Mar
17
2025

How Are Employee Stock Options and RSUs Different?

By | Building Your Career, Growing Wealth, invest, Investing | Comments Off on How Are Employee Stock Options and RSUs Different?

Employee stock options (ESOs) are different from restricted stock units (RSUs). They are both types of deferred compensation, and can be used as incentives, but employee stock options are similar to a call option. They give employees the option to buy company stock at a certain price, by a certain date. RSUs simply give an employee shares of stock on a given date.

Generally speaking there are specific terms the employee must meet in order to get either kind of stock. For example, an employee must work for the company for a year, and then obtain shares on a vesting schedule (i.e., shares become available over time, not all at once).

Sometimes, employees get a choice between ESOs and RSUs. Understanding how each stock plan works, how they differ — particularly when it comes to vesting schedules and taxes — can help you make a decision that best aligns with your financial goals.

Key Points

•   Employee stock options (ESOs) and restricted stock units (RSUs) are types of deferred compensation.

•   ESOs allow an employee to buy company stock at a set price, by a certain date, usually according to a vesting schedule.

•   If the employee chooses not to exercise their options to buy the shares, they expire.

•   RSUs give employees a certain number of shares of stock by a certain date.

•   Like ESOs, RSUs can vest gradually or all at once. Employees don’t have to buy RSUs; they own them on the date they’re given.

•   Depending on the type of stock options you get, you may owe income tax and/or capital gains tax if you sell your shares at a profit.

What Are Employee Stock Options (ESOs)?

Employee stock options (ESOs) give an employee the right to purchase their company’s stock at a set price — called the exercise, grant, or strike price — by a certain date, assuming certain terms are met, usually according to a vesting schedule. In this way, they are similar to call options (a type of derivative contract).

If the employee doesn’t exercise their options within that period, they expire.

Companies may offer stock options to employees as part of a compensation plan, in addition to salary, 401(k) matching funds, and other benefits. ESOs are considered an incentive to help the company succeed, so that (ideally) the stock options are worth more when the employee chooses to exercise them.

In an ideal scenario, exercising stock options allows an employee to purchase shares of their company’s stock at a price that’s lower than the current market price — and realize a profit.

Note that while some of the features of employee stock options are similar to trading stock options, these contracts aren’t exactly the same, and you can’t trade ESOs. Also, options are derivatives based on the value of underlying securities, e.g. stocks, bonds, ETFs — they aren’t a type of employee compensation.

How Do ESOs Work?

Generally, ESOs operate in four stages — starting with the grant date and ending with the exercise date, i.e. actually buying the stock.

1. The Grant Date

This is the official start date of an ESO contract. You receive information about how many shares you’ll be issued, the strike price (or exercise price) for those shares, the vesting schedule, and any requirements that must be met along the way.

2. The Cliff

If a compensation package includes ESOs, they’re generally not available on day one. Contracts often include requirements that must be met first, such as working full time for at least a year.

Those 12 months when you are not yet eligible to exercise your employee stock options is called the cliff. If you remain an employee past the cliff date, you get to level up to the vesting period.

Some companies include a 12-month cliff to incentivize employees to stay at least a year. Other companies may have a vesting schedule.

3. The Vest

The vesting period is when you start to take ownership of your options and the right to exercise them. Vesting can either happen all at once or take place after a cliff (as noted above), or gradually over several years, depending on your company’s plan.

One common vesting schedule is a one-year cliff followed by a four-year vest. On this timeline, you’re 0% vested the first year (meaning you aren’t eligible for any options), 25% vested at the two-year mark (you can exercise up to 25% of the total options granted), and so on until you own 100% of your options. At that point, you’re considered fully vested.

4. The Exercise

This is when you pull the financial trigger and actually purchase some or all of your vested shares.

ESO’s Expiration Date

While the expiration date of stock options isn’t always front and center, it’s important to bear in mind. The strike price you’re given as part of your options package expires on a certain date if you don’t exercise your shares.

One common timeline is 10 years from grant date to expiration date, but specific terms will be in the contract, and it’s important to vet the timing of your ESOs — as part of your career as well as your tax and your long-term financial plan. Again, if you let your stock options expire, you lose the right to buy shares at that price.

Pros and Cons of Employee Stock Options (ESOs)

If you land a job with the right company and stay until you’re fully vested, exercising your employee stock options could potentially lead to gains.

For example, if your strike price is $30 per share, and at the time of vesting the stock is trading at $100 or more per share, you’re getting a great deal on shares.

On the other hand, if your strike price is $30 per share and the company is trading at $10 per share, you might be better off not exercising your employee stock options until the price goes up (when and if it does; there are no guarantees).

