father taking notes with his son

Benefits of Using a 529 College Savings Plan

The growing cost of college means that parents or grandparents who intend to pay part or all of the tab for a child need to chart a course. A tax-advantaged 529 college savings plan is one way to save for future education costs.

Although 529 plans have been around since 1996, many parents still aren’t sure how they work. Yet they are worth knowing about in detail, as they can be used for a variety of educational expenses and are not subject to federal taxes.

Read on to learn more on 529 plans and whether opening one is the right move for you.

Key Points

•   With a 529 plan, contributions grow tax-free, and withdrawals for qualified education expenses are not subject to federal taxes.

•   Funds can be used for a variety of education-related expenses, including tuition, room and board, and even K-12 tuition in some cases.

•   Many states offer high or no contribution limits, allowing substantial savings over time.

•   Assets in a 529 plan have a relatively low impact on federal financial aid eligibility, as they are considered parental assets.

•   Some states offer tax deductions or credits for contributions to a 529 plan, providing additional incentives for saving.

529 Plan Basics

A 529 plan is a tax-advantaged savings account designed to help families save for education expenses. Contributions grow tax-free, and withdrawals for qualified expenses, such as tuition, books, and room and board, are also tax-free. Many states offer additional tax benefits for residents who contribute to their state’s plan.

Funds can be used for various educational institutions, including colleges, universities, trade schools, and even some K-12 expenses. 529 plans offer flexibility and can be transferred to other family members, if needed. There are two types of 529 plans: prepaid tuition plans and education savings plans, each with unique benefits.

Prepaid Tuition Plan

A prepaid tuition plan allows you to prepay tuition and fees at certain colleges and universities at today’s prices for a child’s future educational needs. Such plans are usually available only at public schools and for in-state students. Only nine are accepting new applicants, and the funds saved are typically not able to be used for room and board.

The main benefit of a prepaid college plan is that you could save big on the price of college by prepaying before prices go up. And contributions are considered gifts, so deposits up to a certain threshold each year ($19,000 in 2025, or $38,000 for a married couple splitting gifts) qualify for the annual and lifetime gift tax exclusion.

A few special-case guidelines to note:

•   If your child doesn’t attend a participating college or university, you will likely be able to use the funds you set aside at another school. Another option may be to transfer the plan to an eligible sibling. If no one in the family plans on attending college, most plans will refund your money, perhaps minus a cancellation fee.

•   If your state government doesn’t guarantee the plan, you may lose the payments you’ve made if the state runs into budget shortfalls.

•   Prepaid tuition plans may charge an enrollment fee and ongoing administrative fees.

•   Although most of the plans can’t be used for room and board, Florida Prepaid Plans, for example, offer a prepaid dormitory plan of two semesters of dorm fees for each year of state university coverage.

An alternative to the state-sponsored plans is the Private College 529 Plan, which has over 300 participating institutions nationwide. The Private College 529 Plan is a prepaid tuition plan specifically designed for private colleges and universities. It allows families to lock in current tuition rates at participating private institutions, protecting against future tuition increases.

Recommended: Private vs Public College

Education Savings Plan

The second type of 529 plan is an education savings plan. Here’s how it works:

•   You can contribute monthly, quarterly, or annually, or deposit a lump sum. Beyond parents making regular payments, 529 plans can be a clever way for the extended family to give a meaningful gift on birthdays or holidays. There is no limit on how much you can add yearly, but you’ll have to fill out gift tax Form 709 if you contribute more than the annual gift amount.

•   While contributions are not deductible on the federal level, many states provide tax benefits for saving in a 529 plan, such as deducting contributions from state income taxes or giving matching grants. Check your local tax laws to see if you qualify.

•   Once you contribute, you will likely have a range of investment options to choose from. These vary from state to state and may include mutual funds and exchange-traded funds (ETFs).

•   You may want to tailor your choices to the date you expect to withdraw the money. You can possibly be more aggressive if you have a longer timeline, but may sway more conservatively if you only have a few years.

•   Money can be withdrawn tax-free from a 529 savings plan to pay for any “qualified higher education expense,” which includes tuition, fees, books, computers, and room and board.

•   You can make withdrawals as long as your child is enrolled at least half-time at an accredited school, regardless of where in the United States it is, and occasionally abroad. Parents can also withdraw up to $10,000 a year to pay for K-12 tuition expenses and for student loan repayment.

•   If you withdraw money for the above expenses, you won’t have to pay federal income tax, and often state income tax, on your earnings. If you withdraw the funds for other reasons, you’ll have to pay taxes, and you may or may not be able to avoid the 529 withdrawal penalty, a 10% federal tax penalty on the earnings.

