Oct
03
2024

Guide To How Much You Should Save From Each Paycheck

By | Budgeting & Goals, money | Comments Off on Guide To How Much You Should Save From Each Paycheck

Sure, you know you should be saving money, but, if you’re like many people, you’re not sure exactly how much to be stashing away. Some people put $100 per paycheck away and feel pretty proud of that; others will be able to set aside 10 times that amount. Still others will use a percentage, typically saving 10% to 30% of their salary.

In this guide, you’ll learn more about how much of your paycheck you should save. Many experts recommend 20% of your paycheck toward your total savings, which includes retirement, short-term savings, and any other savings goals. But exactly how much you should save each month, however, will depend on a number of factors, including your goals, current income, and living expenses.

Key Points

•   Financial experts recommend saving between 10% and 30% of your salary, with 20% being a common figure.

•   The 50/30/20 rule suggests allocating 20% of your take-home income to savings, including retirement, short-term savings, and other goals, such as debt repayment beyond the minimum due.

•   The amount to save from each paycheck depends on factors like goals, current income, and living expenses.

•   Saving for an emergency fund, retirement, and other goals are important savings objectives.

•   Cutting spending, automating savings, and choosing the right savings account can help increase savings.

How Much of Your Paycheck Should You Save?

When it comes to what percentage of income to save for future expenses, financial advice can vary depending on where you look. Some experts suggest saving as little as 10% of each paycheck, while others might suggest 30% or more.

For some people who are living paycheck to paycheck, the answer to “How much of my income should I save?” may be lower still. It may be wiser to simply come up with a set amount (say, $25 to $50) to deposit into savings in your bank account.

Rules of Thumb

According to the 50/30/20 rule of budgeting, 50% of your take-home income should go to essentials, 30% to nonessentials, and 20% to saving for future goals (including debt repayment beyond the minimum).

The right amount for you to save from each paycheck will depend on your income, your fixed expenses, as well as your short- and long-term financial goals.

If, for instance, you are a recent grad living at home for a while and your living expenses are very low, you may be able to save a much higher percentage for the time being.

Or, if you have a sizable credit card balance, you might pump money towards paying that off. In this situation, you might minimize or even pause the amount saved while getting that debt eliminated.

Calculating Percentages From Your Paycheck

To figure out how much to save from each paycheck, you’ll need to consider a few factors. The right amount will depend on your income, your fixed expenses, as well as your short- and long-term financial goals.

•   For example, if the cost of living is high in your state or local area, you may need to spend more than half of your take-home pay on living expenses, making it hard to put 20% of each paycheck into savings.

•   On the other hand, if your goal is to buy a home in two years, you may need to put more than 20% percent of your paycheck into savings in order to have your down payment in that timeline.

•   If you want to retire early, you may need to put more of your income towards retirement every month than the average worker.

Recommended: Check out the 50/30/20 budget calculator to see a breakdown of your money.

Earn up to 4.00% APY with a high-yield savings account from SoFi.

No account or monthly fees. No minimum balance.

9x the national average savings account rate.

Up to $2M of additional FDIC insurance.

Sort savings into Vaults, auto save with Roundups.


4 Important Savings Goals to Work Toward

While it’s widely recognized that saving can be a good idea, it can be helpful to really think about what it is you are saving for. Having a few specific goals in mind can help you determine how much you should save from each paycheck as well as motivate you.

Here are some common savings goals that can help you build financial wellness.

1. Emergency Fund

Yes, it can be hard to save money, but one of the most important priorities is to sock away money (even if just a little) regularly into an emergency fund. In SoFi’s April 2024 Banking Survey of 500 U.S. adults, 77% of respondents with a savings account said they use the account to save for emergencies.

An emergency fund is a bundle of easily accessible cash that could help you handle a financial curveball, such as a job loss, medical emergency, or big ticket car or home repair.

Having this back-up fund in place can help ensure that you never have to rely on credit cards to make ends meet.

Ideally, an emergency fund will contain enough money to cover your living expenses for three to six months, but how much you’ll want to put aside will depend on your situation.

•   If you are married with an employed spouse and with no children, for example, you may only need to cover three months’ worth of expenses.

•   If you have kids or you’re single, you may want to have an emergency fund that could cover at least six months’ worth of expenses.

It can help to keep the money in an account that earns more interest than a standard savings account, but allows you to easily access your money. Some good options include a high-yield savings account or money market account.

💡 Need help determining your emergency fund amount? Check out this emergency fund calculator for help.

2. Paying Off High-Interest Debt

Another important thing you could consider doing with your savings is paying off any high-interest debt (or “bad” debt) you may have. Typically, this is credit card debt, which currently has an average rate of well over 20%.

•   One debt payoff strategy you may want to consider is the debt snowball method. With this approach, you start by paying off the debt with the smallest balance and put all your extra payments towards that until it’s paid off (while continuing to pay the minimum on your other debts).

You then put extra payments toward the debt with the next highest balance, and so on. This can give you a sense of accomplishment which can help motivate you to continue your aggressive repayment.

•   Another approach is the debt avalanche method. This Involves putting all your extra payments towards the debt with the highest interest rate, while paying the minimum on the others.

When that debt is paid off, you then focus on the debt with the next-highest interest rate. Since you are concentrating on the debt with the highest interest rate, this strategy can end up being the most cost-effective.

3. Saving for Retirement

Another reason why saving money is important: It can secure your future by providing for your retirement. Exactly how much of your paycheck should go to retirement savings will depend on your age and when you want to retire. Some pointers:

•   If your company offers a 401(k) with matching contributions, it can make sense to put aside at least as much of your paycheck as your company will match (since this is essentially free money).

•   If you don’t have access to a 401(k) or want to contribute beyond that fund, you may want to open a Roth or Traditional IRA. Both types of IRAs have different tax benefits.

•   When you invest in a Roth IRA, the money is taxed at the time of contribution but then in retirement, you can withdraw it tax-free. Contributions made to a traditional IRA might not be taxed at the time they are made but are taxed when they are withdrawn in retirement.

When choosing how much of your paycheck to put into retirement savings, you may want to keep in mind that the IRS sets restrictions on how much you can contribute to your retirement funds each year. IRS retirement guidelines are published and updated regularly.

