Do I Need an IRA If I Have a 401(k)?

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

Many people wonder if they need an IRA if they already have a 401k? This article will address this question and dive into other strategies for saving for retirement.

Establishing Retirement Goals

The first step in retirement planning is figuring out how much you need to save each year to make financial independence a reality during retirement. The most important thing to remember is to start saving early, you’ll want to take advantage of the power of compounding, and if you start early then time is on your side.

Setting retirement goals doesn’t have to be a tough process. It is important as it can help steer you in the right direction for creating a plan of action. First calculate how many years you think you’ll be in retirement. Then consider that The U.S. Department of Labor estimates that people will need around 70%-90% of their pre-retirement income for each year of retirement.

From there you can get a rough estimate of the amount of money you’ll need for retirement. Periodically check in on your goal, SoFi provides an article to help you assess if you are on track for retirement or not.

Maxing Out Your 401k

One important strategy for retirement savings is to max out your retirement accounts each year and taking advantage of your employer match. For example, if you are currently putting $10,000 into your 401(k), that is great.

However, you can save up to $19,500 per year into your 401(k) plan in 2020. If your employer will match 50% of your contribution, you should probably focus your retirement savings into your 401(k).

You want to take advantage of as much matching as possible, since it’s “free” money. Plus, their contribution to your 401(k) doesn’t impact the amount that you can put into the account. If you contribute the maximum, $19,500, and they match at 50%, that’s additional money each year you’re saving for retirement. Not bad.

With that said, if you’re already maxing out your 401(k) or do not like the investment options available to you in the plan—which can happen, since they’re decided upon by your employer—an IRA is another great tax advantaged option for saving for retirement.

Recommended: Understanding the Differences Between an IRA and 401(k)

Utilizing an IRA

Here’s the deal: The maximum amount you can contribute to an IRA is $6,000 ($7,000 if you’re 50 or older) for 2020. But, you have to qualify to make a tax-deductible contribution based on your modified adjusted gross income (MAGI) if either you or your spouse are an active participant in an employer-sponsored plan.

In 2020, the deduction for taxpayers making contributions to a Traditional IRA is phased out for singles and heads of households who are covered by a workplace retirement plan, like a 401(k), and have modified adjusted gross incomes (MAGI ) between $65,000 and $74,000.

For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $124,000 to $206,000. If your contribution is for tax year 2020, the limits are lower, but our IRA Calculator makes it easy to see what works for you.

Pros and Cons of IRAs

So, if you do qualify to make a tax deductible contribution to an IRA, should you do it?

It depends. Here are a few things to think about:

IRA accounts typically have no charges to open and give you the opportunity for low cost and well diversified investment options. While you cannot take out this money until you are 59 ½, there are exceptions. For example, first-time home buyers can take out up to $10,000 penalty free for the purchase of a first home.

You will need to pay taxes on that distribution if it is in a Traditional IRA; there are no taxes or penalties for first-time homebuyers if you put your money in a Roth IRA. (Here’s a rundown on the differences between the two.)

If you are not covered by an employer sponsored plan: Yes.

If you ever leave your job or find yourself without a 401(k), contributing to an IRA is a great option. Since you have no other tax advantaged retirement vehicle available to you, an IRA is probably the best way to save for what is likely the biggest financial goal you will ever have.

If you are on target for retirement through the savings in your 401(k): Maybe.

While saving for retirement is always a good idea, you may want to put any extra money that comes in towards another goal, like a house down payment or grad school. You can put your extra savings into a taxable brokerage account and invest it in a way that may help you reach those goals faster.

Recommended: What is a Brokerage Account?

You won’t get any tax benefit from saving in this account, but there are also no restrictions on when you can take the money out. Most Americans are behind on retirement savings, and the amount of annual savings into 401(k) plans is not enough to get on track.

IRAs provide a tax advantaged opportunity to improve your savings for this goal. I have yet to meet someone who was disappointed saving the most they could for retirement.

Where to Start?

SoFi Invest® offers IRAs (both Traditional and Roth) and our team of financial planners can work with you to create a personalized retirement plan, open an IRA, or rollover an old 401(k) into an IRA.

