Jan
28
2022
IRA Transfer vs Rollover
There are important differences between a rollover and a transfer when making a change to a retirement account.
Read more
SoFi
Student Loan Consolidation and Refinancing
Jan
27
2022
What to Know About Orphan 401k Accounts
The term “orphan 401(k)” refers to 401(k) plans that former employees have forgotten about or otherwise abandoned. (It can also refer to a workplace retirement account that no longer has a sponsor.)
Someone could end up with one or more orphan 401(k) plans if they make frequent job changes throughout their working years. If you have dormant 401(k) accounts with previous employers, you could be leaving a significant amount of money on the table.
Knowing how to find orphan 401(k) plan assets — and what to do with them once you do — matters for planning your financial future.
What Is an Orphan 401(k) Account?
A 401(k) retirement account is a defined contribution plan that allows employees to save money for retirement on a tax-advantaged basis, using elective salary deferrals. A 401(k) plan also allows employers to make matching contributions on the employee’s behalf.
An orphan 401(k) account or dormant 401(k) is a 401(k) plan that a plan participant has left behind after leaving a job. Many people have one or more orphan 401(k) plans. That’s because the typical worker changes jobs approximately 12 times during their lifetime, according to data from the Bureau of Labor Statistics (BLS).
Assuming you enroll in their employer’s 401(k) plan with each new job, you could easily end up with a dozen orphan 401(k) accounts by the time you’re ready to retire. The money left behind in orphan accounts doesn’t disappear but it doesn’t automatically follow the plan participant either.
Orphan 401(k) plans can be costly for employers to maintain on behalf of former employees. And the employee, of course, misses out on the benefit of the money saved in those accounts as they work to get on track for retirement.
What to do with an Orphan 401(k) Account
It’s important to understand what to do with orphan 401(k) accounts, because doing nothing could mean missing out on a valuable addition to your retirement plan. If you have one or more orphan accounts, there are several options for managing them, including:
• Cashing the plan out
• Rolling the money into a 401(k) plan at your current employer
• Rolling orphan 401(k) amounts into an Individual Retirement Account (IRA)
• Leaving it with your former employer
Each option has pros and cons. Cashing out an orphan 401(k), for example, could put a lump sum of cash into your hands. But you’ll owe income tax on the full distribution, along with a 10% early withdrawal penalty if you’re younger than 59 ½.
Rolling the money over into your current 401(k) or into an IRA can help you avoid both taxes and penalties, assuming you pursue a direct rollover. If you don’t have as much extra money as you’d like to invest in your 401(k) at your current job, for example, rolling over money from an orphan 401(k) could give your balance a boost. But it’s important to evaluate investment options when doing so, as you could end up paying higher management fees.
If you’re satisfied with your former employer’s investment options and fees, you could leave your orphan 401(k) where it is for the time being. Keep in mind, however, that your employer may cash you out of the plan if your balance is below $1,000.
If you have one or more orphan 401(k) plans, here’s a simple checklist of what to do next:
• Locate each account, taking note of the account balance and plan investments.
• Consider your overall retirement goals and how much you have saved in total so far.
• Estimate the potential tax consequences and costs of cashing out your old orphan accounts and think about how you’d use those funds.
• Evaluate your current 401(k) and/or IRA to determine if rolling over orphan 401(k) plans makes sense, based on the investment options available and whether doing so might yield fee savings.
Looking at your entire retirement outlook can help you decide the best way to manage orphaned 401(k) accounts while minimizing taxes and investment fees.
Pros and Cons of Orphan Accounts
A 401(k) can be an incredibly useful type of retirement plan, given the tax benefits it infers. With a traditional IRA, the money you contribute is tax-deductible and growth is tax-deferred. If your employer offers a matching contribution, that’s free money you can put toward your retirement.
Your plan may also allow in-service loans at low interest rates, which is helpful if you need to borrow money in a pinch.
Orphan 401(k)s, however, have their own benefits and drawbacks.
Orphan 401(k) Pros
These accounts represent money you could add to the retirement savings pot that informs your retirement plan. You could roll the funds over to your current 401(k) or an IRA in order to keep growing retirement wealth on a tax-advantaged basis. Or you could withdraw the cash in a lump sum if needed.