•   Starting in 2024, families with leftover savings in a 529 college savings account may be able to roll it to a Roth IRA tax- and penalty-free. That is one of several retirement savings changes that are part of the Secure 2.0 Act.

One last note: It is possible to change the beneficiary of a 529 plan to another eligible family member. For example, you can switch to a younger child if your oldest got a scholarship.

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How 529 Savings Plans Compare With Other Options

When planning for education expenses, 529 savings plans are a popular choice due to their tax advantages and flexibility. However, other options are available, each with unique benefits and limitations. Comparing a 529 plan to alternatives like a Coverdell Education Savings Account, basic brokerage account, traditional IRA, Roth IRA, or UGMA/UTMA account can help families choose the best strategy.

Recommended: Financial Aid for Higher-Income Families

Coverdell Account

Like a 529 plan, a Coverdell account, also called an Education Savings Account (ESA), is a tax-advantaged savings account to pay for qualified education expenses.

Unlike a 529 account, total contributions from all sources to a Coverdell account cannot exceed $2,000 annually per beneficiary. Another difference is income limits: You can only use an ESA if your modified adjusted gross income is less than $110,000 (singles) or $220,000 (married couples filing jointly).

You can only make contributions until the child reaches age 18, and all funds must be withdrawn by the time the beneficiary reaches age 30. A 529 plan generally does not restrict the age of the beneficiary.

Basic Brokerage Account

Instead of a 529 plan, some families may favor a brokerage account, which affords the freedom to choose whatever investments they want and the ability to use proceeds for any need a young person has.

The main benefit of a 529 plan is that you don’t have to pay capital gains tax on any distributions used for qualified education expenses. Many families, however, pay a 0% long-term capital gains tax rate anyway. (Long-term capital gains apply to a security held for a year or more. The day-to-day increases or decreases in an asset’s value before it is sold are unrealized gains and losses.)

For 2025, married couples filing jointly with taxable income of $96,700 or less and single filers making $48,350 or less may qualify for the 0% long-term capital gains rate.

A 529 account, then, may be of greatest use to families that need an additional tax shelter.

Recommended: How to Reduce Taxable Income for High Earners

Traditional IRA

Withdrawals from a traditional IRA before age 59 ½ that are used for qualified higher education expenses are not subject to the 10% early distribution penalty — but you will still pay income tax on the distribution.

Money in a qualified retirement plan is not reported on the FAFSA®, but distributions may be reported as untaxed income, and income is weighted much more heavily than assets for financial aid. Remember that a 529 savings plan will have a limited impact on the financial aid offer a student receives.

It is generally thought that retirement plans should be used for just that, and not for college expenses.

Recommended: How College Financial Aid Works

Roth IRA

With a Roth IRA, you can withdraw contributions tax- and penalty-free at any time, but distributions will be reported as untaxed income on the FAFSA, reducing eligibility for need-based financial aid.

You generally must be at least age 59½ and have had the Roth account for at least five years to withdraw earnings tax- and penalty-free. If you are under 59½, you may be able to avoid a penalty (but not taxes) if you withdraw earnings to pay for qualified education expenses.

Some people opt to max out their Roth IRA contributions and then invest additional money in a 529 plan.

UGMA and UTMA Accounts

You can open a Uniform Gifts to Minors Act or Uniform Transfers to Minors Act account on behalf of a child under age 18. The adult custodian controls the money, but gifts and transfers irrevocably become the property of the child.

As with a 529 plan, annual contributions to a UGMA or UTMA account are unlimited, and gifts below the annual gift threshold do not need to be reported to the IRS on gift tax Form 709.

Unlike college savings plans, there is no penalty if the account assets aren’t used to pay for college. Once the minor reaches adulthood, the money is turned over to the former minor, who can use the assets for college or anything else.

But custodial accounts have drawbacks when compared with 529 savings plans: The accounts offer no tax benefits when contributions are made. Earnings are subject to taxes. A custodial account is also counted as a student asset on the FAFSA and will weigh more heavily against financial aid eligibility than parents’ assets or assets held in a 529 account or an ESA.

Choosing a 529 Savings Plan

Every state offers a 529 savings plan, but not all are created equal. When trying to find the best 529 college savings plan, you may want to think about the tax benefits and the fees.

First, you may want to understand whether you qualify for a state income tax deduction or credit for your contributions, based on your state of residence and the plan. Check your state laws and consult a tax professional to learn more about your particular situation.

