What Is a Bond Option? Definition & Examples

What Is a Bond Option? Definition & Examples

A bond option allows the contract holder to buy or sell an underlying investment (in this case, a bond) at a specific price and at a specific time. While considered less risky than stock options, bond options still typically carry higher risk than more traditional investments.

Like all options, bond options are derivative securities, used by investors to bet on the direction of an underlying security. Understanding what bond options are and how they work can help you understand these risks and determine whether bond options make sense for your portfolio.

Here’s a closer look at bond options, and the risks and rewards they bring to investors.

What are Bond Options?

A bond option is a legal contract to buy and sell underlying bond assets, usually via a call bond (i.e., the option to buy an underlying bond) or a put bond (the option to sell a bond) at a specific price (known as the “strike price)” at or before a specific time deadline (known as the “expiration date”).

For example, an investor might purchase a bond call option with a strike price of $900. The level value (also known as “par value”) of the underlying U.S. government bond is $1,000. Let’s say market conditions push the value of that bond up to $1,100. In that scenario, the option holder has the right to buy the government bond at $900 – even as the value of that underlying bond now stands at $1,100.

Investors typically trade options, including bond options, through over-the-counter exchanges. Bond options are also typically available wherever U.S. Treasury bonds are sold in fund form through investment companies.

Recommended: A Beginner’s Guide to Options Trading

Pros and Cons of Bond Options

There are benefits and drawbacks to incorporating bond options in your portfolio.

Pros of Bond Options

Higher return potential. As discussed in the example above, when executed well a bond options strategy can increase a trader’s gains on a particular investment. Bond options can also protect against downside risk. Investors often use bond options as hedges against more risk-laden investment strategies.

Risk hedging. Bond options investors can leverage derivative contracts to take advantage of interest rates and other short-term drives of investment performance. Investors can also lean on bond options to take advantage of pricing variations in options pricing or to position their portfolios ahead of major geopolitical events, like presidential elections, potentially big Federal Reserve policy decisions, or major recessions and other powerful economic forces.

Cons of Bond Options

The risk of non-exercise. Bond options investors may do well to let an options contract expire rather than execute a trade that goes awry and loses money. While a bond options investor isn’t obligated to exercise their bond options contracts, letting a contract expire means the original money used to buy or sell a bond option is gone forever. So, too, are the fees investment companies charge to handle options trades.

The risk of unlimited investment loss. While call options provide an investor with the possibility of unlimited gain if the underlying security rises in value, that same investor faces unlimited loss potential if that investor is selling a call or put option. If the underlying assets plummet to a value of zero, the options investor could face massive financial losses.

The risk of losing money quickly. As options, by nature, are short-term investing instruments, investors need to have extensive knowledge of near-term investment price movements to minimize the downside risk of investing in bond options. Often, traders make decisions about their options strategy based on a short time horizon. That means all options investors must master two key trading objectives – knowing the right time to purchase an options contract and knowing when to sell that contract, or cut losses by allowing the contract to expire without exercising the option to buy or sell by the expiration date.

Recommended: 10 Options Trading Strategies

Types of Bond Options

Bond options offer investors the right to buy or sell (via calls and puts) an underlying investment security at a specific time and at a set price.

Call Option Bonds

With a bond call option, if the price of the underlying bond option rises in value, the contract holder can earn a profit on the call by exercising the option to purchase the asset (with a call option) at a lower price and then selling it when the underlying asset goes up. A call option is in the money if the strike price is lower than the current market price of the underlying bond.

Bond Put Options

A bond options investor who buys believes a bond will go up in price may purchase a put option or put bond. With that option, buy the asset at the current low price and sell it at the rising strike price, assuming the price moves in the direction the trader had hoped. What a bond investor strives to avoid is being on the wrong side of an options trade, i.e., selling at a below market rate or buying at an above-market rate.

If an investor anticipates that bond prices will decline, given future expected market conditions, they’d purchase a put option. If the level value of the underlying bond option were$1,000, a bond put option gives the contract holder the right to sell the option contract at the strike price of $900 – on or before the expiration date. If bond prices fall, the underlying bond is now valued at $870. Now, that bond option investor can exercise the sale of the options contract at the strike price of $900, even as the bond’s value has fallen to $870. That guarantees a big profit for the investor, given the outsized nature of options contracts.

Embedded Bond Options

Embedded bond options are bonds in which the holder or the issuer has a right to take a specific action with a certain period going forward. Examples of embedded bond options include call provision, convertible provisions, and floored floating-rate provisions.

Callable Bond Options

Callable bonds are one type of embedded bond option. With callable bonds, the issuer has the option to repay investors the face value of the bond before the maturity date.