Orphan 401(k) Cons
Orphan 401(k) accounts may be difficult to track down if you’ve changed jobs frequently. Even if you know where your orphan 401(k) accounts are, it can be hard to manage multiple accounts and keep track of your investments and fees across your entire portfolio.
Summary of Pros and Cons of Orphan Accounts
| Pros | Cons |
|---|---|
| You have several options from which to choose (keeping the orphan account, rolling it over, cashing out, etc.) | It can be difficult to manage multiple 401(k) accounts and make holistic portfolio decisions. |
| You may have access to unique investments or lower fees through an old 401(k) than you have at your current account. | It’s easy to lose track of old 401(k) accounts. |
| Money maintained in a 401(k) account may have better protection from creditors than other types of accounts. | If you keep the account with your former employer, you’re only able to invest in those investment options on the plan menu. |
Pros and Cons for Employers
Some employers prefer having orphan accounts remain in plan, but others do not. That’s because keeping former employee assets in plan may give them access to better pricing from financial services providers. But there is also an added administrative cost for employers to manage orphan plans.
How to Find Orphan 401k Plans
It’s possible that you could have one or more orphan accounts you’ve forgotten about over the years. But that doesn’t mean your money is lost forever. Fortunately, there are different possibilities for how to find orphan 401(k) plan assets.
1. Contact Previous Employers
The simplest way to find an old 401(k) account may be to reach out to your previous employer. You can contact your former company’s human resources administrator or the plan administrator who should be able to tell you the status of your orphan account.
There may be three possibilities, depending on the account balance:
• Balance of $1,000 or less: Your former employer could have cashed out the account and sent the check to your last-known address on file.
• Balance of $1,000 to $5,000: Your former employer could have rolled the money over to an IRA on your behalf.
• Balance greater than $5,000: Your account should still be intact with your former employer.
If your employer claims that they sent you a check but you didn’t receive it, you’ll need to try and track that payment down.
If your employer rolled the account into an IRA, your plan administrator or HR administrator should be able to provide the details of the account. You can then reach out to the financial institution that holds the IRA for more details on your account balance and investments.
Assuming your orphan 401(k) is still in place with your former employer, you can then decide whether you’d like to leave it where it is, cash it out or roll it over.
2. Dig Deeper
It’s possible that your former plan administrator may not have details available for where your 401(k) money went. In that case, you’ll need to do a little more digging to try to find it. There are several resources you can use to search for orphan 401(k) accounts online, including:
• Department of Labor’s abandoned plan database
• FreeERISA, which allows you to search for employee benefit plans by zip code
• National Registry of Unclaimed Retirement Benefits , which could help you find orphan 401(k) plans if your former employer’s are registered
The more information you can provide, the easier it may be to find missing 401(k) accounts. For example, to use the Department of Labor’s abandoned plan database, it helps to know your plan name, employer name, city, state and zip code when completing a search.
3. Search Unclaimed Property Databases
If you’re still unsuccessful in turning up orphan 401(k) plans, there are some other databases you can use to search for them. Employers who can not track down plan owners may turn over their assets to their state’s unclaimed property department.
You can look for missing money through these sites:
• Unclaimed.org , sponsored by the National Association of Unclaimed Money
• Administrators
You can also search for abandoned or orphaned pension plans through the Pension Guaranty Corp.’s unclaimed pension benefits database .
Retirement Investing With SoFi
Finding orphan accounts could help you to boost your total retirement savings balance overnight. One way to put that money to use is by rolling that money over to a new IRA to streamline your investment strategy.
If you don’t have one yet, the SoFi Invest® investment app makes it easy to open a Traditional or Roth IRA. Once you’ve created an account, you can use it to build a portfolio of stocks and exchange-traded funds.
FAQ
How can I find out if I have an old 401(k) account?
The easiest way to find out if you have an old 401(k) account is to contact your former employer’s human resources administrator or plan administrator and ask. They should be able to tell you if you were enrolled in the company’s 401(k) plan and if so, where that account is now.
How do I find all my retirement accounts?
If you believe you have multiple orphan 401(k) accounts floating around, you could use a retirement benefits database to search for them. There are multiple databases you can use to search for orphan accounts, including 401(k) plans and pension plans. You can also use unclaimed money databases to search for inactive or dormant 401(k) accounts.
Are unclaimed retirement benefits legit?
