InvestY Archives | Page 33 of 97

May

2024

Roth 401(k) vs Traditional 401(k): Which Is Best for You?

By AJ Smith | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off

A traditional 401(k) and a Roth 401(k) are tax-advantaged retirement plans that can help you save for retirement. While both types of accounts follow similar rules — they have the same contribution limits, for example — the impact of a Roth 401(k) vs. traditional 401(k) on your tax situation, now and in the future, may be quite different.

In brief: The contributions you make to a traditional 401(k) are deducted from your gross income, and thus may help lower your tax bill. But you’ll owe taxes on the money you withdraw later for retirement.

Conversely, you contribute after-tax funds to a Roth 401(k) and can typically withdraw the money tax free in retirement — but you don’t get a tax break now.

To help choose between a Roth 401(k) vs. a traditional 401(k) — or whether it might make sense to invest in both, if your employer offers that option — it helps to know what these accounts are all about.

Key Points

• Traditional 401(k) contributions are made with pre-tax dollars, reducing taxable income for the year of contribution.

• Roth 401(k) contributions are made with after-tax dollars, offering tax-free withdrawals in retirement.

• Withdrawals from traditional 401(k)s are taxed as income, whereas Roth 401(k) withdrawals are tax-free if rules are followed.

• Early withdrawals from both accounts may incur taxes and penalties, though Roth contributions can be withdrawn tax-free.

• Starting January 2024, Roth 401(k)s are not subject to required minimum distributions, unlike traditional 401(k)s.

5 Key Differences Between Roth 401(k) vs Traditional 401(k)

Before deciding on a Roth 401(k) or traditional 401(k), it’s important to understand the differences between each account, and to consider the tax benefits of each in light of your own financial plan. The timing of the tax advantages of each type of account is also important to weigh.

1. How Each Account is Funded

• A traditional 401(k) allows individuals to make pre-tax contributions. These contributions are typically made through elective salary deferrals that come directly from an employee’s paycheck and are deducted from their gross income.

• Employees contribute to a Roth 401(k) also generally via elective salary deferrals, but they are using after-tax dollars. So the money the employee contributes to a Roth 401(k) cannot be deducted from their current income.

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

2. Tax Treatment of Contributions

• The contributions to a traditional 401(k) are tax-deductible, which means they can reduce your taxable income now, and they grow tax-deferred (but you’ll owe taxes later).

• By contrast, since you’ve already paid taxes on the money you contribute to a Roth 401(k), the money you contribute isn’t deductible from your gross income, and withdrawals are generally tax free (some exceptions below).

3. Withdrawal Rules

• You can begin taking qualified withdrawals from a traditional 401(k) starting at age 59 ½, and the money you withdraw is taxed at ordinary income rates.

• To withdraw contributions + earnings tax free from a Roth 401(k) you must be 59 ½ and have held the account for at least five years (often called the 5-year rule). If you open a Roth 401(k) when you’re 57, you cannot take tax-free withdrawals at 59 ½, as you would with a traditional 401(k). You’d have to wait until five years had passed, and start tax-free withdrawals at age 62.

4. Early Withdrawal Rules

• Early withdrawals from a 401(k) before age 59 ½ are subject to tax and a 10% penalty in most cases, but there are some exceptions where early withdrawals are not penalized, including certain medical expenses; a down payment on a first home; qualified education expenses.

You may also be able to take a hardship withdrawal penalty-free, but you need to meet the criteria, and you would still owe taxes on the money you withdrew.

• Early withdrawals from a Roth 401(k) are more complicated. You can withdraw your contributions at any time, but you’ll owe tax proportional to your earnings, which are taxable when you withdraw before age 59 ½.

For example: If you have $100,000 in a Roth 401(k), including $90,000 in contributions and $10,000 in taxable gains, the gains represent a 10% of the account. Therefore, if you took a $20,000 early withdrawal, you’d owe taxes on 10% to account for the gains, or $2,000.

5. Required Minimum Distribution (RMD) Rules

With a traditional 401(k), individuals must take required minimum distributions starting at age 73, or face potential penalties. While Roth 401(k)s used to have RMDs, as of January 2024, they no longer do. That means you are not required to withdraw RMDs from a Roth 401(k) account.

For a quick side-by-side comparison, here are the key differences of a Roth 401(k) vs. traditional 401(k):

Traditional 401(k)	Roth 401(k)
Funded with pre-tax dollars.	Funded with after-tax dollars.
Contributions are deducted from gross income and may lower your tax bill.	Contributions are not deductible.
All withdrawals taxed as income.	Withdrawals of contributions + earnings are tax free after 59 ½, if you’ve had the account for at least 5 years. (However, matching contributions from an employer made with pre-tax dollars are subject to tax.)
Early withdrawals before age 59 ½ are taxed as income and are typically subject to a 10% penalty, with some exceptions.	Early withdrawals of contributions are not taxed, but earnings may be taxed and subject to a 10% penalty.
Account subject to RMD rules starting at age 73.	No longer subject to RMD rules as of January 2024.