Recommended: Popular Options Terminology You Should Know

Bond Options Pricing

Given all the variables, including the current price and future price of a bond, volatility levels, interest rates, and time to expiration, it can be very complicated to properly price a bond option. Investors rely on several different mathematical formulas for this, including the Black-Derman-Toy Model and the Black Model.

The Takeaway

Options traders may use a bond option as a hedge against economic volatility in key areas like interest rates, currency rates, and bond yield rates, a bond option can be a useful portfolio management tool. However, there are plenty of other types of investments that an investor can use when building a portfolio, without trading bond options.

But for investors who are curious to start options trading, SoFi offers a user-friendly platform to do so. With an intuitive and approachable design, you can trade options on the web platform or through the mobile app.

Trade options with low fees through SoFi.


Photo credit: iStock/PeopleImages

SoFi Invest®
SoFi Invest refers to the two 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.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

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. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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What Is the Chicago Board Options Exchange (CBOE)?

What Is the CBOE?

While you may already be familiar with the New York Stock Exchange and Nasdaq, those aren’t the only exchanges that investors use to trade securities.

One such exchange is Cboe Global Markets, the world’s largest option trading exchange. Cboe has also created one of the most popular volatility indices in the world.

What Is the CBOE Options Exchange?

CBOE, or CBOE Global Markets, Inc., is a global exchange operator founded in 1973 and headquartered in Chicago. Investors often turn to CBOE to buy and sell both derivatives and equities. In addition, the holding company facilitates trading over a diverse array of products in various asset classes, many of which it introduced to the market.

The organization also includes several subsidiaries, such as The Options Institute (an educational resource), Hanweck Associates LLC (a real-time analytics company), and The Options Clearing Corporation (a central clearinghouse for listed options).

The group has global branches in Canada, England, Ireland, Netherlands, Hong Kong, Singapore, Australia, Japan, and the Philippines.

CBOE is also a public company with a stock traded on the cboe exchange.

What Does CBOE Stand For?

Originally known as the Chicago Board Options Exchange, the company changed its name to Cboe in 2017.

History of the Chicago Board of Options Exchange

Founded in 1973, CBOE represented the first U.S. market for traders who want to buy and sell exchange-listed options. This was a significant step for the options market, helping it become what it is today.

In 1975, the Cboe introduced automated price reporting and trading along with The Options Clearing Corporation (OCC).

Other developments followed in the market as well. For example, Cboe added “put” options in 1977. And by 1983, the market began creating options on broad-based indices using the S&P 100 (OEX) and the S&P 500 (SPX).

In 1993, the CBOE created its own market volatility index called the Cboe Volatility Index (VIX). In 2015, it formed The Options Institute . With this, Cboe had an educational branch that could bring investors information about options.

CBOE continues its educational initiatives. The Options Institute even schedules monthly classes and events to help with outreach.

From 1990 on, Cboe began creating unique trading products. Notable introductions include LEAPS (Long-Term Equity Anticipation Securities) launched in 1990; Flexible Exchange (FLEX) options in 1993; short-term options known as Weeklys in 2005; and an electronic S&P options contract called SPXpm in 2011.

Understanding What the CBOE Options Exchange Does

The CBOE Options Exchange serves as a trading platform, similar to the New York Stock Exchange or Nasdaq. It has a history of creating its own tradable products, including options contracts, futures, and more. Cboe also has acquired market models or created new markets in the past, such as the first pan-European multilateral trading facility (MTF) and the institutional foreign exchange (FX) market.

The Cboe’s specialization in options is essential, but it’s also complicated. Options contracts don’t work the same as stocks or ETFs. They’re financial derivatives tied to an underlying asset, like a stock or future, but they have a set expiration date dictating when investors must settle or exercise the contract.That’s where the OCC comes in.

The OCC settles these financial trades by taking the place of a guarantor. Essentially, as a clearinghouse, the OCC acts as an intermediary for buyers and sellers. It functions based on foundational risk management and clears transactions. Under the SEC and CFTC, it provides clearing and settlement services for various trading options. It also acts in a central counterparty capacity for securities lending transactions.

CBOE Products

Cboe offers a variety of tradable products across multiple markets, including many that it created.

For example, Cboe offers a range of put and call options on thousands of publicly traded stocks, exchange-traded funds (ETFs), and exchange-traded notes (ETNs). Investors use these tradable products for specific strategies, like hedging.

Or, they use them to gain income by selling cash-secured puts or covered calls. These options strategies give investors flexibility in terms of how much added yield they want and gives them the ability to adjust their stock exposures.

Investors have the Cboe options marketplace and other alternative venues, including the electronic communication network (ECN), the FX market, and the MTF.

Recommended: How to Trade Options

CBOE and Volatility

The Cboe’s Volatility Index (VIX) gauges market volatility of U.S. equities. It also tracks the metric on a global scale and for the S&P 500. That opens up an opportunity for many traders. Traders, both international and global, use the VIC Index to get a foothold in the large U.S. market or global equities, whether it be trading or simply exposing themselves to it.

