Jan
30
2024
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Understanding a Taxable Brokerage Account vs an IRA

By | Growing Wealth, invest, Investing | No Comments

Tax-sheltered accounts like the IRA and 401(k) have long been the go-to investment accounts for retirement planning. These types of accounts offer ways to build up tax-advantaged savings for the future. However, investing in taxable brokerage accounts is another common way to grow wealth for the short or long term.

The most notable difference between an IRA and a taxable brokerage account can be seen around tax season. With taxable brokerage accounts, you typically pay taxes on your capital gains and dividends each year. In contrast, tax-sheltered accounts only involve paying taxes when you make your contribution or withdraw your money, depending on the type of account.

Investors should know the similarities and differences between IRAs and taxable brokerage accounts. Learning the ins and outs of these accounts can help you decide which is right for you to build wealth and meet your financial goals.

What Are Taxable Brokerage Accounts?

Think of taxable brokerage accounts as “traditional” investment accounts — brokerage-offered investment accounts with stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Investors who utilize these accounts invest and trade to build short- or long-term wealth, but not necessarily for retirement.

The investments within a taxable brokerage account are subject to tax on any capital gains, dividends, or interest earned. Brokerage account holders pay taxes each year based on investment income.

It’s also important to note that tax liability can vary based on variables like the types of investments held within the account, the length of time they are held, and an individual’s tax bracket. For example, short-term capital gains, which are gains on investments held for less than a year, are taxed at the same rate as ordinary income. In contrast, long-term capital gains, which are gains on investments held for more than a year, are typically taxed at a lower rate.

💡 Recommended: Capital Gains Tax Guide

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What Is an IRA?

An IRA, or individual retirement account, is an investment account designed specifically to save for retirement. Contributions to an IRA may be tax-deductible, and the accounts’ investments can grow tax-free until they are withdrawn at retirement age.

There are several different types of IRAs, including Traditional IRAs, Roth IRAs, and SEP IRAs, which have different rules for contributions, taxes, and withdrawals. An IRA can be a helpful tool for saving for retirement and taking advantage of potential tax benefits.

Taxable Brokerage Accounts vs IRA Accounts

Tax-sheltered, or tax-deferred, investment accounts like IRAs differ from taxable brokerage accounts because they generally offer tax advantages and have restrictions on contributions and withdrawals. The tax advantages make them designed for long-term retirement saving and investing. Besides having money invested for retirement, the most notable benefits of IRAs are no yearly tax burden and, in some cases, tax-deductible contributions.

Here’s a breakdown of what each tax-deferred account may offer compared to a brokerage account.

Traditional IRAs vs Taxable Brokerage Accounts

The traditional IRA has no income limits; as long as someone has a taxable income, they can contribute to a traditional IRA. The gains, dividends, and interest earned in IRAs grow tax-free during contributing years. Contributions to a traditional IRA may be tax-deductible, though the benefits phase out if you have a high enough income.

With a few exceptions, IRA withdrawal rules say account holders will have to pay a 10% early withdrawal penalty if they take a distribution before reaching age 59 ½. Additionally, account holders are required to start making withdrawals the year they turn age 72 that are taxed as income.

These limitations make a traditional IRA different from a taxable brokerage account, as taxable brokerage accounts do not have withdrawal restrictions and penalties.

With a traditional IRA, as with taxable brokerage accounts, account holders will need to manage it independently or with a financial planner’s help.

A traditional IRA might be a good option for investors who think they will be in a lower tax bracket when they retire. In theory, these investors would save money on taxes by paying them in retirement compared to paying taxes now.

For 2024, account holders can contribute up to $7,000 per year (or up to $8,000 if they are over 50 years old). For 2023, the total contributions investors can make to a traditional IRA is up to $6,500 (or up to $7,500 if they are over 50 years old).

💡 Recommended: Important Retirement Contribution Limits

Roth IRAs vs Taxable Brokerage Accounts

Like taxable brokerage accounts, Roth IRA contributions aren’t tax-deductible. Investors contribute with post-tax dollars, but that also means they won’t be subject to taxes when they withdraw funds in retirement.

However, income limits exist for those who can contribute to a Roth IRA account. If you make more than the income limits, then the amount of money you can contribute to a Roth IRA may be reduced; high earners may not be able to contribute to a Roth IRA. For 2024, income limits start at $146,000 per year for single tax filers and $230,000 for married couples filing jointly. For 2023, income limits start at $138,000 per year for single tax filers and $218,000 for married couples filing jointly.

As with brokerage accounts, Roth IRA account holders can contribute to their accounts at any age. Investors who want to make retirement contributions can do so even after they’ve retired.

Rules around Roth IRA withdrawals are less stringent than those for a traditional IRA. Roth account holders can also begin to take the account’s growth starting at age 59 ½ with no penalty as long as the account has been open for five years.

For those eligible to contribute to a Roth IRA, these accounts make the most sense if the account holder thinks they will be in a higher tax bracket in retirement. Since account holders pay taxes on the contributions in the year they were made, it makes the most sense to pay income taxes when in a lower tax bracket.

💡 Recommended: Traditional vs Roth IRA: How to Choose the Right Plan

401(k)s vs Taxable Brokerage Accounts

Similar to an IRA, 401(k) accounts are one of the most common tax-sheltered accounts. The big difference between an IRA and a 401(k) account is that the 401(k) is employer-sponsored, and employees and employers can contribute to the account.

Employees can contribute to their 401(k) up to $23,000 per year in 2024 and up to $22,500 in 2023. Employees over 50 can make additional catch-up contributions of $7,500 annually in both 2024 and 2023. Many employers offer employees 401(k) plans, some even matching contributions up to a certain percentage.

The 401(k) is one of the most common ways to grow a retirement nest egg because the contributions are automatic and come out of the employee’s paycheck, so employees may not even notice the money is gone.

Tax Advantages of an IRA vs Taxable Brokerage Account

As noted above, IRAs offer several tax advantages compared to taxable brokerage accounts. Investors generally use IRAs for tax efficient investing.

Here are some of the main differences:

•   Contributions to traditional IRAs may be tax-deductible: Contributions to a traditional IRA may be tax-deductible, depending on your income and whether a retirement plan at work covers you or your spouse. This means that the money you contribute to a traditional IRA can be deducted from your taxable income, reducing the amount of tax you owe.

•   Earnings in an IRA grow tax-free: The money you earn in an IRA, including interest, dividends, and capital gains, grows tax-free until you withdraw it in retirement. In a taxable brokerage account, you would have to pay taxes on any capital gains and dividends you earn each year.

•   Withdrawals from traditional IRAs may be taxed at a lower rate: When you withdraw money from a traditional IRA in retirement, it is taxed as ordinary income at your marginal tax rate. However, if you are in a lower tax bracket in retirement than when you made the contributions, your withdrawals may be taxed at a lower rate.

•   Contributions to a Roth IRA are not tax-deductible: Contributions to a Roth IRA are not tax-deductible, but the money you withdraw in retirement is tax-free, provided you meet specific requirements. This can be a good option if you expect to be in a higher tax bracket in retirement than you are now.

Which Type of Account Is Best for Me?

Brian Walsh, Certified Financial Planner™ at SoFi, says ultimately, you’ll have a mixture of accounts. However, what’s right for you depends on your situation. “It depends if you have access to a 401(k) and an employer match … it depends on what you’re eligible for.” Here are a few considerations that can help you assess your situation.

Think About Investing in a Traditional IRA If…

•   You want to take advantage of tax-deferred contributions.

•   You expect to be in a lower tax bracket in retirement.

•   You’ve maxed out your 401(k) contributions and make too much to contribute to a Roth account.

Think About Investing in a Roth IRA If…

•   You expect to be in a higher tax bracket in retirement.

•   You want the option to pass on the account easily to your heirs.

•   You’ve maxed out your traditional 401(k) and want to offset some of your future tax burden with a Roth IRA.

Think About Investing in a 401(k) If…

•   Your employer offers a plan with a match program.