Bear in mind that a traditional 401(k) and Roth 401(k) also share many features in common:

• The annual contribution limits are the same for a 401(k) and a Roth 401(k). For 2024, the total amount you can contribute to these employer-sponsored accounts is $23,000; if you’re 50 and older you can save an additional $7,500 for a total of $30,500. This is an increase over the 2023 limit, which was capped at $22,500 ($30,000 if you’re 50 and older).

• For both accounts, employers may contribute matching funds up to a certain percentage of an employee’s salary.

• In 2024, total contributions from employer and employee cannot exceed $69,000 ($76,500 for those 50 and up). In 2023, total contributions from employer and employee cannot exceed $66,000 ($73,500 for those 50 and up).

• Employees may take out a loan from either type of account, subject to IRS restrictions and plan rules.

Because there are certain overlaps between the two accounts, as well as many points of contrast, it’s wise to consult with a professional when making a tax-related plan.

How to Choose Between a Roth and a Traditional 401(k)

In some cases it might make sense to contribute to both types of accounts (more on that below), but in other cases you may want to choose either a traditional 401(k) or a Roth 401(k) to maximize the specific advantages of one account over another. Here are some considerations.

When to Pay Taxes

Traditional 401(k) withdrawals are taxed at an individual’s ordinary income tax rate, typically in retirement. As a result these plans can be most tax efficient for those who will have a lower marginal rate after they retire than they did while they were working.

In other words, a traditional 401(k) may help you save on taxes now, if you’re in a higher tax bracket — and then pay lower taxes in retirement, when you’re ideally in a lower tax bracket.

On the other hand, an investor might look into the Roth 401(k) option if they feel that they pay lower taxes now than they will in retirement. In that case, you’d potentially pay lower taxes on your contributions now, and none on your withdrawals in retirement.

Your Age

Often, younger taxpayers may be in a lower tax bracket. If that’s the case, contributing to a Roth 401(k) may make more sense for the same reason above: because you’ll pay a lower rate on your contributions now, but then they’re completely tax free in retirement.

If you’re older, perhaps mid-career, and in a higher tax bracket, a traditional 401(k) might help lower your tax burden now (and if your tax rate is lower when you retire, even better, as you’d pay taxes on withdrawals but at a lower rate).

Where You Live

The tax rates where you live, or where you plan to live when you retire, are also a big factor to consider. Of course your location some years from now, or decades from now, can be difficult to predict (to say the least). But if you expect that you might be living in an area with lower taxes than you are now, e.g. a state with no state taxes, it might make sense to contribute to a traditional 401(k) and take the tax break now, since your withdrawals may be taxed at a lower rate.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

The Benefits of Investing in Both a Roth 401(k) and Traditional 401(k)

If an employer offers both a traditional and Roth 401(k) options, employees might have the option of contributing to both, thus taking advantage of the pros of each type of account. In many respects, this could be a wise choice.

Divvying up contributions between both types of accounts allows for greater flexibility in tax planning down the road. Upon retirement, an individual can choose whether to withdraw money from their tax-free 401(k) account or the traditional, taxable 401(k) account each year, to help manage their taxable income.

It is important to note that the $23,000 contribution limit ($30,500 for those 50 and older) for 2024 is a total limit on both accounts.

So, for instance, you might choose to save $13,500 in a traditional 401(k) and $9,500 in a Roth 401(k) for the year. You are not permitted to save $23,000 in each account.

What’s the Best Split Between Roth and Traditional 401(k)?

The best split between a Roth 401(k) and a traditional 401(k) depends on your individual financial situation and what might work best for you from a tax perspective. You may want to do an even split of the $23,000 limit you can contribute in 2024. Or, if you’re in a higher tax bracket now than you expect to be in retirement, you might decide that it makes more sense for you to put more into your traditional 401(k) to help lower your taxable income now. But if you expect to be in a higher income tax bracket in retirement, you may want to put more into your Roth 401(k).

Consider all the possibilities and implications before you decide. You may also want to consult a tax professional.

The Takeaway

Employer-sponsored Roth and traditional 401(k) plans offer investors many options when it comes to their financial goals. Because a traditional 401(k) can help lower your tax bill now, and a Roth 401(k) generally offers a tax-free income stream later — it’s important for investors to consider the tax advantages of both, the timing of those tax benefits, and whether these accounts have to be mutually exclusive or if it might benefit you to have both.

When it comes to retirement plans, investors don’t necessarily have to decide between a Roth or traditional 401(k). Some might choose one of these investment accounts, while others might find a combination of plans suits their goals. After all, it can be difficult to predict your financial circumstances with complete accuracy — especially when it comes to tax planning — so you may decide to hedge your bets and contribute to both types of accounts, if your employer offers that option.

