Jun
25
2024

Guide to Education IRAs

By | Growing Wealth, invest, Investing | Comments Off on Guide to Education IRAs

There are many different ways you can save for education expenses, and each one comes with its own pros and cons. Depending on your situation, you may want to explore 529 college savings plans, Roth IRAs, or education IRAs — also known as Coverdell Education Savings Accounts (or ESAs).

Education IRAs — more commonly called Coverdell ESAs today — provide a tax-advantaged way to save for primary, secondary, and higher education expenses. Unlike 529 Plans, you can only save $2,000 per year, per beneficiary in an ESA, and your contribution limit is determined by your income.

What Is an Education IRA, or ESA?

Despite sometimes being called an education IRA, this is not a retirement account like a traditional IRA, but is rather intended for education-related expenses, including tuition, tutoring, books, and more.

It’s possible for a parent to consider using retirement funds to pay for college, but it’s generally unwise to compromise your own retirement.

Fortunately, there are many tax-advantaged ways to save for a child’s education. It’s even possible to use an education IRA in combination with a 529 plan, especially if you’re looking for creative ways to save for college.

ESA Basics

It’s important to know that different rules apply to each type of educational account. For example, parents, grandparents, and other individuals can open ESAs on behalf of an eligible beneficiary (the student) and make annual contributions.

But contributions are not tax deductible (as they sometimes are when creating a college fund, depending on the state); and contributions are limited to $2,000 per year, total, per beneficiary. So, if a grandparent opens an ESA for a child, and an uncle opens an ESA for the same child, the total contribution amount per year in those two ESA accounts cannot exceed $2,000.

The perks of a 529 savings plan include: No annual contribution limits; no income limits; contributions are tax deductible in some states. But you can only use up to $10,000 in 529 funds for primary and secondary education expenses.

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How Do Education IRAs Work?

ESAs have two primary people involved — the custodian, who manages the account, and the beneficiary, or student. The custodian sets up the education IRA and manages the funds on behalf of the student beneficiary.

An education IRA is a self-directed account, where the custodian can invest the money in assets like stocks, bonds, real estate or mutual funds. The appreciation and interest earned in an education IRA is tax-deferred, which means that appreciation is not subject to tax on capital gains or income. Distributions for qualified educational expenses are also not subject to taxes.

ESA Rules

Here are a few of the rules for setting up education IRAs (i.e., Coverdell ESAs):

Funds Must Be Contributed Before the Beneficiary Turns 18

All funding to an education IRA must be contributed before the beneficiary turns 18 years old, unless they’re a special needs beneficiary per the IRS.

Funds Must Be Distributed Before Age 30

You must distribute all funds in an education IRA before the beneficiary turns 30 (again, this doesn’t apply to those with special needs). However, the custodian may name a new beneficiary if there are still funds in the account when the original beneficiary reaches age 30.

Contribution Limits

Each account may only receive $2,000 in funding each year, total. Additionally, if your modified adjusted gross income (MAGI) is between $95,000 to $110,000 ($190,000 to $220,000 for those filing jointly), you can contribute a partial amount, not the full $2,000. If your MAGI is above $110,000 (or $220,000 for joint filers), you are not permitted to contribute to an ESA.

Tax-free for Qualified Expenses

While contributions are not deductible, assets in an education IRA are considered tax-advantaged, which means you do not pay any capital gains or income tax over time on the money within the account. And as long as you withdraw the money for qualified education expenses, you won’t pay any taxes on the withdrawals either. Nonqualified withdrawals, however, are subject to taxes and a 10% tax penalty.

Pros and Cons of an Education IRA

Pros of an Education IRA

 Cons of an Education IRA
Withdrawals for qualified education expenses are tax-free Limited to $2,000 in contributions per year
Are self-directed, meaning contributors can choose their own investments Ability to contribute is limited by contributors’ MAGI
Can be used for educational expenses from kindergarten through college Can’t contribute after the beneficiary reaches age 18*
Beneficiary of an ESA can be changed to a family member of the original beneficiary Must distribute all funds before the beneficiary turns 30*

*This does not apply to special needs beneficiaries.

Alternatives to Education IRAs

Here are a few alternatives to education IRAs:

529 Plans

A 529 plan is one of the most common ways that people save for college and other educational expenses. Earnings in 529 plans are also tax-deferred and qualified educational expenses can be withdrawn tax free, but in contrast to education IRAs, 529 plans have no limitations on the age of the beneficiary.

Roth IRA

You can also set up a Roth IRA for a child as a way to save for higher education expenses like college. While a Roth IRA is mostly intended for retirement savings, it can also be used for higher-education expenses because you can withdraw your contributions at any time (but there are restrictions on withdrawing investment earnings from a Roth before age 59 ½ ).

High-Yield Savings Account

It is also possible to put some or even the majority of your college savings money in a high-yield savings account. While you lose some of the tax advantages that come with Coverdell ESAs, IRAs, or 529 plans, you also have more flexibility since the money in a savings account can be used for any purpose without penalty. Also, these accounts are typically FDIC insured.

Investing in an IRA With SoFi

While an education IRA is not a retirement account in the way that other types of IRAs are, it can be a good way to save for a child’s education-related expenses until they turn 18. While you cannot currently open an education IRA with SoFi, you can open up a traditional or Roth IRA. Using a Roth IRA is one way to save for both retirement and higher education expenses while giving yourself maximum flexibility.

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).

Help grow your nest egg with a SoFi IRA.

FAQ

Is an education IRA the same as a 529 savings plan?

While education IRAs (now called Coverdell ESAs) and 529 savings plans are both ways to save for education expenses, they are not the same thing. The aggregate contribution limits for 529 plans are much higher than they are for an ESA, so you could save more — and you’re not required to stop making contributions once your child turns 18.

What are the benefits of an education IRA?

An education IRA allows you to save money for a beneficiary and watch that money grow tax-free. And as long as you withdraw that money for qualified education expenses, you won’t ever have to pay income tax or capital gains tax on that money.

What is the income limit for an education IRA?