Open a retirement account with SoFi today.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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

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How Investments Make Money

Many people are afraid to start investing because they don’t have a basic understanding of how it works. And that’s smart. You don’t want to invest your hard-earned money in something you don’t understand.

But it’s also not smart to sit on the sidelines. Because, well, simply socking money away in your savings account probably isn’t going to earn you the kind of returns you need to achieve your big financial goals.

If you’ve ever wondered how, exactly, investments make money, we’ve put together this guide to clear up the confusion. Read on to learn about the different types of investments out there and how each of them can work for you.

Basically, investments make you money in one of three ways:

•   Income: Cash paid to you periodically from your investments (as interest and/or dividends)
•   Capital Appreciation: Owning things that could go up in value over time (like stocks, gold, or real estate)
•   Pass Through Profits: Investing in private businesses and real estate, which may pass through the profits from their operations.

Types of Investments

Most individual investors can invest in lots of things: CDs, T-Bills, stocks, bonds, mutual funds, ETFs, limited partnerships, and more. We’ll talk about each of these to take away the mystery.

Bonds

Bonds are loans you make to either a company or a government for a fixed period of time. The specific terms of the deal change, but essentially: You give someone money, they promise to pay it back in the future, and they pay you interest until they do.

For example, you might lend General Electric money for 20 years at 4% interest. For each $1,000 you invested, you would get $40 per year until 2017; then you’d get your $1,000 back.

There are four broad categories of bonds available to most investors:

•   Treasury Bonds: Bonds issued by the U.S. government.
•   Corporate Bonds: Bonds issued by a corporation.
•   Municipal Bonds: Bonds issued by a state or local government or agency (for example, airports, school districts, and sewer or water authorities).
•   Mortgage and Asset Backed Bonds: Bonds that pass through the interest on a bundle of mortgages or other financial assets such as student loans, car loans, or the accounts receivable of companies.
The difference between them is risk (and thus, the expected return). For example, the U.S. government is less likely to go bankrupt than a single company is, so T-bond returns are typically a conservative bet. Corporate bonds are riskier, but typically have higher returns.

Either way, bonds are a relatively safe investment, compared to other types of assets, and also provide investors with regular, fixed income. Both of these things are especially important in retirement.

Stocks

A stock is a single share of ownership in a public company. (Public companies are those that trade on stock exchanges; companies that are not traded this way are privately owned.)

When you buy stock, you own a tiny piece of the company. This can make you money two ways: you might get dividends if the company decides to pay out part of its profits, and the stock might go up in value and you’ll have a capital gain when you sell it.

People invest in different kinds of stocks for different reasons. Most investors are looking for stocks that will go up in value so they can sell the stock for a gain. They are looking for the value of their portfolio to grow because they’re saving for retirement, a house, or some other long-term goal.

There are two strategies for capital appreciation. “Growth stocks” are companies with sales and earnings that are growing year-over-year. They usually do not pay a dividend because management wants to invest the profits in continued growth.

Another way is to find “value stocks” whose price has been cut by events outside its control. At some point, these stocks may become an attractive buy because people think they’re undervalued and may go up.

Other investors want additional income and don’t want to rely only on bonds, so they choose stocks for their dividends. These are often companies in mature industries that are not growing much and return profits to shareholders as higher dividends. Value stocks may also have good dividends.

It’s easy to focus on the price appreciation that comes from growth and value, because it feels good to see your stock’s price go up and not so good to see it go down.

All three ways stocks make money may work for you, but the market tends to favor each one for a time, and then move on to one of the others. This is why a long-term investor should probably have a mix of all three.

Alternative Investments

As your portfolio grows, you might consider moving beyond stocks and bonds. Most of these “alternative investments” generally provide some combination of growth potential and income. Unlike stocks, they usually pass most of the profits they make through to their owners.

They are less likely to move up and down in sync with the stock or bond market, so they can give you an additional dimension of diversification.

The most common types of alternative investments include:

•   Real Estate Investment Trusts: REITs invest primarily in real estate or real estate loans and are traded like stocks.
•   Direct Investment in Real Estate or a Business: Wealthier investors may own investment real estate or a private business.
•   Limited Partnerships: Entering into a limited partnership with other real estate investors limits your legal exposure and offers the ability to diversify with a smaller investment.
•   Master Limited Partnerships: MLPs are a type of limited partnership that is publicly traded, so you can sell it whenever you want.
•   Gold: You can invest in gold and other precious metals directly by buying the metal as coins or bars, or using ETFs that invest in bullion.
•   Peer to Peer Investing: New regulations have made it easier for private companies to raise money from individual investors.