The National Registry of Unclaimed Retirement Benefits is a legitimate resource for finding lost or missing retirement accounts. The database allows you to search for orphan 401(k)s simply by entering your Social Security number. If the database finds an unclaimed retirement account, you can then reach out to the employer whose contact information is listed for more information.
Photo credit: iStock/LaylaBird
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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 prequalification for any loan product offered by SoFi Bank, N.A.
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.
SOIN1221511
Jan
27
2022
Everything You Need to Know About Lifestyle Funds and Lifestyle Investing
Lifestyle funds are investment funds that base their asset allocation on someone’s age, risk tolerance, and investing goals. Individuals who want to grow wealth over the long term in a relatively hands-off way might consider lifestyle investings.
There are different types of lifestyle funds investors may choose from, based on their appetite for risk, the level of risk needed to achieve their goals, and their investing time horizon. Lifestyle assets often also appear inside different types of retirement accounts, including employer-sponsored retirement plans and Individual Retirement Accounts (IRAs).
Whether becoming a lifestyle investor makes sense for you can depend on what you hope to achieve with your portfolio, how much risk you’re comfortable taking, and your overall time horizon for investing.
What Are Lifestyle Funds?
A lifestyle fund or lifestyle investment holds a mix of investments that reflect an investor’s goals and risk tolerance. These investment funds tailor their investment mix to a specific investor’s needs and age to provide a simplified solution for reaching their goals.
Lifestyle funds may invest in both equities (i.e. stocks) and fixed-income securities, such as bonds and notes. These funds may require fewer decisions by the asset owner, since they adjust automatically through changing lifestyle needs until you reach retirement. With lifestyle assets, as with other types of funds, it’s important to consider the balance between risk and reward.
Lifestyle funds that carry a higher degree of risk may offer higher returns to investors, while those that are more conservative in terms of risk may yield lower returns.
How Do Lifestyle Funds Work?
Typically purchased through a retirement account or a brokerage account, lifestyle funds work by creating a diversified portfolio to meet an investor where they are, while also taking into account where they’d like to be 10, 20 or 30 years from now.
An investor can choose from an initial lifestyle fund allocation, then adjust the risk level up or down based on their preferences. A fund manager reviews the asset allocation for the fund and rebalances periodically to help an investor stay on track with their goals.
The level of risk an investor takes may correlate to the average age of retirement, which for most people is around 65. So someone who’s 25 years old now has 40 years to invest for the future, meaning they can afford to take more risk to achieve their goals. As they get older, their tolerance for risk may decrease which could mean moving away from stocks and toward fixed-income investments.
Unlike target-date funds, the level of risk in lifestyle funds doesn’t change significantly over time. So if you were to choose an aggressive lifestyle fund at 25, the asset allocation of that fund would more or less be the same at age 65. That’s important to understand for choosing the lifestyle fund that’s appropriate for your risk tolerance and goals.
Recommended: Explaining Asset Allocation by Age
Two Stages of Lifestyle Funds
Lifestyle investing can work in different stages, depending on where you are in your investing journey. Lifestyle funds accommodate these different stages by adjusting their asset allocation.
This is something the fund manager can do to ensure that you’re working toward your goals without overexposing yourself to risk along the way. The two stages of lifestyle funds are the growth stage and the retirement target date stage.
1. Growth Stage
The growth stage represents the period in which a lifestyle investor is actively saving and investing. During the growth stage, the emphasis is on diversifying investments to achieve the appropriate balance between risk and reward. This phase represents the bulk of working years for most people as they move from starting their careers to reaching their peak earnings.
In the growth stage, lifestyle funds hold an asset allocation that reflects the investor’s goals and appetite for risk. Again, whether this is more conservative, aggressive or somewhere in-between depends on the individual investor. At this time, the investor is typically concerned with funding retirement accounts, rather than withdrawing from them.
2. Retirement Target Date
The retirement target date stage marks the beginning of the countdown to retirement for an investor. During this stage, the focus shifts to preparing the investor to begin drawing an income from their portfolio, rather than making new contributions or investments.
At this point, a lifestyle investor may have to decide whether they want to maintain their existing asset allocation, shift some or all of their assets into other investments (such as an annuity), or begin drawing them down in cash. For example, an investor in their mid-50s may decide to move from an aggressive lifestyle fund to a moderate or conservative lifestyle fund, depending on their needs, anticipated retirement date, and how much risk they’re comfortable taking.