That’s why ESOs are considered a form of employee incentive: You may work harder to help the company grow, if you know your efforts could translate to a higher stock price.

Recommended: Stock Market Basics

Tax Implications of Employee Stock Options

Given that stock options can generate gains, it’s important to know how they are taxed so you can plan accordingly.

Generally speaking, employers offer two types of stock options: nonqualified stock options (NSOs or NQSOs) and incentive stock options (ISOs).

Nonqualified Stock Options

NSOs are the most common and often the type offered to the general workforce. NSOs have a less favorable tax treatment, because they’re subject to ordinary income tax on the difference between the exercise price and the market price at the time you exercise your options and purchase the stock, assuming the market price is higher.

NSOs are then taxed again at the capital gains rate when you sell the shares at a profit.

Your individual circumstances, tax filing status, and the terms of your stock options may also play into how you’re taxed, so you may want to consult a professional.

Incentive Stock Options

ISOs are “qualified,” meaning you don’t pay any taxes when you exercise the options — unless you’re subject to the alternative minimum tax (AMT).

You will owe taxes, however, if you sell them at a profit later on. (If you don’t sell, and if the stocks gain or lose value, those are considered unrealized gains and losses.) Any money you make when you sell your shares later would be subject to capital gains tax. If you hold your shares less than a year, the short-term capital gains tax rate equals your ordinary income tax rate, which could be up to 37% for the highest tax bracket.

If you hold your shares less than a year, the short-term capital gains tax rate equals your ordinary income tax rate, which could be up to 37% for the highest tax bracket.
For assets held longer than a year, the long-term rate is lower: 0%, 15%, or 20%, depending on your taxable income and filing status.

What Are Restricted Stock Units (RSUs)?

Restricted stock units, or RSUs, simply grant employees a certain number of shares stock by a certain date. When employees are granted RSUs, the company holds onto the shares until they’re fully vested.

The company determines the vesting criteria — it can be a time period of several years, a key revenue milestone, and/or personal performance goals. Like ESOs, RSUs can vest gradually or all at once. When the employee gets their shares, they own them outright; employees don’t have to buy RSUs.

How Do Restricted Stock Units (RSUs) Work?

RSUs are priced based on the fair market value of the stock on the day they vest, or the settlement date. The company stocks you receive from your company will be worth just as much as they would be if you purchased them on your own that same day.

If the stock is worth $40 per share, and you have 100 shares, you would get $4,000 worth of shares (assuming you’re fully vested and have met other terms).

Again, the main difference between employee stock options and restricted stock units is that you don’t have to purchase RSUs.

As long as the company’s common stock holds value, so do your RSUs. Upon vesting, you can either keep your RSUs in the form of actual shares, or sell them immediately to take the cash equivalent. Either way, the RSUs you receive will be taxed as income.

And, of course, if you later sell your shares you may realize a gain or a loss and there will be tax implications accordingly.

Pros and Cons of Restricted Stock Units (RSUs)

One good thing about RSUs, similar to ESOs, is the incentive to stay with the company for a longer period of time. If your company grows during your vesting period, you could see a substantial windfall when your settlement date rolls around.

But even if the stock falls to a penny per share, the shares are still awarded to you on your settlement date. Since you don’t have to pay for them, it’s still money in your pocket.

In fact, you may only lose out on money with RSUs if you leave the company and have to forfeit any units that aren’t already vested, or if the company goes out of business.

Tax Implications of RSUs

When your RSU shares or cash equivalent are automatically delivered to you on your settlement date(s), they’re considered ordinary income and are taxed accordingly. In fact, your RSU distributions are actually added to your W-2 form.

For some people, the additional RSU income may bump them up a tax bracket (or two). In those cases, if you’ve been withholding at a lower tax bracket before your vesting period, you could owe the IRS more money.

As with ESOs, if you sell your shares at a later date and make a profit, you’ll be subject to capital gains taxes.

ESOs RSUs
Definition An employee can buy company stock at a set price at a certain date in the future. An employee receives stock at a date in the future and does not have to purchase them
Pricing The strike price is set when ESOs are offered to an employee, and they pay that price when they exercise their shares. The share price is based on the fair market value of the stock on the day the shares vest, and employees get the full-value shares.
Tax implications The difference between the strike price and the stock’s market value on exercise is considered earned income and added to your W-2, where it’s taxed as income. If you sell your shares later at a profit, you may also be subject to capital gains tax. RSU shares (or cash equivalent) are considered ordinary income as soon as they are vested, and are taxed accordingly.

If you sell the shares later, capital gains tax rules would apply.