The next thing you could consider are the fees associated with your plan, which could include enrollment fees, annual maintenance fees, and asset management fees. Some states let you save on fees if you have a large balance, contribute automatically, are a state resident, or opt for electronic-only documents.

The Takeaway

For many students, the cost of college can be eased with a tax-advantaged 529 savings plan. The accounts allow for tax-free growth of funds that can help dreams of affording higher education come true.

529 plans are still rarely used, though, as most college students take on loans to get through school. Students can rely on both federal and private student loans, in addition to cash savings, scholarships, and grants.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.


Cover up to 100% of school-certified costs including tuition, books, supplies, room and board, and transportation with a private student loan from SoFi.

FAQ

Are 529 plans worth it?

A 529 plan can be a worthwhile college savings vehicle, depending on a family’s situation. If the student is definitely going to attend college and if the state of residence offers tax benefits for these savings, or a prepaid tuition plan, it can be a good option.

Why shouldn’t you invest in a 529 plan?

For some people, a 529 may not be the best option. If a family is unsure whether a child will attend college, lives where there aren’t state-level tax breaks for these programs, or thinks they can earn higher returns elsewhere, they might not want to open a 529 college savings plan.

Is a 529 plan better than a savings account?

A savings account offers more flexibility than a 529 college savings plan, but it won’t offer the tax advantages that a 529 does. With a 529 account, contributions will grow tax-free, and withdrawals for qualified education expenses are also not subject to taxes.


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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.

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.

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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Guide to Custodial Accounts and How They Work

Many parents want to save for their child’s future. One way to do this is by setting up a custodial account. This type of account specifically allows an adult to put money into a savings or investment account for a minor, which they can then access once they reach adulthood.

Custodial accounts can be a great way to give a child a financial gift. These funds can eventually be used for such expenses as their education, a car, wedding, renting an apartment, or even buying a home. If college is a particular goal, you can even open a custodial account designed for this very purpose.

If you’re considering opening up a custodial account for a young person, read on to learn what a custodial account is, the different types, and how they operate.

What Is a Custodial Account?

A custodial account is savings or an investment account, established with a bank, brokerage firm, or mutual fund company, that’s managed by an adult on behalf of a minor, also known as the beneficiary.

Custodial accounts typically allow a parent, grandparent, family friend, or guardian to start saving for the child, until they reach adulthood, which depending on the state of residence, could be 18, 21, or even 25 years of age.

Even though the custodian manages and oversees the funds, the account is in the child’s name. Once the child reaches adulthood, the account legally transfers to their control.

Recommended: What is Retail Banking?

How Custodial Accounts Work

Opening a custodial account is simple. You can likely start one with almost any financial institution, brokerage firm, or mutual fund company. All a custodian probably needs to establish one is to provide basic personal information about themselves and the child. Once a custodial account is created, the adult can start contributing funds into the account.

The financial institution sets the terms of the account, which may include a minimum balance, maintenance fees, and initial investment requirements, among other stipulations. Individuals can usually contribute as much as they want to a custodial account, but there’s a federal cap on how much you can contribute that’s free of the gift tax imposed by the IRS. In 2024, this amount is up to $18,000 for individuals and $36,000 for married couples per child, per year. In 2025, this amount is up to $19,000 for individuals and $38,000 for married couples per child, per year.

Custodial bank accounts usually come with protections for the beneficiary. While the custodian can withdraw money from the account, legally the money must only be used to benefit the minor. This means the adult in charge of the account can’t use the funds for their own personal reasons. Additionally, any contribution made becomes the property of the child, so transactions can’t be changed or reversed.

A monthly contribution to a custodial account can make a big difference in a child’s life because the money can substantially accumulate over the years. According to Fidelity Investments, starting to contribute $50 a month to a custodial account when a child is 5 years old can result in $21,000 once that child reaches age 21. Put in $150 a month and that amount goes up to $63,000, while $250 a month clocks in at $104,900.

Recommended: Tax Credits vs. Tax Deductions: What’s the Difference?

Types of Custodial Accounts

There are two main types of custodial accounts: the Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA). While both have the same objective and eliminate the need to start a trust, they work in slightly different ways. Another option is the Coverdell ESA and 529 accounts that can help with saving for college.

Uniform Gift to Minors Act (UGMA)

The Uniform Gift to Minors Act (UGMA), established in 1956, is a custodial account that grants adults the opportunity to give or transfer many different kinds of financial assets to a child. Here’s what is important to know:

•   Besides cash, assets in an UGMA account can include individual stocks, index funds, bonds, mutual funds, and insurance policies.