•   You’re uncertain about your future tax liability, and your employer allows you to split contributions between a traditional 401(k) and a Roth 401(k).

•   You prefer a hands-off approach to investing.

Think About Investing in a Taxable Brokerage Account If…

•   You’ve maxed out all contribution limits to your 401(k) and IRAs.

•   You want to invest in investments not offered in your 401(k) or IRA, like options or cryptocurrency.

•   You want more control over your investments with the opportunity to withdraw funds at your leisure.

Pros and Cons of Taxable Brokerage Accounts

Here are some of advantages and disadvantages of taxable brokerage accounts:

Pros of Taxable Accounts

•   Flexibility: Taxable brokerage accounts allow you to invest in a wide range of assets, such as stocks and bonds, as well as derivatives. This allows you to create a diversified portfolio that meets your investment goals.

•   Growth potential: Taxable brokerage accounts offer the potential for significant growth, as you can earn capital gains on your investments if they increase in value.

•   No contribution limits: Unlike tax-advantaged accounts, taxable brokerage accounts have no contribution limits. This means you can contribute as much as you want to your account, subject to income limits or restrictions.

Cons of Taxable Accounts

•   Taxes: One of the main disadvantages of taxable brokerage accounts is that you will be required to pay taxes on your investment income and capital gains. This can significantly reduce your overall returns.

•   Lack of tax benefits: Taxable brokerage accounts do not offer the same tax benefits as tax-advantaged accounts. For example, 401(k)s and IRA contributions may be tax-deductible, while investments in taxable brokerage accounts are not.

•   Potential for loss: As with any investment, there is a risk of loss in a taxable brokerage account. If your investments decline in value, you could lose some or all of your initial investment.

Is it Smart to Have Both an IRA and a Taxable Brokerage Account?

It may be a consideration to have both an IRA and a taxable brokerage account, as each type has its specific benefits and drawbacks.

An IRA can be a good option if you are looking to save for retirement and want the potential tax benefits of an IRA. On the other hand, a taxable brokerage account can be a good choice if you are looking to invest for goals other than retirement or if you are not eligible for a tax deduction on your contributions to an IRA.

Having both an IRA and a taxable brokerage account can give you more flexibility and diversification in your investments, which can help you manage risk and improve your overall financial situation.

The Takeaway

Every account — from taxable brokerage accounts to IRAs — has advantages and disadvantages, which is why some investors choose to invest in a few. The old cliche, “don’t put all your eggs in one basket,” is a solid philosophy for financial planning. Investing in several different “baskets” is one way to ensure that your money is working hard for you.

Fortunately, SoFi Invest® offers several accounts that can help you save and invest for retirement or whatever financial goals you have. With SoFi, you can open a retirement account, either a traditional or Roth IRA. For individuals who want to build their own portfolio, SoFi also offers an online brokerage account where investors can trade stocks, ETFs, fractional shares, and more with no commissions.

Take a step toward reaching your financial goals with SoFi Invest.

FAQ

What is the difference between an IRA and a taxable brokerage account?

An IRA is designed specifically to save for retirement. Unlike a taxable brokerage account, which is used for general investing, contributions to an IRA may be tax-deductible, and the investments within the account can grow tax-free until they are withdrawn at retirement age. There are several different types of IRAs, including Traditional IRAs and Roth IRAs, which have different rules for contributions, taxes, and withdrawals.

Is it better to contribute to an IRA or a taxable brokerage account?

Whether to contribute to an IRA or a taxable brokerage account depends on your circumstances and financial goals. In general, an IRA can be a good option if you are looking to save for retirement and want the potential tax benefits of an IRA. However, if you are not eligible for a tax deduction on your contributions or looking to invest for goals other than retirement, a taxable brokerage account may be a better choice.

How is a taxable brokerage account taxed?

The investments held within a taxable brokerage account may be subject to tax on any capital gains, dividends, or interest earned. Short-term capital gains, which are gains on investments held for less than a year, are taxed at the same rate as ordinary income. Long-term capital gains, which are gains on investments held for more than a year, are typically taxed at a lower rate. Dividends and interest income earned are also subject to tax.

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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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Jan
30
2024
401a vs 401k: What's the Difference?

401(a) vs 401(k) Compared

By | Budgeting & Goals, Growing Wealth, invest, Preparing for Retirement, Terminology | No Comments

A 401(k) plan and a 401(a) plan may sound confusingly similar, but there are some differences between the two retirement accounts.

The biggest differences between 401(k) vs 401(a) plans are in the types of companies that offer them and their contribution requirements. While most private sector companies are eligible to offer 401(k) plans, only certain government and public organizations can offer their employees a 401(a) plan. Employers must contribute to 401(a) plans and can make it mandatory for employees to contribute a pre-set amount as well. By contrast, employers do not have to contribute to 401(k) plans and employees are free to choose whether they want to contribute.

Key Points

•   A 401(a) plan is an employer-sponsored retirement account typically available to government workers and employees at educational institutions and nonprofits. Employer contributions are mandatory, while employee contributions may be voluntary.

•   A 401(k) plan is offered by for-profit employers as part of the employee’s compensation package. Employers are permitted but not required to contribute to a 401(k) plan.

•   For 2023, the total contribution limit — from both employer and employee — is $66,000 for 401(a) and 401(k) plans, with an additional $7,500 catchup contribution allowed for employees age 50 or older.

•   Employee contributions to 401(a) or 401(k) plans in 2023 can amount to $22,500, or for people 50 or older the cap is $30,000. However, employee contributions cannot exceed their salary.

•   You can borrow from either a 401(a) or a 401(k) plan with restrictions. Withdrawals before age 59 1⁄2 may incur penalties. Employees can begin to withdraw money without penalty when they turn 59 1⁄2.

What Is a 401(a) Plan?

A 401(a) plan is an employer-sponsored type of retirement account that typically covers government workers and employees from specific education institutions and nonprofits. It is different from an IRA in that the employer sponsors the plan, determines the investment options that the employees can choose from, and sets the vesting schedule (the amount of time an employee will have had to have worked with the organization before all employer contributions become fully theirs, even if they leave the company).

With IRAs, the individual investor decides how much to contribute and if/when they want to make withdrawals from the account. With a 401(a) plan, employer contributions are mandatory; employee contributions are not. All contributions made to the plan accrue on a tax-deferred basis.

Recommended: IRAs vs 401(k) plans

However, withdrawing from either type of plan may incur penalties for withdrawing money before age 59 ½.

What Is a 401(k) Plan?

A 401(k) plan is a benefit offered by for-profit employers as part of the employee’s compensation package. The employer establishes the plan, along with the investment options the employee can choose from and the vesting schedule. As with 401(a) plans, funds contributed are tax-deferred and help employees save for retirement.

Some employers choose to offer a match program in which the company matches employee contributions up to a specific limit.

401(k) plans are also accessible to entrepreneurs and self-employed business owners.

Boost your retirement contributions with a 1% match.

SoFi IRAs now get a 1% match on every dollar you deposit, up to the annual contribution limits. Open an account today and get started.

Only offers made via ACH are eligible for the match. ACATs, wires, and rollovers are not included.

Who Contributes to Each Plan?

Under a 401(a) plan, employer contributions are mandatory, though the employer can decide whether they’ll contribute a percentage of the employees’ income or a specific dollar amount. Employers can establish multiple 401(a) accounts for their employees with different eligibility requirements, vesting schedules, and contribution amounts.

Employee participation is voluntary, with contributions capped at 25% of their pre-tax income.

Under a 401(k) plan, employees can voluntarily choose to contribute a percentage of their pre-tax salary. Employees are not required to participate in a 401(k) plan.

Employers are permitted but not required to contribute to a 401(k) plan, and many will match up to a certain amount — say, 3% — of employees’s salaries.

401(a) vs 401(k) Contribution Limits

For 2023, the total 401(a) contribution limit — from both employer and employee — is $66,000. However, employees with 401(a) plans can also contribute to a 403(b) plan and a 457 plan simultaneously (more on those plans in the 401(a) vs Other Retirement Plan Options section).