Education IRAs do limit who can make a contribution based on the adjusted gross income (MAGI) of the donor. Currently, the income limits for an education IRA are $95,000 for single taxpayers and $190,000 for married taxpayers. Single taxpayers with an MAGI of $95,000 to $110,000 and joint filers with an MAGI of $190,000 to $220,000 can contribute a lesser amount due to a phaseout rule. Single taxpayers and join filers whose MAGI exceeds $110,000 and $220,000, respectively, are not eligible to contribute to an educational IRA.

Photo credit: iStock/Jacob Wackerhausen

SoFi Invest®

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

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.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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Jun
20
2024
Income Investing Strategy

What Is an Income Investing Strategy?

By | Growing Wealth, invest, Investing | Comments Off on What Is an Income Investing Strategy?

An income investing strategy focuses on generating income from your principal rather than growth, i.e. capital gains. Income investors typically seek out investments that provide a regular income stream, such as dividends from stocks, interest from bonds, or rental payments from a property.

Investors might be interested in income investing in order to create an additional income stream during their working years. Other investors may focus on generating monthly income during retirement. Income investors need to take into account several factors, including the tax implications of different types of income.

How Income Investing Works

Income investing can be a way to generate a passive income stream that supplements ordinary income as well as retirement income. Rather than creating a portfolio that’s solely focused on capital gains, i.e. growth, an income investing strategy is geared toward setting up one or more sources of steady income.

Again, dividend-paying stocks, interest-bearing bonds, and real estate proceeds are common types of income investments that may provide steady cash flow. While many people associate investment income with retirement, many investors seek to establish other income streams long before that.

That said, these two aims — growth and income — are not mutually exclusive. In fact, an income-generating portfolio must also have a growth component, in order to keep up with inflation.

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Types of Income Investing Strategies

There are a range of income investing assets and strategies that investors can adopt, depending on their goals and preferences. For example, when creating an income-focused portfolio, it’s important to consider your risk tolerance, as different income investments may have different risk profiles.

1. Dividend Stocks

Dividend stocks are stocks that pay out regular dividends to shareholders. Not all companies pay dividends. Companies that do usually pay dividends quarterly, and they can provide a reliable source of income for investors.

Income investors are generally attracted to companies that pay out reliable dividends, like the companies in the S&P 500 Dividend Aristocrats index. Companies in this index have increased dividends every year for the last 25 consecutive years.

•   Dividend Yield

One metric that income investors should consider is the dividend yield. While dividends are a portion of a company’s earnings paid to investors, expressed as a dollar amount, dividend yield refers to a stock’s annual dividend payments divided by the stock’s current price, and expressed as a percentage.

Dividend yield is one way of assessing a company’s earning potential.

While a high dividend yield might be attractive to some investors, risks are also associated with high-yield investments. Investors who want regular and consistent income tend to avoid stocks that pay high yields in favor of dividend aristocrats that may pay lower yields.

Recommended: Living Off Dividend Income: Here’s What You Need to Know

2. Bonds

Bonds are a debt instrument that normally make periodic interest payments to investors. Also known as fixed-income investments, bonds are typically less risky than stocks and can provide a steady stream of income. The bond’s yield, or interest rate, determines the interest income payment.

There are various bonds that fixed-income investors can consider. For example, government bonds are debt securities issued by a government to support government spending and public sector projects. Government bonds — like U.S. Treasuries and municipal bonds — are generally less risky than other types of bonds and can provide tax-advantaged income and returns.

Investors can also lend money to businesses through corporate bonds, which are debt obligations of the corporation. In return for money to fund operations, companies make periodic interest payments to investors. Corporate bonds carry a relatively higher level of risk than government bonds but also provide higher yields.

However, not all bonds offer yield to investors interested in generating regular income. Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond.

The upside of choosing zero-coupon bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.

Recommended: How to Buy Bonds: A Guide for Beginners

3. Real Estate

Real estate may be a great source of income for investors. Rents paid by tenants act as a regular income payout. Real estate may also offer long-term price growth, in addition to some tax benefits.

There are several ways to invest in real estate, including buying rental properties and investing in real estate investment trusts (REITs).

Recommended: Pros & Cons of Investing in REITs

4. Savings Accounts

Savings accounts are a safe and easy way to earn interest on cash. Savings accounts and other cash-equivalent saving vehicles like high-yield savings accounts or certificates of deposits (CDs) are often considered very low risk. But they also typically offer lower interest rates than you might see with other investments. Because these interest rates are typically lower than the inflation rate, inflation can erode the value of the money in these savings accounts longer term.

In addition, when you purchase a CD it may have more stringent minimum deposit requirements, as well as keeping your money locked up for a specific period of time. Still, they can be a low-risk way to earn income.

5. Money Market Accounts

A money market account (MMA) is an FDIC-insured deposit account that typically pays higher interest rates than a traditional savings account. However, MMAs may be more restrictive than a savings account, often only allowing a certain number of withdrawals each month using checks or a debit card.

Also, money in a money market account can be invested by the bank in government securities, CDs, and commercial paper — which are all considered relatively low-risk investments. With a traditional savings account, money is not invested.

But unlike most investments, money market accounts at most banks are FDIC-insured up to $250,000 for an individual, or $250,000 per co-owner in the case of joint accounts. In some cases investing in a money market account may earn a higher interest rate while still maintaining FDIC-insurance protection.

6. Mutual Funds and ETFs

Investors who don’t want to pick individual stocks and bonds to invest in can always look to mutual funds and exchange-traded funds (ETFs) that have an income investing strategy.

There are many passively and actively managed funds that invest in a basket of securities that provide interest and dividend income to investors. These funds allow investors to diversify their holdings by investing in a single security with high liquidity.

Understanding the Tax Implications of Income Investing

Another important aspect of investing for income is to consider the tax implications of different income-producing assets. Here are a few key considerations to be aware of:

•   Dividends. Most dividends are considered ordinary dividends and are taxed as income. Qualified dividends are taxed at the lower capital gains rate. Be sure to know the difference.

•   Real estate. Income from a rental property is generally taxed as income (although business deductions may apply). Dividend payouts from owning shares of a Real Estate Investment Trust (REIT) are typically higher than traditional equity dividends; these are also taxed as income. However, if there are profits from a REIT, these are taxed at the capital gains rate.

•   Bonds. Bond income may be taxable, or not, depending on the issuer. Some municipal bonds are tax free at the federal and state level (if you live in the state where the bond was issued). Corporate bond income is taxed at the state and federal levels. U.S. Treasuries are generally taxed at the federal level, but not the state.