4. Saving for Other Goals

After establishing plans for debt repayment, an emergency fund, and retirement savings, you may also want to consider working toward your other financial goals, like buying a house, saving for your kids’ future education, or affording a great vacation. This is a popular option for savings account usage, according to SoFi’s data.

•   52% of respondents in SoFi’s survey reported using their savings account to save for a specific goal

•   40% of them are saving equally for long-term and short-term goals

•   35% said they’re saving for short-term goals like a vacation or holiday shopping

•   26% are saving for long-term goals like a house or a child’s education.

How much of your paycheck you should save for these goals will depend on what you want to accomplish and when you want to accomplish it.

When you’re saving for a big purchase, for example, you may want to start by determining how much money you’ll need and when you want to have the money.

You can then break that dollar amount down into the amount you need to save each year and each month. This can help you determine how much of each paycheck you may want to put aside to help you achieve that goal.

•   For savings goals you want to accomplish in the next three to five years, you may want to consider putting the money in a safe account that earns higher-than-average interest (such as a high-yield savings account, checking and savings account, or a CD).

•   Longer-term savings goals, such as your children’s college education, can be invested more aggressively, since you’ll have more time to ride out the ups and downs of the markets (yes, there is risk involved). For college savings, you may want to consider opening a 529 savings plan.

Reducing Your Costs to Save More

You can help ramp up your savings by cutting your spending. Here are some ideas for saving money daily:

•   Review your monthly bills and see if there’s anything you can cut. You might have signed up for a couple of subscriptions and then forgotten about them, or you might see that your restaurant spending is surging lately.

•   Learn how to save on food. You might try planning your meals weekly, so nothing goes to waste; joining a warehouse or wholesale club to lower your grocery bill; and using coupons and discount codes to downsize your food costs.

•   Bundle up: If you get your auto and home (or renters) insurance from one provider, you may save on your premiums.

•   Fight off FOMO (fear of missing out). Just because your friends are upgrading to a luxury car or a social media influencer is frolicking on the French Riviera, that doesn’t mean you have to too.

•   Pause, for a day or a month, before making pricey impulse buys to make sure you really and truly want or need them.

•   Pay in cash. Plastic, whether a credit or debit card, can make it easy to overspend. If you take out the cash you need for the week ahead and use only that to pay for purchases, you may be able to rein in your purchasing.

•   Use budgeting tools to help stay on track. Twenty-three percent of people in SoFi’s survey use budgeting tools offered by their bank, and 20% have knowingly used AI to manage their budget or finances.

Where to Put Your Savings

Once you’ve committed to saving money, you’ll have some options about where to keep it. Some good ideas for funds that you want secure and accessible, as opposed to long-term savings like retirement accounts, include:

•   A high-yield savings account. These pay significantly more than a standard account and are often found at online banks vs. traditional ones. Just be sure to read the fine print and make sure you are aware of and comfortable with any account fees or minimums that might be involved.

•   A certificate of deposit (CD) is an account in which you commit to keeping your money at the bank for a specific term and you know what rate you will earn. Typically, there is a penalty for early withdrawal. The terms for CDs can range from a few months to several years, so you can pick what works best for you. Longer terms will often have higher interest rates.

•   Another option is a money market account (not to be confused with a money market fund, which is an investment) These MMAs offer features of both a checking and a savings account and your money may earn more than with a standard savings account.

Recommended: Plug in APY, deposits, and time to grow into this savings account interest calculator to see how much your money can grow.

Saving With SoFi

Looking for a bank that helps your money grow and gives you tools to take control of your spending and saving? See what SoFi offers.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.


Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.00% APY on SoFi Checking and Savings.

FAQ

Is saving 10% of my paycheck enough?

How much of your paycheck should you save? Most financial experts advise saving between 10% and 30% of your salary, with 20% being a common figure. Based on this, 10% is an adequate amount for some, but if you can ramp that up in the future, so much the better.

Is 20% of your salary enough to save?

According to the 50/30/20 budget rule, saving 20% of your salary is a good goal to have; that’s the 20 in the name of the guideline. This amount can then be divided to address different needs, such as saving for the down payment on a house, for your child’s college education, and for retirement.

How much of a $1,000 paycheck should I save?

Typically, financial experts recommend saving between 10% and 30% of your paycheck, with 20% being a good figure to aim for. For $1,000, that would mean between $100 and $300, with $200 being the 20% figure. However, if you are earning a lower salary and money is tight, it would be understandable if you save less until your salary increases.


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.

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.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

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.

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Oct
03
2024

The Importance of Saving Money

By | Budgeting & Goals, Financial Independence, money | Comments Off on The Importance of Saving Money

Whether from parents, friends, or financial advisors, you have probably heard plenty of people say that you should be saving money. But did you ever stop and consider why exactly saving money is so important?

Saving money is truly a smart move: It can help you achieve your financial aspirations, prepare for the future, and weather unexpected events. It can even help you earn money without doing anything at all. When you look at it in a big-picture way, saving can relieve a lot of money stress from your life.

Granted, there are vacations to be taken, loans to be paid off, and all kinds of other uses for cash that could leave you without any to stash in savings. But by making saving a priority, you can really enhance your financial standing.

Here, you’ll learn more about this topic, including:

•   The reasons why saving money is important

•   How to start saving (as painlessly as possible)

•   Where to store the cash you save.

Reasons Why Saving Money is Important

It can be hard to get motivated to save money just because it’s the “responsible” thing to do. But you may see the appeal once you understand the huge advantages that saving offers. Here are a few.

Peace of Mind

If money is tight, you may find yourself worrying how you will pay the rent or other critical bills if an extra unexpected expense were to suddenly come up, as they often do. After all, cars break down, and dental work can crop up. Or what if your kid discovers a passion for soccer and wants to go to a pricey summer camp.

Having savings in the bank can provide the sense of security that comes with knowing you can get through these kinds of moments without hardship. You’ll be able to have that back-up money to afford many of life’s expenses that crop up. By saving, you may also worry less about tomorrow, knowing that you have stashed away some cash. That means you can breathe a little easier.