In early 2021, Cboe Global Markets announced a change that would occur later in the year. The market operator intends to extend global trading hours (GTH) on Cboe Options Exchange for its VIX options and S&P 500 Index options (SPX) to almost 24 hours per business day, five days a week. Using this update, they hope to give further access to global participants to trade U.S. index options products exclusive to Cboe. These products are based on both the SPX and VIC indices.

This move allows Cboe to meet growth in investor demand. These investors want to manage their risk more efficiently, and the extended GTH will allow them to do so. With it, they can react in real-time to global macroeconomics events and adjust their positions accordingly.

Essentially, they can track popular sentiment and choose the best stocks according to the VIX’s movements.

Recommended: How to Use the Fear and Greed Index to Your Advantage

The Takeaway

While Cboe makes efforts to educate and open the market to a broader range of investors, options trading is a risky strategy that investors should fully understand before implementing it. Investors should recognize that while there’s potentially upside in options investing there’s usually also a risk when it comes to the options’ liquidity, and premium costs can devour an investor’s profits. That means it’s not the best choice for those looking for a safer investment.

While some may want further guidance and less risk, for other investors, options trading may be appealing. If you’re in the latter camp, consider checking out SoFi’s options trading platform. With a user-friendly design, you can trade via the web platform or mobile app, and check out an array of available educational resources about options.

Trade options with low fees through SoFi.


Photo credit: iStock/USGirl

SoFi Invest®
SoFi Invest refers to the two 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.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

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. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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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What Are Vanilla Options? Definition & Examples

What Are Vanilla Options? Definition & Examples

Once you’ve started investing, you may want to learn about different assets beyond stocks and bonds. Among the alternative assets you might consider, are options, and vanilla options are a great way to get started with this type of investment.

Options give investors the — you guessed it — option to purchase or sell a stock at a certain price over a certain period. Options are derivative financial instruments, which means they are based on an underlying asset. Vanilla options are the most basic type of option contract, and they’re often standardized and traded on exchanges.

Vanilla Option Definition

Vanilla options, in contrast to exotic options, which have customization features, have simple and straightforward terms of the strike price, or the price for which an investor buys or sells a stock, and the period in which they can exercise their option. The last day that an investor may exercise an option is known as the expiry date.

How Do Vanilla Trades Work?

Let’s look at how options trading works with vanilla trading.

Each option has a strike price. If that price for purchase is lower than the market value of the stock, investors call that option “in the money.”

Investors pay a premium to own an option. This premium reflects several factors, including:

• How close the strike price is to the market price

• The stock’s volatility

• How length of time before the option expires

Investors don’t have to wait until the option expires to complete the trade, and they are typically under no obligation to exercise the option.

Recommended: Popular Options Trading Terminology to Know

What are the Different Types of Vanilla Options?

When it comes to options for vanilla stock options, there are two types, calls and puts.

Calls

A vanilla call option gives an investor the option to buy an asset at a certain price within a certain period. A call option is a bit like a down payment; the investor pays the premium so that, later, they can buy the stock at a good price and profit from it.

However, an investor can pay the premium and never exercise the option. If they decided not to exercise it, they would either lose what they paid for the premium, or they could sell the call option to someone else before it expires.

Puts

In contrast, a put option allows an investor to sell an asset at a fixed price within a certain time period. If a stock tanks in value over the period that option is exercisable, the investor can still sell it for the put price and not lose as much of his investment. But if the stock’s value goes higher than the put price in the market, the vanilla options are worthless because the investor could sell it at the market price and realize more of a profit.

Characteristics of Vanilla Options

Like all investments, vanilla options include a level of risk and volatility. But they can also provide the opportunity for profit.

Premiums

Whether you are interested in a vanilla call or put, you will pay a premium, in addition to what you would pay to purchase the stock with a call. The premium isn’t refundable, so if you don’t exercise the option, you’ve lost what you paid for the premium.

Volatility

The volatility of an option determines its price. The higher the volatility of the option, the higher the premium because there is more opportunity for profits (as well as the risk of loss).

One way to reduce volatility is to use an options trading straddle where you buy a put and call option simultaneously.

Risk Level

Like most other types of investments, options are not without risk. If a stock is lower in price on the market than a call option, the option is worthless. And if a stock has a higher price on the market, the put option won’t net more return on investment.

However, a vanilla option may be less risky than buying a stock outright, since the only thing you’re guaranteed to spend is the premium.

Pros and Cons of Vanilla Options Trading

Trading vanilla options can have potentially great returns…or large losses. Here are the pros and cons.

Pros

Cons

Minimizes risk; no obligation to exercise Risky; may lose premium investment and more
Option to control more shares than buying them outright May be complex to understand
May offer large returns Fluctuations in market may render option worthless

Pros

Options may be less risky than buying a stock outright, since you’re only buying the option to purchase or sell a stock at a certain price. The premium is all you invest initially.