Different Types of Lifestyle Funds
Lifestyle funds aren’t all alike and there are different options investors may choose from. There are different ways lifestyle funds can be structured, including:
• Income-focused funds. These lifestyle funds aim to produce income for investors, though capital appreciation may be a secondary goal. Fixed-income securities typically make up the bulk of lifestyle income funds, though they may still include some equity holdings.
• Growth-focused funds. Lifestyle growth funds are the opposite of lifestyle income funds. These funds aim to provide investors with long-term capital appreciation and place less emphasis on current income.
• Conservative asset allocation funds. Conservative lifestyle funds may have a long-term goal of achieving a set total return through both capital appreciation and current income. These funds tend to carry lower levels of risk than other lifestyle funds.
• Moderate asset allocation funds. Moderate lifestyle funds often take a middle ground approach in terms of risk and reward. These funds may use a “fund of funds” strategy, which primarily involves investing other mutual funds.
• Aggressive asset allocation funds. Aggressive lifestyle funds may also use a “fund of funds” approach, though with a slightly different focus. These funds take on more risk, though rewards may be greater as they seek long-term capital appreciation.
Lifestyle Investment Risks
Investing for retirement with lifestyle assets has some risks, so it’s important to make sure that the fund you choose matches your risk tolerance. Risk tolerance refers to the amount of risk an investor is comfortable taking in their portfolio. Risk capacity is the amount of risk needed to achieve investment goals.
Typically, younger investors can afford to take more risk in the early years of their investment career as they have more time to recover from market declines. But if that investor has a low risk tolerance, they may still choose to stick with more conservative investments. If their risk tolerance doesn’t match up with the amount of risk they need to take to achieve their investment goals, they could fall far short of them.
When considering lifestyle funds, it’s important to consider your risk mix and risk level. While lifestyle funds can simplify investing in that you don’t necessarily need to make day-to-day trading decisions, it’s still important to consider how your risk tolerance and risk capacity may evolve over time. As you move from the growth stage to the retirement target date stage, for instance, you may need to make some adjustments to your lifestyle fund choices in order to keep pace with your desired goals.
Advantages of Lifestyle Funds
In addition to their risks, lifestyle funds offer numerous advantages to investors, starting with simplicity. When you invest in a lifestyle fund, you know more or less what to expect in terms of asset allocation, based on the risk tolerance that you specify. These funds don’t require you to be an active investor in order to realize returns.
Some funds also automatically rebalance on behalf of investors, so there’s very little you need to do, other than be mindful of how the fund’s risk mix reflects your risk tolerance at any given time.
A lifestyle fund can offer broad diversification, allowing you to gain exposure to a variety of assets without having to purchase individual stocks, bonds or other securities.
Compared to other types of mutual funds or exchange-traded funds (ETFs), lifestyle funds may carry lower expense ratios. That can allow you to retain more of your investment returns over time.
Finally, lifestyle funds encourage investors to stay invested through market ups and downs. That can help you to even out losses through dollar-cost averaging.
Lifestyle Funds vs Target Date Funds
If you have a 401(k), then you’re likely familiar with target date funds as they’re commonly offered in workplace retirement plans. A target date fund, or lifecycle fund, is a mutual fund that adjusts its asset allocation automatically, based on the investor’s target retirement date. These funds are distinguishable from lifestyle funds because they typically have a year in their name.
So a Target Date 2050 fund, for example, would attract investors who plan to retire in the year 2050. Target date funds also take a diversified approach to investing, with asset allocations that include both stocks and fixed-income securities.
The difference between target date funds and lifestyle funds is that target date funds follow a specific glide path. As the investor gets closer to their target retirement date, the fund’s asset allocation adjusts to become more conservative. Lifestyle funds don’t do that; instead, the asset allocation remains the same.
Recommended: Target-date Funds vs. Index Funds: Key Differences
The Takeaway
Whether you choose to invest with lifestyle funds, target date funds, or something else, the most important thing is to get started saving for retirement. The longer your time horizon until retirement, the more time your money has to grow through the power of compounding interest.
An easy way to get started is by opening a retirement account on the SoFi® Invest investment app. Through it, you can open an IRA or taxable account and use it to build a portfolio of stocks and exchange-traded funds.
FAQ
What is a lifestyle pension fund?