Another step to consider is a 401(k) rollover, where you move funds from an old 401(k) into an IRA. When you do a 401(k) rollover it can help you manage your retirement funds.

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FAQ

Is it better to contribute to 401(k) or Roth 401(k)?

Whether it’s better to contribute to a traditional 401(k) or Roth 401(k) depends on your particular financial situation. In general, if you expect to be in a lower tax bracket in retirement, a traditional 401(k) may make more sense for you since you’ll be able to deduct your contributions when you make them, which can lower your taxable income, and then pay taxes on the money in retirement, when you’re in a lower income tax bracket.

But if you’re in a lower tax bracket now than you think you will be later, a Roth 401(k) might be the preferred option for you because you’ll generally withdraw the money tax-free in retirement.

Can I max out both 401(k) and Roth 401(k)?

No, you cannot max out both accounts. Per IRS rules, the annual 401(k) limits apply across all your 401(k) accounts combined. So for 2024, you can contribute a combined amount up to $23,000 (or $30,500 if you’re 50 or older) to your Roth 401(k) and your traditional 401(k) accounts.

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

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

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

SoFi Invest®

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

May

2024

Intrinsic Value and Time Value of Options, Explained

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

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

Intrinsic value and time value are two major determining factors of the value of an options contract. An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right away. In other words, the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security.

An option’s time value is not quite as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset, as well as the amount of time until the option contract expires.

Key Points

• Intrinsic value of an option is the profit from exercising it immediately, based on the current market value versus the strike price.

• Time value of an option reflects its potential profitability over time until expiration.

• The formula for intrinsic value involves subtracting the strike price from the current price of the underlying asset.

• Time value decreases as the option nears expiration, a concept known as time decay.

• Volatility of the underlying asset significantly impacts the time value, with higher volatility increasing the premium.

What Is the Intrinsic Value of an Option?

An investor who purchases an options contract may be buying the right, but not the obligation, to buy or sell the option’s underlying asset at an agreed-upon price, known as the strike price. Options are considered derivatives, because they are tied to the value of the underlying security. The contract may allow the investor to purchase or sell a security at that strike price at any point up until the contract expires.

There are two main kinds of options: calls and puts. The purchaser of a call option buys the right (but not the obligation) to purchase the underlying asset at a given price until a particular date.

The buyer of a put option purchases the right (but not the obligation) to sell the underlying asset at a given price until a particular date.

Important terms: In the Money, At the Money, Out of the Money

There are a few more key terms to know as it relates to options: in the money, at the money, and out of the money.

In the Money

An option is considered to be “in the money” if the investor could sell it at that moment for a profit. For a call option, that means that the price of the underlying asset is higher than the strike price specified in the options contract. For a put option to be in the money, the price of the underlying asset would have to be lower than the strike price in the contract.

At the Money

If an option is “at the money,” the price of the underlying security is equal to the strike price in the contract, and it’s not considered profitable. If an option is “out of the money,” e.g. above the market price for a call option or below the market price for a put option, the contract is also not profitable.

Out of the Money

If an option is not profitable when it expires, then it expires with no value, except for the premium. In those instances, the buyer takes a loss on the premium they paid to enter into the options contract, while the seller, or writer, of the contract collects the premium.

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Formula for the Intrinsic Value of an Options Contract

Time to get down to the math! Here are the formulas for calculating intrinsic values of call and put options.

Intrinsic value formula for a call option:

Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price

Intrinsic value formula for a put option:

Put Option Intrinsic Value = Put Strike Price – Underlying Stock’s Current Price

Example of Intrinsic Value Calculation

Imagine that hypothetical XYZ stock is selling at $48.00. A call option for XYZ with a strike price of $40 would have an intrinsic value of $8.00 ($48 – $40 = $8). So in theory, the option holder could exercise the option to buy XYZ shares at $40, then immediately sell them for a $8.00 profit in the market. Another way to phrase it: The contract would be in the money at $8.

But what if the strike price is higher than the $48.00 market price of XYZ stock? Let’s say the call option strike is $50 ($48 – $50 = –$2.00. The option would be considered out of the money and worth zero, because the intrinsic value of an option can never be negative.

What if it’s a put option? In this scenario, with an underlying price of $48.00 for XYZ stock, a put option with a strike price of $44.00 would have an intrinsic value of zero ($44 – $48 = –$4.00), again because the value of an option cannot fall below zero.

But a put option with a strike price of $50 would be considered in the money, and have an intrinsic value of $2 ($50 – $48 = $2).

While intrinsic value as a term sounds all encompassing, it isn’t. Investors should remember when calculating options strategies that an option’s intrinsic value does not include the premium the investor has to pay in order to buy the options contract in the first place. To get a better sense of the profit of an options trade, it’s important to include that initial premium, along with any other trading commissions and fees charged by the broker.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

What Is the Time Value of an Option?

When an investor buys an option, they pay in the form of a premium, or fee. When they do, that premium is typically based on the option’s intrinsic value, plus its extrinsic value. While higher volatility can result in higher premiums, time value plays a large role as well.The opportunity for an option to be profitable over time is, in essence, its time value.

