produce or process commodities. For example, this type of ETF may invest in oil and gas companies, cattle farming operations, or companies that operate palm oil plantations.

These types of commodity ETFs are similar to equity ETFs, since the investment is in the company rather than the commodity itself.

Examples of Commodity ETFs

Commodity ETFs are not always easily identifiable for investors who are new to this asset class. Here are some of the largest commodity ETF options with a focus on mitigating inflation.

•   SPDR Gold Trust (GLD). SPDR Gold Trust is the largest physically backed gold ETF in the world. The ETF trades on multiple stock exchanges globally, including the New York Stock Exchange (NYSE) and the Tokyo Stock Exchange.

•   Energy Select Sector SPDR Fund (XLE). This commodity ETF invests in companies in the energy industry, including oil and gas companies, pipeline companies, and oilfield services providers.

•   Invesco DB Agriculture Fund (DBA). The Invesco DB Agriculture Fund tracks changes in the DBIQ Diversified Agriculture Index Return, plus the interest income from the fund’s holdings. The index itself is composed of agricultural commodity futures.

•   First Trust Global Tactical Commodity Strategy Fund (FTGC). This commodity ETF is an actively managed fund that offers exposure to energy commodities futures.

•   Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC). PDBC is another actively managed ETF that invests in commodity-linked futures and other financial instruments offering exposure to the most in-demand commodities worldwide.

Pros and Cons of Commodity ETFs

Commodity ETFs have pros and cons like any other investment. It’s helpful to weigh both sides when deciding whether this type of alternative investment aligns with your overall wealth-building strategy.

Pros

•   Diversification. Commodity ETFs can offer a very different risk/return profile than traditional stocks or bonds. Commodities in general tend to have a low correlation with stocks, which can help spread out and manage risk in a portfolio.

•   Inflationary protection. Commodities and inflation typically move in tandem. As the prices of consumer goods and services rise, commodity prices also rise. That can offer investors a hedge of sorts against the impacts of inflation.

•   Access. Direct investment in commodities is generally out of reach for the everyday investor, as it may be quite difficult to hold large quantities of physical goods or raw materials. Commodity ETFs offer a simple and convenient package for investing in commodities without taking physical possession of underlying assets.

Cons

•   Volatility. Compared with other investments, commodities can be much more susceptible to pricing fluctuations as supply and demand wax and wane. Unexpected events, such as a global drought or a war that threatens crop yields, can also catch investors off guard.

•   No dividends. While some ETFs may generate current income for investors in the form of dividends, commodity ETFs typically do not. That could make them less attractive if you’re looking for an additional stream of passive income or are interested in reinvesting dividends to buy more shares.

•   Cost. Physically backed ETFs may pay storage fees to hold underlying commodities. Those costs may be folded into the expense ratio, making the ETF more expensive for investors to own.

Why Invest in Commodity ETFs?

Commodity ETFs can be worth investing in for those who wish to hedge against inflation or generate positive returns when stocks appear to be faltering. They also represent a more accessible alternative to direct investment in commodities, which may be difficult for an individual investor to manage.

Investors who are already trading futures contracts or are learning how to do so may appreciate the accessibility that commodity ETFs can offer. Commodity ETFs tend to be highly liquid, meaning it’s relatively easy to buy and sell shares on an exchange, a feature other alternative investments don’t always share.

A commodity ETF may be less suitable for an investor who has a lower risk tolerance or isn’t knowledgeable about the commodities market or futures trading. Talking to a financial advisor can help you determine whether commodities are something you should be pursuing as part of your broader investment plan.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Tax Considerations When Holding Commodity ETFs

The type of commodity ETF you invest in can determine their tax treatment. Futures-based ETFs, for example, may experience losses or gains as contracts that are approaching expiration are replaced with new ones. Additionally, commodity ETFs that hold gold, silver, platinum, or palladium may be subject to a higher capital gains tax rate as the IRS considers precious metals to be collectibles.

Furthermore, the IRS 60/40 rule specifies that 60% of commodity capital gains or losses will be treated as long-term, while 40% are treated as short-term capital gains or losses for tax purposes. This rule does not consider how long you hold the investments, which could make commodity ETFs less favorable for investors who hold assets for one year or more.

It’s also important to be aware of how a commodity ETF is structured legally. Many operate as limited partnerships (LPs), which means they pass on annual income and gains or losses as a return of capital. Investors bear the responsibility of reporting their portion of fund profits and losses on Schedule K-1. If you’re not familiar with how to do so, that could add another wrinkle to your year-end tax prep.

The Takeaway

Adding a commodity ETF or two to your portfolio may appeal to you if you’re hoping to add some diversification to your holdings, and are comfortable with a potentially more volatile investment. When deciding which commodity ETFs to invest in, it’s wise to consider the underlying investments and the fund’s overall management strategy, as well as the fees you’ll pay to own it.

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).


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FAQ

Why is it risky to invest in commodities?

Commodities can be volatile. Commodity prices depend on supply and demand, which can change dramatically owing to weather patterns, technological innovations, supply chain issues, and more.

Do commodity ETFs pay dividends?

Commodity ETFs typically don’t pay dividends to investors, regardless of which type of ETF you have. The goal of investing in commodity ETFs is more often capital appreciation rather than current income.

Is it better to trade physical commodities or ETFs?

For most investors, trading raw material commodities simply isn’t feasible. There are issues of transport, storage, insurance, and liquidity. For that reason, commodity ETFs have emerged to give investors exposure to desired commodities without the physical demands.

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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.


An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
*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.
Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.

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

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

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

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