Typically you can purchase more shares through options than you could buying them on the market, so if you’re looking for larger investment opportunities, options could provide them.

And while they’re volatile, there is the potential for larger returns.

Cons

That being said, you don’t always see large returns. You can lose your entire investment if the option is out of the money when it expires.

Options can be complicated or confusing for new investors. Not only should you fully understand the risks you take with this investment tool, but you also should understand options taxation.

Examples of Vanilla Options

If you’re considering vanilla options as part of your options trading strategy, here are a few examples to illustrate how they work for both calls and puts.

Example of a Vanilla Put Option

A put is a bit like insurance in case your stock you’re holding goes down in value. It’s one way that investors might short a stock. Here’s an example.

Let’s say you own 100 shares of a stock that is currently trading at $25 per share. You buy a put option at a premium of $1 per share that expires in two months at a strike price of $25. So in total, you paid $100 for a premium for 100 shares.

In a month, the stock price drops to $18 per share. This is a good time to exercise that premium because your strike price allows you to sell the shares for $25 rather than $18. You wouldn’t gain any money because you’re essentially selling the stocks for what you paid for them ($25), and you would even lose a little (that $1 per share premium), but the alternative would be to lose even more if you waited and the price dropped more or you didn’t have the option.

Example of a Vanilla Call Option

A call option allows you to purchase a stock at a certain price within a specified time period. Bullish investors who expect a stock to go up in price typically purchase call options.

For our example, let’s say you’re interested in a stock that trades at $53, and you can buy a call option for this stock within one month to purchase the stock at $55 per share. The option is for 100 shares of this stock.

The premium for this option is $0.15 per share. So you would pay $15 for the premium. You aren’t obligated to purchase the stock. If the stock trades at more than $55.15 (option price plus premium), you can realize a profit.

Let’s say in two weeks, that stock is trading at $59. It is, as they say, “in the money.” Now would be a great time to exercise your option because you can realize $3.85 per share and $385 for 100 shares. You can sell the shares immediately to cash in on that profit or hold onto it to see if the stock price continues to rise.

The Takeaway

Vanilla stock options can be a way to diversify your investment portfolio and increase your investing savvy. When it comes to options trading, it helps to have a platform like SoFi’s, which boasts an intuitive design. Plus, you’ll have access to educational resources to learn about any other terminology that comes up on your options trading journey.

Trade options with low fees through SoFi.


SoFi Invest®
SoFi Invest refers to the two 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.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

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. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Overhead shot of the desk in the office.

A Guide to Tax-Efficient Investing

Any time you make money from your investments you need to consider the impact taxes might have on your earnings. Fortunately, there are a range of tax-efficient investment strategies that can help minimize the bite taxes take out of your gains.

What is tax-efficient investing, and how does it work? By understanding the tax implications of different types of accounts, as well as the investments you choose (e.g. stocks, bonds, mutual funds), you can determine the most tax-efficient strategies for your portfolio.

Tax-efficient investing is important for two reasons. Not only can these strategies help you keep more money in your pocket, tax-efficient investing can enable you to keep more of your money invested in the market, with the potential for growth.

Read on for a description of each of these strategies to learn which might make the most sense for you. Because taxes can be complicated, be sure to consult a tax professional to address questions specific to your particular situation.

At a Glance: Types of Tax-Efficient Accounts

Investment accounts can generally be divided into three categories based on how they’re taxed: taxable, tax-deferred, and tax-exempt. Tax-deferred and tax-exempt accounts are generally used for retirement (like a 401(k) or Roth IRA), and they’re often considered more tax advantageous than a taxable account for long-term investing.

As a quick summary, here are the three main account types, their tax structure, and what that means for the types of investments you might hold in each.

Types of Accounts When Taxes Apply Investment Implications
Taxable
(e.g. brokerage or investment account)
Investors deposit post-tax funds and owe taxes on profits from securities they sell, and from interest and dividends. Investors may want to choose investments with a lower tax impact (e.g. long-term stocks, municipal and Treasury bonds).
Tax-deferred (e.g. 401(k), 403(b), traditional, SEP, and Simple IRAs) Investors contribute pre-tax money, but owe taxes on withdrawals (usually in retirement).* Investments here grow tax free until funds are withdrawn, giving investors more tax flexibility when choosing securities.
Tax-exempt
(e.g. Roth 401(k), Roth IRA)
Investors deposit post-tax funds and don’t owe taxes on withdrawals.** These accounts offer the most tax flexibility as investments grow tax free and investors withdraw the money tax free.
*Withdrawal rules and restrictions apply.
**Income limits apply. Withdrawal rules and restrictions apply.