A pension fund is a type of defined benefit plan, in which employees receive retirement benefits based on their earnings and years of service. A lifestyle pension fund is a pension fund that allocates assets using a lifestyle strategy in order to meet an investor’s goals and needs.
What is a lifestyle strategy?
In investing, a lifestyle strategy is an approach that chooses investments that can help an investor to reach specific milestones or goals while keeping their age and risk tolerance in mind. With lifestyle funds, the asset allocation doesn’t change substantially over time.
What is a lifestyle profile?
A lifestyle profile is a tool that investors use to help them select the most appropriate lifestyle funds based on their age, risk tolerance goals.
Photo credit: iStock/GaudiLab
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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 prequalification for any loan product offered by SoFi Bank, N.A.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
SOIN1221513
Jan
27
2022
What Is Compliance Testing for 401k?
To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.
Compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.
Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.
Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.
401(k) Compliance Testing Explained
Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. Compliance testing for 401(k) plans is the responsibility of the company that offers the plan.
How 401(k) Compliance Testing Works
Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.
There are three nondiscrimination testing standards employers must apply to qualified retirement plans.
• The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan
• The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees
• Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees
The Actual Deferral Percentage (ADP) Test
The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance test measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.
To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.
A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ADP for the group of non-highly compensated employees Or
• The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%
The Actual Contribution Percentage (ACP) Test
Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.
This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ACP for the group of non-highly compensated employees OR
• The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%
Companies may run both the ADP and ACP tests using prior year or current-year contributions.
Top-Heavy Test
The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:
• An officer making over $200,000 for 2022 ($185,000 for 2021 and 2020)
• A 5% owner of the business OR
• An employee owning more than 1% of the business and making over $150,000 for the plan year
Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.
Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.
Why 401(k) Compliance Testing Is Necessary
Compliance testing in 401(k)s ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.
If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.
Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.
Highly Compensated Employees
The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:
• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received, OR
• Received compensation from the business of more than $130,000 (if the preceding year is 2021 or 2020) or $135,000 (if the preceding is 2022) and, if the employer so chooses, was in the top 20% of employees when ranked by compensation
If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.
Non-Highly Compensated Employees
Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.
Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.
How to Fix a Non-Compliant 401(k)
The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:
• Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards
• Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test
Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.
Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:
• Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.
• Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.
Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.
The Takeaway
A 401(k) represents one of the most valuable links in the chain when planning retirement goals. Part of the value of a 401(k) is its tax-preferred status, so it’s important for employers to conduct IRS-mandated compliance testing in order to maintain that tax treatment. However, the 401(k) is not the only way to save for retirement in a tax-favored way.
If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings you may consider opening your first Individual Retirement Account (IRA) instead. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions. An easy way to open an IRA online is by creating an investment account on the SoFi Invest app.
FAQ
What is top-heavy testing for 401(k)?
Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.
What happens if you fail 401(k) testing?
If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.
What is a highly compensated employee for 401(k) purposes?
The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the preceding year. Income limits are set by the IRS and updated periodically.
Photo credit: iStock/tumsasedgars
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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 prequalification for any loan product offered by SoFi Bank, N.A.
SOIN1221509
Jan
25
2022
How Can I Retire Early?
An early retirement used to be considered a bit of a dream, but for many people it’s now a reality — especially those who are willing to budget, save, and invest with this goal in mind.
Take the FIRE movement, which stands for “financially independent, retire early.” FIRE has become a worldwide trend that’s inspiring people to work toward retiring in their 50s, 40s, and even their 30s.
If you think an early retirement could be your next priority — or maybe it already is — here are some steps you can take to help you get there, many of which are part of the FIRE method. Let’s start with The Number itself. How much would you need to save and invest to arrive at an amount that would allow you to retire early?
Early Retirement: What’s Your Number?
Many people wonder: How much do I need to retire early? There isn’t one right answer to that question. The right answer for you is one that you (and maybe your spouse, partner, or other loved ones) must arrive at based on your unique needs and circumstances. That said, to learn whether you’re on track for retirement it helps to start somewhere, and the so-called Rule of 25 provides a good ballpark estimate.
The Rule of 25 recommends saving 25 times your annual expenses in order to retire. Why? Because according to a well-known retirement formula in the industry, you should only spend 4% of your total nest egg every year. By limiting your spending to a small percentage of your savings, the logic goes, your money is more likely to last.
