InvestGen Archives | Page 27 of 62

Dec

2024

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401(k) Taxes: Rules on Withdrawals and Contributions

By Melanie Mannarino | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

Employer-sponsored retirement plans like a 401(k) are a common way for workers to save for retirement. According to the Bureau of Labor Statistics, a little more than half of private industry employees participate in a retirement plan at work. So participants need to understand how 401(k) taxes work to take advantage of this popular retirement savings tool.

With a traditional 401(k) plan, employees can contribute a portion of their salary to an account with various investment options, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and cash.

There are two main types of workplace 401(k) plans: a traditional 401(k) plan and a Roth 401(k). The 401(k) tax rules depend on which plan an employee participates in.

Traditional 401(k) Tax Rules

When it comes to this employer-sponsored retirement savings plan, here are key things to know about 401(k) taxes and 401(k) withdrawal tax.

401(k) Contributions Are Made With Pre-tax Income

One of the biggest advantages of a 401(k) is its tax break on contributions. When you contribute to a 401(k), the money is deducted from your paycheck before taxes are taken out, which reduces your taxable income for the year. This means that you’ll pay less in income tax, which can save you a significant amount of money over time.

If you’re contributing to your company’s 401(k), each time you receive a paycheck, a self-determined portion of it is deposited into your 401(k) account before taxes are taken out, and the rest is taxed and paid to you.

For 2025, participants can contribute up to $23,500 each year to a 401(k) plan, plus $7,500 in catch-up contributions if they’re 50 or older. The contribution limits are up from 2024, when the limit was $23,000. The annual catch-up amount is unchanged at $7,500.

But now there is an extra catch-up provision: For 2025, those ages 60 to 63 may contribute an additional $11,250 per year instead of $7,500, thanks to SECURE 2.0 — for a total of $34,750.

401(k) Contributions Lower Your Taxable Income

The more you contribute to your 401(k) account, the lower your taxable income is in that year. If you contribute 15% of your income to your 401(k), for instance, you’ll only owe taxes on 85% of your income.

Withdrawals From a 401(k) Account Are Taxable

When you take withdrawals from your 401(k) account in retirement, you’ll be taxed on your contributions and any earnings accrued over time.

The withdrawals count as taxable income, so during the years you withdraw funds from your 401(k) account, you will owe taxes in your retirement income tax bracket.

Early 401(k) Withdrawals Come With Taxes and Penalties

If you withdraw money from your 401(k) before age 59 ½, you’ll owe both income taxes and a 10% tax penalty on the distribution.

Although individual retirement accounts (IRAs) allow penalty-free early withdrawals for qualified first-time homebuyers and qualified higher education expenses, that is not true for 401(k) plans.

That said, if an employee leaves a company during or after the year they turn 55, they can start taking distributions from their 401(k) account without paying taxes or early withdrawal penalties.

Can you take out a loan or hardship withdrawal from your plan assets? Many plans do allow that up to a certain amount, but withdrawing money from a retirement account means you lose out on the compound growth from funds withdrawn. You will also have to pay interest (yes, to yourself) on the loan.

Roth 401(k) Tax Rules

Here are some tax rules for the Roth 401(k).

Your Roth 401(k) Contributions Are Made With After-Tax Income

When it comes to taxes, a Roth 401(k) works the opposite way of a traditional 401(k). Your contributions are post-tax, meaning you pay taxes on the money in the year you contribute.

If you have a Roth 401(k) and your company offers a 401(k) match, that matching contribution will go into a pre-tax account, which would be a traditional 401(k) account. So you would essentially have a Roth 401(k) made up of your own contributions and a traditional 401(k) of your employer’s contributions.

Recommended: How an Employer 401(k) Match Works

Roth 401(k) Contributions Do Not Lower Your Taxable Income

When you have Roth 401(k) contributions automatically deducted from your paycheck, your full paycheck amount will be taxed, and then money will be transferred to your Roth 401(k).

For instance, if you’re making $50,000 and contributing 10% to a Roth 401(k), $5,000 will be deposited into your Roth 401(k) annually, but you’ll still be taxed on the full $50,000.

Roth 401(k) Withdrawals Are Tax-Free

When you take money from your Roth 401(k) in retirement, the distributions are tax-free, including your contributions and any earnings that have accrued (as long as you’ve had the account for at least five years).

No matter what your tax bracket is in retirement, qualified withdrawals from your Roth 401(k) are not counted as taxable income.

It can also be helpful to know that, like a Roth IRA, a Roth 401(k) no longer requires participants to start taking required minimum distributions at age 73.

There Are Limits on Roth 401(k) Withdrawals

In order for a withdrawal from a Roth 401(k) to count as a qualified distribution — meaning, it won’t be taxed — an employee must be age 59 ½ or older and have held the account for at least five years.