Earn up to 4.00% APY with a high-yield savings account from SoFi.

No account or monthly fees. No minimum balance.

9x the national average savings account rate.

Up to $2M of additional FDIC insurance.

Sort savings into Vaults, auto save with Roundups.


Avoiding Debt

When you have money in the bank, you can make purchases, planned or not, with your money that’s in the bank. That means you can avoid using high-interest credit cards or potentially taking out a personal loan or a home equity line of credit (HELOC) to pay for things.

That can help you side-step debt, which can help save a significant amount of cash in the long run.

Expanding Your Options

Generally, the more money you have saved, the more control you can have over your life and your financial security.

If you’re unhappy with where you live, for instance, having some savings can open up the possibility of moving to a more desirable location or putting a downpayment on a new home.

If you dislike your job, having a cushion of savings might afford you the option of leaving that job even before you have another one lined up.

Money certainly does not solve all problems, but having savings can give you a little bit of breathing room and allow you to take positive steps in your life.

Having Financial Freedom

Another benefit of savings is that you are on a program that can give you financial freedom. If you stick to a plan of stashing 10% or 20% into savings, as many financial experts recommend, you can avoid always living paycheck to paycheck and have more financial freedom.

For example, with adequate savings, you might be able to take a sabbatical from work and pursue a passion project. You might have enough cash to start your own business or retire early. Or you might plan a luxe anniversary celebration somewhere tropical. Savings can enable your dreams.

Recommended: Guide to Improving Your Money Mindset

Saving for Big Purchases

Having a savings account is a great way to afford big purchases without racking up credit card debt and the high interest that goes along with it or turning to other expensive financing options.

Let’s say you want to take your kids on a Disney vacation or you really need that second car. Or maybe there’s a designer bag that you’re totally in love with. By putting money aside in a savings account and earning interest on those funds, you can be in a position to buy your wish-list item outright, rather than borrowing funds to do so.

Saving Money for Emergencies

Here’s another reason why it is important to save money: Life has its twists and turns. One minute, everything is humming along nicely, the next, your car needs $2,000 worth of repairs. Or the hot water heater conks out or you lose your job. These situations and others can put a real strain on your finances.

That’s why financial experts generally recommend building up an emergency fund of at least three to six months’ worth of living expenses to prepare for any financial surprises.

It can be hard to prioritize this, but saving for an emergency fund is important. To help make it happen, you might set up an automatic transfer from your checking into savings the day after payday. This can painlessly, seamlessly whisk money to your emergency fund so it doesn’t sit in savings, tempting you to spend it. Whether the amount is $15 or $150, just do it. Every bit helps.

Earning Interest

Savings accounts come with interest, which is the bank’s way of thanking you for keeping your money with them, where they can use it until you withdraw it.

Granted, the average savings accounts aren’t currently paying that much interest. The average rate is 0.45% APY as of October 21, 2024. However, if you look into an online savings account, you will likely find a much higher rate. Online banks, which don’t have to fund bricks-and-mortar branches, typically pass those savings along to their clients. They may offer a 3.00% APY or even higher.

That can help your savings along. If you have $5,000 in a savings account with a 3.00% APY earning compound interest monthly, that would give you an extra $152 at the end of the year. Add $20 per month to the account and let it sit for five years, and you’ll have $7,101. Nice! That’s cash in your account for doing absolutely nothing.

Reducing Your Taxes

Here’s the part about how saving money makes you money, beyond interest you’ll earn. If you save money into certain tax-advantaged retirement vehicles, not only do you have that nest egg for later in life, but you can lower your tax liability.

By putting money into your employer’s 401(k), if available, you can lower the income on which taxes are assessed. If you are self-employed, there are various IRA (individual retirement accounts) that may allow you to put pre-tax dollars away for the future.

When you save money this way, you could even challenge yourself to put the tax savings back into a savings account. That’s a way to increase your money in the bank another notch or two.

Giving Back

Another reason why saving money is important is it can enable you to give back to others. When you have a cash cushion and aren’t living paycheck to paycheck, you have the opportunity to help those around you.

That might involve sending a few hundred dollars to a relative who has a big dental bill and is struggling to pay it. Or you might donate to a medical research cause, a disaster fund, or a local after-school program that you love. The choice is yours, but having a healthy savings account can make it possible.

Benefiting from Compound Interest

Another big incentive to save, as mentioned above, is the power of compound interest.

Compound interest means you earn a return not just on the amount you originally put away, but also on the interest that accumulates.

Over time, that means you can end up with much more than you started with. And the earlier you start saving, the more your money grows, since compound interest is able to work its magic over a longer time horizon.

You saw an example above that involved putting money into a savings account at a bank. Now, consider investing: A person who starts putting $100 per month towards retirement at age 25 will wind up putting $12,000 more of their money into their retirement fund by age 65 than the person who started saving $100 per month at age 35.

But because of compound interest (and assuming a 7.00% annual rate of return), the person who started at 25 will wind up with over $120,000 more at age 65 (way more than the extra $12,000 they invested). Please note that this is a hypothetical scenario and does not represent an actual investment. All investing involves risk.

How to Get Started with Saving

If you’re convinced that saving is the right move, how do you actually do it? The key is to make a budget and make sticking to it easy.

This doesn’t have to be intimidating. The key is to get familiar with what you spend, what you earn, and what your goals are.

Here are some steps you could take to help get started.

Figuring Out What You’re Saving For

Is it a long-term goal, like retirement or your kids’ college tuition? A short-term goal, like an emergency fund? Or a medium-term goal, like a wedding or home renovation? It can help to get a sense of how much you need to stash away and by when.

The point of this is twofold:

•   First, you can divide the amount you need by the months left until your deadline to get a clear picture of how much you’ll need to save each month.

•   Second, you will know where to put your money. If your goal is less than a couple of years away, you may want to keep your savings in an online savings account, a certificate of deposit (CD), or money market account.

These options can help you earn more interest than a standard savings account but still allow you to access your money when you need it.

If your goal is in the distant future, you might want to invest the money in a retirement account, 529 college savings plan, or brokerage account so that it has the chance to grow over time.