Cash Deposits

By cash, we don’t mean stacks of twenty dollar bills in a safe. It’s the money you keep in bank accounts, certificates of deposit (CDs), cash management accounts, and money market funds. In each of these cases, you lend money to the bank or financial institution, and you get interest on those loans.

Since these deposits don’t go down in amount and you can get your money out any time, as opposed to bonds, which need to be sold and can lose value, they are considered a different class of asset than bonds.

Currently, interest rates are so low that you earn very little interest on these deposits. You should consider only keeping in cash the money you need quick and easy access to—for example, your checking account, your emergency fund, or a savings account for a purchase you plan to make within the next couple of years.

Mutual Funds

Financial advisors recommend that people invest in a combination of these asset classes tailored to help them reach a specific financial goal (for example, buying a house or retiring). The specific mix of assets is primarily determined by how long they have to reach their goal.

Of course, most new investors don’t have the cash to spend on all these different types of investments. That’s where mutual funds come in.

Mutual funds and exchange traded funds (ETFs) can make it easier for you to invest in stocks, bonds, REITs, MLPs, gold, or most other legal investments. Think of mutual funds as suitcases filled with different types of investments, such as stocks and bonds. Buying a share of the fund can invest you in hundreds of individual securities the fund holds.

The benefit of mutual funds is instant diversification. If you invest in one company’s stock, and that company goes bankrupt, you’ve just lost your money. If you invest in a mutual fund that contains that stock, you may have lost something, but not everything.

There are a wide range of mutual funds that cover every investing strategy you can imagine—even securities that trade outside the US. They make it easy and inexpensive for a new investor, just starting out, to build a well diversified portfolio of stocks, bonds, and alternatives with just a few thousand dollars.

Investing with SoFi

We hope this article demystified investing a bit. While there are no guarantees, investments can make money many different ways. But, they can’t do any of them if you don’t get started. If you’re not sure what to do next, we can help.

An online investing account with SoFi makes it easy: Our technology helps you determine the right asset allocation mix for you, while advisors are available to offer you complimentary, personalized advice if you need it.

Consider working with a SoFi Invest advisor today.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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

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5 Reasons People Don’t Invest Their Money

There are plenty of reasons people don’t invest their money. Some of them are valid—for example, you probably shouldn’t invest a ton if you don’t have all of your high-interest credit card debt paid off. Or, if you’re planning to make a big purchase next year, you wouldn’t want to take the risk that comes with investing your savings.

But other reasons don’t quite make sense, and they’re often based on misconceptions about investing, or a lack of knowledge about the process. The truth is, if you have long-term financial goals, like buying a home, starting a business, or retiring someday, investing may get you there far more quickly than saving alone.

Here the most common reasons people drag their feet when it comes to investing—and why they might be holding you back.

Common Reasons People Avoid Investing

1. Saving Money in a Savings Account

Savings accounts pay you interest—but not a lot. The average savings account interest rate is only .01%, and the best rates out there hover around 1.7%. But, with the current inflation rate at 0.6%, all that money you’ve socked away in savings is actually losing money.

Yes, having money in savings is recommended for any cash you need to access immediately or don’t want to risk losing in the short-term. But for the rest of it? If you want it to grow, it may be a good idea to put it somewhere else.

2. Investing Later When They Have a Higher Salary

Let’s say you’re 25 years old and you hope to retire when you’re 65. (That may seem like forever, but ask any 65-year-old—it goes by in a flash.) If you save $5,500 a year and average 7% return per year (the average return on the S&P 500 from 1950-2009), you’d have a little over a million dollars.

If you wait until age 30 and do the same thing, you’d only have about $760,000. Start at age 40, and you’d only have about $348,000! If you’re reaching retirement age and want to have a million dollars before you retire, you’ll need to save much more each year to catch up to that goal. Want to see if you are on track? Consult SoFi’s article: Am I On Track For Retirement?