You may also owe ordinary income or capital gains tax if you make a profit when selling a bond.

As you can see, tax issues can be complex and it’s often necessary to consult a tax professional.

Example of an Income Investing Portfolio

When building a portfolio for any investing strategy, investors must consider their financial goals, risk tolerance, and time horizon. As with any investment portfolio, it’s possible to have lower or higher exposure to risk.

Here are some examples of hypothetical income investment allocations.

Lower Risk Tolerance

Asset type

 Percent of holdings
Bonds (government and corporate) 60%
Dividend stocks 20%
Rental property or REITs 10%
Cash (savings account, money market account, and CDs) 10%

This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.

Moderate Risk Tolerance

Asset type

 Percent of holdings
Bonds (government and corporate) 35%
Dividend stocks 30%
Rental property or REITs 30%
Cash (savings account, money market account, and CDs) 5%

This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.

Higher Risk Tolerance

Asset type

 Percent of holdings
Bonds (government and corporate) 25%
Dividend stocks 30%
Rental property or REITs 45%
Cash (savings account, money market account, and CDs) 0%

This is an illustrative portfolio and not intended to be investment advice. Nor is it a representation of an actual ETF or mutual fund. Please consider your risk tolerance and investment objective when creating your investment portfolio.

Benefits and Risk of Income Investing

Like any investing strategy, there are both advantages and drawbacks to focusing on earning income through investments.

Benefits

The potential benefits of income investing include receiving a steady stream of payments, which can help to smooth out fluctuations in the market. In other words, even with a certain amount of market volatility, an income-generating strategy may produce income that provides a certain amount of ballast.

If an investor reinvests some or all of the income generated from a certain assets, whether bonds or dividend-paying stocks, this can add to the overall growth of the portfolio, thanks to compounding.

An income investing strategy may also provide diversification. For example, investing in REITs is considered a type of alternative investment strategy. That means, REITs don’t move in tandem with conventional assets like stocks, which may provide some protection against risk (although REITs can have their own risk factors to consider).

Risks

Investors who are pursuing an income investing strategy should be aware that investments that offer high yields may also be more volatile. The income from these investments may be less predictable than from more established investments, like blue chip stocks that pay out reliable dividends.

For example, a company with a high dividend yield may not be able to sustain that kind of payout and could suspend payment in the future.

When investing in bonds, investors need to know about the potential risks associated with fixed-income assets:

•   Credit risk is when there is a possibility that a government or corporation defaults on a bond.

•   Inflation risk is the potential that interest payments do not keep pace with inflation.

•   Interest rate risk is the potential of fixed-income assets fluctuating in value because of a change in interest rates. For example, if interest rates rise, the value of a bond will decline, which could impact an investor who intends to sell some of their bond holdings.

Additionally, if investors take the income from their investment for day-to-day needs rather than reinvesting it, they may miss out on the benefits of compound returns. Investors could reinvest the income they earn on certain investments to take advantage of compounding returns and accelerate wealth building.

Factors to Consider When Building Your Income Investing Strategy

Building an income investing strategy takes work and time. Before creating a portfolio, you need to define your financial goals and consider your timeline for when you need the income streams. Below are some additional steps you could follow to create an income investing strategy:

•   Assess your risk tolerance: It’s important to determine whether you want to invest more heavily in riskier assets, like dividend-paying stocks that may fluctuate in share price, or relatively safer securities, like interest-paying bonds.

•   Choose your investments: As mentioned above, potential options for income investors include bonds, dividend stocks, and real estate investment trusts (REITs).

•   Be mindful of taxes: Different types of income-producing assets may be taxed in different ways. It’s generally desirable to keep your portfolio tax efficient.

•   Monitor your portfolio: It’s critical to regularly check in on your investments to ensure they are still performing according to your expectations.

•   Rebalance as needed: If your portfolio gets out of alignment with your goals, consider making adjustments to get it back on track.

The Takeaway

An income investment strategy is, as it sounds, focused on using specific assets to provide income, not only growth (although income and growth strategies can work in harmony). Investing in dividend-paying stocks, interest-paying bonds, and other income-generating assets allows you to get the benefits of regular income streams and potential capital appreciation.

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

What’s the difference between income investing and growth investing?

The goal of income investing is to create a certain amount of steady income from different types of assets. Investing for growth is focused on the potential gains of the securities in a portfolio. In a sense, income investing can be more present focused, while growth investing may be oriented toward the longer term.

What is the best investment for income?

There are various income-generating investments, each with its own risk profile and tax considerations. When choosing the best income investments for you, be sure to consider how different factors might impact your plan.

What investments give you monthly income?

While it’s possible to obtain monthly income from various types of investments, even dividend-paying stocks (dividends are often paid quarterly), a common source of monthly income is property. If monthly income is important to you, be sure to select assets that can meet your goal.

Photo credit: iStock/LeszekCzerwonka

SoFi Invest®

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

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.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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.

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

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

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.

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Jun
18
2024
How to Invest in Carbon Credits

How to Invest in Carbon Credits

By | Growing Wealth, invest, Investing | Comments Off on How to Invest in Carbon Credits

When a company reduces its greenhouse gas emissions, it can earn carbon credits which may then be traded to other companies which need to offset their own emissions. Individuals can invest in the carbon credit market in a few different ways, including direct investment in low-carbon companies, or via exchange-traded funds (ETFs).

The global carbon market has expanded fairly fast in recent years, and the market is only expected to continue to grow in the years ahead. That means there should be plenty of opportunities for interested investors, assuming they know what they’re getting into.

What Are Carbon Credits?

Carbon credits are a way of valuing or pricing how much a company is reducing its greenhouse gas emissions. Companies that directly reduce their own greenhouse gas emissions, including carbon (CO2) can earn credits for doing so.

These carbon credits can be valuable to other companies that aren’t able to meet greenhouse gas reduction targets. So, they buy carbon credits from the companies that have them. Typically, companies that are in a position to sell carbon credits can make a profit. Each carbon credit represents one metric ton of carbon dioxide emissions. They are traded as transferable certificates or permits until they are actually used by a company and effectively retired.

For investors who are interested in ESG-centered strategies (i.e. companies that follow proactive environmental, social, governance policies) learning how to invest in carbon credits may be compelling.