Employee contributions for 401(k) plans have a $23,000 limit in 2024 and a $22,500 limit in 2023. Employees who are 50 or older may contribute up to an additional $7,500 for a total of $30,500 in 2024 and a total of $30,000 in 2023. An employee with a 401(k) plan can also have a Roth or traditional IRA. However, there are limits on how much they can contribute to an IRA account — $7,000 for a traditional IRA for 2024 and $6,500 for a traditional IRA for 2023, with an extra $1,000 for people over age 50.

401(a) vs 401(k) Investment Options

401(a) vs 401(k) plans often offer various investment options, which may include more conservative investments such as stable value funds to more aggressive investments such as stock funds. Some 401(a) plans may allow employees to simplify diversified portfolios or seek investment advice through the plan’s advisor.

Most 401(k) plans also offer various investment choices ranging from low-risk investments like annuities and municipal bonds to equity funds that invest in stocks and reap higher returns.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

401(a) vs 401(k) Tax Rules

The tax rules in a 401(a) plan may be one difference between a 401(k) and 401(a).

With a 401(a), employees make pre-tax or after-tax contributions, depending on how their employer decides to structure the plan. Pre-tax means contributions are not taxed at the time of investment, but later upon withdrawal. After-tax means contributions are taxed before being deposited into the account

A 401(k), on the other hand, is a tax-deferred retirement plan, meaning all contributions are pre-tax. The wages employees choose to contribute to their plan are untaxed upon initial investment. Income taxes only kick in when the employee decides to withdraw funds from their account.

Can You Borrow from Each Plan?

You can borrow from either a 401(a) or a 401(k) plan if you have an immediate financial need, but there are some restrictions and it is possible to incur early withdrawal penalties.

An employer can limit the amount borrowed from a 401(a) plan — and may choose not to allow employees to borrow funds. If the employer does allow loans, the maximum amount an employee can borrow is the lesser of:

•   $10,000 or half of the vested account balance, whichever is greater OR

•   $50,000

Because the employee is borrowing money from their account, when the employee pays back the loan’s interest, they are paying it to themselves. However, the IRS requires employees to pay back the entire loan within five years . If they don’t pay the loan back, the IRS will consider the loan balance to be a withdrawal and will require taxation on the remaining loan amount as well as a 10% penalty if the employee is under age 59 ½.

Borrowing from a 401(k) plan is similar. Employees are limited to borrowing $50,000 or half of the vested balance — whichever is less. One big difference between borrowing from a 401(a) vs. a 401(k) plan is employees lose out on a tax break if they borrow from their 401(k) because they are repaying it with after-tax dollars. Because the money is taxed again when withdrawn during retirement, an investor is essentially being taxed twice on that money.

Can You Borrow Money from a 401(a) or 401(k) to Buy a Home?

You may be able to use the funds from a 401(a) or 401(k) account to purchase a home. Remember, with 401(a) plans, the employer ultimately decides if loans are permitted from the 401(k).

If you borrow money from your 401(a) or 401(k) to fund the purchase of a home, you have at least five years to repay what you’ve taken out.

The maximum amount you’re allowed to borrow follows the rules stated above:

•   $50,000 OR

•   The greater between $10,000 or half of what’s vested in your account,

Whichever is less.

When Can You Withdraw From Your Retirement Plan?

Employees can begin to withdraw money from their 401(a) plan without penalty when they turn 59 ½. If they make any withdrawals before 59 ½, they will need to pay a 10% early withdrawal penalty. Once they reach 70 ½, they’re required to make withdrawals if they haven’t already started to.

With a 401(k) plan, if an employee retires at age 55, they can start withdrawing money without penalty. However, to take advantage of this early-access provision, they need to have kept the money in the 401(k) plan and not have rolled it into a Roth IRA.

Employees also need to have ended their employment no earlier than the year in which they turn 55.

Otherwise, the restrictions are the same as with a 401(a) plan, and they can begin to withdraw money penalty-free once they turn 59 ½.

401(a) vs 401(k) Rollover Rules

Generally, 401(a) and 401(k) accounts have similar rollover rules. When an employee chooses to leave their job, they have the option to roll over funds. The employee can choose to roll the account into another retirement plan or take a lump-sum distribution. Generally, if the employee decides to roll over their plan to another plan, they have to do so within 60 days of moving the funds.

The rules for a 401(a) rollover dictate that funds can be transferred to another qualified plan like a 401(k) or an individual retirement account (IRA). The rules for 401(k)s are the same.

If the employee decides to take a lump-sum distribution from the account, they will have to pay income taxes on the full amount. If they are under 59 ½, they will also have to pay the 10% penalty.

Recommended: How To Roll Over a 401(k)

What Happens to Your 401(a) or 401(k) If You Quit Your Job?

If you quit your job, you can leave the money in your former employer’s plan, roll it into the plan of your new employer, transfer it to a Rollover IRA, or cash it out. If you are under age 59 ½ and cash out the plan, you will likely need to pay taxes and a 10% penalty.

However, if you quit your job before you are fully invested in the plan, you will not get your employer’s contributions. You will only get what you contributed to the plan.

What Is a 401(a) Profit Sharing Plan?

A 401(a) profit sharing plan is a tax-advantaged account used to save for retirement. Employees and employers contribute to the account based on a set formula determined by the employer. Unlike 401(a) plans, the employer’s contributions are discretionary, and they may not contribute to the plan every year.

All contributions from employees are fully vested. The ownership of the employer contributions may vary depending on the vesting schedule they create.

Like 401(a) plans, 401(a) profit sharing plans allow employees to select their investments and roll over the account to a new plan if the employee leaves the company. If an employee wants to take a distribution before reaching age 59 ½, they are subject to income taxation and a 10% penalty.

Summarizing the Differences Between 401(k) and 401(a) Plans

The main differences between a 401(k) and 401(a) are:

•   401(a) plans are typically offered by the government and nonprofit organizations, while 401(k) plans are offered by private employers.

•   Employees don’t have to participate in a 401(K), but they often must participate in a 401(a).

•   An employer decides how much employees contribute to a 401(a), while 401(k) participants can contribute what they like.

•   With a 401(a), employees make pre-tax or after-tax contributions, depending on how their employer decides to structure the plan. With a 401(k), all contributions are pre-tax.

Summarizing the Similarities Between 401(a) vs 401(k) Plans

A 401(k) vs. a 401(a) has similarities as well. These include:

•   Both types of plans are employer-sponsored retirement accounts.

•   Employees can borrow money from each plan, though certain restrictions apply.

•   There may be a 10% penalty for withdrawing funds before age 59 ½ for both plans.

401(a) vs Other Retirement Plan Options

401(a) vs 403b

A 403b is a tax-advantaged retirement plan offered by specific schools and nonprofits. Like 401(a) and 401(k) plans, employees can contribute with pre-tax dollars. Employers can choose to match contributions up to a certain amount. Unlike the 401(a) plan, employers don’t have mandatory contributions.

For 2024, the employee contributions limit is $23,000. For 2023, the employee contributions limit is $22,500. If the plan allows, 50 or older employees may contribute a catch-up amount of $6,500.

Generally, 403b plans are either invested in annuities through an insurance company, a custodian account invested in mutual funds, or a retirement income account for church employees.

Additionally, 403b plans allow for rollovers and distributions without a 10% penalty after age 59 ½. Like similar plans, employees may have to pay a 10% penalty if they take a distribution before reaching age 59 ½ unless the distribution meets other qualifying criteria.

401(a) vs 457

457 plans are retirement plans offered by certain employers such as public education institutions, colleges, universities, and some nonprofit organizations. 457 plans share similar features with 401(a) plans, including pre-tax contributions, tax-deferred investment growth, and a choice of investments that employees can select.

Employees can also roll over funds to a new plan or take a lump-sum distribution if they leave their job. However, unlike a 401(a) or 401(k) plan, the withdrawal is not subject to a 10% IRS penalty.

Another option offered through 457 plans is for employees to contribute to their account on either a pre-tax or post-tax basis.