If you make a withdrawal before this point — even if you’re age 61 but have only held the account since age 58 — the withdrawal would be considered an early, or unqualified, withdrawal. If this happens, you would owe taxes on any earnings you withdraw and could pay a 10% penalty.

Early withdrawals are prorated according to the ratio of contributions to earnings in the account. For instance, if your Roth 401(k) had $100,000 in it, made up of $70,000 in contributions and $30,000 in earnings, your early withdrawals would be made up of 70% contributions and 30% earnings. Hence, you would owe taxes and potentially penalties on 30% of your early withdrawal.

If the plan allows it, you can take a loan from your Roth 401(k), just like a traditional 401(k), and the same rules and limits apply to how much you can borrow. Any Roth 401(k) loan amount will be combined with outstanding loans from that plan or any other plan your employer maintains to determine your loan limits.

You Can Roll Roth 401(k) Money Into a Roth IRA

Money in a Roth 401(k) account can be rolled into a Roth IRA. Like an employer-sponsored Roth 401(k), a Roth IRA is funded with after-tax dollars.

It’s important to note, however, that there’s also a five-year rule for Roth IRAs: Earnings cannot be withdrawn tax- and penalty-free from a Roth IRA until five years after the account’s first contribution. If you roll a Roth 401(k) into a new Roth IRA, the five-year clock starts over at that time.

Do You Have to Pay Taxes on a 401(k) Rollover?

If you do a direct rollover of your 401(k) into an IRA or another eligible retirement account, you generally won’t have to pay taxes on the rollover. However, if you receive the funds from your 401(k) and then roll them over yourself within 60 days, you may have to pay taxes on the amount rolled over, as the IRS will treat it as a distribution from the 401(k).

Recommended: How to Roll Over Your 401(k)

Do You Have to Pay 401(k) Taxes after 59 ½?

If you have a traditional 401(k), you will generally have to pay taxes on withdrawals after age 59 ½. This is because the money you contributed to the 401(k) was not taxed when you earned it, so it’s considered income when you withdraw it in retirement.

However, if you have a Roth 401(k), you can withdraw your contributions and earnings tax-free in retirement as long as you meet certain requirements, such as being at least 59 ½ and having had the account for at least five years.

Do You Pay 401(k) Taxes on Employer Contributions?

The taxation of employer contributions to a 401(k) depends on whether the account is a traditional or Roth 401(k).

In the case of traditional 401(k) contributions, the employer contributions are not included in your taxable income for the year they are made, but you will pay taxes on them when you withdraw the funds from the 401(k) in retirement.

In the case of Roth contributions, the employer contributions are not included in a post-tax Roth 401(k) but rather in a pre-tax traditional 401(k) account. So, you do not pay taxes on the employer contributions in a Roth 401(k), but you do pay taxes on withdrawals.

How Can I Avoid 401(k) Taxes on My Withdrawal?

The only way to avoid taxes on 401(k) withdrawals is to take advantage of a Roth 401(k), as noted above. With a Roth 401(k), your contributions are made post-tax, but withdrawals are tax-free if you meet certain criteria to avoid the penalties mentioned above.

However, even if you have to pay taxes on your 401(k) withdrawals, you can take the following steps to minimize your taxes.

Consider Your Tax Bracket

Contributing to a traditional 401(k) is essentially a bet that you’ll be in a lower tax bracket in retirement — you’re choosing to forgo taxes now and pay taxes later.

Contributing to a Roth 401(k) takes the opposite approach: Pay taxes now, so you don’t have to pay taxes later. The best approach for you will depend on your income, your tax situation, and your future tax treatment expectations.

Strategize Your Account Mix

Having savings in different accounts — both pre-tax and post-tax — may offer more flexibility in retirement.

For instance, if you need to make a large purchase, such as a vacation home or a car, it may be helpful to be able to pull the income from a source that doesn’t trigger a taxable event. This might mean a retirement strategy that includes a traditional 401(k), a Roth IRA, and a taxable brokerage account.

Decide Where To Live

Eight U.S. states don’t charge individual income tax at all: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. And New Hampshire only taxes interest and dividend income.

This can affect your tax planning if you live in a tax-free state now or intend to live in a tax-free state in retirement.

The Takeaway

Saving for retirement is one of the best ways to prepare for a secure future. And understanding the tax rules for 401(k) withdrawals and contributions is essential for effective retirement planning. By educating yourself on the rules and regulations surrounding 401(k) taxes, you can optimize your retirement savings and minimize your tax burden.

Another strategy to help stay on top of your retirement savings is to roll over a previous 401(k) to a rollover IRA. Then you can manage your money in one place.

SoFi makes the rollover process seamless. The process is automated so there’s no need to watch the mail for your 401(k) check — and there are no rollover fees or taxes.

Easily manage your retirement savings with a SoFi IRA.