•   UGMA accounts aren’t limited to educational expenses. In fact, the money can be used by the beneficiary for anything once they come of age. A UGMA doesn’t have restrictions or contribution and withdrawal limits, but, as previously noted, gift tax limits apply.

•   This kind of custodial account is available in all 50 states and is easy to set up at many financial institutions and brokerages nationwide. Keep in mind there may be a minimum deposit required to open an UGMA.

•   There aren’t any tax benefits for contributions, but up to $1,300 of any earnings from a custodial account in 2024 may be tax-free (up to $1,350 in 2025). And earnings above the tax-free threshold are taxed at the child’s (not parent’s) tax rate, up to certain limits.

•   Since education costs are one main reason parents or loved ones open a custodial account, one thing to know is because the funds are considered an asset owned by the child, it can affect their ability to get financial aid and student loans.

Uniform Transfers to Minors Act (UTMA)

The Uniform Transfers to Minors Act (UTMA), is a newer, expanded version of an UGMA. There are some differences between them to be aware of:

•   The main difference is that an UTMA account can include physical assets, such as cars, art, jewelry, and real estate.

•   You are not able to open a UTMA in every state. Currently, South Carolina and Vermont are two that don’t allow you to open a UTMA custodial account. And many states have a higher age at which a beneficiary can take control of a UTMA compared to a UGMA account.

•   The zero contribution limits, tax benefits, and financial aid impact that come with UGMAs are the same for UTMAs.

Coverdell Education Savings Account (ESA) and 529 Plans

There are two educational savings plans that fall under the umbrella of custodial accounts and can help a parent save for college for their child. One is the Coverdell Education Savings Account (ESA).

•   This type of custodial account exists solely for saving for a child’s future educational needs. According to the IRS, ESA contributions made must be in cash and are not tax deductible.

•   Unlike UTMAs and UGMAs, there’s a $2,000 limit per year to how much you can contribute to the ESA’s account beneficiary.

•   ESA custodial accounts also have income-based restrictions and are only available to families who fall under a certain income level. Coverdell ESA’s are created by each state so you’ll need to see if your state offers one.

A 529 College Savings Plan, also known as a “qualified tuition plan” is often considered a kind of custodial account because it’s created to pay for the beneficiary’s educational expenses, whether it’s for college, tuition costs for kids in grades K-12, certain apprenticeship programs, and even to pay student loans.

•   Unlike other custodial plans, a 529 College Savings account can remain in the holder’s name even when the beneficiary reaches the age of majority in their state.

•   There aren’t any income limits for a 529 Plan, which differentiates it from a Coverdell ESA.

•   The 529 Plans are state-sponsored and most states offer at least one. You must be a U.S. resident to open a 529 Plan.

•   You don’t have to be a resident of the state and can pick another state’s plan, but your state may offer a tax deduction if you live there and open one. The Federal Reserve features a list of state 529 Plans.

Custodial Accounts vs. Traditional Savings Account

Both a custodial account and a traditional kid’s savings account can be opened with the goal of putting money away for a child’s future. However, they are two separate types of accounts that operate in different ways.

•   A traditional savings account opened for a minor is a type of joint account that typically can be accessed and used by both the minor and their parent or guardian. Some states and financial institutions have age limits or restrictions on whether a child can be on a joint account. With a custodial account, as previously mentioned, a minor can’t make any transactions until they reach the age of maturity.

•   Traditional savings accounts typically have no limits on how much money you can keep in the account, but banks may have a base amount you need to open an account along with minimum balance requirements.

•   Custodial accounts may be better for long-term savings, while a traditional savings account can teach kids about banking and good finance habits.

Recommended: Understanding the Different Types of Bank Accounts

Pros and Cons of Custodial Accounts

Custodial accounts have their upsides and downsides. Here’s some pros and cons to consider, presented in chart form:

Pros of Custodial Accounts Cons of Custodial Accounts
Easy to set up Custodian loses monetary control when beneficiary comes of age
Can be inexpensive to establish May have a cap on how much you can contribute due to gift-tax laws
May have tax benefits Not as tax-exempt as other types of financial accounts
Money is the property of the child Can impact the ability to get financial aid
Anyone can make a contribution to the account Contributions are irrevocable

4 Steps to Opening a Custodial Account

Setting up a custodial account is simple and doesn’t take up a lot of time. Here’s how to open a custodial account in four steps.

🛈 Currently, SoFi does not offer custodial bank accounts and requires members to be 18 years old and above.