The Takeaway

Employee stock options (ESOs) and restricted stock units (RSUs) are two different types of equity or share-based compensation.

An employee stock option gives an employee the option to buy company stock at a certain price, by a certain date. An RSU is the promise that on a future date the employee will receive actual company stock (without having to purchase the shares).

Because these types of compensation are often considered incentives, they’re designed to encourage employees to stay with the company for a certain amount of time. As such, employees often don’t get their options (in the case of ESOs) or the actual shares (in the case of RSUs) until certain terms are met. There may be a vesting schedule or company benchmarks or other terms.

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SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
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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.

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.
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.

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.

SOIN-Q125-051

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Mar
17
2025

Tips for Buying a Foreclosed Home in 2024

By | Home Ownership, mortgage | Comments Off on Tips for Buying a Foreclosed Home in 2024

Who doesn’t dream of nabbing a really good deal when shopping for a home? Maybe you’re even considering a fixer-upper, a property that would allow for some sweat equity and would, over time and with work, help you grow your wealth.

If you have been studying the real estate listings, you have probably seen some potentially excellent deals on repossessed or bank-owned properties.

While the prices may look enticingly low, when it comes to how to buy a foreclosed house, you may be in for a lot of research, a long timeline, and financing issues.

Key Points

•   Know the options for purchasing foreclosed homes, including pre-forclosures, bank or real-estate-owned (REO) properties, auctions, and direct sales.

•   Consider hiring an experienced real estate agent who specializes in foreclosures to guide you through the process.

•   Peruse free or fee-based websites to find foreclosed properties for sale.

•   Get preapproved for a mortgage, which will help you to understand your borrowing limits and compete with cash buyers.

•   Before you purchase, obtain a home inspection and appraisal to assess needed repairs and negotiate the best price.

What Is a Foreclosed House?

A foreclosed house is a home that a mortgage lender owns. Homebuyers agree to a voluntary mortgage lien when they borrow funds. If they don’t keep current with their payments and end up defaulting, the lender can take control of the property.

When the lender does so, the house is called a “foreclosed home” and can be offered for sale. Read on to learn more about the foreclosure process.

What Does ‘Foreclosure’ Mean?

A foreclosure is a home a lender or lienholder has taken from a borrower who has not made payments for a period of time. The lender or lienholder hopes to sell the property for close to what is owed on the mortgage.

Who can place a lien on a home? A mortgage lender or the IRS can. So too can the U.S. Department of Housing and Urban Development (aka HUD) for nonpayment of an FHA loan, resulting in HUD homes for sale.

A county (for nonpayment of property taxes), an HOA, or a contractor also can place a lien on a home.

Recommended: Foreclosure Rates for All 50 States

Types of Home Foreclosures

There are three main types of home foreclosures:

•   Judicial foreclosures: This type of foreclosure occurs when the lender files suit (that is, in court, hence the word “judicial”) to begin the foreclosure process. This usually happens when the borrower fails to pay three consecutive payments. If the loan isn’t brought up to date within 30 days of that point, the home can be auctioned off by a sheriff’s office or the court.

•   Nonjudicial foreclosures: Known as a power of sale or a statutory foreclosure, this process may currently take place in 32 out of the 50 states. The contract in this situation allows for an auction of a foreclosed property to occur without the judicial system becoming involved, as long as certain notifications and waiting periods are appropriately observed.

•   Strict foreclosures: This kind of foreclosure only occurs in Connecticut and Vermont, and usually these only happen when the value of the loan debt is more than that of the house itself. If the defaulting borrower doesn’t become current with their loan in a certain amount of time, the lender gets possession of the property directly but is not obliged to sell.

How Does the Foreclosure Process Work?

Foreclosure processes differ by state. The main difference is whether the state generally uses a judicial or nonjudicial foreclosure process. A judicial foreclosure may require an order from a judge.

•   Once a borrower has missed three to six months of payments, depending on state law, the lender will post a public notice, sometimes known as a notice of default or “lis pendens,” which means pending suit.

•   A borrower then typically has 30 to 120 days to attempt to avoid foreclosure. During pre-foreclosure, a homeowner may apply for a loan modification, ask for a deed in lieu of foreclosure, pay the amount owed, or attempt a short sale.

   A short sale is when the borrower sells the property and the net proceeds are short of the amount owed on the mortgage. A short sale needs to be approved by the lender.

•   If none of the options work, the lender might sell the foreclosed property at auction — a trustee or sheriff’s sale. Notice of the auction must be given at the county recorder and in the newspaper.

•   If no one buys the home at auction, it becomes a bank or real estate-owned (REO) property. These properties are sold in the traditional real estate market or in bulk to investors at liquidation auctions.