401(a) vs Pension

A 401(a) is a defined contribution plan, where a pension is a defined benefit plan. With a pension, employees receive the benefit of a fixed monthly income in retirement; their employer pays them a fixed amount each month for the rest of their life. The monthly payment can be based on factors like salary and years of employment.

With a 401(a), employees have access to what they and their employer contributed to their 401(a) account. In contrast to a pension plan, retirees aren’t guaranteed a fixed amount and their contributions may not last through the end of their life.

Pros and Cons of 401(k) vs 401(a) Plans

Both 401(k) and 401(a) plans have pros and cons.

Pros of a 401(k):

•   Employers may match a portion of the employee’s contributions.

•   The plan is fairly easy to set up.

•   Employees generally have a wide range of investment options.

Pros of a 401(a):

•   Lower fees

•   Contributions are tax-deferred.

•   Both the employer and employee make monthly contributions.

Cons of a 401(k):

•   Fees may be high.

•   Need to wait until fully vested to keep employer matching contributions.

•   Penalty for withdrawing funds early.

Cons of a 401(a):

•   Investment choices may be limited.

•   Participation may be mandatory.

•   Penalty for withdrawing funds early.

💡 Quick Tip: How much does it cost to set up an IRA? Often there are no fees to open an IRA, but you typically pay investment costs for the securities in your portfolio.

Other Retirement Account Options

Roth IRAs

Roth IRAs are funded with after-tax contributions, which means they aren’t tax deductible. However, the withdrawals you take in retirement are tax-free.

You can withdraw the amount you contributed to an IRA at any time, without penalty.

The Roth IRA contribution limit for 2024 is $7,000 ($8,000 if you’re 50 or older) and for 2023 is $6,500 ($7,500 if you’re 50 or older).

Traditional IRAs

A traditional IRA is similar to a 401(k): both plans offer tax-deferred contributions that may lower your taxable income. However, in retirement, you will owe taxes on the money you withdraw from both accounts.

Unlike a 401(k), a traditional IRA is not an employer-sponsored plan. Anyone can set up an IRA to save money for retirement. And if you have a 401 k), you can also have a traditional IRA.

The IRA contribution limit for 2024 is $7,000 ($8,000 if you’re 50 or older) and for 2023 is $6,500 ($7,500 if you’re 50 or older).

HSAs

An HSA, or Health Savings Account, allows you to cover healthcare costs using pre-tax dollars. But you can also use an HSA as a retirement account. At age 65, you can withdraw the money in your HSA and use it for any purpose. However, you will pay taxes on anything you withdraw that’s not used for medical expenses.

In 2024, you can contribute up to $4,150 in an HSA as an individual, or $8,300 for a family. In 2023, you can contribute up to $3,850 in an HSA as an individual, or $7,750 for a family.

Investing In Your Retirement

The largest difference between 401(a) and 401(k) plans is the type of employers offering the plans. Whereas 401(a) plans typically cover government workers and employees from specific education institutions and nonprofits, 401(k) plans are offered by for-profit organizations. Thus, a typical employee won’t get to choose which plan to invest in — the decision will be made based on what organization they work for.

Both 401(a) plans and 401(k) plans do have restrictions that might bother some investors. For example, an employee will be at the mercy of their employer’s choice when it comes to investing options.

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

Easily manage your retirement savings with a SoFi IRA.

FAQ

Is a 401(a) better than a 401(k)?

It’s not necessarily a matter of which plan is “better.” 401(k) plans are offered by private employers, while the government and nonprofits offer 401(a) plans. Both plans allow you to save for retirement in a tax-deferred way.

How are 401(a)s different from 401(k)s?

There are some differences between 401(k) and 401(a) plans. For instance, 401(a) plans are typically offered by the government and nonprofit organizations, while 401(k) plans are offered by private employers. In addition, employees don’t have to participate in a 401(k), but they often must participate in a 401(a). An employer decides how much employees contribute to a 401(a), while 401(k) participants can contribute what they like. And finally, those who have a 401(k) may have more investment options than those who have a 401(a).

Can you roll a 401(a) into a 401(k)?

Yes, you can roll a 401(a) into a 401(k) if you leave your job and then get a new job with a private company that offers a 401(k). You can also roll over a 401(a) into a traditional IRA.

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

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

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

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31 Facts About FAFSA

31 Facts About FAFSA for Parents

By | Going to College, Student Loans, student_loan | Comments Off on 31 Facts About FAFSA for Parents
Editor’s Note: The new, simplified FAFSA form for the 2024-2025 academic year is available, although applicants are reporting a number of glitches. Try not to worry, take your time, and aim to submit your application as soon as possible.

Applying for federal aid is a crucial step most high school students take while transitioning to college life. Parents going through the college admissions process for the first time, though, may not realize that they also play a huge role in helping their children apply for grants and scholarships through the Free Application for Federal Student Aid or FAFSA®.

Applications for the 2023-2024 round of FAFSA opened on Oct. 1 and will remain open until June 30, 2024. If you’re looking for facts about FAFSA that will help your child apply for college aid during the 2023-2024 academic year, we’ve compiled some of the most important information on how you can help your child during the FAFSA process.

Recommended: FAFSA Guide

FAFSA Facts and Tips

Filling out FAFSA for the first time? These facts and FAFSA tips can help you prepare for the application process and offer suggestions for getting the most aid.

1. FAFSA Is Required to Receive Government Student Loans

For those who may be new to the financial aid process, FAFSA is the form students fill out to apply for federal financial aid. Just over 18 million students fill out the FAFSA each year. Your child won’t be eligible for government-funded college aid, such as federal loans or grants if they don’t apply.

Recommended: 12 Steps to Filling Out the FAFSA Form for School Year 2023-2024

2. Your Child Could Qualify for Grants by Filling Out FAFSA

While you can get subsidized or unsubsidized loans through FAFSA, your child may also be eligible for grants. One common federal grant is the Pell grant, which is awarded to first-time undergraduate students who show exceptional financial need, such as coming from a low-income family.

Recommended: Types of Federal Student Loans

3. It Determines Work-Study Eligibility

Federal work-study is a way for students to earn income at a part-time job while in college. These jobs can be on or off-campus and vary by school, although not all schools participate in the program. You have to fill out FAFSA to determine if you’re eligible for work-study programs.

4. Some Schools Use FAFSA to Determine What Aid They Offer

If the schools your child applies to offer their own aid, such as need-based scholarships, they may use FAFSA to determine eligibility. You may want to check with the schools your child is applying to and ask if they have a separate application for internal scholarships and grants.

5. Most Applicants Under Age 22 Are Considered Dependents

Most students under the age of 22 who are neither married nor parents themselves won’t be able to apply as an independent student . As a result, for most incoming freshmen, their parents’ income is counted in the determination of financial need.

Recommended: Independent vs Dependent Student: Which One Are You?

6. Your Child Needs Your Information to Apply

If your child is filing as a dependent, then they’ll need some basic information about your finances, such as your income and paid taxes. You may also elect to apply for a Parent PLUS loan, which can help cover your child’s educational expenses if they don’t receive enough in loans and grants to cover costs. Note that you may need additional information to apply for a Parent Plus loan.

7. High-Income Families May Want to Still Apply

If your family is middle- or upper-class, you may wonder if your child will receive any FAFSA aid. However, applying is free, and family income is just one of many factors considered during the application process. Additionally, your child’s school still may require FAFSA to be eligible for institutional aid, so it may be worth applying for even if you don’t think your child will need or receive aid.

8. Grades Don’t Affect FAFSA Eligibility

FAFSA does not have a GPA requirement to apply. However, your child may want to keep in mind that they could lose any aid given to them through FAFSA if they have poor grades for multiple semesters after they receive the aid.

9. Deadlines May Differ by State and School

While the FAFSA doesn’t close until June 30, 2024 for the 2023-24 academic year, FAFSA application deadlines may vary by state and school. State and school deadlines may close prior to the federal deadlines. If you’re not sure what deadlines apply to your student, consider checking with the financial aid office of each school your child applies to and ask what their FAFSA deadlines are.