1. Decide on the Type of Custodial Account

Research the various options to determine which kind of account would best suit your goals and those of the child. For example, is the goal strictly for educational expenses? Are there limits to contributions? Do you want contributions to include physical assets as well as monetary funds?

2. Figure out Where You Want to Open the Account

Banks, brokerage firms, and mutual fund companies all offer custodial accounts. Pick the one that best suits your comfort level, familiarity, and goals for the child.

3. Gather the Child’s Personal Information as Well as Your Own

When you open the account, you’ll want to have the necessary information ready, such as the custodian and child’s Social Security numbers, addresses, phone numbers, and dates of birth.

The person who will be controlling the account will most likely have to provide employment information and have the account number(s) ready for another bank or investment account they want linked so they can transfer the money between accounts.

4. Open the Account

Many financial institutions make it easy for you to start an account online through their websites, or you can go to the financial institution in person.

The Takeaway

Custodial accounts can be a solid way to sock money away for a child’s future, whether it be for their education, a financial gift, or to provide them with a leg up on savings once they become young adults. These accounts can be opened at financial institutions and banks around the country, and you don’t even need to leave home to set one up. Depending on which type of custodial account you choose, you may also enjoy some tax-advantages too.

FAQ

Are custodial accounts a good idea?

They can be. Saving and investing money on behalf of a child can make their lives easier once they’ve become an adult. Having a built-in financial cushion they can use for their education, housing, a trip, or even towards retirement can be a valuable gift to someone as they start their adult life.

How does a custodial account work?

A parent, grandparent, guardian, or loved one can open a custodial account for a child, at a bank, brokerage, or mutual fund firm. The account is for the benefit of the child and managed by an adult or the custodian of the account, with contributions added over time, if desired. Once the child turns 18, 21, or 25 (depending on which state they live in), the money is turned over to them.

What are the pros and cons of custodial accounts?

The advantages of a custodial account are an automatic savings available to the child when they become of age, typically to spend on whatever they want; some potential tax breaks for the person who opens the account; and the ease of setting them up. Downsides of a custodial account include a possible cap on how much you can give because of gift-tax restrictions; the inability to reverse any transaction after its completed; and, since the account is considered an asset of the child, it could affect their ability to be eligible for financial aid when applying to schools.


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SoFi members with direct deposit activity can earn 4.00% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.00% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.00% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 12/3/24. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

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

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

This article is not intended to be legal advice. Please consult an attorney for advice.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Opening a Savings Account For a Baby

Opening a Savings Account for a Newborn Baby: What You Need to Know First

When a new baby arrives, there’s much to celebrate and so many milestones ahead. It’s not uncommon to want to help secure a child’s future by opening a savings account. That can start Junior off with a little nest egg and hopefully, in time, some good financial habits.

If you’re thinking you might like to open one of these accounts, read on to learn more.

Key Points

•   Opening a savings account for a newborn can secure their future and instill good financial habits.

•   Compounding interest over time significantly increases the initial savings placed in these accounts.

•   Such accounts typically feature low initial deposits, minimal balance requirements, and nominal fees.

•   Essential documents for opening an account include the baby’s birth certificate and Social Security number.

•   Alternatives like 529 College Savings Accounts or custodial accounts offer different benefits for long-term financial planning.

•   At this time, SoFi only allows members 18 years old or above to open a savings account.

🛈 Currently, SoFi does not offer custodial bank accounts and requires members to be 18 years old and above.

Why Open a Savings Account for a Baby?

There are actually some very good reasons to consider opening a bank account for a baby and start saving. You might be wondering why someone would open this kind of account for a newborn. After all, they don’t have any bills or expenses to pay so what would they need to have money in the bank for? Consider how opening an account and saving for a baby can have real benefits:

•   Time is on your side. Compounding interest can help you grow your baby’s savings account over time. The younger your child is when you start saving, the longer that money has to earn compound interest.

•   Plan for specific goals. Opening a savings account for a baby can make it easier to fund long-term goals. For example, you might want to set aside money to help them buy their first car or pay for college when the time comes.

•   Tax advantages. Savings accounts may not be earning a lot of interest right now. Still, the fact that babies usually don’t typically earn enough dough to pay taxes is a bonus.

•   Increase financial literacy. Teaching kids about saving from an early age can help them get into the habit. By opening a savings account for them when they’re young, you can help them learn the money skills they’ll need as adults.

Kids’ savings accounts can also be appealing because they tend to have low initial deposit requirements, low minimum-balance requirements, and low fees. So you don’t need a lot of money to start saving on behalf of your newborn — and you may not have to worry about paying a lot of fees to maintain the account as they grow.