FAQ

Do you get taxed on your 401(k)?

You either pay taxes on your 401(k) contributions — in the case of a Roth 401(k) — or on your traditional 401(k) withdrawals in retirement.

When can you withdraw from 401(k) tax free?

You can withdraw from a Roth 401(k) tax-free if you have had the account for at least five years and are over age 59 ½. With a traditional 401(k), withdrawals are generally subject to income tax.

How can I avoid paying taxes on my 401(k)?

You never truly avoid paying taxes on a 401(k), as you either have to pay taxes on contributions or withdrawals, depending on the type of 401(k) account. By contributing to a Roth 401(k) instead of a traditional 401(k), you can withdraw your contributions and earnings tax-free in retirement.

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.
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For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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.

Update: The deadline for making IRA contributions for tax year 2020 has been extended to May 17, 2021.
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Dec

2024

What Is 401(k) Auto Escalation?

By Austin Kilham | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

One way to ensure you’re steadily working toward your retirement goals is to automate as much of the process as possible. Some employers streamline the retirement savings process for their employees with automatic enrollment, signing you up for a retirement plan unless you choose to opt out.

There are many ways to automate a 401(k) experience at every step of the way. You can have contributions taken directly from your paycheck before they ever hit your bank account and invest them right away. With automatic deductions, you’re more likely to save for your future rather than spending on immediate needs.

In some cases, you may also be able to automatically increase the amount you save. Some employers also offer a 401(k) auto escalation option that could increase your retirement savings amount as you get older. Here’s a closer look at how 401(k) auto escalation works and how it may help you on your way to your retirement goals.

Key Points

• 401(k) auto escalation automatically increases contributions at regular intervals until a preset maximum is reached.

• The SECURE Act allows auto escalation up to 15% of an employee’s salary.

• Auto escalation helps employees save more for retirement without needing to adjust contributions manually.

• Employers benefit from auto escalation by attracting and retaining talent and possibly reducing payroll taxes.

• Employees should assess if auto escalation aligns with their financial capabilities and retirement goals.

401(k) Recap

A 401(k) is a defined contribution plan offered through your employer. It allows employees to contribute some of their wages directly from their paycheck. Contributions are made with pre-tax money, which may reduce taxable income in the year they are made, providing an immediate tax benefit.

In 2025, employees can contribute up to $23,500 a year to their 401(k), up from $23,000 in 2024. Those aged 50 and older can contribute an extra $7,500, bringing their potential contribution total to $31,000 in 2025 and $30,500 in 2024. For 2025, those aged 60 to 63 may contribute an additional $11,250 instead of $7,500, thanks to SECURE 2.0.

For many individuals, the goal is to eventually max out a 401(k) up to the contribution limit. Employers may offer matching funds to help encourage employees to save. Individuals should aim to contribute at least enough to meet their employer’s match, in order to get that “free money” from their employer to invest in their future.

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

How 401(k) Auto Escalation Works

An auto escalation is a 401(k) feature that automatically increases your contribution at regular intervals by a set amount until a preset maximum is achieved. The SECURE Act, signed into law in 2019, allows auto escalation programs to raise contributions up to 15%. Before then, the cap on default contributions was 10% for auto escalation programs.

For example, you may choose to set your auto escalation rate to raise your contributions by 1% each year. Once you hit that 15% ceiling, auto escalation will cease. However, you can still choose to increase the amount you are saving on your own beyond that point.

Advantages of 401(k) Auto Escalation

When it comes to auto escalation programs, there are important factors to consider — for employees as well as for employers who sponsor the 401(k) plan.

Advantages for Employees

• Auto escalation is one more way to automate savings for retirement, so that it is always prioritized.

• Auto escalation may increase the amount employees save for retirement more than they would on their own.

• Employees don’t have to remember to make or increase contributions themselves until they reach the auto escalation cap.

• Increasing tax-deferred contributions may help reduce an employee’s tax burden.

Advantages for Sponsors

Employers who offer auto escalation may find it helps with both employee quality and retention as well as with reducing taxes.

• Auto escalation provides a benefit that may help attract top talent.

• It helps put employees on track to automatically save, which may increase retention and contribute to their sense of financial well-being.

• It reduces employer payroll taxes, because escalated funds are contributed pre-tax by employees.

• It may generate tax credits or deductions for employers. For example, matching contributions may be tax deductible.

• As assets under management increase, 401(k) companies may offer lower administration fees or even the ability to offer additional services to participants.

Disadvantages of 401(k) Auto Escalation

While there are undoubtedly benefits to 401(k) auto escalation, there are also some potential downsides to consider.

Disadvantages for Employees

Even on autopilot, it can be important to review contributions so as to avoid these disadvantages.

• Auto escalation may lull employees into a false sense of security. Even if they’re increasing their savings each year, if their default rate was too low to begin with, they may not be saving enough to meet their retirement goals.