What Is Cap and Trade?

An important dynamic to understand when deciding how to invest in carbon credits is the worldwide cap-and-trade market. Certain governments have put programs in place that place a limit or cap on the amount of greenhouse gasses that companies can emit each year. Caps vary according to industry and company size.

Over time, the cap can be reduced to force companies to invest in green technologies and reduce their emissions. Any emissions above the cap must be covered with the purchase of carbon credits (hence the term “cap and trade”), otherwise the company must pay a fine.

If a company is able to reduce their emissions, they can then sell those carbon credits to other companies, and make a profit on them. If they need to emit more than the cap, they buy additional carbon credits. As governments lower emissions caps, demand increases for carbon credits, and their price goes up.

Not every country has a cap-and-trade policy, but they have gained traction in the European Union, certain states in the U.S., the U.K., China, and New Zealand.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

How Have Carbon Credits Become a Big Market?

For those interested in investing in carbon credits, consider this: A significant (and growing) portion of global greenhouse gas emissions are now covered by carbon pricing initiatives, and even more are covered by voluntary carbon market purchases. This article focuses on the compliance carbon credit market created by governments, but it’s important to know the distinction between that and the voluntary carbon market.

In the voluntary market, companies choose to purchase carbon offsets as a way to cancel out their emissions. Carbon offset projects include emissions-reduction and removal initiatives such as tree planting and producing renewable energy.

In theory, this system allows certain companies to participate in the global system of reducing harmful emissions like carbon, even if those companies are still striving to attain low-emission goals in their own production or distribution systems. For example, some industries, such as cement and steel manufacturing, are unable to reach net zero emissions, so they can purchase carbon credits to help offset the emissions from their manufacturers.

3 Ways to Start Investing in Carbon Credits

Carbon markets are not as robust in the U.S. as they are in other countries, but this will likely change in the future. For now, there are a few ways investors can get started investing in carbon credits. This could be considered a form of impact investing.

1. Carbon Credit ETFs

An exchange-traded fund (ETF) is a pooled investment fund that tracks the performance of a certain group of underlying assets. There are carbon credit ETFs that track the performance of carbon markets. Some ETFs track a certain group of companies, while others track indices, futures contracts, or other asset groups.

2. Carbon Credit Futures

Another way to consider investing in carbon credits is through carbon credit futures contracts. Futures contracts are derivatives linked to underlying assets. A buyer and seller enter into an agreement to trade a particular asset for a certain price on a certain future date. With carbon credit futures, the underlying asset is the carbon credit certificate.

Carbon credits, such as the European Union Allowances and the California Carbon Allowances, have futures available on exchanges. However, carbon credit futures are complicated investments so they are only recommended for more experienced investors.

💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

3. Individual Companies

A third way that investors can get involved in carbon markets is by investing in stocks of individual companies that generate or actively trade carbon credits. By investing in those companies investors can indirectly invest in carbon credits.

Other companies are investing significantly in decarbonization and decreasing their own carbon footprint. These are sometimes referred to as green stocks.

Also some companies have a business model focused on investing in carbon projects, so investing in those provides a targeted exposure to carbon credits.

Other Ways to Invest in Carbon Credits

There are also some newer private companies in the carbon credit space to keep an eye on. Although there isn’t a way for a retail investor to invest in private companies, it might be worth tracking these companies as they may go public in the future.

Additionally, some new exchanges have started offering retail investors exposure to portfolios of curated carbon credits. These credits may be grouped by region or by type, such as forestry or renewable energy projects.

Pros and Cons of Investing in Carbon Credits

While there are several benefits to investing in carbon credits, there are some risks and downsides as well.

Pros

•   Profitability: Investing in carbon credits may be very profitable, and it’s possible that the market could grow in the years ahead.

•   Environmental and social benefits: Carbon pricing incentivizes companies to reduce their emissions, and as emissions caps tighten, and the price of carbon credits goes up, it gets more expensive for companies to pollute. By investing in carbon credits, investors can contribute to an emissions-reduction strategy that benefits both people and the environment.

•   Accessibility: Investing in a carbon credit ETF is more or less the same process as investing in any other ETF. Investors can gain exposure to carbon markets without directly trading futures or researching individual companies.

•   Low supply and increasing demand: Currently there is a limited supply of carbon credits, and corporate demand for them is increasing. Companies are pre-purchasing them to cover emissions many years out, so their value is increasing.

•   Diversification: Carbon credits may be a way to diversify a portfolio outside of standard stocks and bonds.

Cons

•   Potential risks: Certain carbon credit ETFs track carbon credit futures, which can be volatile and risky assets. Also, the carbon credit market is relatively new, so there is a limited amount of past performance data to refer to.

•   Narrow exposure: Carbon markets are limited to certain regions and are still a relatively small market, so investing in them doesn’t provide a lot of portfolio diversification.

•   Limited environmental impact: Cap-and-trade policies are designed to limit corporate emissions and reduce them over time, but they are also essentially permits to pollute. Rather than reducing emissions, companies can simply purchase more carbon credits. Therefore, the actual environmental benefit of investing in carbon credits is limited.

•   Not all carbon credits are the same: Some carbon credits are higher quality than others, and various factors go into determining their true value. It’s important to purchase through reputable ETFs or brokers to ensure the credits are legitimate and have value.

Risks, and What to Watch For When Trading Carbon Credits

Investing in carbon credits may potentially be profitable, but all commodities markets, including carbon markets, come with some risks investors should be aware of.

Carbon credit futures are speculative and can be very volatile, so ETFs that track them come with associated risks. Additionally, carbon credit ETFs only provide exposure to markets that have cap-and-trade programs, such as Europe and California. Therefore, they don’t provide investors with a broad exposure to carbon markets.

Also, carbon credit schemes are created by governments, and there is a risk at any time that a government could intervene and change the program or reduce the price by increasing the cap.

For this reason, carbon credit ETFs can be a good way to diversify one’s portfolio, but aren’t necessarily a place where investors should allocate a large portion of their money.

Steps to Start Investing in Carbon Credits

As an individual investor the way to invest in carbon credits is through ETFs and other pools. There are a few simple steps to start investing in carbon credits.