Taxable Accounts

In order to understand tax-deferred and tax-exempt accounts, it helps to first understand taxable accounts, which are also called brokerage accounts or investment accounts. A taxable account has no special tax benefits.

Taxable accounts can be opened in the name of an individual or trust, or as a joint account. Money that is deposited into the investment account is post-tax, i.e. income taxes have already been paid or will be paid on those funds (similar to the money you’d put into your checking or savings accounts).

Taxes come into play when you sell investments in the account and make a profit. You may owe taxes on the gains you realize from those investments, as well as earned interest and dividends.

With some securities, like individual stocks, the length of time you’ve held an investment can impact your tax bill. Other investments may generate income or gains that require a different tax treatment.

For example:

•  Capital gains. The tax on an investment gain is called capital gains tax. If an investor buys a stock for $10 and sells it for $50, the $40 is a “realized” gain and will be subject to either short- or long-term capital gains tax. The tax rate will be higher or lower depending on how long the investor held the investment — more or less than a year — and their personal income tax bracket and filing status.

•  Interest. Interest that is generated by an investment, such as a bond, is typically taxed as ordinary income. In some cases, bonds may be free from state or local taxes. If you sell a bond or bond fund at a profit, short- or long-term capital gains tax could apply.

•  Dividends. Dividends are distributions that may be paid to investors who hold certain dividend-producing stocks. Dividends are generally paid in cash, out of profits and earnings from a corporation — and can be taxed as short- or long-term capital gains within a taxable account.

Recommended: How Do Dividends Work?

But the terms are different when it comes to tax-deferred and tax-exempt accounts — and understanding where the differences lie is crucial to a tax-efficient strategy.

Tax-deferred Retirement Accounts

A 401(k), 403(b), traditional IRA, SEP IRA, and Simple IRA fall under the tax-deferred umbrella, a tax structure typical of retirement accounts. They’re considered tax efficient for a couple of reasons.

•  Pre-tax contributions. First, the money you contribute to a tax-deferred account is not subject to income tax; you owe taxes when you withdraw the funds later, e.g. in retirement. Thus the tax is deferred.
This means the amount you contribute to a tax-deferred account for a given year can be deducted from your taxable income, potentially reducing your tax bill for that year.

Speaking hypothetically: If your taxable income for a given year is $100,000, and you’ve contributed $5,000 to an IRA, your taxable income would now be $95,000. And you wouldn’t pay taxes on the $5,000 contribution until you withdrew that money later, likely in retirement.

•  Tax-free growth. The money in a tax-deferred retirement account grows tax free. Thus you don’t incur any taxes until the money is withdrawn.

•  Potentially lower taxes. By deducting the contribution from your taxable income now, you may avoid paying taxes at your highest marginal tax rate. The idea is that investors’ effective (average) tax rate might be lower in retirement than their highest marginal tax rate while they’re working.
That said, it’s hard to bank on this particular tax advantage, as tax rates could change. And while some people tend to fall into a lower tax bracket when they retire, that’s not always the case.

The Tradeoffs of Tax-free Growth

Because of the advantages tax-deferred accounts offer investors, there are restrictions around contribution limits and the timing (and sometimes the purpose) of withdrawals.

•  Contribution limits. The IRS has limits for how much you can save in tax-deferred accounts. For example, the maximum contribution for a 401(k) is $19,500 in 2021, with an additional $6,500 allowed for those age 50 and older. (An employer’s match is not counted toward the contribution limit.)

◦  The maximum contribution to a traditional IRA is $6,000 for 2021, with an additional $1,000 for those 50 and over.

•  Restrictions on early withdrawals. For 401(k) plans and IRAs, there is a 10% penalty if you withdraw money before age 59½, with some exceptions. You would also owe taxes on the amount you withdrew. Some exceptions apply (e.g. taking an emergency loan from your 401(k) and other qualifying events).

•  Required withdrawals. At age 72, investors must begin to take withdrawals; these are called required minimum distributions, or RMDs, and this additional income can have tax implications. Although RMDs were suspended during 2020 owing to the pandemic, the policy is back in effect for 2021.

◦  There are no RMDs for Roth IRAs (see tax-exempt accounts below).

The terms governing required distributions can be complex, and the penalty for missing or skipping an RMD can be onerous. Consult a tax professional for guidance.

Tax-exempt Retirement Accounts

Tax-exempt accounts include retirement accounts like the Roth IRA and Roth 401(k), and also 529 College Savings Plans and Health Savings Accounts (HSAs).

When you contribute money to a tax-exempt account, you use post-tax funds — money that’s already been taxed. Although that means you can’t deduct contributions from your taxable income, the money grows tax free — just as it does in a tax-deferred account — but the real tax advantage here is that you get to withdraw the money free of taxes.