• If an employee experiences a pay freeze or hasn’t received a raise in a number of years, auto escalation will mean 401(k) contributions represent an increasingly larger proportion of take-home pay.

Disadvantages for Sponsors

Employers may want to consider these potential downsides before offering 401(k) auto escalation.

• Auto escalation requires proper administrative oversight to ensure that each employee’s escalation amounts are correct — and it may be time-consuming and costly to fix mistakes.

• This option may increase the need to communicate with 401(k) record keepers.

• Auto escalation may cause employer contribution amounts to rise.

💡 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.

Is 401(k) Auto Escalation Right for You?

If your employer offers auto escalation, first determine your goals for retirement. Consider whether or not your current savings rate will help you achieve those goals and whether escalation could increase the likelihood that you will.

Also decide whether you can afford to increase your contributions. Perhaps your default rate is already set high enough that you are maxing out your retirement savings budget. In this case, auto escalation might land you in a financial bind.

However, if you have room in your budget, or you expect your income to grow each year, auto escalation may help ensure that your retirement savings continue to grow as well.

If your employer does not offer auto escalation, or you choose to opt out, consider using pay raises as an opportunity to change your 401(k) contributions yourself.

The Takeaway

A 401(k) is one of many tools available to help you save for retirement — and auto escalation can help you increase your contributions regularly without any additional thought or effort on your part.

If you’ve maxed out your 401(k) or you’re looking for a retirement account with more flexible options, you might want to consider a traditional or Roth IRA. Both types of IRAs offer tax-advantaged retirement savings.

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).

Help grow your nest egg with a SoFi IRA.

FAQ

Is 401(k) auto enrollment legal?

Yes, automatic enrollment allows employers to automatically deduct 401(k) contributions from an employee’s paycheck unless they have expressly communicated that they wish to opt out of the retirement plan.

What is automatic deferral increase?

Automatic deferral increase is essentially the same as auto escalation. It automatically increases the amount that you are saving by a set amount at regular intervals.

Can a company move your 401(k) without your permission?

Your 401(k) can be moved without your permission by a former employer if the 401(k) has a balance of $5,000 or less.

Photo credit: iStock/Halfpoint

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

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Dec

2024

Bid and Ask Price: Definition, Example, How It Works

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

Bid and ask are commonly used investing terms, and they refer to the best potential price at which a security on the market could be bought or sold for at any given time. In other words, the best price that buyers and sellers would potentially be willing to buy (the “bid” price) or sell (the “ask” or offer price) the asset.

It’s important for traders to understand the bid vs. ask price of a security, as well as the difference between the two, which is known as the bid-ask spread. The market price is a historical price: the price of the last trade that occurred with the security. The bid and ask prices, on the other hand, show what buyers and sellers would be willing to trade the security for now.

Key Points

• The bid price is the highest price a buyer is willing to pay for a security, reflecting market demand.

• The ask price is the lowest price a seller is willing to accept, representing market supply.

• The bid-ask spread, the difference between bid and ask prices, serves as a transaction cost and indicates market liquidity.

• Narrow bid-ask spreads suggest high liquidity and trading volume, while wider spreads indicate lower liquidity.

• Investors use the bid-ask spread to assess market sentiment and risk, with narrower spreads indicating lower risk.

What Are Bid and Ask?

If you’re new to online investing or investing in stocks, you’re probably wondering about bid vs. ask prices. Bid and ask prices show the current market supply and demand for the security. The bid price represents demand for a security; the ask price represents supply.

When an asset has high liquidity — i.e. the market has a high trading volume not dominated by selling — the bid and ask prices will be fairly close. In other words the bid-ask spread, or the difference between the bid and ask prices, will be narrow in a highly liquid market. When there’s a greater gap between demand and supply, the spread will be wider.

That’s why the bid-ask spread is often considered a gauge of liquidity.

Bid Price

The bid price is the best potential price that retail investors would be willing to pay to buy a security.

So if a trader wants to sell a security, they would want to know how much they’d be able to sell it for. They can find out the best price they could get for the security by looking at the current bid price in the market, which would show the highest potential amount they could get for it.

Ask Price

Conversely, ask price is the lowest price investors are willing to sell a security for at any given time. If a trader wants to buy a security, they want to get the lowest possible price, so they look at the ask price to find out what that is.

Bid and Ask Price Examples

Let’s imagine that an investor wants to buy Stock X at the quoted price of $75, so they plan to buy 10 shares for $750. But they end up paying $752. That’s not an error, but rather because the ask price (the selling price) is $75.20.

The current price of $75 per share is the last traded price. But prices can change quickly, and in this case the ask price was 20 cents higher. The bid or buyer’s price is almost always lower than the ask price.