Here’s an example: if you spend (not earn, spend) $75,000 a year, you’ll need a nest egg of $1,875,000 in order to retire.
$75,000 x 25 = $1,875,000
With that amount saved, and assuming an annual withdrawal rate of 4%, you would have $75,000 per year in income.
Obviously, this is just an example. You might need less income in retirement or more — perhaps a lot less or a lot more, depending on your situation. If your desired income is $50,000, for example, you’d need to save $1,250,000. You can plug-and-play with different amounts.
Remember, once you reach the traditional retirement age of 62, you would then be able to claim Social Security. (Age 67 is considered “full retirement” age, and you can wait to claim benefits until age 70.) The longer you wait to claim Social Security, the higher your monthly payments will be. Depending on your needs, you could add those Social Security benefits to your income or consider reinvesting the money, depending on your circumstances as you get older.
The bigger question, then, is how do you save the amount of money you’d need for your early retirement plan?
8 Early Retirement Tips
How to Retire Early in 8 Steps
- Step 1: Make an early retirement roadmap
- Step 2: Find a budget you can live with
- Step 3: Take advantage of employee benefits
- Step 4: Consider a Health Savings Account (HSA)
- Step 5: Open a Roth IRA
- Step 6: Pay off debt
- Step 7: Invest early and often
- Step 8: Stay within your spending limits in retirement
Following are eight steps that can help you build a nest egg that’s substantial enough for you to consider an early retirement. Note that this article is focused on cash savings, as well as investments (including different types of retirement plans). We are not including the potential value of real estate or business assets here. Of course, the beauty of the Rule of 25 is that it’s flexible enough to include details that are particular to your plan.
Speaking of your plan …
1. Make an early retirement roadmap
The first step in your early retirement plan is to commit to this new path, and all that it will entail. An early retirement requires determination and, in many cases, making changes to how you think as well as some of your day-to-day habits. Divide your plan into two parts: Money and Vision.
Money
• Start by doing the math, using the Rule of 25. Be brave. Based on your current nest egg, how much more would you need to save to get to your goal?
• Next: If you hypothetically needed to save $500,000 more to reach your goal, divide that by the number of years until your early retirement date. If you have 15 years until your early retirement, you’d have to save about $33,333 per year, or $2,777 per month, to save an extra $500,000.
• Use a calculator to explore different potential investment returns. While there’s no way to predict what your investments will earn over time, a conservative return rate of, say, 5% isn’t unreasonable considering that the average stock market return of the last decade was about 13.9%, although it’s always important to remember that past performance is no guarantee of future performance.
Also, that historic return rate assumes being invested 100% in stocks, so a lower rate of return would reflect the assumption that you’d also invest in bonds or cash, and/or that market returns might be lower in the future.
Vision
Schedule a few check-ins with yourself, and/or a partner or loved ones, to discuss what “early retirement” means, and what it might look like. Not working? Working a little? Working in a different field? Starting a business? Going back to school? Volunteering? Traveling?
It’s different for everyone, so the clearer you can get about the details now, the smarter you can be about how much money you need to make your plan work.
2. Find a budget you can live with
By now you’ve probably realized that having a budget you can live with is critical to making this plan a success. The essential word here isn’t budget, it’s the whole phrase: a budget you can live with.
There are countless ways to manage how you spend and save (a.k.a. budgets). There’s the 50-30-20 plan, the envelope method, the zero-based budget, etc. One suggestion: Search up what types of spending plans other people in the early retirement community are using.
Test a couple of them for a couple of months each. Find one you can live with.
The reason you need a budget to retire early is because few people have the stamina and self-discipline to stick to a plan unless they have specific numbers to work with.
Recommended: Typical Retirement Expenses to Prepare For
3. Take advantage of employee benefits
If your employer offers a retirement plan like a 401(k) or 403(b), that’s the first thing you want to take advantage of — especially if there is an employer match involved (e.g. your employer matches a percentage of your savings). These employer-sponsored plans allow you to invest in mutual funds, target date funds, and more.
The other reason to save and invest in an employer-sponsored plan is that in most cases the money you save reduces your taxable income. So the more you save, the less you might pay in taxes.
The caveat here is that you can’t access those funds before you’re 59½ without paying a penalty. So if you plan to early retire at 50, you will need to tap other savings for roughly the first decade to avoid the withdrawal penalties you’d incur if you tapped your 401(k) or Individual Retirement Account (IRA) early.