The more time an investor in an options contract has, the better their chances of being able to exercise that option in the money, simply because the underlying security has a greater chance of moving in the desired direction. Longer time periods come with greater possibility for profit.

Conversely, as an options contract gets closer to expiring, its value goes down. The reason is that there is less time for the security underlying the options contract to make profitable moves.

One rule of thumb is that an option loses a third of its value during the first half of its life, and two-thirds during the second half. This phenomenon is known as the time decay of options. It’s a critical concept for options investors because the closer the option gets to expiration, the more the underlying security must move to impact the price of the option.

The intrinsic value of the option plays a role in how fast the time value of an option decays. An in-the-money option faces less dramatic time decay, because the elimination of time value takes the overall value of the option to the level of its intrinsic value. But for an out-of-the-money option, time decay is more dramatic, since the option will be entirely worthless if it expires out of the money.

Formula for the Time Value of an Options Contract

The formula for the time value of an options contract is as such:

Time Value = Option Price − Intrinsic Value

How Does Volatility Impact Time Value?

Another important factor that can impact time value is the volatility of the underlying asset.

Stocks with higher volatility typically have the potential for greater price movements — and thus related options may have a higher probability of expiring in the money. That’s one reason why time value, as reflected by the option’s premium, is typically higher when the underlying asset is more volatile.

With stocks and other assets that have lower volatility and therefore are not expected to show big price fluctuations, the time value and the option premium is likely to be lower.

Volatility, as every investor knows, cuts both ways. It can help generate gains or lead to losses.

How Can Intrinsic and Time Value Help Traders?

When calculating the value of the options contracts that they’re buying and selling, intrinsic value and time value can be vital to help traders gauge the potential risks and rewards of the options trade. While the intrinsic value is easy to assess, it only tells part of the story. Traders need to understand the extrinsic or time value of options as well in order to gauge how profitable the option is likely to be.Investors use this deeper understanding to inform which options trading strategies they use.

When it comes to the profitability of an options trade, investors also need to take into account the premiums they pay to buy an option, along with related commissions and fees. There are also other factors that play a role in the pricing of an options contract, such as the option’s implied volatility. This is the aspect of options pricing that takes into account the market sentiment as to the future volatility of an option’s underlying security, and can have a major influence on the price of an option as well.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

The Takeaway

Understanding how options are priced is a complicated business, and knowing the two main components — intrinsic value and time value — is essential. While intrinsic value is simply the tangible face value of the contract — because it’s the amount the buyer would receive if they exercised the option right now — time value is a more complex calculation.

The time value of an option, expressed as its premium, is part of an option’s extrinsic value and it includes the volatility of the underlying asset and the time to expiration. The more volatility and the more time to the option’s expiry date, the higher the premium or value of the option.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

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Photo credit: iStock/Moyo Studio

SoFi Invest®

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

May

2024

A Walkthrough of What Leverage Trading Is

Understanding Leverage Trading

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

Leverage allows investors to allocate a small amount of capital to get exposure to a much bigger position. Leverage, also called margin, is effectively a way of borrowing cash for increased trading power. A leverage ratio of 20:1 means a $1 investment can buy $20 worth of an asset.

Using leverage, traders can place bigger bets and potentially earn higher returns on their initial capital. However, leveraged trading also increases a trader’s risk of losses; if the asset moves in the wrong direction, the trader not only suffers a loss but must repay the amount borrowed, plus interest and fees.

This is one reason that only experienced investors qualify for leverage accounts, e.g. margin accounts, and leveraged trading opportunities.

Key Points

• Leverage trading involves using borrowed funds to increase potential investment returns.

• A leverage ratio of 20:1 means a small investment can control a much larger position.

• Risks include the potential to lose more than the initial investment.

• Not all securities are eligible for leverage; rules vary by broker and security type.

• Leverage is typically reserved for experienced investors due to its high risk.

What Is Leverage Trading?

In both business and finance, the term leverage refers to the use of debt to fuel expansion or purchase securities. In leverage trading, traders can use margin to buy assets like stocks, options, and forex.

Leverage and margin are similar concepts, but they’re different. One way to think of the differences is that a trader can use margin to increase their leverage. Margin is the tool, and leverage is the force behind the tool, which can be used to potentially increase returns (or losses).

A margin account allows you to borrow from the brokerage to purchase securities that are worth more than the cash you have on hand. In this case, the cash or securities already in your account act as collateral.

Which Securities Are Eligible for Margin?

Not all securities can be bought using leverage, however. Industry rules dictate that equities known as penny stocks and Initial Public Offering (IPO) stocks are not marginable. Generally, stocks and exchange-traded funds (ETFs) that are worth more than $3 per share, as well as mutual funds and certain types of bonds are eligible for leverage trades using margin. Check with your broker, as rules can vary by jurisdiction.