Step 1: Open a Trading Account

The first step is to open a brokerage account that offers ETFs. There are easy to use online trading platforms, such as SoFi Invest, where investors can buy ETFs, stocks, and other assets.

Step 2: Research and Decide on a Carbon Credit ETF

There are several different carbon credit ETFs to choose from. The next step is to research and choose one or more ETFs to invest in.

Step 3: Invest

The final step is to invest in the chosen carbon credit ETF using the trading account. Once the purchase has been made, the investor can track the ETF in the same way they would track any other stock or asset in their portfolio. Historically, carbon markets have shown volatility in the short term, but have increased over the long term, so investors should keep that in mind when deciding how long to hold onto their investment.

Is Carbon Credit Investing Right for You?

Investing in carbon credits may be a way to get involved in a growing market and support the transition to a low-carbon global economy. However, they do come with risks, and past performance is not a predictor of future performance.

If an investor is looking to diversify their portfolio, allocating a small amount to carbon credit ETFs may be one good option.

The Takeaway

Carbon markets are a large industry, and there are several ways for retail investors to get involved by investing in carbon credits. Carbon credits are generated by companies that are able to reduce their own greenhouse gas emissions over and above what the company itself may need.

This puts the carbon-credit-generating company in a position to sell their carbon credits for a profit, to the companies that need to offset their own emissions. This system has some pros and cons from an environmental perspective, as well as from an investing perspective.

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).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How do you make money with carbon credits?

Carbon credits increase in value when demand for them increases and supply decreases. As regulated emissions caps decrease, demand increases, as does price. Investors can make money with carbon credits by purchasing carbon credits and selling them when their market value increases.

How much does it cost to buy a carbon credit?

By investing in carbon credit ETFs, investors can gain exposure to carbon markets with a small amount of capital. The value of an individual credit fluctuates based on various market factors.

How much is an acre of carbon credits worth?

The market price for carbon credits ranges from under $1 to over $150. The per-acre rate that suppliers make depends on the type of land and project as well as the current carbon credit market rate.

Photo credit: iStock/Eva-Katalin

SoFi Invest®

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

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.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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.

Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q224-1911923-V1

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Jun
18
2024
Why-Portfolio-Diversification-Matters

Portfolio Diversification: What It Is and Why It’s Important

By | Growing Wealth, invest, Investing | No Comments

Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one class. The logic is that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk, and thereby, hopefully, improve returns.

Taking portfolio diversification to the next step — further differentiating the investments you have within asset classes (for example, holding small-, medium-, and large-cap stocks, or a variety of bonds) — may also be beneficial.

Building a diversified portfolio is only one of many financial tools that can help mitigate investment risk and improve performance. But there is a lot of research behind this strategy, so it’s a good idea to understand how it works and how it might benefit your financial plan.

What Is Portfolio Diversification?

Portfolio diversification refers to spreading a portfolio’s investments across asset classes, industries, sectors, geographies, and more, in an effort to reduce investment risk, as noted.

When you invest in stocks and other securities, you may be tempted to invest your money in a handful of sectors or companies where you feel comfortable. You might justify this approach because you’ve done your due diligence, and you feel confident about those sectors or companies. But rather than protecting your money, limiting your portfolio like this could make you more vulnerable to losses.

To understand this important aspect of portfolio management, it helps to know about the two main types of risk: Systemic risk, and unsystematic risk.

•   Systematic risk, or market risk, is caused by widespread events like inflation, geopolitical instability, interest rate changes, or even public health crises. You can’t manage systematic risk through diversification, though; it’s part of the investing landscape.

•   Unsystematic risk is unique or idiosyncratic to a particular company, industry, or place. Let’s say, for example, a CEO is implicated in a corruption scandal, sending their company’s stock plummeting; or extreme weather threatens a particular crop, putting a drag on prices in that sector. This is what may be referred to as unsystematic risk.

While investors may not be able to do much about systematic risk, portfolio diversification may help mitigate unsystematic risk. That’s because even if one investment is hit by a certain negative event, another holding could remain relatively stable. So while you might see a dip in part of your portfolio, other sectors can act as ballast to keep returns steady.

This is why diversification matters.

You can’t protect against the possibility of loss completely — after all, risk is inherent in investing. But building a portfolio that’s well diversified helps reduce your risk exposure because your money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

Get up to $1,000 in stock when you fund a new Active Invest account.*

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*Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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

What Should a Diversified Portfolio Look Like?

60:40 stock bond split returns 1977-2023

A fairly basic example of a relatively diversified portfolio may concern the 60-40 rule, which is a basic rule-of-thumb for asset allocation: You invest 60% of your portfolio in equities and 40% in fixed income and cash.

But that’s just one example. A portfolio can contain a broader mix of assets that includes stocks, bonds, alternative assets, real estate, and much more.

The mix you choose will likely be determined by factors such as your age, investment objectives, and/or risk tolerance. But this model reflects the basic principles of diversification: By investing part of your portfolio in equities and part in bonds/fixed income, you can manage some of the risk that can come with being invested in equities.

Stocks

You can fill your portfolio with stocks, and that would have some upsides and downsides. Most prominently, perhaps, is that stocks, compared to fixed-income assets, offer the potential for higher returns in exchange for higher risk.

If you’re invested 100% in equities, you’re more vulnerable to a market downturn that’s due to systematic risk, as well as shocks that come from unsystematic risk. By balancing your portfolio with bonds, say, which usually react differently than stocks to market volatility, you can offset part of that downside.

Of course, that also means that when the market goes up, you likely wouldn’t see the same gains as you would if your portfolio were 100% in equities.

Bonds

By the same token, if your portfolio is invested 100% in bonds offering a fixed rate of return, you might be shielded to a certain extent from market volatility and other risk factors associated with equities, but you likely wouldn’t get as much growth either.

Other Investments

As noted, you can also add other types of investments to the mix. While a typical portfolio may mostly comprise stocks and bonds, a smaller portion — maybe 10%-20%, just as an example — could hold real estate, or even cryptocurrencies. But again, there would ideally be a mixture of different types of those assets, too, in a diversified portfolio.

Again, a 60-40 portfolio is an example of simple diversification (sometimes called naive diversification) — which means investing in a range of asset classes. Proper diversification would have you go deeper, and invest in several different stocks (domestic, international, tech, health care, and so on), as well as an assortment of fixed income instruments.