As with all investment accounts, there are different rules and restrictions that apply. For the purposes of this guide, we’ll focus on the rules pertaining to Roth accounts. The rules governing 529 plans and HSAs are somewhat different: These accounts do allow tax-free withdrawals, but only for qualified educational or health-related expenses.

Withdrawal Rules

Roth accounts, whether an online IRA account or a 401(k), are the only retirement accounts that permit tax-free withdrawals.

Because contributions to Roth accounts are made post-tax, there is also more flexibility on when the money can be withdrawn. You can withdraw the amount of your contributions tax and penalty free at any time. However earnings on those investments may incur a penalty for early withdrawal, with some exceptions.

Recommended: What Is the Roth IRA 5-Year Rule?

For example, if you contributed $5,000 to a Roth IRA, and that amount grew to $7,000, you could withdraw the $5,000 at any time. But, with some exceptions, the $2,000 in investment gains could be penalized for early withdrawal if you’re younger than 59½ and have held the account for less than five years.

Contribution Limits

It’s also possible to earn too much to be eligible to contribute to a Roth IRA, so be sure to consult a tax professional on the current income limits for Roth accounts.

Contribution limits for Roth IRAs and 401(k)s are similar to their traditional, tax-deferred counterparts. For 2021, you can contribute a maximum of $6,000, with an additional $1,000 in catch-up contributions available to investors over 50. An investor can contribute up to $19,500 to a Roth 401(k), with an additional $6,500 in catch-up contributions.

A Roth account may make sense for an investor who has a low overall tax rate (and those who meet the income requirements). Because of this, Roth accounts tend to be popular with younger investors. Other investors may simply prefer to pay income taxes now and not have to worry about the tax bill in retirement.

Types of Tax-Efficient Investments

When deploying a tax-efficient investment strategy, it’s crucial to know how an investment is going to be taxed because ideally you’d want more tax-efficient investments in a taxable account. Conversely, you may want to hold investments that can have a greater tax impact in tax-deferred and tax-exempt accounts, where investments can grow tax free.

Next, it is helpful to know that some investment types are more tax efficient in their construction — so you can make the best investment choices for the type of investment account that you have. For example, ETFs are considered to be more tax efficient than mutual funds because they don’t trigger as many taxable events. Investors can trade ETFs shares directly, while mutual fund trades require the fund sponsor to act as a middle man, activating a tax liability.

There’s an important lesson here: Investments that are less tax efficient might make sense to hold in a tax-sheltered account, like a retirement account, because no profit-related taxes are levied on the earnings in those accounts.

Investment types that are more tax efficient might be better suited for taxable accounts, where an investor must pay both capital gains tax and income tax on interest earned.

Here’s a list of some tax-efficient investments:

•  ETFs: These are similar to mutual funds but more tax efficient due to their construction. Also, most ETFs are passive and track an index, and thus tend to be more tax efficient than their actively managed counterparts (this is also true of index mutual funds versus actively managed funds).

•  Treasury bonds: Investors will not pay state or local taxes on interest earned via Treasury bonds.

•  Municipal bonds: These are bonds issued by local governments, often to fund municipal buildings or projects. Interest is generally exempt from federal taxes, and state or local taxes if the investor lives within that municipality.

•  Stocks that do not pay dividends: When you sell a non-dividend-paying stock at a profit, you’ll likely be taxed at the long-term capital gains rate, assuming you’ve held it longer than a year. That’s likely lower than the tax you’d pay on ordinary dividends, which are generally taxed as income at your ordinary tax rate.

Note that actively trading stocks can have additional tax implications (more on that in the following section).
Typically, tax consequences will vary from person to person. A tax professional can help navigate tricky tax questions.

Tax-Efficient Trading Strategies

It may also be possible to minimize taxes by incorporating a few trading strategies as you manage your investments.

Minimizing Capital Gains Tax

Securities that are sold at an investment gain may be subject to capital gains tax (within a taxable account). But capital gains tax has two rates: short term, for investments held less than a year, when gains are taxed as ordinary income, and long term, for investments held longer than a year.

For investments held longer than a year, most investors will only pay either 0% or 15%, depending on their income tax bracket. Those who earn more than $434,550 (filing single) are subject to a higher 20% rate, but these tax rates can still be significantly lower than those applied to the capital gains on short-term investments. Short-term capital gains can be taxed up to 37% depending on your income tax bracket.

Tax-Loss Harvesting

Within taxable accounts, there may be an additional way to minimize some of the tax bill created by selling profitable investments: tax-loss harvesting. This advanced move involves canceling out an investment gain with an investment loss.

For example, an investor wants to sell a few investments and the sale would result in $2,000 in capital gains. Tax-loss harvesting rules allow them to sell investments with $2,000 in total capital losses, effectively canceling out the gains. In this scenario, no capital gains taxes are due for the year.