•   In some states under the judicial foreclosure process, borrowers may have the right to redeem their property after the sale by paying the foreclosure sale price or the full amount owed to the lender, plus other allowable charges.

Recommended: Home Affordability Calculator

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with as little as 3% down.

Questions? Call (888)-541-0398.

How to Find Foreclosed Homes for Sale

In addition to checking with local real estate companies for foreclosed homes, there are paid and free sites to search when you are shopping for a repossessed or foreclosed home.

Among the free:

•   Equator.com

•   HomePath.fanniemae.com (Fannie Mae’s site)

•   HomeSteps.com (Freddie Mac’s site)

•   Realtor.com

•   foreclosures.bankofamerica.com

•   treasury.gov/auctions/irs/cat_All%2066.htm for IRS auctions

•   properties.sc.egov.usda.gov/ for USDA resales

•   hudhomestore.gov (the official government website for foreclosed homes)

Paid sites include foreclosure.com and RealtyTrac.com, among others.

Note: SoFi does not offer USDA loans at this time. However, SoFi does offer FHA, VA, and conventional loan options.

How to Buy a Foreclosed Home

Here are the usual steps for buying a foreclosed house. Whether you qualify as a first-time homebuyer or someone who has purchased before, it can be wise to acquaint yourself with the process before searching for a home.

Step 1: Know the Options

Buying foreclosed houses at an auction or through a lender are the main ways to purchase these homes. Keep in mind that a foreclosure is usually an “as-is” deal.

Buying at Auction: In almost all cases, bidders in a live foreclosure auction must register and show that they have sufficient funds to pay for the property in full.

Online auctions have gained popularity. You can sign up with a site to find foreclosure auctions in an area where you want to buy. Or you might research foreclosure sales data by county online, at the county courthouse, or from the trustee (the third-party foreclosure sales agent).

It’s important to look into how much the borrower owes and whether there are any liens against the property. The winning bidder may have to pay off liens. It’s smart to hire a title company or real estate attorney to provide title reports on properties you’re interested in bidding on.

Buying From the Lender: You can find listings on websites that aggregate REO properties or on a multiple listing service. When checking out the homes you like, take note of the real estate agent’s name. Banks usually outsource the job of selling foreclosed homes to REO agents, who work with standard real estate agents to find a buyer.

REO listings are often priced at or below market value. Also good to know: The lender usually clears the title and evicts the occupants before anyone buys a foreclosed home.

Looking at Opportunities Before Foreclosure: If the lender allows a short sale, potential buyers work with the borrower’s real estate agent and the lender to find a suitable price.

With pre-foreclosures, when borrowers have missed three or more mortgage payments but still own the home, the lender might work with them to avoid foreclosure. Another scenario: The homeowner might entertain purchase offers, whether the home is listed or not.

Step 2: Hire a Real Estate Agent

It’s a good idea not to go with just any agent, even if you like them and have used their services for a standard home purchase, but to find an agent who specializes in foreclosure sales.

That agent can help you search for a home, understand the buying process, negotiate a price, and order an inspection. Your offers might be countered as well, and an agent can help you figure out the best next step.
An agent can also help you understand the market in general and ways to smooth your path to homeownership, such as programs for first-time homebuyers.

Step 3: Find Foreclosures for Sale

As mentioned above, there are paid and free sites where one can scan for homes. Some divisions of the government offer foreclosed homes, as do some lenders.

Also, there are real-estate companies that specialize in these properties and can help you with your search.

Step 4: Get Preapproved for a Mortgage

If you want to act fast on buying a foreclosed home, you’ll want to get preapproved for a mortgage. Preapproval tells you how much money you are eligible to borrow and lays out the terms of final approval on a mortgage in a preapproval letter.

Preapproval may help you compete with the all-cash buyers who are purchasing foreclosures. Bonus: As you move through this step, you are also likely to learn important home buying and financing concepts, like loan-to-value (LTV) ratio.

(If you are looking into repossessed properties, owner financing, or a purchase-money mortgage, will not be an option.)

Step 5: Get an Appraisal and Inspection

Buyers of REO properties would be smart to order a home inspection. A thorough check-up can document flaws and help you tally home repair costs.

An REO property appraisal usually consists of an as-repaired valuation — the market value if the property is repaired, compared with comps — and an as-is valuation. Some lenders also ask for a quick-sale value and a fair market value.

You can challenge the results of an appraisal if you think the figures are off, and you can hire another appraiser for an independent assessment.

Step 6: Purchase Your New Home

If you decide to move forward, contact your mortgage lender to finalize your loan. Submit your offer with the help of your real estate agent. If your offer is accepted, you will sign a contract and transfer ownership. You may be required to pay an earnest money deposit.