Sticking to a Budget

You don’t really know where your money is going unless you track it. That’s why for a month or two, you may want to take note of all your daily and monthly expenses.

Next, you’ll want to tally up your net monthly income, meaning what goes into your account after the different types of taxes and deductions are taken out.

The difference between your monthly income and your expenses (everything from rent to student loan payments to food and dining out) is what you have left over to save. If there’s not enough left over, you can work on finding ways to cut spending or increase your income. You might try following the 50/30/20 budget rule to help guide your spending and saving.

Putting Savings on Autopilot

If you’re manually putting cash away every month, it can be easy to fall behind.

For one thing, you may forget to move money into savings regularly amid your busy schedule. And, unless you protect the money in advance by transferring it to a different account, you may accidentally spend it.

One way to avoid this is to set up automated savings through your bank account or retirement plan.

If you’re putting away the amount you identified you need for your goal, you may get there without even thinking about it.

Recommended: The Different Types of Savings Accounts

Common Places to Save Your Money

Where to put your money as you save? Consider these options:

•   Savings account: You could put your money in a savings account at a financial institution, like your local bank branch. However, as outlined above, you may not earn the highest possible interest.

•   Online savings account or high-yield savings account: These accounts are likely to pay a much higher interest rate than a conventional savings account while offering the same convenience and security as a traditional savings account.

•   CD: A CD gives you a specific rate of interest but you must agree to keep your money in the account (that is, not withdrawing any of it) for a specific term, whether months or years. Withdrawing earlier could trigger penalties.

•   Investments: There are many options here, such as Treasury bills and bonds. These can earn healthy returns and are typically considered safe places to keep money.

The Takeaway

Why is it important to save money? For a variety of reasons. It can provide peace of mind, open up options that improve your quality of life, increase your wealth due to compound interest and possibly lower your tax liability, and may even allow you to retire early. Many people earn wealth through a combination of working and savvy saving.

Looking for a smart way to save? Consider opening an online bank account with SoFi. Our FDIC-insured Checking and Savings account earns a competitive APY, and charges no account fees, both of which can help your money grow faster. And with Vaults and Roundups, you can track and grow your savings, assisting you as you aim for your personal financial goals.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.00% APY on SoFi Checking and Savings.

FAQ

What are the benefits of saving money?

There are many benefits of saving money: It helps you save for your future, cover unexpected expenses, make major purchases, and have financial freedom. What’s more, the money you save can help make you more money, thanks to compounding interest and lowering your tax bill.

What are common things to save money for?

Common things to save money for are an emergency fund, retirement, a big purchase (like a car, a vacation, or the down payment on a home), and educational expenses, among others.

What happens if you don’t save money?

If you don’t save, you may lack financial security and the ability to meet certain aspirations. For instance, you won’t have a retirement fund and would therefore have to keep working indefinitely. You wouldn’t have money for a big purchase like a car or a home or your child’s education. Plus you wouldn’t be able to handle some expenses, whether planned or unexpected, and might have to take out a loan or use credit cards, which means you are paying for the privilege to borrow funds. That takes away from your earnings.

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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.

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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.

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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.

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.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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Oct
02
2024
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How to Roll Over Your 401(k): Knowing Your Options

By | Budgeting & Goals, Building Your Career, Growing Wealth, invest, Investing, Life & Career | No Comments

It’s pretty easy to rollover your old 401(k) retirement savings to an individual retirement account (IRA), a new 401(k), or another option — yet millions of workers either forget to rollover their hard-won retirement savings, or they lose track of the accounts. Given that a 401(k) rollover typically takes minimal time and, these days, minimal paperwork, it makes sense to know the basics so you can rescue your 401(k), roll it over to a new account, and add to your future financial security.

Whether you’re starting a new job and need to roll over your 401(k), or are looking at what other options are available to you, here’s a rundown of what you need to know.

Key Points

•   Rolling over a 401(k) to an IRA or new 401(k) is typically straightforward and your retirement funds will continue to have the opportunity to grow.

•   Moving 401(k) funds to another 401(k) is often the simplest option and allows you to continue to have a higher contribution limit.

•   Moving 401(k) funds to an IRA may provide more investment choices and control over those investments.

•   Leaving a 401(k) with a former employer is an option but may involve additional fees and complications.

•   Direct transfers are simpler and generally preferred over indirect transfers, which run the risk of incurring tax liabilities and penalties.

401(k) Rollover Options

For workers who have a 401(k) and are considering next steps for those retirement funds — such as rolling them to an IRA or another 401(k), here are some potential avenues.

1. Roll Over Money to a New 401(k) Plan

If your new job offers a 401(k) or similar plan, rolling your old 401(k) funds into your new 401(k) account may be both the simplest and best option — and the one least likely to lead to a tax headache.

That said, how you go about the rollover has a pretty major impact on how much effort and paperwork is involved, which is why it’s important to understand the difference between direct and indirect transfers.

Here are the two main options you’ll have if you’re moving your 401(k) funds from one company-sponsored retirement account to another.

Direct Rollover

A direct transfer, or direct rollover, is exactly what it sounds like: The money moves directly from your old account to the new one. In other words, you never have access to the money, which means you don’t have to worry about any tax withholdings or other liabilities.

Depending on your account custodian(s), this transfer may all be done digitally via ACH transfer, or you may receive a paper check made payable to the new account. Either way, this is considered the simplest option, and one that keeps your retirement fund intact and growing with the least possible interruption.

Indirect Rollover

Another viable, but more complex, option, is to do an indirect transfer or rollover, in which you cash out the account with the expressed intent of immediately reinvesting it into another retirement fund, whether that’s your new company’s 401(k) or an IRA (see above).

But here’s the tricky part: Since you’ll actually have the cash in hand, the government requires your account custodian to withhold a mandatory 20% tax. And although you’ll get that 20% back in the form of a tax exemption later, you do have to make up the 20% out of pocket and deposit the full amount into your new retirement account within 60 days.

For example, say you have $50,000 in your old 401(k). If you elected to do an indirect transfer, your custodian would cut you a check for only $40,000, thanks to the mandatory 20% tax withholding.