Note that even though the investor sold the investment at a loss, the “wash sale” rule prevents him from buying back the same investment within 30 days after those losses are realized. This rule prevents people from abusing the ability to deduct capital gain losses, and applies to trades made by the investor, the investor’s spouse, or a company that the investor controls. Because this strategy involves the forced sale of an investment, many investors choose to replace it with a similar — but not too similar — investment. For example, an investor that sells an S&P 500 index fund to lock in losses could replace it with a similar U.S. stock market fund.

Recommended: What Are the Benefits of Tax Loss Harvesting?

Tax-Loss Carryover

Tax-loss harvesting rules also allow an investor to claim some of that capital loss on their income taxes, further reducing their annual income and potentially minimizing their overall income tax rate. In 2021, this can be done with up to $3,000 in realized investment losses, or $1,500 if you’re married but filing separately.

Should your capital losses exceed the federal $3,000 max claim limit ($1,500 if you’re married and filing separately), you have the option to carry that loss forward and claim any amounts excess of that $3,000 on your taxes for the following year. For example, if you have a total of $5,000 in capital losses for this year, by law you can only claim $3,000 of those losses on your 2021 taxes. However, due to tax-loss carryover, you are able to claim the remaining $2,000 as a loss on your 2022 tax form in addition to any capital gains losses you happen to experience during the 2022 year. This in turn lowers your capital gains income and the amount you may owe in taxes.

Tax-Efficiency Through Diversification

A highly effective method for minimizing the tax impact on your investments is by diversifying your portfolio. A well-considered combination of taxable, tax-deferred, and tax-exempt accounts can help mitigate the impact of taxes on your investment earnings.

For example, with some investments — such as IRAs — your current tax bracket can have a substantial impact on the associated tax on withdrawals. Having alternate investments to pull from until your tax bracket is more favorable is a smart move to avoid that excess tax.

Also, with multiple investment accounts, you could potentially pull early retirement income from a tax-free Roth IRA and leave your company-sponsored 401(k) to grow until RMDs kick in.

Having a variety of investments spread across account types gives you an abundance of options for many aspects of your financial plan.

•  Need to cover a sudden large expense? Long-term capital gains are taxed significantly less than short-term capital gains, so consider using those funds first.

•  Want to help with tuition costs for a loved one? A 529 can cover qualified education costs at any time, without incurring a penalty.

•  Planning to leave your heirs an inheritance? Roth IRAs are tax free and transferrable. And because your Roth IRA does not have required distributions (as a traditional IRA would), you can allow the account to grow until you pass it on to your heir(s).

Creating a Tax-Efficient Investment Strategy

Once you understand the tax rules that govern different types of investment accounts, as well as the tax implications of your investment choices, you’ll be able to create a strategy that minimizes taxes on your investment income for the long term. Ideally, investors should consider having a combination of tax-deferred, tax-exempt, and taxable accounts to increase their tax diversification. To recap:

•  A taxable account (e.g. a standard brokerage account) is flexible. It allows you to invest regardless of your income, age, or other parameters. You can buy and sell securities, and deposit and withdraw money at any time. That said, there are no special tax benefits to these accounts.

•  A tax-deferred account (e.g. 401(k), traditional IRA, SEP IRA, Simple IRA) is more restrictive, but offers tax benefits. You can deduct your contributions from your taxable income, potentially lowering your tax bill, and your investments grow tax free in the account. Your contributions are capped according to IRS rules, however, and you will owe taxes when you withdraw the money.

•  A tax-exempt account (e.g. a Roth IRA or Roth 401(k)) is the most restrictive, with income limits as well as contributions limits. But because you deposit money post-tax, and the money grows tax free in the account, you don’t owe taxes when you withdraw the money in retirement.

Whether you’d like to open a taxable, tax-deferred, or tax-exempt account, an online investing app like SoFi Invest® can help. There are no SoFi fees to open an account and to buy investments. Trading stocks and ETFs is user-friendly with SoFi Invest. Investors can stay up to date on breaking news, conduct research on investments, and place trades, all from within the SoFi app.

Best of all, SoFi offers access to financial planners at no additional charge. Question about saving, investing, or debt-payoff strategy? No problem. SoFi financial advisors are here to help.

For additional questions or specific advice regarding your personal tax situation, it’s best to consult a tax professional.

Ready to jumpstart your tax-efficient investing strategy? Open a traditional IRA, Roth IRA, or SEP IRA with SoFi Invest.


SoFi Invest®
SoFi Invest refers to the two 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.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

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.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

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SegWit: Definition & How it Works

SegWit: Definition & How it Works

SegWit is an update to Bitcoin’s protocol that changed the way that the blockchain transfers information. Protocols are the rules that govern the way that Bitcoin and other cryptocurrencies work.

What Is SegWit?

SegWit is an example of the Bitcoin development community being able to solve a problem while still maintaining the integrity of the Bitcoin protocol and blockchain.