Investors can use limit orders to set specific parameters around the price at which they’re willing to buy or sell a security. This can give investors some control, so they’re not simply paying the current price, which may or may not be advantageous.

Evaluating the bid-ask spread can be part of an investor’s due diligence when trying to gauge rates of return for different securities.

What the Bid-Ask Spread Signals

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 security 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 security’s value.

How Are Bid and Ask Prices Determined?

Essentially it’s the supply and demand of the market that sets the bid and ask prices. And many factors can play into supply vs. demand. Because of this, investors who are interested in active investing can use the difference in price between the bid and the ask of a security to gauge what the market thinks the security is worth.

Investors and market-makers can place buy or sell orders at a price they set. These orders will be fulfilled if someone is willing to sell or buy the security at that bid or ask price. Those order placements determine the bid and ask price.

What’s the Difference Between Bid and Ask Prices?

In any market, from stocks to real estate to lemonade stands, there is almost always a difference between what someone is willing to pay for an item versus what someone wants to sell it for.

A buyer may want to buy a house for $300,000, but the seller is selling it for $325,000. An investor may want to buy a stock for $100, but the sell or ask price is $105.

That difference in price is called the spread, and when the spread is narrow it’s a lot easier to close the sale. When the spread is wider, there is a bigger gap between what the buyer thinks an item is worth vs. what the seller thinks it’s worth.

What Does It Mean When Bid and Ask Are Close?

A narrow spread, i.e. when the bid and ask price are close, means traders will be able to buy and sell the security at roughly the same price. This generally means there is a high trading volume for the security, with a lot of people willing to buy and sell because of high demand.

If demand increases for the security, the bid and ask prices will move higher, and vice versa. If there is a surge in demand, but not enough supply, that might drive the bid price up. Conversely, if supply outpaces demand, the bid price of a security could fall In either case, the spread would likely get wider when the bid or the ask prices outweighs the other.

The Bid-Ask Spread

The bid-ask spread is the gap between the two prices: the bid or buyer’s price and the ask or offer price. There are different factors that can affect a stock’s spread, including:

• Liquidity. A measure of how easily a stock or 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 the market is in agreement about what the security is worth.

• Trading volume. This 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. A way of gauging 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 as market makers attempt to profit from the price changes.

Who Benefits From the Bid-Ask Spread?

The difference in price between the bid and the ask is where brokers and market makers make their profit.

But traders can also benefit from the bid-ask spread, if they use limit orders to get the best possible price on a desired trade, as opposed to using market orders.

How the Bid-Ask Spread Is Used

When you understand how bid-ask spread works, 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.

Bid-Ask Spread Impact on Trading Profits

Naturally, the bid-ask spread impacts trading profits, and in fact can act almost as a hidden cost.

For example, if an investor places a market order on a stock with a bid price of $90 and an ask price of $91, they’ll get the stock at $91 per share. If the price of the stock rises 5%, so the bid price is now $94.50 and the ask price is $95.55 and the bid-ask spread is $1.05.

If the investor decides to sell the shares they bought at $91 through a market order, they will receive $94.50 per share. So their profit is $3.50 per share, even though the stock price rose by $4.55. The $1.05 gap in profit reflects the $1.05 bid-ask spread on this stock.

Wide vs Narrow Bid-Ask Spread

What is the difference between wide and narrow bid-ask spreads, and what is the significance of each? Here’s a rundown.

Narrow Bid-Ask Spreads

The bid-ask spread, often just called the spread, is tighter when a security has more liquidity, i.e. there’s higher trading volume for that stock. When you think of big companies, industry leaders, constituents of different indexes like the Dow Jones or the S&P 500, those companies may have higher volume and narrower spreads.

Wider Bid-Ask Spreads

Conversely, smaller companies or those that aren’t in demand tend to have wider spreads, reflecting a lower level of market interest. These trades tend to be more expensive, as investors must contend with lower liquidity.

Impact of the Bid-Ask Spread

The narrower the bid-ask spread, the more favorable it is for traders. If an investor wants to buy 100 shares of Stock A at $60, but shares are being offered at $60.25, that 25 cent spread may not seem like much. It would add up to $25 (100 x 0.25). But if that trader wanted to buy 500 shares or more, the cost of the spread is about $125.

The Takeaway

Bid and ask prices help traders know exactly how much they may buy and sell securities for. The bid price is the highest price a buyer is willing to pay for a security. The ask price is the lowest price a seller is willing to accept. The difference between them is the bid-ask spread, or “spread.” The spread ends up being a transaction cost, as market makers pocket the cost of the spread.

Since the bid price and the ask price are essentially a function of supply and demand in the market, investors can consider the bid-ask spread as a gauge of risk. The narrower the spread, the more aligned buyers and sellers are on the value of a certain security, and thus there’s higher volume and more liquidity — and lower risk to the investor that the stock or security might lose value (although it could, as there are no guarantees).