The certificate of title may take days to complete. During that time, the original borrower may, in some states, be able to file an objection to the sale and pay the amount owed to retain their rights to the property. This is called redeeming or repurchasing a home, but it rarely happens. Nevertheless, it’s a good idea to not dig in and start any work on the property until you receive the certificate of title.

Recommended: What’s the Difference Between Preapproved vs Prequalified?

Benefits of Buying a Foreclosed Home

Buying a foreclosed home can be a great deal for a buyer who sees the potential, is either handy or budgets realistically for repairs, and knows the fixed-up value. Some points to consider:

•   Not all foreclosed properties are in poor shape, as you might expect. If a homeowner dies or has a reverse mortgage that ends, a home that was well maintained may be returned to the lender.

•   REO properties rarely have title discrepancies. The repossessing lender has extinguished any liens against the property and ensured that taxes were paid.

•   It can be possible to negotiate when buying REO properties. You could ask the lender to pay for a termite inspection, the appraisal, or even the upgrades needed to bring the property up to code.

Risks of Buying a Foreclosed Home

Buying a foreclosed home can be complicated. The process is governed by state and federal laws. Take note of these possible downsides:

•   Some foreclosed homes have indeed been sitting empty and may have maintenance/repair issues, necessitating that you have cash available to get the work done.

•   Because many REO properties have sat vacant and most are sold as-is, financing can be a challenge. See below for more details.

•   Many people, especially first-time home buyers, think foreclosures are offered at a deep discount, but even low-priced homes might get multiple offers above the asking price from buyers eager to snap up a fixer-upper. You might find yourself tempted to pay more than you had expected just to close the deal.

What Are Financing Options for Foreclosed Homes

When it comes to financing the purchase of a foreclosed property, here’s what you need to know:

•   Some sales may be cash-only. If you don’t have access to the amount needed, it’s smart to sidestep looking at these kinds of auctions.

•   If the home is in livable condition, you may be able to get a conventional or government-back mortgage loan.

If you are planning to finance the purchase of a repossessed home, consider this:

•   Fannie Mae dictates that for a conventional conforming loan, the home must be “safe, sound, and structurally secure.”

•   For an FHA, VA, or USDA loan, the home must be owner occupied (that is, not a multi-family home where you will rent out all units) and in livable condition, with a functional roof, foundation, and plumbing, electrical, and HVAC systems, and no peeling paint.

•   A standard FHA 203(k) loan includes the purchase of a primary house and substantial repairs costing up to the county loan limit. But relatively few lenders offer these loans. Also, the application process is more labor-intensive, and contractors must submit bids and complete paperwork. Mortgage rates are somewhat higher than for standard FHA loans.

Who Should Buy a Foreclosed Home

Buying a foreclosed home is usually best for people who are prepared for a lengthy and potentially expensive process to buy a home at a good price.

•   You will need to do considerable research to find available homes and know how to make an offer.

•   You will likely face a significant amount of paperwork and time delays.

•   Having cash reserves to pay for repairs and deferred maintenance issues is important, as well as dealing with unpaid taxes and liens on the property.

Who Should Not Buy a Foreclosed Home

A foreclosed home may not be the right move for someone who is under time pressure to move into a new home.
It can also be a problematic process for those who don’t have a good amount of cash set aside to pay for rehabilitating a property that has been sitting empty or to take care of overdue tax bills and liens.

The Takeaway

Buying a foreclosed home requires vision, risk tolerance, and realistic number crunching. If you need financing, it’s a good idea to get preapproved for a mortgage so that all your ducks are in a row when you spot a potential deal.

If you’re shopping for a mortgage, consider what SoFi offers. Our home mortgage loans have competitive, flexible options, and down payments as low as 3% for first-time borrowers or as low as 5% for all other borrowers.

Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.

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FAQ

What are the disadvantages of buying a foreclosed home?

Disadvantages of buying a foreclosed home can include the amount of research involved, the considerable amount of paperwork and potential delays, and the cash often required to make repairs, pay back taxes, and remedy liens.

How are repossessed houses sold?

Foreclosed homes are often sold at auction, by a lender, or by a real estate company (often ones that specialize in such repossessed properties).

How long does it take for a repossessed house to be sold?

Depending on the state and the specific property, the sale of a foreclosed house may take anywhere from a few months to a few years.

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

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.

SOHL-Q125-046

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Mar
16
2025

What Is an Annuity and How Does It Work?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is an Annuity and How Does It Work?

An annuity is a contract with an insurance company where the buyer typically pays a lump sum premium to purchase the annuity, with the promise of a steady stream of income when they retire.