Many people think that it’ll be easier to save more when they’re older and making more money. And even if that is true, know that the earlier you start investing, the more time you have to weather the ups and downs of the market. Which brings us to:

3. Trying to Time the Market

It’s tempting to delay getting started because you think the market is too high, or you want to wait for stock prices to go down. The issue with that is, when the market does take a dip, most people fear it will go down more, so they continue to wait.

Few professional investors even try to time the market, and even fewer succeed. In reality, people who do try to time the market tend to buy at or near market tops and sell at or near market lows.

4. Investing is Too Risky

You might hear about the stock market going up or down by a number of points each day, and therefore assume it fluctuates too much for your taste. Market volatility is a reality, but there are ways to invest for every level of risk tolerance. Diversified retirement accounts, mutual funds, and ETFs, for example, all allow you to invest in a variety of assets in one fund.

Yes, financial crises have happened and chances are, they’ll happen again. But when you take a long-term view of our history, those crises are blips on the timeline.

Consider this: In the time period between 1929 and 2015 (when a whole lot of upswings and downturns happened), a diversified portfolio of 70% stocks and 30% bonds averaged 9.1% per year .

5. Investing is Intimidating

If you’re new to investing, it can be difficult to wrap your head around the concept. But the good news is, you don’t have to go at it alone.

A great place to start is investing for retirement in an employer-sponsored 401(k), an IRA, or (ideally) both.

Once you’re contributing the maximum possible to both of those accounts ($19,500 per year and $6,000 per year in 2020, respectively), you can consider opening a brokerage account, which lets you invest in stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs).

But you don’t even have to pick those investments yourself. A SoFi Invest® account makes it easy to get started. Our technology helps you set your financial goals and recommends the right investment strategy and level of risk to help you reach them within your desired time frame.

And our SoFi Invest Financial Planners help you plan for your future and answer any questions you have—absolutely free.

The bottom line: Investing is not just for the wealthy; it’s for anyone who wants to work toward achieving financial goals. Sounds like you? Well, it’s time to get started.

Not sure what the right investing account or investment strategy is for you? SoFi Invest financial planners are available to offer you complimentary, personalized advice. Consider working with a SoFi Invest advisor today.

Open an Invest Account today.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.

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

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How Does a Roth 401k Work?

Good retirement planning? No big deal. All it takes is serious option weighing, laser-beam-like consideration, a flexible strategy that lets you change your play at a moment’s notice and a Nostradamus-like ability to see the future.

You’ll often have to predict where the economy, your career, and your money may be decades from now, and how you’ll want to spend (and spend money in) your retirement. Sound like a plan? Actually, though, there is a way to say “I got this” and really mean it.

If your employer gives you individual retirement account (IRA) options, you could be well on your way to nailing down your financial future without excessive hand-wringing. Even better, choosing between a traditional IRA and a Roth 401(k) may not even be a choice you have to make—you could benefit from both. Both investments can serve different purposes and give you different benefits.

A Roth 401(k), for instance, gives you years — possibly even decades, depending on your age — of investment growth, tax free. Ultimately, the difference between a traditional Roth IRA and a Roth 401(k) is when you pay taxes on them.

Traditional 401(k) vs. Roth 401(k)

Here’s the shortcut (and more about this soon). Memorize this and you could be halfway there:

•   Traditional 401(k): Pre-tax retirement account. Your contributions are not yet taxed, lowering your taxable income.
•   Roth 401(k): Post-tax retirement account. Your contributions will already be taxed before you contribute the money.

Traditional Roth IRA vs Roth 401(k)

It’s easy to confuse the two, but it’s also easy to distinguish between them. Let’s break it down:

Traditional Roth IRA

•   No early withdrawal penalty. If you need the money for an emergency, you can withdraw contributions without a penalty from the IRS. However, you may have to pay taxes and penalties on earnings in your Roth IRA if you withdraw money from a Roth IRA you’ve had for less than five years.
•   No minimum distributions. Starting in 2020, after age 72, you are not required to withdraw a certain amount of money periodically. (In 2019, the age was 70½). You can let your savings sit in the account and only tap into it when you need it.
•   You can continue to contribute to the account. Even after age 72, you can continue to contribute to your Roth IRA. A traditional IRA does not allow contributions after you reach that age.