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

FAQ

Do I buy a stock at the bid or ask price?

You buy a stock at the ask price, that’s the lowest price the seller is willing to offer.

Is the last price the same as the market price?

The last price is the last traded price for a security, or the last price at which it closed. The market price is the best current price.

Is it better if your bid is higher than the asking price?

The bid price is typically lower than the seller’s price or ask price, so it would be unusual if the bid was higher than the ask. If a bid price is higher than the ask, a trade would occur, but it would put the buyer at risk of a potential loss.

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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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q424-021

Dec

2024

What Is a Shareholder Activist?

By Michael Flannelly | Growing Wealth, invest, Investing | Comments Off

A shareholder activist may be a hedge fund, institutional investor, or wealthy individual who uses an ownership stake in a company to influence corporate decision-making. Shareholder activists, sometimes called activist investors, typically seek to change how a company is run to improve its financial performance. However, they may also have other objectives, such as increasing transparency or promoting social responsibility.

Activist shareholders can impact the way a company is managed, thus affecting its stock price. As such, you may benefit from understanding shareholder activism and how these investors may impact the stocks in your portfolio.

Key Points

• Shareholder activists use ownership stakes to influence corporate decisions, aiming to improve financial performance or promote transparency and social responsibility.

• Activists can be hedge funds, institutional investors, or wealthy individuals seeking changes in company management.

• Activist investors may use media and shareholder voting to gain support for their proposals and influence company strategies.

• Goals of activism vary, from improving environmental impact to unlocking shareholder value through strategic changes.

• Activism can lead to stock volatility, but targeted stocks may still be valuable for diversified portfolios if proposed changes are supported.

How Shareholder Activism Works

Shareholder activism is a process in which investors purchase a significant stake in a company to influence the management of the company. When an investor builds up a large enough stake in a company, this usually opens up channels where they may discuss business proposals directly with management.

Activist investors may also use the shareholder voting process to wield influence over a company if they believe it is mismanaged. This more aggressive tactic may allow activist shareholders to nominate their preferred candidates for the board of directors or have a say on a company’s management decisions.

Activist investors typically own a relatively small percentage of shares in a company, perhaps less than 10% of a firm’s outstanding stock, so they may need to convince other shareholders to support their proposals. They often use the media to generate support for their campaigns.

Shareholder activists may also threaten lawsuits if they do not get their way, claiming that the company and its board of directors are not fulfilling their fiduciary duties to shareholders.

Activist investors’ goals can vary. Some investors may want to see companies improve their environmental and social impact, so they will suggest that the company adopt a Corporate Social Responsibility framework. Other investors try to get the company to adopt changes to unlock shareholder value, like selling a part of the company or increasing dividend payouts.

However, shareholder activism can also be a source of conflict between shareholders and management. Some activist investors may prefer the company unlock short-term gains that benefit shareholders, perhaps at the expense of long-term business operations. These investors may exit a position in a company once they unlock the short-term gains with little concern for the company’s future prospects.

Types of Shareholder Activists

There are three primary types of shareholder activists: hedge funds, institutional investors, and individual investors. So, your average investor who may be doing a bit of online investing or building a retirement portfolio likely wouldn’t qualify as a shareholder activist. Each type of shareholder activist has its distinct objectives and strategies.

Hedge Funds

Hedge funds are private investment vehicles usually only available to wealthy individuals who make more than $200,000 annually or have a net worth over $1 million. These funds often take a more aggressive approach to shareholder activism, like public campaigns and proxy battles, to force a company to take specific actions to generate a short-term return on its investment.

Institutional Investors

Institutional investors are typically large pension funds, endowments, and mutual funds that invest in publicly-traded companies for the long term. These investors often use their voting power to influence a company’s strategy or management to improve their investment’s financial performance.

Individual Investors

Though less common than hedge funds and institutional investors, very wealthy individual investors sometimes use their own money to buy shares in a company and then push for change.

Examples of Shareholder Activists

Shareholder activism became a popular strategy in the 1970s and 1980s, when many investors – called “corporate raiders” – used their power to push for changes in a company’s management. Shareholder activism has evolved since this period, but there are still several examples of activist investors

For example, Carl Icahn is one of the most well-known shareholder activists who made a name for himself as a corporate raider in the 1980s. He was involved in hostile takeover bids for companies such as TWA and Texaco during the decade.

Since then, Icahn has been known for taking large stakes in companies and pushing for changes, such as spin-offs, stock buybacks, and management changes. More recently, Icahn spearheaded a push in early 2022 to nominate two new directors to the board of McDonald’s. His goal was to get McDonald’s to change its treatment of pigs. However, his preferred nominees failed to get elected to the board.

Another well known activist investor is Bill Ackman, the founder and CEO of Pershing Square Capital Management, a hedge fund specializing in activist investing. Ackman is known for his high-profile campaigns, including his battle with Herbalife.