But in order to avoid fees and penalties, you’d still need to deposit the full $50,000 into your new retirement account, including $10,000 out of your own pocket. In addition, if you retain any funds from the rollover, they may be subject to an additional 10% penalty for early withdrawal.

Pros and Cons of Rolling Over to a New 401(k)

With all of that in mind, rolling over your money into a new 401(k) has some pros and cons:

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Pros:

•   Often the simplest, easiest rollover option when available.

•   Should not typically result in any tax liabilities or withholdings.

•   Allows your investments to continue to grow (hopefully!), uninterrupted.

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Cons:

•   New employer may change certain aspects of your 401(k) plan.

•   There may be higher associated fees or costs with your new plan.

•   Indirect transfers may tie up some of your funds for tax purposes.

Get a 1% IRA match on rollovers and contributions.

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

2. Roll Over Your 401(k) to an IRA

If your new job doesn’t offer a 401(k) or other company-sponsored account like a 403(b), you still have options that’ll keep you from bearing a heavy tax burden. Namely, you can roll your 401(k) into an IRA.

The entire procedure essentially boils down to three steps:

1. Open a new IRA that will accept rollover funds.

2. Contact the company that currently holds your 401(k) funds and fill out their transfer forms using the account information of your newly opened IRA. You should receive essential information about your benefits when you leave your current position. If you’ve lost track of that information, you can contact the plan sponsor or the company HR department.

3. Once your money is transferred, you can reinvest the money as you see fit. Or you can hire an advisor to help you set up your new portfolio. It also may be possible to resume making deposits/contributions to your rollover IRA.

Pros and Cons of Rolling Over to an IRA

This option also has its pros and cons, however.

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Pros:

•   IRAs may have more investment options available.

•   You’ll have more control over how you allocate your investments.

•   You could potentially reduce related expenses, depending on your specifications.

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Cons:

•   May require you to liquidate your holdings and reinvest them.

•   Lower contribution limit compared to 401(k).

•   May involve different or higher fees and additional costs.

•   IRAs may provide less protection from creditor judgments.

•   You’ll be subject to new distribution rules – namely, you’ll need to be 59 1/2 before withdrawing funds to avoid incurring penalties.

3. Leave Your 401(k) With Your Former Employer

Leaving your 401(k) be – or, with your former employer – is also an option.

If you’re happy with your portfolio mix and you have a substantial amount of cash stashed in there already, it might behoove you to leave your 401(k) where it is.

You’ll also want to dig into the details and determine how much control you’ll have over the account, and how much your former employer might.

You might also consider any additional fees you might end up paying if you leave your 401(k) where it is. Plus, racking up multiple 401(k)s as you change jobs could lead to a more complicated withdrawal schedule at retirement.

Pros and Cons of Leaving Your 401(k) Alone

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Pros:

•   It’s convenient – you don’t do anything at all, and your investments will remain where they are.

•   You’ll have the same protections and fees that you previously had, and won’t need to get up to speed on the ins and outs of a new 401(k) plan.

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Cons:

•   If you have a new 401(k) at a new employer, you could end up with multiple accounts to juggle.

•   You’ll no longer be able to contribute to the 401(k), and may not get regular updates about it.

4. Cash Out Your Old 401(k)

Cashing out, or liquidating your old 401(k) is another option. But there are some stipulations investors should be aware of.

Because a 401(k) is an investment account designed specifically for retirement, and comes with certain tax benefits — e.g. you don’t pay any tax on the money you contribute to your 401(k), depending on the specific type — the account is also subject to strict rules regarding when you can actually access the money, and the tax you’d owe when you did.

Specifically, if you take out or borrow money from your 401(k) before age 59 ½, you’ll likely be subject to an additional 10% tax penalty on the full amount of your withdrawal — and that’s on top of the regular income taxes you’ll also be obligated to pay on the money.

Depending on your income tax bracket, that means an early withdrawal from your 401(k) could really cost you, not to mention possibly leaving you without a nest egg to help secure your future.

This is why most financial professionals generally recommend one of the next two options: rolling your account over into a new 401(k), or an IRA if your new job doesn’t offer a 401(k) plan.

Pros and Cons of Cashing Out Your 401(k)

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Pros:

•   You’ll have immediate access to your funds to use as you like.

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Cons:

•   Early withdrawal penalties may apply, and there will likely be income tax liabilities.

•   Liquidating your retirement account may hurt your chances of reaching your financial goals.

When Is a Good Time to Roll Over a 401(k)?

If there’s a good time to roll over your 401(k), it’s when you change jobs and have the chance to enroll in your new employer’s plan. But you can generally do a rollover any time.

That said, if you have a low balance in your 401(k) account — for example, less than $5,000 — your employer might require you to do a rollover. And if you have a balance lower than $1,000, your employer may have the right to cash it out without your approval. Be sure to check the exact terms with your employer.

When you receive funds from a 401(k) or IRA account, such as with an indirect transfer, you’ll only have 60 days from the date you receive them to then roll them over into a new qualified plan. If you wait longer than 60 days to deposit the money, it will trigger tax consequences, and possibly a penalty. In addition, only one rollover to or from the same IRA plan is allowed per year.

The Takeaway

Rolling over your 401(k) — to a new employer’s plan, or to an IRA — gives you more control over your retirement funds, and could also give you more investment choices. It’s not difficult to rollover your 401(k), and doing so can offer you a number of advantages. First of all, when you leave a job you may lose certain benefits and terms that applied to your 401(k) while you were an employee. Once you move on, you may pay more in account fees for that account, and you will likely lose the ability to keep contributing to your account.

There are some instances where you may not want to do a rollover, for instance when you own a lot of your old company’s stock, so be sure to think through your options.

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

How can you roll over a 401(k)?

It’s fairly easy to roll over a 401(k). First decide where you want to open your rollover account, then contact your old plan’s administrator, or your former HR department. They typically send funds to the new institution directly via an ACH transfer or a check.

What options are available for rolling over a 401(k)?