Related Content: What is an IRA?

Roth 401(k)

•   Allows for a company match.
•   You won’t be taxed when you withdraw your money (if you’ve held the account for at least five years) because you already paid your taxes on this fund.
•   Distribution is required after age 72 unless you’re still working.

Keep in mind, though, not to treat any type of 401(k) like an ATM. The money in an IRA is meant for your retirement, and you might want to fight off any temptation to dip your beak into the fund too early.

How the Roth 401(k) Came to Be

The Roth 401(k) began in 2006 as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 . It was based on the already-existing Roth IRA, allowing investors to stash their after-tax money in a safe place, for later use.

Contribute to a Roth 401(k) and you won’t be able to claim it as a tax deduction, but you also won’t owe any taxes on any qualified distributions. If you participate in a 403(b) plan, you’re also eligible to participate in a Roth fund.

Roth 401(k) Benefits

Pay today so you don’t have to pay tomorrow. Roth 401(k) contributions are made after you’ve already paid taxes on that money.

When you are able to withdraw your Roth 401(k) money at age 59½, your money is tax free and will remain so going forward, throughout your retirement. The IRS likes this deal too, because they get their taxes now instead of waiting years or even decades.

Roth 401(k) Contribution Limits

The traditional Roth IRA has limits and restrictions on how much income you’re allowed to receive from it. Not so for the Roth 401(k).

However, you’re still limited to how much money you can contribute to your Roth 401(k) each year. In fact, it’s the same for any 401(k) account. Let’s break it down:

•   Starting in 2020, if you’re age 50 or younger, you cannot contribute more than $19,500 to your Roth 401(k) account in one year.
•   If you’re age 50 or older, you cannot contribute more than $25,500 to your Roth 401(k) within one year, starting in 2020.

Which Plan Should You Choose: Traditional Roth IRA or Roth 401(k)?

It all depends on your financial situation and ultimate financial goals. A good indicator for choosing the Roth 401(k) is if you expect to be in a higher tax bracket toward your retirement age. It might make sense to pay taxes on the account now, while you are making less money and in a lower tax bracket.

Determining Your Tax Bracket

Note that a tax bracket is the taxpayer group you’re assigned to, according to how much income you generate. Your taxes are calculated based on your group, or bracket. This is usually done by a percentage , to keep it fair (presumably). Your tax bracket is calculated for both state and federal taxes.

The trick (which is perfectly legal) is to consider deductions that could lower your taxable income, thereby lowering your tax bracket.

Of course, any deduction you claim (child support or business expenses, for example) must be approved by the IRS. You could check with your tax expert before claiming any deduction to make sure that the deduction you make is legal and acceptable.

The IRS has a specific calculation for figuring out your tax bracket.

Why a Roth 401(k) May Be a Good Move Now Rather Than Later

You never know what new tax laws may bring in the future—it’s pretty unpredictable. It may be better to pay up now, before a law comes along that is not friendly to your financial plan.

Considerations When Weighing Your Roth Options

Minimum distributions. With a traditional IRA, once you turn age 72, you will be required to take a minimum distribution, whether you want or need it. If you want to avoid this requirement, simply roll over your fund to a traditional Roth IRA.

What If You Change Jobs?

You can leave your Roth 401(k) plan with whomever is sponsoring it, even after you change jobs or retire. This means that even after you go to a new job, you can still contribute to the Roth 401(k) from your old job.

However, you’ll be working with the plan sponsor (and the plan sponsor’s rules) and not your former employer. You could also roll it over to a new employer plan or into an individual Roth IRA. You might even request a cash distribution.

Why a Roth 401(k) Is a Great Retirement Option

It’s all about the taxes, or, more specifically, not having to pay them. When you’re retired, you might want to use your money without having to pay taxes on it.

Also, the more income you have, the higher your tax bracket. This could affect how your Social Security benefits are taxed. The goal is to keep your taxable income low and avoid being placed in a higher tax bracket.