Margin can be used to trade options and futures, but this type of leverage trading can be highly risky. Forex options trading, for example, allows traders to place big bets using very small amounts of cash.

While there is no standard amount of margin in the forex market, it is common for traders to post 1% margin, which allows them to trade $100,000 of notional currency for every $1,000 posted — a ratio of 100:1.

Leverage Risks and Rewards

Leverage trading can only be successful if the return on an investment is higher than the cost to borrow money, which you must repay with interest and fees.

Leverage trading can significantly increase potential earnings, but it is also very risky because you can lose more than the entire amount of your investment. For that reason leverage is usually only available to experienced traders.

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How Leverage Works in Trading

Leverage trading in a brokerage account consists of a trader borrowing money from the broker, then using that along with their own funds to enter into trades.

The key to understanding how using leverage can help generate higher returns, but also greater losses, is that the funds borrowed are a fixed liability. Suppose a trader starts with $50, and borrows $50 to buy $100 worth of stock. Whether the stock’s value goes up or down from there, the trader is on the hook to give back $50, plus interest, to the broker.

Example of Leverage Trading

Using the above example, suppose the stock appreciates by 10%, and the trader closes out the position. They return the $50 they borrowed, and keep the remaining $60. That equates to a $10 gain on their $50 of capital, and a 20% return — double the return of the underlying stock.

On the flip side, consider what happens if the stock declines in value by 10%. The trader closes out the position and receives $90, but has to give the broker back the $50 they borrowed, plus interest. They are left with $40, a loss of $10, plus any interest or fees, which is a 20% loss or more.

Understanding Leverage Ratio

Leverage is often expressed as a ratio. For example, a leverage ratio of 2:1 is generally the rule for using margin for equity trades. If you have $50, you can buy $100 worth of stock.

In the case of other types of securities, the leverage ratio can be much higher. A leverage ratio of 20 means a $1,000 investment would allow you to open a trading position of $20,000; 50:1 would allow you to take a position of $50,000.

Maximum Leverage

Brokers have limits on how much they’ll lend traders based on the amount of funds the trader has in their account, their own regulations, and government regulations around leverage trading. If you’re considering using leverage, be sure to understand the rules.

• Stocks. Thanks to the Federal Reserve Board’s Regulation T, plus a FINRA rule governing margin trades in brokerage accounts, the maximum you can borrow is 50% for an equity trade.

• Forex. The foreign currency market tends to allow greater amounts of leverage. In some cases, you can place bets as high as 100:1 in the U.S.

• Commodities. Commodities rules around maximum leverage, and leverage ratios can fluctuate based on the underlying.

Types of Leverage Trading

There are a few different types of leverage trading, each with similarities and differences.

Trading on Margin

Margin is money that a trader borrows from their broker to purchase securities. They use the other securities in their account as collateral for the loan. If their leveraged trade goes down in value, a trader will need to sell other securities to cover the loss.

Many brokers charge interest on margin loans. So in order for a trader to earn a profit, the security has to increase in value enough to cover the interest.

Leveraged ETFs

Some ETFs use leverage to try and increase potential gains based on the index they track. For example, there is an ETF that specifically aims to return 3x the returns that the regular S&P 500 index would get.

It’s important to note that most funds reset on a daily basis. The leveraged ETF aims to match the single day performance of the underlying index. So over the long term even if an index increases in value, a leveraged ETF might decrease in value.

Derivatives

Traders can also use leverage trading with derivatives and options contracts. Buying a single options contract lets a trader control many shares of the underlying security — generally 100 shares — for far less than the value of those 100 shares. As the underlying security increases or decreases in value, the value of the options contract changes.

Options are derivatives contracts that give buyers the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) an asset at a specified price within a certain period of time. Traders can choose to sell call options on a stock if they think it is going to decrease in value.

Options trading is one of the riskiest types of leverage trading. A trader could potentially lose an unlimited amount of money if they sell a call option and the underlying stock price skyrockets in value.

If the option seller exercises the trade, the trader will have to purchase the associated amount of the underlying security to sell to the option seller. If the security has gone up a significant amount this could cost millions of dollars or more.

Recommended: Options Trading 101

Leverage Trading Terms to Know

There are several key terms to know in order to fully understand leverage trading.

Account balance: The total amount of funds in a trader’s account that are not currently in trades.

Buying power: This is the total amount a trader has available to enter into leverage trades, including both their own capital and the amount they can borrow.

Coverage: The ratio of the amount of funds currently in leveraged trades in one’s account to the net balance in their account.

Margin Requirement: This is the amount of funds a broker requires a trader to have in their margin account when entering into leverage trades. If a trader incurs losses, those funds will be used to cover them. Traders can also use securities they hold in their account to cover losses. Margin requirement is often a percentage. For example, at a leverage amount of 100:1, the margin requirement is 1%.