There are several options for rolling over a 401(k), including transferring your savings to a traditional IRA, or to the 401(k) at your new job. You can also leave the account where it is, although this may incur additional fees. It’s generally not advisable to cash out a 401(k), as replacing that retirement money could be challenging.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
28
2024
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How to Invest During a Recession

By | Financial Independence, Growing Wealth, Investing | No Comments

When the economy contracts and enters a recession, it’s often accompanied by rising unemployment and a declining stock market. For that reason, some investors are caught on their heels, unsure of what to do. But some simple strategies may help investors invest during a recession – and there can be some surprising benefits to doing so.

It may be a good idea to try and keep in mind that because your investments may be trending downward, you shouldn’t let fear or your emotions override your strategy. That’s not easy, of course, but may be helpful to keep in mind.

What You Need to Know About Investing in a Recession

Investors looking to buy and sell stocks or other securities during a time of economic upheaval need to keep many things in mind.

A recession describes a contraction in economic activity, often, though not officially defined as a period of two consecutive quarters of decline in the nation’s real Gross Domestic Product (GDP) — the inflation-adjusted value of all goods and services produced in the United States. However, the National Bureau of Economic Research, which officially declares recessions, takes a broader view — including indicators like wholesale-retail sales, industrial production, employment, and real income.

The point is that the markets tend to price in those indicators, so much so that you may see the prices of stocks start to drop (and bond prices start to rise) even before a recession is officially declared. For example, the S&P 500 Index declined significantly from October 9, 2007, through March 9, 2009, a bear market that started two months before the Great Recession, which lasted from December 2007 through June 2009.

From those lows in March 2009, the S&P 500 delivered a return of 400% through February 2020, surpassing the previous peak in April 2013. Those that stayed in the market despite unprecedented economic declines were still able to experience a positive return.

But that stock volatility can give investors the jitters — and that emotional state that can be contagious.

Behavioral finance experts have dubbed this tendency “herd mentality,” which means you’re more likely to behave similarly to a larger group than you realize. Combine that behavioral bias with another common one — loss aversion — and you can see how emotions can lead some investors to make impulsive choices in a moment of panic or doubt.

However, there is some good news: history shows that most recessions don’t last as long as you might think — about 17 months, according to the National Bureau of Economic Research (NBER). So while an economic downturn can be scary while it lasts, it’s likely that time is on your side.

By staying the course and sticking with your investment strategy (and not yielding to emotion), the market recovery could help you recoup any losses and possibly see some gains — especially if you buy the dip (when prices are low). Though, remember, that nothing is guaranteed.

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Investing Strategies for a Recession

The following are a few investment strategies that may help investors weather a recession:

Dollar-Cost Averaging

While it’s critical for investors to stay true to their long-term strategy during a recession, what about investing new money? This is where the concept of dollar-cost averaging is important for investors to keep in mind.

Dollar-cost averaging, simply put, is a systematic way of investing a fixed amount of money regularly. It’s often used to describe the way most people invest, on a paycheck-by-paycheck basis, through workplace 401(k) and 403(b) plans.

This approach spreads the cost basis out over a long period of time and a wide range of prices. By doing so, it provides a degree of insulation against market fluctuations. During times of rapidly rising share prices, the investor will have a higher cost basis than they otherwise would have had. During times of collapsing stock prices, the investor will have a lower cost basis than they otherwise would have had.

Taken together, then, dollar-cost averaging can help you pay less for your investments on average over time and help to improve long-term returns.

Buy and Hold

Because most investors invest with a long-term time horizon, it may be best to employ a buy and hold investment strategy. This strategy can often be paired with a dollar-cost averaging strategy.

In short, a buy and hold strategy is a passive strategy in which investors buy stocks, exchange-traded funds, and other securities and hold on to them for a long time.

By buying and holding, investors believe that they are likely to earn long-term investment returns despite whatever short-term market volatility may come their way. They think an extended time horizon allows them to ride out short-term dips in the market.

This strategy can also help investors avoid emotional investing or trying to time the market.

Rebalancing

Investors try to gauge how close or far they are from their goals because your time horizon determines how you invest. For instance, a younger investor may have a portfolio that’s heavier in growth stocks and lighter when it comes to bonds and cash.

For an investor nearing an important goal, like retirement, the priority may be safety and security or investments like high-quality (but lower-yielding) bonds. Over time, investors need to rebalance their portfolios, shifting the allocation of different asset classes. A younger investor may start with an allocation of 70% stocks and 30% bonds and cash. But as they near retirement, that equity allocation might shift toward 50% stocks or even lower.

Tax-Loss Harvesting

A recession can also be a chance to sell out of a mix of investments, owing to tax considerations. Investors can take advantage of tax-loss harvesting by selling stocks or mutual funds that have appreciated alongside those that have lost value. This strategy allows investors to use investments that have declined in value to offset investment gains and potentially reduce their annual tax bill.

When an investor wants to reduce capital gains taxes they owe on investments they’ve sold, tax-loss harvesting can allow an investor to deduct $3,000 in losses per year. As such, the strategy can be the silver lining on investments that didn’t work out.

Potential Investments During a Recession

It’s worth remembering some investments tend to perform better than others during recessions. Recessions are generally bad news for highly leveraged, cyclical, and speculative companies. These companies may not have the resources to withstand a rocky market.

By contrast, the companies that have traditionally survived and even outperformed during a downturn are companies with very little debt and strong cash flow. If those companies are in traditionally recession-resistant sectors, like essential consumer goods, utilities, defense contractors, and discount retailers, they may deserve closer consideration.

Recommended: What Types of Stocks Do Well During Volatility?

Some investors might also seek out even more defensive positions during a recession by buying real estate, precious metals (e.g., gold), or investing in established, dividend-paying stocks.

Additionally, some investors may look to move some money out of riskier investments like stocks, bonds, or commodities and into cash and cash equivalents. For some investors, having adequate cash on hand or having money invested in certificates of deposit (CDs) and money market funds may be a good option for a portfolio during a recession.

Bear in mind that every recession impacts different sectors in different ways. During the Great Recession of 2008-09, financial companies suffered — because it was a financial crisis. In 2020, biotech companies tended to thrive, but investments in energy companies have been hit harder owing to fluctuating oil prices.

As an investor, you must do the math on where the risks and opportunities lie during a recession.