How to Open a Savings Account for a Baby

Opening a bank account for a baby isn’t a complicated process. To open a savings account for a newborn, you’ll need the following:

•   Information about yourself

•   Information about your baby

•   Required documentation

•   Minimum initial deposit and funding details.

You should be able to open a savings account for a baby either at an online bank or a traditional bank or credit union. You’ll need to fill out the savings account application and provide the deposit via check, money order, cash or ACH transfer if you’re opening an account with an online bank. The minimum deposit may be as little as $1 or even $0, though some banks may require a larger deposit ($25 and up) to open a baby savings account.

Keep in mind that some banks may require you to have an account of your own before you can open a savings account for a child. That could influence where you decide to set up a savings account for a newborn.

Also look into any account maintenance fees that may be assessed monthly. You don’t want fees eating up the principal and interest in the account. Let’s look at this a little more closely next.

Can You Withdraw Money from Your Baby’s Savings Account?

Because a child cannot legally open or hold a bank account, an adult is a required presence. The parent or custodian who opens the account holds it jointly with the child and can indeed withdraw funds. It’s similar to a joint account that couples may have. However, there may be limits regarding whether your child can make withdrawals as they age and for how much.

If you were to open what’s called a custodial account (which becomes property of the child at adulthood; more on these accounts below), you may withdraw funds, but the intention is that they only be used for the kid’s benefit.

Types of Savings Account for Newborns

The best savings accounts for newborns are ones that allow you to save regularly, earn interest, and avoid high fees. You might look to your current bank first to open a savings account for the baby. Consider what type of features or benefits are offered. If you have to pay a monthly service fee, for example, you may be better off considering a savings account for a newborn at an online bank instead.

Online banks can offer the dual advantages of higher annual percentage yields, or APYs, on savings and lower fees. You won’t have branch banking access but that may not be important if you prefer to deposit money via mobile deposit or ACH transfer anyway. And once your child gets a little bigger, you can introduce them to the world of mobile banking and how to manage it on their own.

Also, consider how well a newborn savings account can grow with your kid’s needs. Some questions you might ask: Can you switch the account to a teen savings account or teen checking account down the line? Could you add a prepaid debit card for teens into the mix at some point? Asking these kinds of questions can help you pinpoint the best savings account for a newborn, based on your child’s needs now and in the future.

For some people, it can be a benefit to know that the bank has figured out ways to help accounts grow with their youngest customers and coach them along their journey to financial literacy.

Requirements for Opening a Savings Account for a Baby

The requirements for opening a bank account for a newborn are a little different from opening a bank account for yourself. That’s because the bank needs to be able to verify your identity as well as the baby’s.

Generally, the list of things you’ll be required to provide to open a savings account for baby include:

•   Your name and your baby’s name

•   Dates of birth for yourself and the baby

•   A copy of your government-issued photo ID

•   The baby’s birth certificate

•   Your address, phone number, email address, and Social Security number.

The bank may ask for the baby’s Social Security number though it’s possible you may not have this yet at the newborn stage. And if you don’t have a Social Security number of your own, you may have to provide a substitute federal ID.

Alternatives to Newborn Savings Accounts

A savings account at a bank or credit union isn’t the only way to set aside money for a newborn. While these accounts can earn interest, there are other types of savings you might use to fund different goals for your child. Here are some of the other options you might consider when saving money for a baby.

529 College Savings Accounts

Many parents — even brand-new ones! — wonder how to start saving for college. A 529 college savings account is a type of tax-advantaged plan that’s designed to help you save for education expenses. These accounts can be opened by the parent but anyone can make contributions, including grandparents, aunts and uncles, or family friends.

All 50 states offer at least one 529 plan. There are no annual limits on 529 plan contributions and you can open any state’s plan, regardless of which state you live in. Contributions are subject to annual gift tax exclusion limits, which are $18,000 for individuals and $36,000 for married couples in 2024 ($19,000 and $38,000, respectively, in 2025).

With a 529 plan, you’re investing money rather than saving it. You can invest the money you contribute in a variety of mutual funds, including index funds and target-date funds. This money grows tax-deferred, and withdrawals are tax-free when used for qualified education expenses, such as tuition and fees, books and room and board.

Coverdell Education Savings Accounts

There are other ways to save for a child’s college tuition. A Coverdell Education Savings Account (ESA) is a type of custodial account that can be set up to save for education expenses. This account grows tax-deferred just like a 529 plan and qualified withdrawals are tax-free. But there are some key differences:

•   Annual contributions are capped at $2,000 and are not tax-deductible

•   Contributions must end once the child reaches age 18 (an exception is made for special-needs beneficiaries)

•   All funds must be distributed by the time the child reaches age 30.