In 2012, Ackman shorted the stock of Herbalife, betting the company would collapse. He accused Herbalife of being a pyramid scheme and called for a government investigation. Herbalife denied the allegations, and the stock continued to rise. Ackman eventually closed out his position at a loss.

Other examples of shareholder activists include Greenlight Capital, led by David Einhorn, and Third Point, a hedge fund founded by Dan Loeb.

In 2013, Einhorn took a stake in Apple and pushed for the company to return more cash to shareholders through share repurchases and dividends. Apple eventually heeded his advice and initiated a plan to return $100 billion to shareholders through dividends and buybacks.

In 2011, Loeb’s hedge fund took a stake in Yahoo and pushed for the company to fire its CEO, Scott Thompson. Thompson eventually resigned, and Yahoo appointed Loeb to its board of directors. More recently, in 2022, Loeb took a significant stake in Disney and started a pressure campaign calling on the company to spin-off or sell ESPN. However, he eventually backed off that suggestion.

Is Shareholder Activism Good for Individual Investors?

Depending on the circumstances, a shareholder activist campaign may be good for investors. Some proponents argue that shareholder activism can improve corporate governance, promote ESG investing, and lead to better long-term returns for investors.

Others contend that activist investors are primarily interested in short-term gains and may not always have the best interests of all shareholders in mind. While individual investors may benefit from a stock’s short-term spike after an activist shareholder’s campaign, this rally may not last for investors interested in long-term gains.

The Takeaway

Shareholder activists use their financial power to try to influence the management of publicly traded companies. Because activist investors often leverage the media to promote their goals, individual investors may read about these campaigns and worry about how they could affect their holdings.

Generally, the impact of shareholder activism on investors depends on the specific goals of the activist and the response of the company’s management. If an activist successfully pressures management to make changes that improve the company’s performance, this can increase shareholder value. However, if an activist’s campaign is unsuccessful or the company’s management resists the activist’s demands, this can lead to a decline in the stock price.

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.

Photo credit: iStock/xavierarnau

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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q424-015

Dec

2024

Guide to Investment Risk Pyramids

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

An investment risk pyramid is an illustration used to help investors understand the risk/reward profile of various assets. The investment risk pyramid uses a base, middle, and top to rank investments by the likelihood of losing money or seeing big returns. The tool is useful when getting started with investing.

Building a portfolio is no easy task. It requires due diligence and an assessment of your risk tolerance and return goals. The investment risk pyramid may help you determine what approaches work best for you.

What Are Investment Pyramids?

Investment pyramids are practical tools for gauging how risky certain asset types are. The pyramid model has been used in many areas for a long time, and it’s useful when learning what your risk tolerance is.

An investment risk pyramid has three levels grouped by risk/return profile. The least-risky securities are found in the large base; growth and moderately risky assets are in the middle; then the most speculative strategies are at the top.

Again, this can be helpful to investors who are looking to buy and sell stocks or other securities, and also get a sense of how much associated risk they’re introducing or jettisoning from their portfolio.

How Investing Pyramids Work

There are many investing risk need-to-knows, and the pyramid of investment risk works by helping investors understand the connection between their asset allocation and their risk tolerance.

The visual should ultimately lead individuals to better grasp what percentage of their investable assets should go to which types of investments based on risk level and return potential.

Using a risk pyramid investment strategy provides a basic framework for analyzing portfolio construction. The investment risk pyramid is structured so that it suggests people hold a higher percentage of lower-risk assets, and relatively little in the way of ultra-high-risk, speculative assets.

Base of the Pyramid

Managing investment risk is among the most fundamental aspects of investing, and risk is controlled by ensuring an allocation to some safe securities. The base of the investment risk pyramid, which is the bulk of total assets, contains low-risk assets and accounts. Investments such as government bonds, money markets, savings and checking accounts, certificates of deposit (CDs), and cash are included in the base.

While these securities feature relatively low risk, you might lose out to inflation over time if you hold too much cash, for example.

Middle of the Pyramid

Let’s step up our risk game a bit by venturing into the middle of the investment risk pyramid. Here we will find medium-risk assets. In general, investments with some growth potential and a lower risk profile are in this tier. Growth and income stocks and capital appreciation funds are examples.

Other holdings might include real estate, dividend stock mutual funds, and even some higher-risk bond funds.

Top of the Pyramid

At the top of the investment risk pyramid is where you’ll find the most speculative asset types and even margin investing strategies. Options, futures, and collectibles are examples of high-risk investments.

You will notice that the top of the pyramid of investment risk is the smallest – which suggests only a small portion of your portfolio should go to this high-risk, high-reward niche.