What to Avoid In a Recession

During a recession, it’s important to remember two key tenets that will help you stick to your investing strategy. The first is: While markets change, your financial goals don’t. The second is: Paper losses aren’t real until you cash out.

The first tenet refers to the fact that investors go into the market because they want to achieve certain financial goals. Those goals are often years or decades in the future. But as noted above, the typically shorter-term nature of a recession may not ultimately impact those longer-term financial plans. So, most investors want to avoid changing their financial goals and strategies on the fly just because the economy and financial markets are declining.

The second tenet is a caveat for the many investors who watch their investments — even their long-term ones — far too closely. While markets can decline and account balances can fall, those losses aren’t real until an investor sells their investments. If you wait, it’s possible you’ll see some of those paper losses regain their value.

So, investors should generally avoid panicking and making rash decisions to sell their investments in the face of down markets. Panicked and emotional selling may lead you into the trap of “buying high and selling low,” the opposite of what most investors are trying to do.

The Takeaway

Investing during a recession is really what you make of it. While market volatility can spark investor worries, it’s possible to manage your emotions, stay in control of your investment strategy, and possibly come out ahead. Sticking to some broad strategies may be able to help, such as dollar-cost averaging or a buy-and-hold approach. Of course, nothing will guarantee that you generate positive returns during a recession, but certain strategies may help buoy your portfolio during economic upheaval.

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

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

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Sep
28
2024
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What Is a Recession?

By | Financial Independence, Growing Wealth, Investing | No Comments

A recession is a period of general economic contraction. Recessions are typically accompanied by falling stock markets, a rise in unemployment, a drop in income and consumer spending, and increased business failures.

Recessions tend to have a wide-ranging economic impact, affecting businesses, jobs, everyday individuals, and investment returns. But defining what, exactly, a recession is, and the long-term repercussions they may have on personal financial situations is tricky.

Different Recession Definitions

A recession is often defined as a drop in gross domestic product (GDP) — which represents the total value of goods and services produced in the country — for at least two quarters in a row. However, this is not an official definition of a recession, and instead, is just a shorthand that some economists and investors use when analyzing the economy.

Recessions are officially defined and declared by the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). So, when GDP dropped two straight quarters in 2022 (Q1 and Q2), the NBER didn’t declare a recession because other indicators, such as unemployment, didn’t necessarily align with a recessionary environment.

Consumers and workers may believe that the economy is in a recession when unemployment or inflation rises, even though economic output may still be growing. That can affect all sorts of things, including the stock market, and put a damper on investors’ hopes as they trade stocks and other securities.

Recommended: Recession Survival Guide and Help Center

NBER’s Definition

The NBER defines a recession as a significant and widespread decline in economic activity that lasts a few months. The economists at the NBER use a wide range of economic indicators to determine the peaks and troughs of economic activity. The NBER chooses to define a recession in terms of monthly indicators, including:

•   Employment. Job growth or job loss can be used to gauge the likelihood of a recession, and serve as a litmus test of sorts for which way the economy is moving.

•   Personal income. Personal income can play a direct role in influencing recessionary environments. When consumers have more personal income to spend, that can fuel a growing economy. But when personal income declines or purchasing power declines because of rising interest rates, that can be a recession indicator.

•   Industrial production. Industrial production is a measure of manufacturing activity. If manufacturing begins to slow down, that could suggest slumping demand in the economy and, in turn, a shrinking economy.

These indicators are then viewed against the backdrop of quarterly gross domestic product growth to determine if a recession is in progress. Therefore, the NBER doesn’t follow the commonly accepted rule of two consecutive quarters of negative GDP growth, as that alone isn’t considered a reliable indicator of recessionary movements in the economy.

Additionally, the NBER is a backward-looking organization, declaring a recession after one has already begun and announcing the trough of economic activity after it has already bottomed.

Julius Shiskin Definition

The shorthand of using two negative quarters of GDP growth can be traced back to a definition of a recession that first originated in the 1970s with Julius Shiskin, once commissioner of the Bureau of Labor Statistics. Shiskin defined recession as meaning:

•   Two consecutive quarters of negative gross national product (GNP) growth

•   1.5% decline in real GNP

•   15% decline in non-farm payroll employment

•   Unemployment reaching at least 6%

•   Six months or more of job losses in more than 75% of industries

•   Six months or more of decline in industrial production

It’s important to note that Shiskin’s recession definition used GNP, whereas modern definitions of recession use GDP instead. GNP, or gross national product, measures the value of goods and services produced by a country both domestically and internationally. Gross domestic product only measures the value of goods and services produced within the country itself.

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How Often Do Recessions Occur?

Economic recessions are a normal part of the business cycle. According to the NBER, the U.S. experienced 33 recessions prior to the coronavirus pandemic. The first documented recession occurred in 1857, and the most recent was caused by the Covid-19 pandemic, which started in February 2020 and ended in April 2020.

Since World War II, a recession has occurred, on average, every six years, though the actual timing can and has varied.

U.S. Recessions Since World War II
Start of Recession

 End of Recession

 Number of Months
November 1948 October 1949 11
July 1953 May 1954 10
August 1957 April 1958 8
April 1960 February 1961 10
December 1969 November 1970 11
November 1973 March 1975 16
January 1980 July 1980 6
July 1981 November 1982 16
July 1990 March 1991 8
March 2001 November 2001 8
December 2007 June 2009 18
February 2020 April 2020 2
Source: NBER

How Long Do Recessions Last?

According to the NBER, the shortest recession occurred following the onset of the Covid-19 pandemic and lasted two months, while the longest went from 1873 to 1879, lasting 65 months. The Great Recession lasted 18 months between December 2007 and June 2009 and was the longest recession since World War II.

If you consider the other 12 recessions following World War II, they have lasted, on average, about ten months.
Periods of economic expansion tend to last longer than periods of recession. From 1945 to 2020, the average expansion lasted 64 months, while the average recession lasted ten months.

Between the 1850s and World War II, economic expansions lasted an average of 26 months, while recessions lasted an average of 21 months.

The Great Recession between 2007 and 2009 was the most severe economic drawdown since the Great Depression of the 1930s. This recession was considered particularly damaging due to its duration, unemployment levels that peaked at around 10%, and the widespread impact on the housing market.