How SoFi Can Help You

Need a little help with the navigation? Don’t fret—most people do. It’s not an easy decision, and sometimes you have to hash it out, out loud, with someone who lives and breathes this stuff. You could talk with a SoFi Financial Planner and get free, no-obligation, personalized advice on how you can maximize your Roth 401(k) benefits.

With a SoFi Invest account, you can easily open an IRA. How easy? It takes about five minutes or less, and you can choose automated or active investing. The choice is yours.

Open a retirement account with SoFi today.


External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

Advisory services are offered through SoFi Wealth, LLC an SEC-registered Investment adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at adviserinfo.sec.gov .

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Investing in Private Companies

The goal of investing is to grow money for long-term goals like retirement, and do it strategically so that it can work for you while you’re out living your life.

There are a variety of strategies when it comes to investing—and it’s important to get as much information as possible so you can decide what would be the best fit for your life and goals. And, just as there are several different ways to invest, there are also different types of companies that you may consider investing in.

Broadly speaking, there are two types of companies: public and private. And while you are likely more familiar with public-company investments—stocks traded on stock exchanges—there are also investment opportunities to be had with private companies.

There can be benefits that come with investing in privately held companies. Depending on your current circumstances, risk tolerance, and financial goals, you will likely approach the types of companies you consider investing in differently. And it’s important to understand that there are significant risks involved, and develop your expectations accordingly.

Read on to learn some basics of investing in both public and private companies, pros and cons of investing in private companies, and more.

The Difference Between Public and Private Companies

Typically, when most people think about investing they think about the stock market, where the companies are publicly held.

A public company has undergone an initial public offering (IPO), which means that it has publicly issued stock in hopes of raising more capital and making more shares available for purchase by the public. IPOs are usually underwritten by an investment bank—or broker dealers—which purchase shares from the company and then sell them to investors. As a general rule of thumb, until a company has an IPO, it’s considered private.

The world of private investment often seems exciting, and there can certainly be some big payoffs. Some investors might lament that they missed the chance to buy pre-IPO stock in a company like Uber back in its early days, when it wasn’t yet public. After all, the transportation giant had an estimated valuation of over $80 billion at its IPO.

Unlike the world of public investing, private investing happens off of Wall Street and takes place anywhere new, buzzy ventures are cropping up. However, for every company that hits it big, there are several companies that go bust. Take, for example, the blood-testing startup Theranos, which in its heyday was worth $9 billion and is now worth nothing.

Public companies, especially ones that are bigger, are more easily bought and sold on the stock market, and individuals are able to invest in them. These companies are also regulated by organizations like the Securities and Exchange Commission (SEC).

The SEC is a government body that makes sure these businesses stay accountable to their investors and shareholders, and it requires publicly traded companies to share how they are doing, based on their revenue and other financial metrics.

In contrast, a privately held company is owned by either a small number of shareholders or employees and does not trade its shares on the stock market. Instead, company shares are owned, traded, or exchanged in private.

The landscape of investing in private companies can sometimes be mystifying, in part because private stock transactions happen behind closed doors. But even though private companies may be less visible than their public counterparts, they still play an important role in the economy and can be a worthwhile investment.

Investing in a private company can also be incredibly risky, and it’s important to understand some of the pros and cons of investing in this landscape.

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Pros of Investing in Private Companies

Before considering the potential benefits of investing in private companies, it’s important to understand how venture capitalism works, and what a venture capitalist is. Essentially, a venture capitalist (VC) is an investor with capital, be it an individual with wealth to spare, an insurance company, a foundation, and so on.

These investors may contribute money to a venture capital fund, usually led by a management team. Together, a committee of members led by investment managers will choose businesses to invest in—often ones with high risk, but also high potential payoff. (It’s important to note that individual investors often have amassed a large amount of wealth, and can invest a large amount into the firm.)

Because private companies are often smaller businesses, they may offer investors an opportunity to get more involved behind the scenes. This might mean that an investor could play a role in operational decisions and have a more integrated relationship with the business than they could if they were investing in a large, public company.

In an ideal scenario, if you invest in a private company, you’ll get in earlier than you would when a company goes public. (Note: This is the ideal scenario.) And getting in early can potentially produce impressive results—if you’ve made a sound investment decision.

Another possible benefit of investing in a privately traded company is that there is generally less competition for equity than with a public company. This means you could end up with a bigger slice of the pie.