That said, annuity terms and conditions vary widely. In some cases, the individual might pay premiums over time in order to purchase the annuity. Some annuities make fixed payments; some are variable. Some annuities also offer an investment component.

Annuities come with a number of pros and cons. The upside is the potential for guaranteed lifetime income. The downside is that these contracts can be immensely complex, and often come with hidden fees and terms.

Key Points

•   Annuities are a type of insurance contract that investors can purchase with a lump sum premium, or with a series of premium payments.

•   In exchange for this cash investment, annuities are designed to provide retirees with guaranteed income for a period of time, or for a person’s lifetime.

•   Annuity features vary widely, and it’s important to understand the terms governing payouts, payout periods, death benefit, and more.

•   The addition of certain conditions, like inflation protection, can add to the cost of an annuity, so it’s important to know what you’re paying for.

How Does an Annuity Work?

When purchasing an annuity, the account holder begins making premium payments, either over time or as a lump sum. The years of paying into an annuity are known as the accumulation phase. Sometimes, the payments can be made from an IRA or 401(k).

The money paid into the annuity account may be invested into the stock market or mutual funds, or it might earn a fixed interest rate over time.

Money paid into the annuity typically can’t be withdrawn for a certain amount of time, called the surrender period.

After the accumulation phase is over, the company begins making regular income payments to the annuity owner. This is known as the distribution phase, or amortization period, when the annuitant (the annuity holder) can withdraw funds from the annuity.

The annuitant can choose the length and start date of the distribution phase. For example, you might choose to receive payments for 10 years, or perhaps you prefer guaranteed payments for the rest of your life. Terms and fees depend on the structure of the distribution phase.

In many cases, withdrawals can only begin after the surrender period, and when the annuity holder is at least 59 ½. Before age 59 ½ the withdrawal would be considered an early withdrawal, and subject to a penalty (in addition to taxes).

Types of Annuities

The main annuity categories are fixed, variable, and indexed, but within those types there are various options and subcategories. The most important thing to remember about these contracts is that the terms and conditions vary widely; be sure to ask questions and fully understand what you’re buying.

Fixed Annuities

The principal paid into a fixed annuity earns a fixed amount of interest, usually around 5%. Although the interest is typically not as high as the returns one might get from investing in the stock market, this type of annuity provides predictable and guaranteed payments.

Variable Annuities

This type of annuity lets buyers invest in different types of securities, usually mutual funds that hold stocks and bonds. Although this can result in a higher payout if the securities do well, it also comes with the risk of losing money. Some variable annuities do come with a guarantee that investors will at least get back the money they put in.

Indexed Annuities

An indexed annuity is pegged to a particular index, such as the S&P 500 stock market index. How the index performs will determine how much the annuity pays out. Usually, indexed annuities cap earnings in order to ensure that investors don’t lose money.

For example, they might cap annual earnings at 6% even if the index performed better than that. But then in a bad year, they would pay out 0% earnings rather than taking a loss, and investors would still receive their base payment amount.

Immediate Annuities

With immediate annuities, investors begin receiving regular payments within a year of purchasing the annuity, depending on the terms of the surrender period. Immediate annuities can be expensive, but they offer retirees a way to plan for a more immediate income stream.

Deferred-Income Annuities

This type of annuity, also called a longevity annuity, is for people who are concerned they might outlive their retirement savings. Investors must wait until around age 80 to begin receiving payments, but they are guaranteed payments until they die.

The monthly payouts for deferred-income annuities can be higher than for immediate annuities, but risk is involved. If the investor dies before starting to receive payments, heirs may not receive the money in the annuity account.

Married couples might opt for a joint-life version, which has lower monthly payouts but continues payments for as long as either spouse lives.

Equity-Indexed Annuities

Equity-indexed annuities offer a combination income strategy. Investors receive a fixed minimum amount of income, in addition to a variable amount that’s pegged to a market index. These products provide some guaranteed income, and thus a certain protection against downside risk, but can be expensive.

Fixed-Period Annuities

Fixed period annuities allow buyers to receive payments for a specific number of years.

Retirement Annuities

With retirement annuities, investors pay into the account while still working. Once they retire, they begin receiving payments.

Direct-Sold Annuities

These annuities have no sales commission or surrender charge, making them less expensive than other types of annuities.

Pros of Annuities

There are several reasons people choose to pay into annuities as part of their retirement plan. The upsides of annuities include:

•   Guaranteed and predictable payments: Depending on the annuity, a guaranteed minimum income benefit (GMIB) can be set for a specific number of years or for the buyer’s lifetime. Payments may even be made to a buyer’s spouse or other beneficiary in case of death.