10. Having Multiple Kids in College No Longer Affects Financial Aid Awards

Since 2021, the number of children in a family who are in college or applying to college no longer affects aid eligibility. Before, families with multiple children in college may have qualified to receive more aid. This is one of many changes throughout the FAFSA Simplification Act, which aims to simplify the FAFSA form and therefore hopefully encourage more families to fill out FAFSA.

11. Expected Family Contribution Is Also Changing

Expected family contribution (EFC) is an estimate of how much FAFSA believes families can contribute to the cost of a student’s education. However, as part of the FAFSA Simplification Act, EFC will be replaced with the Student Aid Index, or SAI, starting on July 1, 2024 (for the 2024-2025 academic year). While that may sound far off, a freshman during the 2023-2024 academic year will be a sophomore when SAI is put into effect.

12. FAFSA Is Changing the Process for Children of Divorce

Before the new simplified FAFSA, in the case when a child’s parents are separated, the custodial parent’s information was included on the form. However, with the new changes, the parent who provides the most financial support to the student is responsible for filling out the FAFSA.

Recommended: How much FAFSA Money Can I Expect?

13. Your Child Will Need Their Social Security or Alien Registration Number

As your child prepares to fill out the FAFSA, they’ll need their Social Security or Alien Registration number.

14. Have Nontaxable Income at the Ready

One question that may trip up parents is what FAFSA considers nontaxable income. For FAFSA, that generally includes (but is not limited to):

•   Workers compensation

•   Disability benefits

•   Welfare benefits

•   Social Security income

•   Veteran’s benefits

•   Military or clergy allowances (if applicable)

•   Foreign income not taxed by any government

15. Your Child May Need to Report Grants and Scholarships

Most first-time college students won’t need to report any grants or scholarships they received. However, they may if they had to report them on their taxes, such as:

•   AmeriCorps benefits, such as living allowances or awards

•   Taxable work-studies, assistantships or fellowships

•   Combat pay, special combat pay, or cooperative education program earnings

•   Other grants or scholarships reported to the IRS

If you have any doubts about what types of grants may be taxable, consider consulting a tax professional.

16. Have Bank Statements Available

To fill out FAFSA, you’ll need bank statements for both you and your child. This information helps determine how much aid your child will be eligible for.

17. You Don’t Have to Have a Social Security Number to Sign the Form

If you’re filing for FAFSA online, you can create a federal student aid (FSA) ID . This is simply your login and password. Your child can create one here . But if you don’t have a Social Security number, you can print out the signature page of the form, sign it, and mail it in.

18. You Don’t Need to File Taxes Before Submitting FAFSA

If you filed for an extension for your tax return, you can use your W-2 or 1099 statements. But you will need to update FAFSA once you file. This is because which tax bracket you’re in can impact how much aid your child is eligible for.

Recommended: What Tax Bracket Am I In?

19. You’ll Need to Have a List of Assets Ready

FAFSA uses parental assets to help determine aid eligibility. You’ll need to know how much in assets you have, which include (but are not limited to):

•   Money in cash, savings, and checking accounts

•   Non-retirement investments (such as stocks and mutual funds)

•   Businesses that have more than 100 full-time equivalent employees and you and your family have minority stakes in

•   Investment farms (in other words, you don’t live on and operate the farm)

•   Other investments, such as real estate and stock options

20. 529 Plans Are Also Considered Assets

When filling out information about assets, you’ll also need to provide the value of all 529 College Savings Plans you own — including the accounts for siblings. Also, if your child owns a 529 plan (often called an UGMA or UTMA 529 plan), you will need to report it as a parental asset – and not as the student’s asset. (Please note, however, that if your child owns a UGMA or UTMA account that is not a 529 plan, you don’t list it as an asset — your child does as their asset.)

21. Your Primary Home Doesn’t Need to Be Listed as an Asset

One common FAFSA mistake is listing your primary home as an asset. However, FAFSA does not require you to do so. In fact, listing it as an asset can decrease the amount of aid your child receives.

22. You Don’t Need Your Retirement or Insurance Information

FAFSA also doesn’t count retirement or insurance accounts as assets. Again, including them can inflate the number of assets you have and therefore may decrease the amount of aid your child is offered.

23. You’ll Need to Include Each School Your Child Is Applying To

When you and your child fill out the FAFSA, you’ll want to have a list of all the schools your child may be interested in applying to. You’ll need each school’s federal school code to add them to the list of schools you want your FAFSA information sent to, although you can also search for this information on the form itself if you can’t find it on the school’s website. It may be wise to include schools your child isn’t sure they want to apply to yet since it’s easier to simply add the school to the list now than having to send the school your FAFSA information later.

24. Schools, Not the Government, Will Give You Financial Aid Updates

Part of the reason you’ll need to send your FAFSA to schools your child is considering applying to is because schools, not the government, send out financial aid packages. As such, each school your child applies to may offer a different financial aid package.

25. Skipping Information Can Be Costly

Before hitting submit, you might want to double check that every section of the FAFSA is filled out (and accurate). Skipping FAFSA sections may result in delays in your application being processed, errors that prevent you from submitting, or even a decrease in the amount of aid offered.

26. Your Child Will Need to Take Student Loan Exit Counseling

While filing FAFSA or talking to your school’s financial aid office, you may hear about something called student loan exit counseling. This is mandatory for anyone who gets federal student loan aid. Counseling is simply an online module that will help your child navigate how the student loan repayment process works. A reminder will be sent to your child’s email in their last year of school about when this exit counseling is due. However, you and your child may want to consider reviewing student loan exit repayment options before the counseling is due to ensure they pick the best option based on their financial situation.

27. File Early to Get the Most Aid

While it may seem like you have a ton of time to fill out the FAFSA, it may be best to complete it sooner rather than later. Delaying can mean financial aid for your state or school dries up before your child can even be considered for it. Additionally, knowing how much aid each school is offering your child may help them when deciding on which school to attend.

28. You Could Be Selected for FAFSA Verification

After your child receives their student aid report, they may get a message saying they were selected for verification. FAFSA verification is used by some schools to simply verify that students’ FAFSA information is accurate. Some schools randomly select people to be verified, some verify all students, and some may elect not to verify any students.

Recommended: 14 Must-Know College Financial Aid Terms for Parents

29. You Can Appeal Your Aid Package

Once your child has their financial aid packages, they may find that they were offered less than they expected or hoped for. If your child’s dream college didn’t offer enough aid (or perhaps even didn’t offer them any aid), they may be able to appeal for more financial aid. This process may be especially important if your financial situation has changed since you and your child first applied for FAFSA. While schools may deny the request, it doesn’t cost you or your child anything but time to ask for more aid.

30. You Can List Unusual Circumstances That Affect Your Finances

Another way to try and increase your financial aid package is by listing unusual financial circumstances both on your FAFSA and in an appeal letter to schools you’re applying to. Some common unusual circumstances include (but are not limited to):

•   Having tuition expenses in elementary and/or secondary schools

•   Experiencing unusual medical or dental expenses not covered by insurance

•   Having a family member become unemployed recently

•   Experiencing changes in income and/or assets that could affect aid eligibility

31. You’ll Have to Reapply Every Year

Once you’ve filed your FAFSA, you may want to keep your login information in a safe place. You’ll need that information to file for FAFSA every year your child is in school, and losing your FSA login information may delay your ability to apply next year. You may also want to set a reminder on your phone or calendar to apply next year, although FAFSA will send you an email reminder when next year’s FAFSA is open.

The Takeaway

Filing for FAFSA is an important first step in helping your child pay for college. Knowing how FAFSA works and how to optimize the amount of aid your child receives can help increase the amount of federal aid they’re offered.

However, if their financial aid package isn’t enough to cover college costs, they may want to consider private student loans. Private student loans aren’t required to offer the same borrower protections as federal student loans, and are, therefore, generally considered as an option only after all other sources of funding have been exhausted.