Diversification Considerations for Different Stages

It’s also important to take your stage of life into account when considering how to diversify your portfolio and what asset allocation may be right for you.. Broadly speaking, the younger you are, the more risk you may be willing to take with your specific mix of investments (likely more stocks). While stocks may be more volatile and risky in the short-term, they tend to perform better than other lower-risk assets over the long-term.

The older you are, and the closer you are to retiring or needing to liquidate the equity in your portfolio, the less risk you may be willing to take.

Again, this will depend on the individual’s goals and risk tolerance, but consider the stage of your life and investing journey when deciding on your allocation and diversification strategy.

It may be a good idea to regularly review your allocation and change up your asset mix every few years, or work with a financial professional to make sure that your portfolio is aligned with your goals.

6 Ways to Diversify Your Portfolio

To attain a diversified portfolio, it’s important to think through your asset allocation, based on your available capital and risk tolerance. It’s also important to spread investments out within each asset class.

There can be a number of ways to diversify your portfolio, including (but not necessarily limited to) the following strategies.

Invest in a Range of Stocks or Index Funds

Diversifying a stock portfolio requires thinking about a number of factors, including quantity, sector, the risk profile of different companies, and so on.

•   Quantity. Instead of owning shares of just one company, a portfolio may have a margin of protection when it’s invested in many stocks (perhaps dozens or even hundreds).

•   Sector. You may want to think about a range of sectors, e.g. consumer goods, sustainable energy, agriculture, energy, and so on.

•   Variety. Variety is the spice of life, as they say, and variety in the types of stocks you are selecting is also an important factor. A mix of small-, mid-, and large-cap companies may offer diversification. Small-cap stocks, which might include startups, for example, have the potential to offer substantially higher returns than more stable large-cap companies, but they also come with greater risk.

You can further diversify by style. Some investors may opt for a mix of cyclical versus defensive companies, those closely tied to economic growth cycles versus ones that aren’t. Some investors may prefer value vs. growth stocks, companies that are underpriced rather than those that demonstrate faster revenue or earnings growth.

One common way to diversify a stock portfolio is to avoid picking individual stocks and invest instead in a mutual fund or exchange-traded fund (ETF) that offers exposure to dozens of companies or more. This is known as passive investing, as opposed to active. But it can be an effective way to diversify.

Invest in Fixed Income Assets, Such as Bonds

Investing in bonds is a good way to diversify your portfolio because they tend to perform very differently from stocks. Bonds offer a set interest rate, and though bond yields can be lower than the return on some stocks, you can generally predict the income you’ll get from bond investments.

Bonds tend to be less risky than stocks, but they aren’t risk free. They can be subject to default risk or call risk — and can also be subject to market volatility, especially when rates rise or fall. But bonds generally move in the opposite direction from stocks, and so can serve to counterbalance the risk associated with a stock portfolio.

You can diversify your mix of bonds, as well. High-yield bonds offer higher interest rates, but have a greater risk of default from the borrower. Short-term Treasury bonds, on the other hand, tend to be safer, but the return on investment isn’t as high.

You may also consider specific types of bonds, such as green bonds, which typically invest in sustainable organizations or municipal projects, or municipal bonds, which can offer tax benefits. And you can expand your options, and create more diversification, when you invest in bond mutual funds, or exchange-traded bond funds.

Consider Investing in Real Estate

Real estate may provide a hedge against inflation and tends to have a low correlation with stocks, so it can also provide diversification. The housing market and equity market can influence each other — case in point: the 2008 recession, when widespread troubles in real estate led to a stock market crash. But they don’t always have such a strong relationship. When stocks or bonds drop, real estate prices can take much longer to follow.

Conversely, when the markets improve, housing can take a while to catch up. Also, every real estate market is different. Location-specific factors that have nothing to do with the broader economy can cause prices to soar or plummet. Real estate can also be unpredictable and comes with risk, such as illiquidity and changing property values, which is something to keep in mind.

These are all factors to consider when investing in real estate. In addition, there are different types of investments, like Real Estate Investment Trusts (REITs), which can provide exposure to different types of properties without you having to own them.

Alternative Investments

While stocks, bonds, and cash equivalents are among the most common investments, you can diversify your portfolio by putting money into alternative investments, such as commodities, private credit, private equity, foreign currencies, and real estate, mentioned above. Alternatives can also include collectibles, such as art, wine, cars, or even non-fungible tokens (NFTs).

Alternatives have a low correlation with conventional assets, and have the potential to offer investors higher returns. Of course, knowing something about the area you want to invest in, or doing a bit of research, is likely a good idea before you get started.

However, alternative investments can be particularly risky compared to other types of assets. Their values may be particularly volatile and subject to a variety of factors, and it’s possible that some investors may even find themselves being targeted as a part of a scam — which is common, for instance, in the crypto space. Remember that though alternative investments may offer the opportunity to secure high returns, they can also subject investors to high potential losses.

Short-term Investments and Cash

Another possibility is to opt for low-risk short-term investments, such as certificates of deposit (CDs). A CD is a savings account that requires you to keep your funds locked up for a set amount of time (typically a few months to a few years). In exchange it pays you a fixed interest rate that may be higher than a traditional savings account.

A diversification strategy can also involve holding some funds in cash, just in case the bottom falls out on other investments.

International Investments

Another strategy for diversification is to invest in both U.S. and foreign stocks. Spreading out your investments geographically might protect you from market volatility concentrated in one area. When one region is in recession, you may still have holdings in places that are booming. Also, emerging and developed markets have different dynamics, so investing in both can potentially leave you with less overall risk.

Why Is Portfolio Diversification Important?

Diversification is important mainly because it can help investors mitigate risk. Although creating a well-diversified portfolio may help improve performance, risk minimization is the true end of diversification efforts.

Of course past performance is no guarantee that outcomes of those portfolio allocations will be the same in the future. But the research is interesting in that it suggests certain strategies might be effective in mitigating risk.

Introducing greater diversification, by way of bonds and fixed income instruments, actually may create a portfolio with similar returns, but lower volatility over time.

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Pros and Cons of Diversification

As with any investment strategy, diversification has its pros and cons.