•   Tax-deferred growth: Interest earned on annuity deposits is not taxed immediately. Annuity owners generally don’t pay taxes on their principal investment; they pay income taxes on the earnings portion in the year they receive payments, similar to withdrawals from a 401(k) or IRA.

•   Low involvement: Once the annuity is purchased, the annuity company uses an annuity formula to figure out how much each payment should be and to keep track of account balances. All the investor has to do is pay into the account during the accumulation phase.

•   No investment limits or required minimum distributions: Unlike an IRA or 401(k), there is no limit to the amount of money that can be invested into an annuity. Further, there is no specific age at which investors must begin taking payments (i.e., no required minimum distributions).

•   Option to bolster other retirement savings: For those closer to retirement, an annuity may be a good option if they’ve maxed out their other retirement savings options and are concerned about having enough money for living expenses.

Cons of Annuities

Like any type of investment, annuities come with downsides:

•   Lower potential returns: The interest earned by annuities is generally lower compared to what investors would earn in the stock market or bonds.

•   Penalty for early withdrawals: Once money is invested in an annuity, there can be restrictions on withdrawals. For example, an early withdrawal before age 59 ½ might incur taxes/penalties. Be sure to understand the withdrawal terms of the annuity you own, as well as state regulations.

•   Fees: Annuities can have fees of 3% or more each year. There may also be administrative fees, and fees if the investor wants to change the terms of the contract. It’s important before buying an annuity to know the fees included and to compare the costs with other types of retirement accounts.

•   Death benefit terms: If investors die before they start receiving payments, they miss out on that income. Some annuities include a death benefit (where money invested in the annuity is passed to a beneficiary), but others do not. There may be a fee for passing the money on.

•   Potential to lose savings in certain circumstances: If the insurance company that sold the annuity goes out of business, the investor will most likely lose their savings. It’s important for investors to research the issuer and make sure it is credible.

•   You pay for inflation adjustments: Annuity payments usually don’t account for inflation, but it’s possible to pay for an inflation adjustment for your payouts.

•   Risk: Variable annuities in particular are risky. Buyers could lose a significant amount, or even all of the money they put into them.

•   Complexity: With so many choices, buying annuities can be confusing. The contracts can be dozens of pages long, requiring close scrutiny before purchasing.

What Are Annuity Riders?

When investors buy an annuity, there are extra benefits, called riders, that they can purchase for an additional fee. Optional riders include:

•   Lifetime income rider: With this rider, buyers are guaranteed to keep getting monthly payments even if their annuity account balance runs out. Some choose to buy this rider with variable annuities because there’s a chance that investments won’t grow a significant amount and they’ll run out of money before they die.

•   COLA rider: As mentioned above, annuities don’t usually account for inflation and increased costs of living. With this rider, payouts start lower and then increase over time to keep up with rising costs.

•   Impaired risk rider: Annuity owners receive higher payments if they become seriously ill, since the illness may shorten their lifespan.

•   Death benefit rider: An annuity owner’s heirs receive any remaining money from the account after the owner’s death.

How to Buy Annuities

Annuities can be purchased from insurance companies, banks, brokerage firms, and mutual fund companies. As mentioned, it’s important to look into the seller’s history and credibility, as annuities are a long-term contract.

The buyer can find all information about the annuity, terms, and fees in the annuity contract. If there are investment options, they will be explained in a mutual fund prospectus.

Some of the fees to be aware of when investing in annuities include:

•   Rider fees: If you choose to buy one of the benefits listed above, there will be extra fees.

•   Administrative fees: There may be one-time or ongoing fees associated with an annuity account. The fees may be automatically deducted from the account, so contract holders don’t notice them, but it’s important to know what they are before sealing the deal.

•   Surrender charges: An annuity owner who wants to withdraw money from an account before the date specified in the contract will face a surrender charge.

•   Penalties: Owners who want to withdraw money before age 59 ½ will be charged a 10% penalty by the IRS (in addition to the usual income tax due on the income from the annuity).

•   Mortality and expense risk charge: Generally annuity account holders are charged about 1.25% per year for the risk that the insurance company is taking on by agreeing to the annuity contract.

•   Fund expenses: If there are additional fees associated with mutual fund investments, annuity owners will have to pay these as well.

•   Commissions: Insurance agents are paid a commission when they sell an annuity. Commissions may be up to 10%.

The Takeaway

No matter what stage of life you’re in, it’s not too early or too late to build an investment portfolio. Younger investors may not be ready to buy into an annuity, but they can still start saving for retirement. For those who are considering an annuity as a retirement investment, it’s important to weigh both the pros and cons — as well as the opportunity cost of putting money into an annuity versus other investments.