SegWit stands for “segregated witness,” and it’s a key turning point in the history of Bitcoin and cryptocurrency, and represents a fork in the road, or at least a fork in Bitcoin. The SegWit fork changed the rules, allowing for larger blocks and removing signature data from Bitcoin transactions.

How Does SegWit Work?

SegWit removes (or segregates) the signature (or witness) from the block, moving it instead to the back of the transaction. This frees up more space for the transaction itself.

What Problems Does SegWit Solve?

SegWit solves several issues with earlier versions of the Bitcoin protocol.

The Transactions Problem

The original Bitcoin protocol limits the size of “blocks” to a single megabyte. The whole Bitcoin network “confirms” a new block every ten minutes, with a few transactions taking place every second. These blocks and the confirmation process comprise the foundation of Bitcoin.

As Bitcoin scaled and got bigger and more miners, developers, and users became part of the Bitcoin community, a debate arose around the size of blocks. Should it increase beyond founder Satoshi Nakamoto’s original vision or stay the same?

If the community decided to make an increase, it would have to receive approval by consensus, or perhaps risk splitting Bitcoin apart into separate protocols.

The Malleability Problem

The Blockchain also had some security and efficiency issues, known as “malleability.” Prior to Segwit, every Bitcoin transaction included a “signature” that became part of the transaction confirmation. The signature, with the use of a private key, would become part of the block transfer, taking up space that could have been more Bitcoin transactions. Another word for these signatures is “witness,” and so was born the idea of Segregated Witness, or SegWit.

The theory behind SegWit held that Bitcoin transactions could be more efficient, more secure, and better recorded on the Blockchain itself. This would also allow for developers to build transfer improvements on top of the original Bitcoin protocol, leading to the development of the Lightning Network.

The Scalability Problem

One of the major issues addressed by SegWit was the so-called “scalability problem,” which refers to the issue with block sizes that can limit the speed and scale of transactions on a Blockchain network.

When Was SegWit Created?

The Bitcoin Segwit update took place on August 23, 2017 and changed the way information was transferred on the blockchain.

Prominent Bitcoin developer Pieter Wuille originally proposed the update in 2015 as a way to address a problem in the less-than-a-decade-old protocol that governed the cryptocurrency. He and others believed that transactions took too long to process and that they had some security issues.

There were two ways, known as forks, to address the problem.

A hard fork

A hard fork creates a new system all together. Bitcoin Cash is an example of a hard fork, which enabled large block sizes, but ultimately created a new network.

A soft fork

With a soft fork, the new system works with the old one. This is the option that developers used for SegWit, which became one of the most prominent and important Bitcoin forks. In the dispute between soft fork vs hard fork, SegWit’s successful adoption is a victory for the soft forks.

Recommended: Differences Between Bitcoin Soft Forks and Hard Forks

What Was Segwit2x?

Some prominent Bitcoin miners supported several approaches to the scale issue inherent in the original Bitcoin protocol. To move forward, they came to what’s known as the “New York Agreement,” a plan to implement SegWit and do a hard fork of Bitcoin to increase the block size limit. This was “SegWit2X.”

However, Bitcoin’s developers didn’t endorse the plan and it never reached the consensus necessary for a successful hard fork. These developers have huge sway over the greater Bitcoin community and without their support, a fork wouldn’t have enough takers to challenge Bitcoin in its present set-up. By late 2017, SegWit2X had collapsed and early the next year, SegWit was fully operational on consumer cryptocurrency platforms like Coinbase. And major crypto wallets, the hardware and software products that allow for safe crypto storage, had signed on to the SegWit update.

The failure of SegWit2x shows that even large Bitcoin mining pools, groups of miners that run the hardware that creates new Bitcoin, don’t have total sway over the Bitcoin community and can’t singlehandedly dictate its direction – or its forks. Bitcoin miners have tended to prefer Bitcoin changes that would increase the block size as opposed to segregating out signatures, since that would bolster the fees they get from the network for processing blocks. But the Bitcoin community is more than just its miners, and so their opinion only means so much.

Should You Use SegWit?

While the Bitcoin scalability debate is hardly over, for the time being, Bitcoin itself remains in the driver’s seat in terms of usage and developer activity compared to its rivals and hard forks.

By early last year, at least two thirds of transactions used SegWit, indicating that the soft fork “works” for many in the Bitcoin community. By the end of 2020, one of the last exchanges to hold out, Binance, announced that it would support SegWit.

There are several benefits to using Segwit for crypto transactions, including lower transaction fees and faster transactions.

The Takeaway

SegWit was a major upgrade to the Bitcoin protocol, and one that has helped accelerate widespread adoption of the cryptocurrency in recent years.

Photo credit: iStock/BartekSzewczyk


SoFi Invest®
SoFi Invest refers to the two 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.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

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