Pros

The clearest benefit, or pro, to diversification is that it may help reduce risk in a portfolio. That can create a smoother ride, so to speak, for investors during times of high market volatility, and there is also evidence, as discussed, that diversified portfolios can provide equal or better returns over time.

Cons

The drawbacks to diversification include the fact that short-term gains may be limited by a more risk-averse approach. It can also take more time and energy to manage your portfolio, or to check in and consider your allocation — although that will depend on your specific strategy.

The Takeaway

Portfolio diversification is one of the key tenets of long-term investing. Instead of putting all your money into one investment or a single asset class like stocks or bonds, diversification spreads your money out across a range of securities. Investors should make sure they vary their investments in a way that matches their goals and tolerance for risk.

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).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is an example of a well-diversified portfolio?

An hypothetical example of a well-diversified portfolio could be one used by hedge fund founder Ray Dalio, who constructed an example portfolio that includes 30% stocks, 40% bonds, 15% U.S. bonds, 7.5% gold, and 7.5% other commodities. Again, this is just one example, and this particular mix is likely not ideal for many investors.

What are the dangers of over-diversifying your portfolio?

The main risk associated with over-diversification is that you stymie your portfolio’s potential gains while seeing diminishing returns in terms of risk mitigation. In other words, you cost yourself potential gains while not meaningfully reducing risk.

When should you diversify your portfolio?

It may be a good idea to diversify your portfolio as soon as you start investing. Further, you can repeatedly check your allocation at regular intervals, to ensure you’re properly diversified in accordance with your risk tolerance, age, and goals.

SoFi Invest®

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

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.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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.

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

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.

Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN-Q224-1905286-V1

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Jun
18
2024
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How to Negotiate Your Signing Bonus

By | Building Your Career, Growing Wealth, invest, Investing, Life & Career | No Comments

Although many people believe that the negotiation process ends once they have accepted a job offer, that’s often not the case. One of the most critical aspects of the negotiation process is negotiating your signing bonus. A signing bonus is a monetary incentive that an employer agrees to pay you. This bonus is meant to entice you to accept the job offer, and is typically negotiable.

It can be beneficial to know the nuances of negotiating a signing bonus to get the most out of your job hunt. If you are offered a signing bonus, be sure to negotiate it to get the most money possible. And even if your initial job offer doesn’t include a signing bonus, it might be worth asking for one.

Understanding Why Companies Offer a Hiring Bonus

Employers aren’t obligated to offer job candidates a hiring bonus, which is sometimes called a signing bonus or sign-on bonus. However, companies may choose to extend this one-time financial benefit to attract new talent, especially in a competitive hiring landscape.

This one-time signing bonus can help an employer close the gap between a candidate’s desired pay and what the company can offer. Additionally, the hiring bonus may compensate a new hire for any benefits the candidate might otherwise miss out on by changing jobs or forgoing other job offers.

Companies may also use a sign-on bonus to incentivize an employee to stay with a company for a certain period of time. If an employee quits within an agreed-upon time after accepting the position, they may be required to pay back the bonus.

💡 Recommended: What Is a Good Entry Level Salary?

How Signing Bonuses Work

If you’re being considered for a job, the hiring company can include a signing bonus as part of the job offer. You can then decide whether to accept the bonus and the position, attempt to negotiate for a larger sign-on bonus, or walk away from the offer altogether.

Should you accept the offer, the hiring bonus can be paid out to you as a lump sum or as employee stock options. If the company pays the bonus as a lump cash sum, they may pay it out with a first paycheck, or after a specified period, like 90 days.

Like any other bonuses, salary, or wages you receive, a signing bonus is taxable. So you’ll have to report that money on your tax return when you file. If the signing bonus is paid with regular pay, it’s taxed as ordinary income. If it isn’t, then the sign-on bonus is taxed as supplemental wages. For 2024, the supplemental wage tax rate is 22%, which increases to 37% if your bonus exceeds $1 million.

Additionally, bonuses, whether they’re paid when starting a new job or as a year-end bonus, may also be subject to Social Security and Medicare tax as well as state income tax. Employers withhold these taxes and pay them to the IRS for you. So when you get your bonus, you’re getting the net amount, less taxes withheld.

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

Average Signing Bonus

The average signing bonus can vary greatly depending on the company, position, and location. In general, signing bonuses may range from $10,000 to more than $50,000 for management and executive positions, while entry and mid-level position hiring bonuses are usually less than $10,000.

But again, there’s no guarantee that you’ll be offered a signing bonus, or that they’ll be pervasive in your given industry.

What Industries Offer the Highest Hiring Bonuses?

The industries that offer the highest hiring bonuses tend to be in the financial and technology sectors.

However, during competitive labor markets, signing bonuses may be offered in various industries that usually don’t offer a bonus. For instance, following the Covid-19 pandemic and subsequent labor shortage, industries like healthcare, warehousing, and food and beverage offered substantial hiring bonuses to attract potential employees.

💡 Recommended: The Highest-Paying Jobs in Every State

Pros & Cons of Signing Bonuses

Receiving a sign-on bonus could make a job offer more attractive. But before you sign on the dotted line, it’s helpful to consider the advantages and potential disadvantages of accepting a bonus.

Signing Bonus Pros

A signing bonus could help make up a salary shortfall. If you went into salary negotiations with one number in mind, but the company offered something different, a sign-on bonus could make the compensation package more attractive. While the bonus won’t carry on past your first year of employment, it could give you a nice initial bump in pay that might persuade you to accept the position.

You may be able to use a signing bonus as leverage in job negotiations. When multiple companies make job offers, you could use a signing bonus as a bargaining chip. For instance, if Company A represents your dream employer but Company B is offering a larger bonus, you might be able to use that to persuade Company A to match or beat their offer.

A sign-on bonus could make up for benefits package gaps. Things like sick pay, vacation pay, holiday pay, insurance, and a retirement plan can all enhance an employee benefits package. But if the company you’re interviewing with doesn’t offer as many benefits as you’re hoping to get, a large sign-on bonus could make those shortcomings easier to bear.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Signing Bonus Cons

Since sign bonuses are taxable as supplemental wages, you might see a temporary bump in your tax liability for the year. You may want to talk to a tax professional about how you could balance that out with 401(k) or IRA contributions, deductions for student loan interest payments, and other tax breaks.