6 Common Causes of Recessions

The causes of recessions can vary greatly. Generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers.

The mechanics behind a typical recession work like this: consumers lose confidence and stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing, and a continued decline in consumer spending.

Here are some common characteristics of recessions:

1. High Interest Rates

High interest rates make borrowing money more expensive, limiting the amount of money available to spend and invest. In the past, the Federal Reserve has raised interest rates to protect the value of the dollar or prevent the economy from overheating, which has, at times, resulted in a recession.

For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation.” To fight it, the Fed raised interest rates throughout the decade, which created the recessions between 1980 and 1982.

2. Falling Housing Prices

If housing demand falls, so does the value of people’s homes. Homeowners may no longer be able to tap their house’s equity. As a result, homeowners may have less money in their pockets to spend, reducing consumption in the economy.

3. Stock Market Crash

A stock market crash occurs when a stock market index drops severely. If it falls by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession since individual investors’ net worth declines, causing them to reduce spending because of a negative wealth effect. It can also cut into confidence among businesses, causing them to spend and hire less.

As stock prices drop, businesses may also face less access to capital and may produce less. They may have to lay off workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.

4. Reduction in Real Wages

Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.

When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, leading to less spending and economic slowdown.

5. Bursting Bubbles

Asset bubbles are to blame for some of the most significant recessions in U.S. history, including the stock market bubble in the 1920s, the tech bubble in the 1990s, and the housing bubble in the 2000s.

An asset bubble occurs when the price of an asset, such as stock, bonds, commodities, and real estate, quickly rises without actual value in the asset to justify the rise.

As prices rise, new investors jump in, hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts — for example, if demand runs out — the market can collapse, eventually leading to recession.

6. Deflation

Deflation is a widespread drop in prices, which an oversupply of goods and services can cause. This oversupply can result in consumers and businesses saving money rather than spending it. This is because consumers and businesses would rather wait to purchase goods and services that may be lower in price in the future. As demand falls and people spend less, a recession can follow due to the contraction in consumption and economic activity.

How Do Recessions Affect You?

Businesses may have fewer customers when the economy begins to slow down because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.

As more people lose their jobs, they have less to spend on discretionary items, which means fewer sales and lower revenue for businesses. Individuals who can keep their jobs may choose to save their money rather than spend it, leading to less revenue for businesses.

Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.

When consumer spending declines, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.

Recommended: How to Invest During a Recession

Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus to boost employment and spending.

Central banks, like the Federal Reserve, can provide monetary policy stimulus. The Fed can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.

Fiscal stimulus can come from tax breaks or incentives that increase outputs and incomes in the short term. Governments may put together stimulus packages to boost economic growth, as the U.S. government did in 2009 and in 2020.

For example, stock market volatility increased wildly amid fears of the coronavirus pandemic and its economic fallout. To ward off recession, the U.S. government put together trillions in Covid-19 stimulus packages that included direct payments to citizens, suspended student loan payments, a boost to unemployment benefits, and a lending program for businesses and state and local governments.

Recessions vs Depressions and Bear Markets

Though recessions, depressions, and bear markets may all feel or seem similar, there are some differences investors should be aware of.

Recessions vs Depressions

When a recession occurs, it could stir up uneasy feelings that perhaps the economy will enter a depression. However, there are significant differences between recessions and depression. While recessions are a normal part of the business cycle that last less than a year, depressions are a severe decline in economic output that can last for years. Consider that the Great Recession lasted 18 months, while the Great Depression lasted about ten years.

Recessions vs Bear Markets

A recession is also different from a bear market, even though many think the two events go hand-in-hand.

A bear market begins when the stock market drops 20% from its recent high. If you look at the benchmark S&P 500 index, there have been 14 bear markets since 1945.

Yet, not all bear markets result in recession. During 1987’s infamous Black Monday stock market crash, the S&P 500 lost 34%, and the resulting bear market lasted four months. However, the economy did not dissolve into recession.
That’s happened three other times since 1947. Bear markets have lasted 14 months on average since World War II, and the most significant decline since then was the bear market of 2007–2009.

That’s why it’s important to keep in mind that the stock market is not the same as the economy, though they are related. Investors react to changes in economic conditions because what’s happening in the economy can affect the companies in which investors own stock.

So, if investors think the economy is growing, they may be more willing to put money in the stock market. They will likely pull money out of the stock market if they believe it is contracting. These reactions can function as a sort of prediction of recession.

Recommended: Bear Market Investing Strategies

Is It Possible to Predict a Recession?

Economists and investors try to predict recession, but it’s difficult to do, and they often end up wrong. Economists usually frame the possibility of a recession as a probability. For example, they may say there’s a 35% chance of a recession in the next year.

There are several methods economists use to try to predict recessions. Some of the most common include analyzing economic indicators, such as employment and inflation, as well as consumer and business confidence surveys. Economists build models with these economic indicators as inputs, hoping the data will help them determine the path of economic growth. While these methods can indicate whether a recession might be on the horizon, they are far from perfect.

One issue in predicting a recession is that a lot of data analysts use to forecast the economy are backward looking indicators. These data, like the unemployment rate or GDP, present a picture of the economy as it was a month or more prior. Using this data to paint a picture of the present economy becomes difficult and adds to the complexity of predicting a recession.

However, many analysts believe the yield curve is the best indicator to help predict a recession. When the yield curve inverts, meaning that the interest rate on short-term Treasuries is higher than on long-term Treasuries, it is a warning sign that the economy is heading to a recession. An inverted yield curve has occurred before all 10 U.S. recessions since 1955. Notably, however, the yield curve inverted in 2022, and a recession did not subsequently occur (yet).

The Takeaway

Recessions are periods of economic contraction, and are usually accompanied by rising unemployment and a falling stock market – though that’s not always the case.

The possibility of a recession can be unsettling, causing you to think of economic hardships and spark fears of personal financial troubles. However, recessions are a regular part of the business cycle, so you should be prepared for one if and when it comes. When it comes to investing, this means building and maintaining a portfolio to meet long-term goals.

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