Sample Investment Pyramid

Here’s what a sample investment risk pyramid might contain:

Top of the pyramid, high risk: Speculative growth stocks, put and call options, commodities, collectibles, cryptocurrency, and non-fungible tokens (NFTs). Generally, just a small percentage of an overall portfolio should be allocated to the top of the pyramid.

Middle of the pyramid, moderate risk: Dividend mutual funds, corporate bond funds, blue-chip stocks, and variable annuities. Small-cap stocks and foreign funds can be included, too. A 30-40% allocation could make sense for some investors.

Base of the pyramid, low risk: U.S. government Treasuries, checking and savings accounts, CDs, AAA-rated corporate bonds. This might comprise 40-50% of the portfolio.

Pros and Cons of Investment Pyramids

The investment risk pyramid has advantages and disadvantages. Let’s outline those to help determine the right investing strategy for you.

Pros

The investment risk pyramid is useful as a quick introduction to asset allocation and bucketing. Another upside is that it is a direct way to differentiate asset types by risk.

Cons

While the investment risk pyramid is helpful for beginners, as you build wealth, you might need more elaborate strategies beyond the pyramid’s simplicity. Moreover, in the end, you determine what securities to own – the pyramid is just a suggestion.

Examples of Low-Risk Investments

Let’s describe some low-risk investments in more detail since these are including the investment risk pyramid’s biggest tier.

Bonds

Bonds are essentially a loan you make to the government or other entity for a set amount of time. In return for lending your money, the debtor promises to pay you back at maturity along with periodic coupon payments, like interest.

Lower-risk bonds include short-term Treasury bills while riskier bonds are issued by speculative companies at a higher yield.

Cash

Cash feels like a low-risk asset, but ideally you would store it in an interest-bearing savings account in order to keep up with inflation.

Also consider that holding too much cash can expose you to inflation risk, which is when cash loses value relative to the cost of living.

Bank Accounts

You can earn a rate of return through a bank account with FDIC insurance. Keeping an emergency fund in a checking account can be a prudent move so you can pay expenses without having to sell assets like stocks and bonds or take on debt.

Examples of High-Risk Investments

At the top of the pyramid, you will find assets and strategies that may generate large returns, but also expose you to serious potential losses. Margin trading is a method often employed by some investors to try and increase their returns.

Margin Trading

Margin trading is using borrowed funds in an attempt to amplify returns. A cash account vs. margin account has key differences to consider before you go about trading. Trading with leverage offers investors the possibility of large short-term gains as well as the potential for outsize losses, so it is perhaps best suited for sophisticated investors.

Options

Options on stocks and exchange-traded funds (ETFs) are popular these days. Options, through calls and puts, are derivative instruments that offer holders the right but not the obligation to buy shares at a specific price at a predetermined time. These are risky since you can lose your entire premium if the option contract strategy does not work out for the holder.

Collectibles

Collectibles, such as artwork or wine, are alternative investment types that may provide some of the benefits of diversification, but it’s hard to know what various items are worth since they are not valued frequently. Consider that stocks and many bonds are priced at least daily.

Collectibles might also go through fad periods and booms and bust cycles, which can add to the risk factors in this category.

Discovering Your Risk Tolerance

The investment risk pyramid is all about helping you figure out your ability and willingness to accept risk. It is a fundamental piece of being an investor. You should consider doing more research and even speaking with a financial advisor for a more detailed risk assessment along with an analysis of what your long-term financial goals are.

The Takeaway

Using an investment risk pyramid can make sense for many investors. It’s an easy, visual way to decide which asset classes you might want to hold in your portfolio, so that the percentage of each (i.e. your asset allocation) is aligned with your risk tolerance.

The other helpful aspect of the investment risk pyramid is that it presumes a bigger foundation in lower-risk investments (the bottom tier), with gradually smaller allocations to moderate risk and higher-risk assets, as you move up the pyramid. This can be helpful for a long-term strategy. In a nutshell, the investment risk pyramid helps you figure out how to allocate investments based on your risk tolerance and return objectives.

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, 11%*

FAQ

What are the levels of an investment pyramid?

The levels of an investment risk pyramid are low-risk at the base, moderate-risk in the middle, and high-risk at the top. The risk/return investment pyramid helps investors understand how to think about various assets they may want to own.

What does investment risk refer to?

Investment risk can be thought of as the variance in return, or how great the chance is that an investment will experience sharp losses. While the risk investment pyramid helps you build a portfolio, you should also recognize that a diversified stock portfolio performs well over time, while cash generally loses out due to the risk of inflation.

What are some examples of high-risk investments?

High-risk investments include speculative assets like options, trading securities on margin, and even some collectibles that might be hard to accurately value since they are based on what someone might be willing to pay for them. The low-risk to high-risk investments pyramid can include virtually any asset.

Photo credit: iStock/MicroStockHub

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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.

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

Claw Promotion: Customer must fund their Active Invest account with at least $50 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q324-024