Additionally, changing jobs might mean having to repay the bonus, depending on your contract. Employers can include a clause in your job offer that states if you leave the company within a specific time frame after hiring, you’d have to pay back your sign-on bonus. If you have to pay back a bonus and don’t have cash on hand to do so, that could lead to debt if you have to get a loan to cover the amount owed.

This might cause you to get stuck in a job you don’t love. If your employer requires you to pay back a signing bonus and six months into the job, you realize you hate it, you could be caught in a tough spot financially. Unless you have money to repay the bonus, you might have to tough it out with your employer a little longer until you can change jobs without any repayment obligation.

Get up to $1,000 in stock when you fund a new Active Invest account.*

Access stock trading, options, auto investing, IRAs, and more. Get started in just a few minutes.

*Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

Reasons to Negotiate a Signing Bonus

There are several reasons it can be beneficial to negotiate a signing bonus rather than just accept whatever the employer offers.

For one, a signing bonus can help offset the costs of relocating for a new job. Additionally, a signing bonus can help you maintain your current standard of living while you transition to a new city or state. Finally, a signing bonus can allow you to negotiate for other perks and benefits, such as a higher salary, stock options, or a more generous vacation policy.

When Is a Hiring Bonus Negotiated?

A hiring bonus is typically negotiated during the job offer stage after the employer has extended a job offer to the candidate. You don’t want to get ahead of yourself and ask for a hiring bonus immediately because that could hurt your chances of getting one. You generally want to wait for the hiring manager to start the conversation.

After receiving your official job offer with your projected salary and benefits, you will be able to gauge your potential bonus opportunity; one rule of thumb is that a hiring bonus is about 10% of your annual salary. And if the hiring manager offers you a bonus initially, you might have an advantage in negotiating for a better one.

Tips on How to Ask for a Signing Bonus

If an employer doesn’t offer a sign-on bonus, you don’t have to assume it’s off the table. It’s at least worth it to make the request since the worst that can happen is they say no.

Here are some tips on how to ask for a signing bonus:

1. Know Your Value to the Company

Before asking for more money, either with a bonus or your regular salary, get clear on what value you can bring to the company. In other words, be prepared to sell the company on why you deserve a signing bonus.

2. Choose a Specific Amount

Having a set number in mind when asking for a bonus can make negotiating easier. Do some research to learn what competitor companies are offering new hires with your skill set and experience. Then use those numbers to determine what size bonus it makes sense to ask for.

3. Make Your Case

Signing bonuses are gaining steam in industries such as technology, engineering, and nursing, where there is more competition for the best job candidates. You are also sometimes in a better position to ask for a signing bonus if the company did not meet the salary you requested when interviewing — a signing bonus is an opportunity to recoup some of that difference. Regardless, it never hurts to consider asking for more money.

Just be sure to do your research first. For instance, perhaps discreetly ask your contacts whether the company might be open to offering a signing bonus, and be sure to do some research online or within your network to see how your job offer stacks up.

4. Split the Difference With Your Salary

One way to potentially have your cake and eat it, too, when it comes to signing bonuses is to use your salary to offset it. Specifically, instead of asking for a large bonus, you could ask for a smaller one while also asking for a bump in pay.

An employer may be more open to paying you an additional $2,000 a year to keep you on the payroll, for instance, versus handing out a $20,000 bonus upfront when there’s no guarantee you might stick around after the first year.

5. Get it in Writing

If a signing bonus wasn’t part of your original job offer, and you’ve negotiated for one, ensure you receive an updated contract with the bonus included.

The agreement should spell out the amount of the bonus, how it will be paid (separate check or part of your regular paycheck), and the terms of the bonus. The contract should note how long you must stay employed at the company to retain your bonus (typically one year).

How to Maximize Your Signing Bonus

After receiving a signing bonus, the next question should be: What do I do with the extra money?

There are several ways you can put a signing bonus to work. For example, if you have credit card debt, your best move might be to pay that off. This could be especially helpful if you have credit cards with high-interest rates.

You could also use a sign-on bonus to eliminate some or all of your remaining student loan debt. But if you’d rather save your bonus, you might refinance your loans and use the bonus money to grow your emergency fund. Having three to six months’ worth of living expenses saved up could be helpful in case you lose your job or get hit with an unexpected bill.

Recommended: Don’t know how much to save for unexpected expenses? Try our intuitive emergency fund calculator.

You might also consider longer-term savings goals, such as buying a car or putting money down on a home. Keeping your money in a savings account that earns a high-interest rate can help you grow your money until you’re ready to use it.

Using Your Bonus for Retirement

If you are caught up with your credit card payments and already have an emergency fund, you might consider investing your bonus for the long-term.

This could be a wise financial move considering that a $5,000 signing bonus isn’t as lucrative as negotiating a $2,000 increase in your annual salary. If you can’t negotiate the higher salary, you can at least use your bonus to invest. Investing can be an excellent way to build wealth over time.

For example, you might use part of the money to open a traditional or Roth IRA. This can help you get a head start on saving for retirement and supplement any money you’re already saving in your employer’s 401(k). And you can also enjoy tax advantages by saving your bonus money in these accounts.

💡 Recommended: Should I Put My Bonus Into My 401(k)?

The Takeaway

There’s a lot to think about when you’re looking for a new job. You want to make sure you find a position you love that will compensate you fairly. So adding another step in the job search process may seem overwhelming. However, asking for and negotiating a signing bonus using the tips above is critical to help you get hired with the bonus you deserve.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.60% APY on SoFi Checking and Savings.

FAQ

What is a signing bonus?

A signing bonus, also known as a hiring bonus or a sign-on bonus, is a bonus given to employees when they are hired. A company will pay a signing bonus to help entice the employee to accept the job offer.

How can you negotiate your signing bonus?

To negotiate a signing bonus, you should be clear about what you are asking for, be reasonable in your request, and have a backup plan if your initial request is not met. It is also important to remember that the company you are negotiating with likely has a budget for signing bonuses, so be mindful of that when making your request.

What is the average signing bonus?

The average signing bonus depends on several factors, including the company, position, and location. In general, the average hiring bonus for managers and executives may range from $10,000 to more than $50,000. For lower-level employees, a signing bonus may be less than $10,000.

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.

*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.

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