If you leave money in a Coverdell ESA past the child’s 30th birthday, the IRS can impose a tax penalty. Any withdrawals of ESA funds that aren’t used for qualified education expenses are subject to income tax.

Custodial Accounts

Custodial accounts are savings accounts that allow minors to hold assets other than savings, such as stocks or other securities. You can set up a custodial account with a brokerage on behalf of your child. As the custodian, you maintain ownership of the account and its assets until your child reaches the age of majority, typically either 18 or 21. At that point, all the money in the account becomes theirs.

Opening a custodial account could make sense if you want to make irrevocable financial gifts to your kids. This could be one of the best strategies for building an investment plan for your child. The biggest drawback, however, is that once they turn 18 (or 21) you no longer have control over the account or how the money inside of it is used. For some parents, relinquishing that control can be hard, but remember: There’s lots of financial literacy that can be gained between your child’s birth and officially entering adulthood.

FAQ

Can I start a savings account for my baby?

Yes, opening a savings account for a baby is something you can do even if they’re still a newborn. Traditional banks, credit unions, and online banks can offer savings account options for babies and kids. You can also explore savings account alternatives, such as 529 college savings plans or custodial accounts.

What type of savings account should I open for my newborn?

The type of savings account you open for a baby can depend on your financial goals. If you just want to get them started saving early, a basic savings account might work best. On the other hand, you might consider creating an investment plan for your child that includes a 529 savings account if you’re interested in putting aside money for future college expenses.

What are the typical requirements for opening a bank account for a newborn baby?

You’ll likely need to provide your name, address, and phone number, plus your email address, Social Security number, and government-issued photo ID. You’ll probably be asked for the baby’s birth certificate and an opening deposit as well, which may be as little as $1 or even zero.


Photo credit: iStock/michellegibson

SoFi members with direct deposit activity can earn 4.00% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.00% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.00% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 12/3/24. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.


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.

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Default Deferral Rate 401(k) Explained

Default Deferral Rate 401(k) Explained

Your 401(k) deferral rate is the amount that you contribute to the plan via your paychecks. Many companies have a default deferral rate on 401(k) plans, in which they automatically direct a certain amount of your paycheck to your 401(k) plan. This occurs automatically, unless you opt out of participation or select a higher default rate.

The default deferral rate on 401(k) plans varies from one plan to another (and not all plans have a default rate), though the most common rate is 7%. If you’re currently saving in a 401(k) plan or will soon enroll in your employer’s plan, it’s important to understand how automatic contributions work.

What Is a 401(k) Deferral Rate?

A deferral rate is the percentage of salary contributed to a 401(k) plan or a similar qualified plan each pay period. Each 401(k) plan can establish a default deferral percentage, which represents the minimum amount that employees automatically contribute, unless they opt out of the plan.

For example, someone making a $50,000 annual salary would automatically contribute a minimum of $1,500 per year to their plan if it had a 3% automatic deferral rate.

Employees can choose not to participate in the plan, or they can contribute more than the minimum deferral percentage set by their plan. They may choose to contribute 10%, 15% or more of their salary into the plan each year, and receive a tax benefit up to the annual limit. Again, the more of your income you defer into the plan, the larger your retirement nest egg may be later.

There are several benefits associated with changing your 401(k) contributions to maximize 401(k) salary deferrals, including:

•   Reducing taxable income if you’re contributing pre-tax dollars

•   Getting the full employer matching contribution

•   Qualifying for the retirement saver’s credit

If you qualify, the Saver’s Credit is worth up to $1,000 for single filers or $2,000 for married couples filing jointly. This credit can be used to reduce your tax liability on a dollar-for-dollar basis.

Get a 1% IRA match on rollovers and contributions.

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1


1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

Average Deferral Rate

Studies have shown that more employers are leaning toward the higher end of the scale when setting the default deferral rate. According to research from the Plan Sponsor Council of America (PSCA), for instance, 32.9% of employers use an automatic default deferral rate of 6% versus 29% that set the default percentage at 3%.

In terms of employer matching contributions, a recent survey from the PSCA found that 96% of employers offer some level of match. The most recent data available from the Bureau of Labor suggests that the average employer match works out to around 3.5%. Again, it’s important to remember that not every employer offers this free money to employees who enroll in the company’s 401(k).

Research shows that higher default rates result in higher overall retirement savings for participants.

What Is the Actual Deferral Percentage Test?