If you’re considering private loans to pay for college, you may want to review the differences between private and federal student loans to ensure that you and your child choose the best options for them to pay for college. SoFi offers private student loans that have no hidden fees and allow borrowers to choose between four repayment options.

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

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Please borrow responsibly. SoFi Private Student Loans are not a substitute for federal loans, grants, and work-study programs. You should exhaust all your federal student aid options before you consider any private loans, including ours. Read our FAQs. SoFi Private Student Loans are subject to program terms and restrictions, and applicants must meet SoFi’s eligibility and underwriting requirements. See SoFi.com/eligibility-criteria for more information. To view payment examples, click here. SoFi reserves the right to modify eligibility criteria at any time. This information is subject to change.

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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.

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

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

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Jan
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2024
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Roth IRA Conversion: Rules and Examples

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on Roth IRA Conversion: Rules and Examples

A Roth IRA is a retirement savings account that offers tax-free withdrawals during retirement. You can convert a traditional IRA or a qualified distribution from a previous employer-sponsored plan, such as a 401(k), into a Roth IRA. This is known as a Roth IRA conversion.

A Roth IRA conversion may be worth considering for the potential tax benefits. Along with tax-free qualified withdrawals in retirement, the money in a Roth IRA has the potential to grow tax-free. Read on to learn how a conversion works, the Roth IRA conversion rules, and whether a Roth IRA conversion may make sense for you.

What Is a Roth IRA Conversion?

With a Roth IRA conversion, an individual moves the funds from another retirement plan into a Roth IRA. You pay taxes on the money in your existing account in order to move it to a Roth IRA.

Many retirement plans, such as 401(k)s and traditional IRAs are tax-deferred. The money is contributed to your account with pre-tax dollars. In retirement, you would pay taxes on your withdrawals. But by doing a Roth conversion, you pay taxes on the money you convert to a Roth IRA, and the money can then potentially grow tax-free. In retirement, you can make qualified withdrawals from the Roth IRA tax-free.

You can convert all or part of your money to a Roth IRA.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

How Does a Roth IRA Conversion Work?

As mentioned, when converting to a Roth IRA, an individual must pay taxes on the contributions and gains in their current retirement plan because only after-tax contributions are allowed to a Roth IRA. They can typically convert their funds to a Roth IRA in one of three ways:

•   An indirect rollover: With this method, the owner of the account receives a distribution from a traditional IRA and can then contribute it to a Roth IRA within 60 days.

•   A trustee-to-trustee, or direct IRA rollover: The account owner tells the financial institution currently holding the traditional IRA assets to transfer an amount directly to the trustee of a new Roth IRA account at a different financial institution.

•   A same-trustee transfer: This is used when a traditional IRA is housed in the same financial institution as the new Roth IRA. The owner of the account alerts the institution to transfer an amount from the traditional IRA to the Roth IRA.

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Only offers made via ACH are eligible for the match. ACATs, wires, and rollovers are not included.

Roth IRA Conversion Rules

There are a number of rules that govern a Roth IRA conversion. Before you proceed with a conversion, it’s important to understand what;’s involved. Roth IRA conversion rules include:

Taxes

You’ll pay taxes on a traditional IRA or 401(k) before you convert it to a Roth IRA. This includes the tax-deductible contributions you’ve made to the account as well as the tax-deferred earnings. They will be taxed as ordinary income in the year that you make the conversion. Because they’re considered additional income, they could put you into a higher marginal tax bracket. You’ll also need to make sure you have the money on hand to pay the taxes.

Limits

There are two types of limits to be aware of with a Roth IRA conversion. First, there is no limit to the number or size of Roth IRA conversions you can make. You might want to convert smaller amounts of money into a Roth IRA over a period of several years to help manage the amount of taxes you’ll need to pay in one year.

Second, Roth IRAs have contribution limits. For instance, in 2024, you can typically contribute up to $7,000, or up to $8,000 if you’re 50 or older.

Withdrawals

The withdrawals you make from a Roth IRA are tax-free. However, with a Roth IRA conversion, if you are under age 59 ½, you will need to wait at least five years before withdrawing the money or you’ll be subject to a 10% early withdrawal penalty (more on that below).

Backdoor Roth IRAs

A Roth IRA conversion may be an option to consider if you earn too much money to otherwise be eligible for a Roth IRA. Roth IRAs have contribution phase-out ranges, and individuals whose income exceeds those limits cannot contribute to a Roth fully or at all. For 2024, the income limits begin to phase out at $230,000 for those who are married and filing jointly, and $146,000 for those who are single.

However, if you have a traditional IRA and convert it to a Roth IRA — a process known as a backdoor Roth IRA — those income phase-out rules don’t apply. You can use a backdoor IRA as long as you pay taxes on any contributions to the traditional IRA that you deducted from your taxes, as well as any profits you earned.

5-Year Rule

According to the 5-year rule, if you are under age 59 ½, the funds that you convert to a Roth IRA must remain in your account for at least five years or you could be subject to a 10% early withdrawal penalty.

The five years starts at the beginning of the calendar year in which you do the conversion. So even if you don’t do the conversion until, say, December 2024, the five years still begins in January 2024. That means you could withdraw your funds in January 2029.

Also, if you complete separate Roth IRA conversions in different years, the 5-year rule would apply to each of them, so keep this in mind.

💡 Quick Tip: How much does it cost to set up an IRA? Often there are no fees to open an IRA, but you typically pay investment costs for the securities in your portfolio.

Is Converting to a Roth IRA Right for You?

Doing a Roth IRA conversion means paying taxes now on the funds you are converting in order to withdraw money tax-free in retirement. Here’s how to decide if converting a Roth IRA may be right for you

Reasons For

If you anticipate being in a higher tax bracket in retirement than you’re in now, a Roth IRA conversion may make sense for you. That’s because you’ll pay taxes on the money now at a lower rate, rather than paying them when you retire, when you expect your tax rate will be higher.

In addition, with a Roth IRA, you won’t have to take required minimum distributions (RMDs) every year after the age of 73 as you would with a traditional IRA. Instead, the money can stay right in the account — where it may continue to grow — until it’s actually needed.

If your income is too high for you to be eligible for a Roth IRA, a Roth IRA conversion might be beneficial through a backdoor IRA. You will just need to put your funds into a traditional IRA first and pay the taxes on them.

Finally, if you won’t need the funds in your Roth IRA for at least five years, a conversion may also be worth considering.

Reasons Against

A Roth IRA conversion may not be the best fit for those who are nearing retirement and need their retirement savings to live on. In this case, you might not be able to recoup the taxes you’d need to pay for doing the conversion.

Additionally, if you receive Social Security or Medicare benefits, a Roth IRA conversion would increase your taxable income, which could increase the taxes you pay on Social Security. The cost of your Medicare benefits might also increase.

Those who don’t have the money readily available to pay the taxes required by the conversion should also think twice about an IRA conversion.

And if you expect to be in a lower tax bracket in retirement, a conversion also likely doesn’t make sense for you.

Finally, if you think you might need to withdraw funds from your account within five years, and you’re under age 59 ½, you could be subject to an early withdrawal penalty if you convert to a Roth IRA.

The Takeaway

A Roth IRA conversion may help individuals save on taxes because they can make qualified withdrawals tax-free withdrawals in retirement. For those who expect to be in a higher tax bracket in retirement, a Roth IRA may be worth considering.

It’s important to be aware of the tradeoffs involved, especially the amount of taxes you might have to pay in order to do the conversion. Making the right decisions now can help you reach your financial goals as you plan and save for retirement.

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

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

How much tax do you pay on a Roth IRA conversion?

You pay tax on the money you convert, but the specific amount of tax you’ll pay depends on the marginal tax rate you’re in. Before doing a Roth IRA conversion, you may want to calculate to see if the funds you’re converting will put you into a higher tax bracket.

How many Roth iRA conversions are allowed per year?

There is no limit to the number of Roth conversions you can do in one year.

When is the deadline for Roth IRA conversions?