Be sure to find out, from HR and from your colleagues, if there are any other employee benefits you might qualify for: e.g. stock options, a pension, deferred compensation, etc.
4. Consider a Health Savings Account (HSA)
If your employer offers a Health Savings Account as part of your employee benefits, you might consider opening one.
Even though your 401(k) and IRA may have contribution caps, a Health Savings Account allows you to save additional money: In 2022, the HSA contribution caps are $3,650 for individuals and $7,300 for those with family coverage.
Your contributions are considered pre-tax, similar to 401(k) or IRA contributions, and the money you withdraw for qualified medical expenses is tax free (although you’ll pay taxes on money spent on non-medical expenses).
The downside of saving in an HSA is that your investment options may be limited. If you find they are too limited, you may want to consider saving more in your employer plan
5. Open a Roth IRA
The advantage of saving in a Roth IRA vs. a regular IRA is that you’re contributing after-tax money that can be withdrawn penalty and tax free at any time.
To withdraw your earnings without paying taxes or a penalty, though, you must have had the account for at least five years (the so-called 5 Year Rule), and you must be over 59½.
If you already have the bulk of your savings in a 401(k), you might want to consider doing a Roth conversion for some of that money. Although you’d have to pay taxes on the money you rolled over into a Roth (because a Roth must be funded with after-tax dollars), this would enable you to withdraw those contributions penalty free.
6. Pay off debt
Obviously, it’s very difficult to achieve a big goal like saving for an early retirement if you’re also trying to pay down debt. It’s wise to start your plan with a clean slate, and work first to pay off any and all debts you might have (credit card, student loan, personal loan, car loan, etc.).
That’s not only because being debt free feels better — it saves you money. For example, the interest rate you’re paying on credit card or store cards can be quite high, often above 10% or 15%. If you own $6,000 on a credit card at 17% interest, for example, when you pay that off, you’re essentially saving the 17% that debt was costing you each year.
7. Invest early and often
How do you invest to retire early? You can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), target date funds, and more.
One factor to consider is how aggressively you want to invest. That means: Are you ready to invest more in equities, say, taking on the potential for greater risk in order to reap potential gains? Or would you feel more at ease if you invested using a more conservative strategy, with less exposure to risk (but potentially less reward)?
Whichever strategy you choose, you may want to invest on a regular cadence. This approach, called dollar-cost averaging, is one way to maximize potential market returns and mitigate the risk of loss.
8. Stay within your spending limits in retirement
The budget you make in order to save for an early retirement is probably a good blueprint for how you should think about your spending habits after you retire. Unless your expenses will drop significantly after you retire (e.g. if you move, if you need one car instead of two, etc.), you can expect your spending to be about the same.
That said, you may be spending on different things. You may be spending less on commuting and gas and work-related expenses and more on your new business or on travel. Whatever your retirement looks like, though, it’s wise to keep your spending as steady as you can, to keep your nest egg intact.
Investing for Early Retirement With SoFi
SoFi makes it easy to get started on your early retirement journey when you open a SoFi Traditional or Roth IRA.
If early retirement is your priority, taking the steps to not only save your money but actually invest it can help you make progress toward that goal.
You might consider a so-called robo advisor, like SoFi’s automated investing portfolio. Once you identify your retirement goal, a computer algorithm helps you set up a portfolio that matches your preferences. It also helps rebalance and manage the portfolio over time. While there are no guarantees of specific outcomes with any investing strategy, using an automated investing portfolio may help you stick to your plan and invest steadily over time — habits that might help you reach your early retirement goal.
The Takeaway
An early retirement may appeal to many people, but it takes a real commitment to actually embrace that as your goal. These days, many people are using movements like FIRE (financial independence, retire early) to help them take the steps necessary to retire in their 30s, 40s, and 50s.
You can make progress toward an early retirement too, by following some of the steps outlined in this article. And by opening an investment account with the SoFi Invest® online brokerage, you not only have the ability to start an IRA, but to invest in stocks, ETFs, and even crypto. Even better, SoFi members have complimentary access to financial advice from a professional, who could likely help to answer some of your questions about making an early retirement plan that works for you.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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 prequalification 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.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected] Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
SOIN19026
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