The actual deferral percentage (ADP) test is one of two nondiscrimination tests employers must apply to ensure that employees who contribute to a 401(k) receive equal treatment, as required by federal regulations. The ADP test counts elective deferrals of highly compensated employees and non-highly compensated employees to determine proportionality. A 401(k) plan passes the ADP test if the actual deferral percentage for highly compensated employees doesn’t exceed the greater of:

•   125% of the ADP for non-highly compensated employees, or the lesser of

•   200% of the ADP for non-highly compensated employees or the ADP for those employees plus 2%

If a company fails the ADP test or the second nondiscrimination test, known as actual contribution percentage, then it has to remedy that to avoid an IRS penalty. This can mean making contributions to the plan on behalf of non-highly compensated employees.

How Much Should I Contribute to Retirement?

If you’re ready to start saving for retirement, using your employer’s 401(k), one of the most important steps is determining your personal deferral rate. The appropriate deferral percentage can depend on several things, including:

•   How much you want to save for retirement total

•   Your current age and when you plan to retire

•   What you can realistically afford to contribute, based on your current income and expenses

A typical rule of thumb suggested by financial specialists is to save at least 15% of your gross income toward retirement each year. So if you’re making $100,000 a year before taxes, you’d save $15,000 in your 401(k) following this rule. But it’s important to consider whether you can afford to defer that much into the plan.

Using a 401(k) calculator or retirement savings calculator can help you to get a better idea of how much you need to save each year to reach your goals, based on where you’re starting from right now. As a general rule, the younger you are when starting to invest for retirement the better, as you have more time to take advantage of the power of compounding returns.

If you don’t have a 401(k), you can still save for retirement through an individual retirement account (IRA) and set up automatic deposits to mimic paycheck deferrals and give you the benefit of dollar-cost averaging.

Contribution Limits

It’s important to keep in mind that there are annual contribution limits for 401(k) plans. These limits determine how much of your income you can defer in any given year and are established by the IRS. The IRS adjusts annual contribution limits periodically to account for inflation.

For 2024, employees are allowed to contribute $23,000 to their 401(k) plans. An additional catch-up contribution of $7,500 is allowed for employees aged 50 or older. That means older workers may be eligible to make a total contribution of $30,500.

For 2025, employees can contribute $23,500 to their 401(k), and those 50 and older can make an additional catch-up contribution of $7,500. Those aged 60 to 63 can make an extra contribution of $11,250, instead of $7,500 in 2025, for a total of $34,750, thanks to SECURE 2.0

The total annual 2024 contribution limit for 401(k) plans, including both employee and employer matching contributions, is $69,000 ($76,500 with the catch-up). For 2025, the total annual contribution limit is $70,000 ($77,500 with the standard catch-up and $81,250 with the SECURE 2.0 catch-up).

The money that you contribute to the 401(k) is yours, but you might not own the contributions from your employer until a certain period of time has passed, if your plan uses a 401(k) vesting schedule.

You’re not required to max out the annual contribution limit and employers are not required to offer a match. But the more of your salary you defer to the plan and the bigger the matching contribution, the more money you could end up with once you’re ready to retire.

The Takeaway

Contributing to a 401(k) can be one of the most effective ways to save for retirement but it’s not your only option. If you don’t have a 401(k) at work or you want to supplement your salary deferrals, you can also save using an Individual Retirement Account (IRA).

An IRA allows you to set aside money for the future while snagging some tax breaks. With a traditional IRA, your contributions may be tax-deductible. A Roth IRA, meanwhile, allows for tax-free distributions in retirement.

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

What is a good deferral rate for 401(k)?

A good deferral rate for 401(k) contributions is one that allows you to qualify for the full employer match if one is offered, at a minimum. The more money you defer into your plan, the more opportunity you have to grow wealth for retirement.

What is an automatic deferral?

An automatic deferral is a deferral of salary into a 401(k) plan or similar qualified plan through paycheck deductions. Your employer automatically redirects money from your paycheck into your retirement account.

What is the maximum default automatic enrollment deferral rate?

This depends on your employer. Some employers may set the threshold higher to allow employees to make better use of the plan.


Photo credit: iStock/guvendemir

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.

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

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

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.

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401(k) Taxes: Rules on Withdrawals and Contributions

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.

Recommended: Understanding the Different Types of Retirement Plans

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.

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.

One of the significant differences between a Roth 401(k) and a Roth IRA is that the 401(k) requires participants to start taking required minimum distributions at age 72, but there is no such requirement for a Roth IRA.

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®

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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.

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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