Margin call: If a trader’s account balance falls below the margin requirement, the broker will issue a margin call. This is a warning telling the trader they have to either add more funds to their account or close out some of their positions to meet the minimum margin requirement. The broker does this to make sure the trader has sufficient funds in their account to cover potential losses.

Used margin: When an investor enters into trades, some of their account balance is held by the broker as collateral in case it needs to be used to cover losses. That amount will only be available for the trader to use after they close out some of their positions.

Usable margin: This is the money in one’s account that is currently available to put into new trades.

Open position: When a trader is currently holding an asset they are in an open position. For instance, if a trader owns 100 shares of XYZ stock, they have an open position on the stock until they sell it.

Close position: The total value of an investment at the time the trader closes it out.

Stop-loss: Traders can set a price at which their asset will automatically be sold in order to prevent further losses if its value is decreasing. This is very useful if a trader wants to hold positions overnight or if a stock is very volatile.

Pros and Cons of Leveraged Trading

On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.

Pros of Leverage	Cons of Leverage
Increases buying power	Leverage funds must be repaid, with interest
Potential to earn higher returns	Potential to lose more than your initial investment
Relatively easy to use, if you qualify	Investors must meet specific criteria in order to use leverage or open a margin account

Pros

Using leverage can increase your trading power, sometimes to a large degree. It’s important to know the rules, as leverage ratios vary according to the securities you’re trading, the jurisdiction you’re in, and sometimes your broker’s discretion.

If you meet the criteria for using leverage or opening a margin account to trade, it’s relatively easy to access the funds and open bigger positions. Sometimes, placing that bigger bet can pay off with a much higher return than you would have gotten if you invested just the capital you had on hand.

Cons

Just as using leverage can amplify gains, it can amplify losses — in some cases to the point where you lose your initial investment, you must repay the money you borrowed, and you may owe fees and interest on top of that.

For that reason, many brokers require investors to meet certain criteria before they can place leveraged trades.

Tips for Managing the Risks of Leveraged Trading

Experience and skill can help you manage the risk factors inherent in leveraged trades, and a couple of basic protective strategies may help.

Hedge Your Bets

It might be possible to hedge against potential losses by taking an offsetting position to the leverage trade.

Limit Potential Loss of Capital

One rule of thumb suggests that traders limit their loss of capital to no more than 3% of the actual cash portion of the trade. While it’s difficult to know the exact risk level.

Decide Whether Leverage Trading Is Right for You

Although there is potential for significant earnings using leverage trading, there is no guarantee of any earnings, and there is also potential for significant loss. For this reason leverage trading is often said to be best left to experienced traders.

If an investor wants to try leverage trading it’s important for them to assess their financial situation, figure out how much they’re willing to risk, and conduct detailed analysis of the securities they are looking to trade.

Setting up a stop-loss order may help decrease the risk of losses, and traders can also set up a take-profit order to automatically take profits on a position when it reaches a certain amount.

The Takeaway

Leveraged trading is a popular strategy for investors looking to increase their potential profits. By using borrowed funds it’s possible to take much bigger positions, and possibly see bigger wins. But using leverage is very risky, and you can lose more than you have (because the money you borrow has to be repaid in full, plus interest).

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

Get one of the most competitive margin loan rates with SoFi, 12%*

FAQ

What leverage is good for $100?

If you only wanted to invest a small amount of capital, say $100, you would first need to check the policies at your brokerage about the use of lower amounts. If approved, you might want to use a lower amount of leverage, e.g. 10:1. That means for every $1 of cash you put down, you can get $10 in leverage. So a $100 leverage trade would be worth $1,000.

How much leverage is too high?

Knowing how much you can afford to lose is an important calculation when making leveraged trades. In addition, the amount of leverage available to you will also be restricted by existing regulations or brokerage rules. And remember, if a trade goes south, your broker can liquidate existing assets to cover your losses and any margin.

Photo credit: iStock/ljubaphoto

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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May

2024

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

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

By LeeMarie Kennedy | Growing Wealth, invest, Preparing for Retirement | Comments Off

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

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

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

Key Points

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

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

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

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

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

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

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

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

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

Funding

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

Investments

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

Value

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

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

Pension Plan Overview

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

Types of Pension Plans

There are two common types of pension plans:

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

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

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

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

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

Pros and Cons

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

Advantages of a pension plan include:

Funded by employers

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

Higher contribution limits

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

A set amount in retirement

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

Disadvantages of a pension plan include:

Lack of control

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

Vesting

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

Earnings and years employed

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

401(k) Overview

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

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

Contribution Limits and Withdrawals

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

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

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

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

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

Pros and Cons

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

Advantages of a 401(k) include:

Self-directed investment opportunities

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

Tax advantages

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

Employer matching

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

Disadvantages of a 401(k) include:

No guaranteed amount in retirement

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

Contributions are capped

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

Less stability

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

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

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

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

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

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

Did 401(k)s Replace Pension Plans?