Investing in a private company might also mean that you are able to set up an exit provision for your investment—meaning you could set conditions under which your investment will be repaid at an agreed upon rate of return by a certain date.

Generally speaking, investing in a private company can have some strong benefits, including increased potential for financial gain and the opportunity to become more involved in the future of a business. However, there are also some major risks involved, and it’s important to understand them before handing over your cash.

Cons of Investing in Private Companies

One of the biggest risks involved in investing in a private company is that you may have less access to information as an investor. Not only is it more challenging to get hold of data in order to understand how the company performance compares to the rest of the industry, private companies are also not held to the same standards as publicly-traded ones.

For example, because of SEC oversight, public companies are held to rigorous transparency and accounting standards. In contrast, private companies generally are not. From an investor’s standpoint, this means that you may sometimes be in the dark about how the business is doing.

In addition to this, many private companies may lack access to the capital they need to grow. And even though there may be an opportunity to set up an exit provision as an investor in a private company, unless you make such a provision, it could be a huge challenge to get out of your investment.

Knowing Your Business Categories

If you have decided to move forward and start investing in private companies, a good place to start is by understanding different business categories as well as the risks and rewards involved. Some of these categories include startup, turnaround, and growth-opportunity companies.

In broad terms, startups are typically higher risk than other business categories as they are new and may have no track record or effective business model. It’s worth noting that most startups fail, so investing in this space can be tricky.

Turnaround companies are failing companies that need intervention. When it comes to investing in this category, it may be important to identify whether cash flow or poor management are to blame for the difficulties the business is experiencing.

If it’s the former, it may be a sound investment; if it’s the latter, it might be worth further investigation, or just passing on the investment.

Businesses in the growth-opportunity stage are companies that are being stunted due to lack of access to capital. If you’ve done your research and identified that a company and its team are solid and in a good position to handle a growth spurt, it may be a great opportunity for investment.

These are just some of the possible categories you may encounter, and there are many more. Once you have an idea of the type of category you’d like to go after, it’s important to get to know the specific company you want to invest in. This could mean paying a visit to the offices and seeing the operations close up.

It could also mean combing through bank statements, financial reports, and developing a thorough understanding of the company team and their track record. Make sure to research the company thoroughly—even if it’s one that you already know you love.

Deciding What Type of Investor You Want to Be

Once you have established what type of business you would like to invest in, you may also need to decide what type of investor you want to be and how involved you would like to get.

You will likely also need to decide whether you are looking to be a majority or minority owner, and understand both the risks and responsibilities that come along with each level of involvement. For some context, a minority interest typically means ownership of less than 50% of a company.

Some investors may choose to play a more active role in the operations and decision-making processes of a private company they invest in, others may prefer to take a back seat.

From here, it may also be a good idea to familiarize yourself with the market niche and have a good understanding of the competition that may be involved, as well as trends and projected revenue. All of these pieces of information can clarify the role you may play as an investor in the company.

Understanding the Risks Involved

Even if the company you are thinking of investing in seems solid, it’s important to have an understanding of the challenges that may come up along the way. There are some red flags to look out for, such as a company whose revenue is earned from just a couple of clients—or just one client—as opposed to several.

In order to make sure you’re staying on top of things and are able to keep an eye on potential risks and build better strategies, you may want to consider building relationships with experts and industry players who can help you optimize your investment strategy.

Investing in What’s Right for You

Investing can be a crucial tool in building long-term wealth. So it may be worth familiarizing yourself with different strategies and approaches and find the one that works best for you.

Ultimately, no investment is free of risk, but there are certain steps you can take to make sure you have a good idea of what you’re getting into. The world of private investment isn’t for everyone, but if done properly it might mean the ability to reap greater financial rewards.

At the end of the day, you might decide that investing in private companies feels too risky, you have other investment options—one of which is SoFi Invest®.

SoFi offers options for the more hands-on investor, with active investing, and for the hands-off investor, with the automated investing platform. Either way, you have access to financial advisors and up-to-date market news to help inform your investing strategy—all for zero management fees.

Think you might be interested in potentially building long-term wealth through investing? SoFi Invest® provides learning tools to help get you on your way.


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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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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