The deadline for a Roth IRA conversion is December 31 of the year you’re doing the conversion.

Is there a loophole for Roth IRA conversions?

A backdoor IRA might be considered a loophole for a Roth IRA conversion. Roth IRAs have contribution phase-out ranges, and individuals whose income exceeds those limits cannot contribute to a Roth fully or at all. However, a backdoor IRA may be a way to get around the income limits. To do it, you will need to have a traditional IRA that you convert to a Roth IRA.

How do I avoid taxes on Roth conversion?

You cannot avoid paying taxes on a Roth conversion. You must pay taxes on the money you convert.

How do you not lose money in a Roth IRA conversion?

To reduce the tax impact of a Roth IRA conversion, you may want to split the conversion into multiple conversions of smaller amounts over several years. If possible, try to do the conversions in years when your taxable income is lower.

Do you have to pay taxes immediately on Roth conversion?

Taxes on a Roth conversion are not due until the tax deadline of the following year.

Should a 65 year old do a Roth conversion?

It depends on an individual’s specific situation, but a Roth conversion may not make sense for a 65 year old if they need to live off their retirement savings or if they are receiving Social Security or Medicare benefits. A Roth IRA conversion could increase the taxes they pay on Social Security, and the cost of their Medicare benefits might rise.

Does a Roth conversion affect my Social Security?

It might. A Roth IRA conversion increases your taxable income, which could potentially increase the taxes you pay on Social Security.

Does a Roth conversion affect Medicare premiums?

A Roth IRA conversion may affect your Medicare premiums. Because it increases your taxable income, the cost of your Medicare benefits might increase as well.

What is the best Roth conversion strategy?

The best Roth conversion strategy depends on your particular situation, but in general, to help reduce your tax bill, you can aim to make the conversion in a year in which you expect your taxable income to be lower. You may also want to do multiple smaller conversions over several years, rather than one big conversion in one year, to help manage the taxes you owe.

Can you do Roth conversions after age 72?

Yes, you can do Roth conversions at any age. Some individuals may want to consider a Roth IRA conversion at 72 if they prefer to avoid paying the required minimum distributions (RMDs) for traditional IRAs that begin at age 73. If you convert before you turn 73, you will not be required to take RMDs.

How do I calculate my Roth conversion basis?

The concept of basis, or money that you’ve paid taxes on already, might be applicable if you’ve made non-deductible contributions to a tax-deferred retirement account. When you convert the money in that account, in order to calculate the percentage that’s tax-free, you need to divide your total nondeductible contributions by the end-of-year value of your IRA account plus the amount you’ve converting.

Do you have to wait 5 years for each Roth conversion?

No. There is no time limit for doing Roth conversions, and in fact, you can do as many as you like in one year. However, if you’re under age 59 ½, you do have to wait five years after each conversion to be able to withdraw money from the account without being subject to an early withdrawal penalty.

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

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

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

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SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
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2024
Comparing Personal Loans vs Business Loans

Comparing Personal Loans vs Business Loans

By | Budgeting & Goals, Financial Independence, Life & Career, personal_loan, SMB | Comments Off on Comparing Personal Loans vs Business Loans

If you’re looking to start or grow a side hustle or small business, you might think a business loan is the right next step. A personal loan, however, is another popular financial product that you also might be able to use. Or it could free up some cash by covering expenses elsewhere in your budget, so you can put more of your income toward funding your business.

Because there are potential benefits and disadvantages to both types of financing, it’s important to understand the differences. You’ll find that information here and be better equipped to decide whether a business loan vs. personal loan might work best for you.

What Is a Personal Loan?

A personal loan is a source of financing that a borrower typically can use for just about anything. (That said, you may need to get approval from your lender if you plan to use the money directly for your business. This is not always possible.)

Typically, you’ll find unsecured personal loans, with the borrower agreeing to pay back the full amount, plus interest, in fixed monthly payments within a predetermined time frame.

Some lenders also offer secured personal loans, however,which means some form of collateral is involved. Also, some offer personal loans with variable interest rates.

How Personal Loans Work

When you apply for a personal loan, you can expect the lender to review your personal financial information — including your credit score, credit reports, and income — to determine your eligibility. In general, the better your credit, the better your chances of receiving a lower interest rate.

Personal loan amounts vary, but some lenders offer personal loans for as much as $100,000.

Although most personal loans have shorter repayment terms, the length of a loan can vary from a few months to several years. Typically, they last from 12 to 84 months.


💡 Quick Tip: Some personal loan lenders can release your funds as quickly as the same day your loan is approved.

What is a Business Loan?

A business loan is a type of financing used specifically to pay for business expenses. It could be used to purchase equipment or inventory, for example, or to fund a new project.

There are many kinds of small business loans available — with different rates and repayment terms — including Small Business Administration (SBA) loans, equipment loans, micro loans, and more. Rates, terms, and loan requirements also can vary significantly depending on the lender.

How Business Loans Work

Applying for a business loan tends to be more complicated than getting a personal loan. For one thing, you’ll likely have to submit more paperwork to back up your application, including your business’s financial statements and an up-to-date business plan. The lender also usually will want to review your personal and business credit scores. And you may have to be more specific about what the loan will be used for than you would with a personal loan.

If your business is brand new, lenders may be reluctant to give you a business loan. Some lenders might ask you to put up some type of collateral to qualify.

Differences Between Business and Personal Loans

There are several factors you may want to evaluate if you’re trying to decide between a personal loan vs. a business loan, including the loan costs, how you plan to use the money, and how much you hope to borrow. Here’s a look at a few basic differences.

Cost Differences Between Business and Personal Loans

Whether you’re considering applying for a business loan or a personal loan to use for your business, it’s important to be clear about how much it could cost you upfront and over the life of the loan.

Interest Rates

Interest rates for business loans can be lower than for the interest rates for personal loans, but the rates for both can vary depending on the type of loan, the lender you choose, and your qualifications as a borrower.

Fees

Fees also can affect the upfront and overall cost of both personal and business loans, so it’s a good idea to be clear on what you’re paying. Some of the more common fees for business loans and personal loans that you might see include origination, application, packaging, and underwriting fees, and late payment and prepayment penalties.

Some fees may be subtracted from the loan amount before the borrower receives the money. But fees also may be folded into a loan’s annual percentage rate (APR) instead, which can increase the monthly payment.

Down Payment

Business loans may be available for larger amounts than a personal loan. For a larger business loan — a substantial SBA loan or commercial real estate loan, for example — you could be required to come up with a down payment. This amount can add to your upfront cost. However, just as with a mortgage or car loan, a larger down payment can help you save money over the long term, because you’ll pay less in interest.

Whether you’ll need a down payment, and the amount required, may depend on your individual and business creditworthiness.

Different Uses for Business and Personal Loans

One of the biggest differences between business vs. personal loans is the way borrowers can use them.

•   A business loan can be used to finance direct business costs, such as paying for supplies, marketing, a new piece of equipment, business debt consolidation, or a business property. But it typically can’t be used for indirect business costs, which means a borrower can’t pay off personal debts with the money or buy personal property with it.

•   Some business loans have a very specific purpose, and the borrowed money must be used for that purpose. For example, if you get an equipment loan, you must buy equipment with it. Or, if you get a business car loan, you must buy a business car with the money.

•   Because you may be able to use the influx of cash for both business and personal expenses, the uses of a personal loan can be very flexible. But personal loans are typically smaller than business loans, and they generally come with a shorter repayment term. It can be helpful to have a clear intent for how the money will be spent and to keep separate records for business and personal expenses.

•   It’s also important to note that some lenders put restrictions on how personal loans can be used, so you should read the fine print before applying and share your plans with the lender if asked.

Differences When Applying for Business and Personal Loans

The criteria lenders look at can be very different when approving a small business loan vs. a personal loan. Here’s what you can expect during the application process.

Applying for a Personal Loan

When you apply for a personal loan, your personal creditworthiness usually plays a large role in the application and approval process.

•   Lenders typically will review a borrower’s credit scores, credit reports, and income when determining the interest rate, loan amount, and repayment term of a personal loan.