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

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

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

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

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

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

The Takeaway

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

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

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

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

Easily manage your retirement savings with a SoFi IRA.

FAQ

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

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

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

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

Photo credit: iStock/Sam Edwards

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

May

2024

NPV Formula: How to Calculate Net Present Value

Net Present Value: How to Calculate NPV

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

Net present value or NPV represents the difference between the present value of cash inflows and outflows over a set period of time. Knowing how to calculate NPV can be useful when trying to determine whether an investment — either business or personal — will eventually pay off.

In capital budgeting, calculating the net present value can help with estimating the profitability of an investment or expansion project. Meanwhile, investors use the net present value calculation to gauge an investment’s potential rate of return based on the present value of its future cash flows and a discount rate, based on the cost of borrowing or financing.

Key Points

• Net Present Value (NPV) measures the difference between the present value of cash inflows and outflows over time.

• Calculating NPV helps determine the profitability of investments or projects by considering future cash flows and a discount rate.

• The NPV formula incorporates the time value of money, emphasizing that money now is worth more than the same amount in the future.

• A positive NPV indicates that the earnings from an investment are expected to exceed the cost.

• NPV is used in capital budgeting to assess the return on project investments before committing funds.

What Is Net Present Value (NPV)?

Net present value is a measure of the value of all future cash flows over the life of an investment, discounted to the present after factoring in inflows, outflows, and inflation, which can erode the value of money over time.

When applying the net present value formula, you’re looking at whether revenues are greater than costs or vice versa to determine whether an investment or project is likely to yield a gain or a loss.

As mentioned, net present value is often used in capital budgeting. Businesses and governments can use capital budgeting methods to determine how much of a return they’re likely to see on a project before funding it. The NPV formula takes into account the time value of money, a concept which suggests that a sum of money received now is worth more than that same sum received at a future date.

How to Calculate NPV

Calculating net present value is a fairly simple operation.

If you want to calculate net present value using the NPV formula, you’d first need to know the expected positive and negative cash flows for an investment or project. You’d also need to know the discount rate. From there, you could complete your calculations in this order:

• List future cash flows for each year you expect to receive them.

• Calculate the present value for each cash flow.

• Add all present values for future cash flows together.

• Subtract cash outflows from the present value sum of future cash flows.

You’ll need to know the present value calculation to complete the second step.

NPV Formula

Here’s what the NPV formula looks like:

PV = FV/(1 + k)^N

In this formula, k is the discount rate and n is the number of time periods.

Again, net present value calculations follow a distinct formula. A positive NPV means earnings from the investment should outpace the cost. Negative NPV, on the other hand, means you’re more likely to lose money on the investment.

The application of the formula depends on the number of expected cash flows for an investment or project.

Example of NPV with a Single Cash Flow Investment

If you’re evaluating potential investments with a single cash flow, then you could use this formula to calculate NPV:

NPV = Cash flow / (1 + i)t – initial investment

In this formula, i represents the required return or discount rate for the investment while t equals the number of time periods involved. The discount rate is an interest rate used to discount future cash flows for a financial instrument.

Weighted average cost of capital (WACC) usually serves as the discount rate for calculating NPV. The WACC measures a company’s cost of borrowing or financing.

Example of NPV with Multiple Cash Flows

If you’re evaluating projects or potential investments with multiple cash flows, you’ll use a different net present value formula. Here’s what the NPV formula looks like in that scenario:

NPV = Today’s value of expected cash flows – Today’s value of invested cash

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Tools to Help Calculate NPV

If you want to simplify your calculations you could look for an online net present value calculator. Or you could use the NPV function in spreadsheet software, such as Microsoft Excel or something similar. The NPV function helps calculate net present value for an investment based on the discount rate and a series of future cash flows, both positive and negative.

To use this function, you’d simply create a new Excel spreadsheet, then navigate to the “Formulas” tab. Here, you’d choose “Financial”, then from the dropdown menu select “NPV”. This will bring up the function where you can enter the rate and each value you want to calculate.

What Does NPV Show You?

The NPV formula should tell you at a glance whether you’re likely to make money from an investment, lose money or break-even. This can help when comparing multiple investments to decide where to put your money when you have a limited amount of capital to work with.

It works the same way in capital budgeting. Say a fast-food chain is trying to decide whether to expand into a new market which entails opening up 10 more locations. They could calculate the net present value for each location, based on expected cash flows, to determine whether moving ahead with the project is a financially sound business decision.

What Is a Good NPV?

Generally speaking, a net present value greater than zero is good. This means that the investment or expansion project is likely to yield a gain. When the net present value is below zero, you have negative NPV which means the project or investment is likely to result in a loss.

The higher the number produced by a net present value calculation, the better. But it’s important to remember that the results produced by applying the NPV formula are only as reliable as the data points used in the calculation.

Inaccurate cash flow projections could result in skewed numbers which may produce a net present value estimate that’s above or below the actual returns you’re likely to realize.

Comparing NPV

Here are some ways that NPV stacks up to other types of calculations.

NPV vs Present Value

NPV and present value may sound similar but they measure different things. Present value or PV is the present value of all future cash inflows over a set period of time. Companies use this calculation to estimate values for future revenues or liabilities. When you calculate present value, you’re trying to measure the value of future cash flows today.

Net present value, on the other hand, is the sum of the present values for both cash inflows and cash outflows. With the NPV formula, you’re trying to determine how profitable an investment might be, based on the initial investment required and expected rate of return.

NPV vs IRR

Analysts use IRR or internal rate of return to evaluate proposed capital expenditures. The IRR calculation determines the percentage rate of return at which a project’s cash flows result in a net present value of zero. Like NPV, internal rate of return is also a part of capital budgeting.

Both NPV and IRR measure potential profitability but in different ways. When calculating the net present value of an investment, you’re estimating returns in dollars. With an internal rate of return, you’re estimating the percentage return an investment or project should generate.

Depending on whether you’re trying to target a specific dollar amount or percentage amount for returns, you may apply one or both formulas when evaluating an investment.

NPV vs ROI

Net present value measures expected cash flows for potential investments. You’re looking at future discounted cash flows to determine whether an investment makes sense financially.

Return on investment, or ROI, measures the efficiency of an investment, in terms of the rate of return that the investment is likely to produce. With ROI, you’re looking at the cash flows you’re likely to gain from an investment. To find ROI, you’d add up the total revenues less the total costs involved, then divide that figure by the total costs.

NPV vs Payback Period

The payback period is the period of time required for a return on investment to equal the initial investment. Payback period calculations don’t account for the time value of money. Instead, they look at how long it will take for you to realize a return from an investment that’s equal to the dollar amount that you invested.

Calculating the payback period helps determine how long to hold onto an investment. You might use this method if you’re trying to compare multiple investments to see which one is a better fit for your personal investing timeline. But if you want to get a sense of the total return you’re likely to realize, then you’d still want to apply the net present value formula.

Benefits and Drawbacks of NPV

Net present value can help analyze and evaluate business projects or personal investments. You can easily see at a glance what you could stand to gain — or lose — from making a particular investment. But the NPV formula does have some limitations that are important to be aware of.

Benefits of NPV

Net present value’s main advantage is that it takes the time value of money into consideration. By looking at discounted cash flows you can get a better understanding of the viability of an investment, based on what you’ll get out of it versus what you’ll put in.

This can help with decision-making when choosing investments for your portfolio or making strategic capital investments in a business. Net present value calculations can also help companies with projecting future value based on the investments they make today.

Drawbacks of NPV

The biggest disadvantage or flow associated with net present value is that results depend on the quality of the information that’s being used. If your projections for future cash flows are off, that can produce inaccurate results when using the net present value formula.

NPV can also overlook some hidden costs involved in an investment or project which may detract from total returns. It also doesn’t take into account the margin of safety, or the difference between an investment’s price and its value.

Finally, it’s difficult to use net present value to evaluate projects or investments that are different in size or nature, as the input values are likely to be very different.

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How Investors Can Use NPV

You can use NPV to evaluate stocks and other securities, including alternative investments, based on your time frame and projected profits. With stocks, for example, net present value can give you an idea of whether a company is a good buy or not by calculating NPV per share.

To do that, you’d divide the company’s net present value by the number of outstanding shares in the company to get this number. If the net value per share is higher than the stock’s current market price, then the stock could be considered a good buy. On the other hand, if the net value per share is below the stock’s current market price that suggests you might lose money if you decide to buy in.

The Takeaway

As discussed, Net present value, or NPV, represents the difference between the present value of cash inflows and outflows over a set period of time. Understanding the net present value formula can help with making smarter investment decisions.

As with any tool, most investors use NPV along with other financial ratios and forms of analysis before deciding whether to purchase any asset. If you have questions about how NPV can be used as a part of an investment strategy, it may be worthwhile to consult with a financial professional.

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FAQ

Is a higher NPV better?

A higher NPV isn’t necessarily a good thing or means that an investment is better than another investment. But in general, a good NPV is a number that’s higher than zero.

What is the basic NPV investment rule?

The basic NPV investment rule is that projects or investments should only be pursued if they’ll lead to gains or productive gains.

Is NPV the same as profit?

NPV is not the same thing as profit, although a positive NPV is indicative of profit, while negative NPV is related to a loss.

Is a NPV of 0 acceptable?

An NPV of zero means that a project or investment isn’t expected to produce significant gains or losses. Whether that’s acceptable or not is up to the individual making the investment decision.

When should NPV not be used?

NPV might not be helpful or useful for comparing investments of drastically different sizes, or projects of different sizes.

Is Excel NPV accurate?

Excel’s NPV calculations should be accurate, but they’re only as accurate as the data that’s entered to make the calculation. So, it could be inaccurate, and it’s a good idea to double-check the calculation.

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