•   Generally, you can expect to be asked for a government-issued photo ID, your Social Security number, and/or some other proof of identity.

•   You also may be asked for proof of your current address. And the lender will want to verify your income.

Applying for a Business Loan

When you apply for a business loan, your personal finances still will be a factor, though other aspects of your application will be reviewed carefully.

•   The loan underwriters also will evaluate your business’s cash flow, how long you’ve been in business, your profitability, the exact purpose of the loan, trends in your industry, your business credit score, and more.

•   The lender may ask for a current profit-and-loss statement, a cash-flow statement, recent bank statements and tax returns for the business, your business license and a business plan, and any other current loan documents or lease agreements you might have.

•   You also will have to provide information about your collateral if you are applying for a secured loan.

Recommended: Understanding Credit Score Ranges

Structural Differences in Business and Personal Loans

Knowing the differences in how personal loans vs. business loans are structured could help you decide which is right for you and your business. A few factors that might affect your choice include:

Loan Amount

A business loan may be more difficult to apply for and get than a personal loan, especially if your business is a startup or only a few years old. But if you can qualify, you may be able to borrow more money with a business loan. While personal loan amounts typically top out at $50,000 to $100,000, some SBA loans can go as high as $5.5 million.

Loan Length

You’ll likely find personal and business loans with both short and long repayment terms. But generally, personal loans have shorter terms (typically one to seven years), while some business loan repayment periods can be up to 25 years.

Tax Advantages

If you have a business loan, deducting the interest you pay on the loan may be possible when filing income taxes if you meet specific criteria.

With a personal loan, it might get a little more complicated. If you use the borrowed money only for business costs, you may be able to deduct the interest you paid. But if you use the loan for both business and personal expenses, you would only be able to deduct the percentage of the interest that was used for qualifying business costs.

And you should be prepared to itemize deductions, documenting exactly how you spent the money. Your financial advisor or tax preparer can help you determine what’s appropriate.

Support

Along with the traditional banking services you might expect to get with any type of loan, a business loan also may come with operational support and online tools that can be useful for owners and entrepreneurs.

Risk

When you’re deciding between a personal vs. business loan, it’s also a good idea to think about what could happen if, at some point, the loan can’t be repaid.

•   If your business has financial problems and you have a personal loan, you (and your cosigner, if you have one) could be held responsible for the debt. You could lose your collateral (if it’s a secured loan) or damage your personal credit.

•   If your business defaults and it’s a business loan, the impact to your personal credit would depend on how the loan is set up.

◦   If you’re listed as a sole proprietor or signed a personal guarantee, it’s possible you could be sued, your personal and/or business credit scores could take a hit, and your personal and business assets could be at risk.

◦   If your business is set up as a distinct legal entity, on the other hand, your personal credit score might not be affected — but your business credit score could suffer. And it could be more difficult for you to take out a business loan in the future.

Structural Differences in Business and Personal Loans
Business Loans Personal Loans
Loan Amount Typically come in larger amounts (up to $5 million) Generally are limited to smaller amounts (up to $100,000)
Loan Length Usually have longer repayment periods (up to 25 years) Generally have shorter terms (a few months to a few years)
Tax Advantages Interest paid on a business loan is often tax-deductible Interest paid on a personal loan used for business expenses may be tax-deductible
Support Lenders may offer operational support and online business tools to borrowers with business loans Lenders may offer more personal types of support to borrowers with personal loans
Risk Defaulting on a business loan could affect the borrower’s business credit score or business and personal credit scores (based on how the loan is structured) Defaulting on a personal loan could affect the borrower’s personal credit score

Pros and Cons of Business Loans

There are advantages and disadvantages to keep in mind when deciding whether to apply for a business loan vs. personal loan.

•   A business loan can be more difficult to get than a personal loan, especially if the business is new or still struggling to become profitable.

•   If you qualify for a business loan, you may be able to borrow a larger amount of money and get a longer repayment term.

•   A business loan also could make it easier to separate your business and personal finances.

•   There could be fewer personal consequences if the business defaults on the loan.

Pros of Business Loans

 Cons of Business Loans
Borrowers may qualify for larger amounts than personal loans offer Applying can require more time and effort
Longer loan terms available Qualifying can be difficult
Interest rates may be lower Collateral and/or a down payment may be required
Interest is usually tax deductible Loan must be used for business purposes only
Lenders may offer more business-oriented support New businesses may pay higher interest rates
Debt may be the responsibility of the business, not the individual (depending on loan structure) Responsibility for the debt could still land on individual borrowers

Recommended: Can You Refinance a Personal Loan?

Pros and Cons of Personal Loans

A personal loan vs. business loan can have advantages and disadvantages to consider if you are wondering if you can use one to fund a business.

•   Personal loans can offer borrowers more flexibility than business loans in terms of usage.

•   They’re generally easier to qualify for and may have lower interest rates.

•   One major hurdle may be tracking whether the funds were used for business or personal expenses, which can be crucial, especially for income taxes.

Pros of Personal Loans

 Cons of Personal Loans
Application process is usually quick and easy Lending limits may be lower than business loans
Qualifying can be less challenging than with a business loan because it’s based on personal creditworthiness Borrower doesn’t build business credit with on-time payments
Can use funds for both personal and business expenses (unless there are lender restrictions) Defaulting can affect personal credit score/finances
Most personal loans are unsecured Interest rates are generally higher than for a business loan
Interest may be tax deductible (when funds are used for business) Shorter loan terms than business loans typically offer



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Is a Business or Personal Loan Right for You?

Considering the differences between a personal loan and a business loan can help you decide which is right for your needs. You may want to do some online research, compare rates and terms, and/or ask a financial professional or business mentor for advice before moving forward with this important decision. Here are some things to think about as you look for a loan that’s a good fit for your personal and professional goals.

A business loan may make sense if:

•   You’re seeking a lower interest rate and/or repayment term.

•   You want to keep personal and business expenditures separate.

•   You’ve been successfully running your business for a while.

•   You need more money than you can get with a personal loan.

•   You hope to build your business credit.

•   You want to limit your liability.

A personal loan may make sense if:

•   Your goal is to grow your startup or new business and the loan allows this usage.

•   You plan to use the money for both business and personal expenses.

•   You can find a personal loan with a lower interest rate than a comparable business loan, and the lender approves the loan for business expenses.

•   You want to get the money as quickly as possible.

•   You are seeking a shorter repayment term.

•   You don’t want to secure the loan with collateral.

•   You feel confident about your personal ability to repay the loan.

Recommended: Can I Pay Off a Personal Loan Early?

The Takeaway

If you’re seeking funding to start or grow your business, you may have to decide between personal and business loans. Personal loans are typically easier to apply for and offer quicker access to funds, but often at a somewhat higher interest rate and shorter term vs. business loans. Also, business loans usually offer significantly higher loan amounts and the interest can be tax-deductible. It’s worthwhile to consider the tax and credit implications of each type of loan too, among other factors.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.


SoFi’s Personal Loan was named NerdWallet’s 2024 winner for Best Personal Loan overall.

FAQ

Are business loans more expensive than personal loans?

Business loans typically have lower interest rates than personal loans. Still, it’s probably worth comparing both types of loans and the rates lenders are willing to offer you and/or your business before making a final decision between the two.

Is it illegal to use personal loans for business?

Most (but not necessarily all) personal loans can be used for just about anything. Your lender may not even ask how you intend to spend the money. But it’s a good idea to check the lending agreement in case there are any restrictions. And if the lender wants to know the purpose of the loan, you should be honest about your intentions.

Are startup loans personal loans?

There are a few different options for funding a startup, including SBA loans, family loans, or crowdfunding platforms. But if you have good credit and are confident you can make the monthly payments, taking out a personal loan could be an effective strategy for funding a startup, if the loan permits that usage.

Photo credit: iStock/MicroStockHub

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Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

Non affiliation: SoFi isn’t affiliated with any of the companies highlighted in this article.

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

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

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

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