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

Easily manage your retirement savings with a SoFi IRA.

🛈 SoFi does not offer annuities to its members, though SoFi Invest offers investments that may provide income through dividends.

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 https://sofi.app.link/investchat. 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.
Mutual Funds (MFs): 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 clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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.

SOIN-Q125-047

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Mar
14
2025
What Are Securities in Finance? How Security Trading Works

What Are Securities in Finance? How Securities Trading Works

By | Growing Wealth, invest, Investing | Comments Off on What Are Securities in Finance? How Securities Trading Works

Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.

A security can refer to a number of different types of assets, including stocks, bonds, Treasury notes, derivatives, and more. Securities are fungible and can be traded via public as well as private markets.

The three main types of securities, broadly speaking, include: equity securities, where the investor owns a share in an organization; debt securities, where the investor loans capital and earns interest, and derivatives, which are contracts based on the value of an underlying asset.

Securities trading is regulated by the Securities and Exchange Commission, or SEC.

Key Points

•   Securities is a broad term that refers to tradable financial instruments, including stocks, bonds, and derivatives.

•   Equity securities represent ownership in a company, while debt securities (bonds) function as loans, where borrowers pay interest to lenders.

•   Derivatives, such as futures and options, are higher-risk investments linked to underlying assets. These appeal mainly to experienced investors due to their complexity.

•   Trading securities typically occurs on regulated exchanges, with investors using brokerage or retirement accounts to engage in buying and selling activities.

What is a Security?

A security is a tradable type of investment that traders can buy and sell on financial exchanges or other platforms, whether investing online or through a traditional brokerage. Securities have monetary value; buyers and sellers determine their value when trading them.

Securities include different types of asset classes. In general, investors earn money by buying securities at a low price and selling them at a higher one, but there are a range of investing strategies that can include profiting when the price of a security drops, as well as other means.

Here are some common security categories.

Equity Securities

These include stocks and stock mutual funds. Typically traded on exchanges, the price of equity securities rise or fall depending on the economy, the performance of the underlying company that offers the stock (or the companies in the fund), and the sector in which that company or fund operates.

Individual stocks may also pay dividends to investors who own them.

Debt Securities

This group includes bonds and other fixed-income vehicles, where lenders borrow money from investors and pay interest via periodic payments on the investment principal (also called the yield).

Investors can buy bonds from a variety of bond issuers, including: states, local and municipal governments, companies, and banks and other financial institutions. Typically, debt securities pay investors a specific interest rate paid usually twice per year until a maturity date, when the bond expires.

Some common debt securities include:

•   Treasury bills. Issued by the U.S. government, T-Bills are considered among the safest securities.

•   Corporate bonds. These are bonds issued by companies to raise money without going to the equity markets.

•   Bond funds. These types of mutual funds allow investors to get exposure to the bond market without buying individual bonds.

Derivatives

This group of securities includes higher-risk investments like options trading and futures which offer investors a higher rate of return but at a higher level of risk.

Derivatives are based on underlying assets, and it’s the performance of those assets that drive derivative security investment returns.

For example, an investor can buy a call option based on 100 shares of ABC stock, at a specific price and at a specific time before the option contract expires. If ABC stock declines during that contract period, the call option buyer has the right to buy the stock at a reduced rate, thus locking in gains when the stock price rises again.

Derivatives allow investors to place higher-risk bets on stocks, bonds, and commodities like oil or gold, and currencies. Typically, institutional investors, such as pension funds or hedge funds, are more active in the derivative market than individual investors.

Hybrid Securities

A hybrid security combines two or more distinct investment securities into one security. For example, a convertible bond is a debt security, due to its fixed income component, but also has characteristics of a stock, since it’s convertible.

Hybrid securities sometimes act like debt securities, as when they provide investors with a floating or fixed rate of return, as bonds normally do. Hybrid securities, however, may also pay dividends like stocks and offer unique tax advantages of both stocks and bonds.

How Security Trading Works

Securities often trade on public exchanges where investors can buy or sell securities with the goal of making a financial profit.

Stocks, for example, are listed on global stock exchanges and investors can purchase them during market trading hours. Exchanges are highly regulated and expected to comply with strict fair-trading mandates. For example, U.S.-based stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq must adhere to the rules and regulations laid out by Congress and enforced by the U.S. Securities and Exchange Commission (SEC).

Each country has their own rules and regulations for fair and compliant securities trading, including oversight of stocks, bonds, derivatives, and other investment vehicles. Debt instruments, like bonds, usually trade on secondary markets while stocks and derivatives are traded on stock exchanges.

There are many ways for investors to engage in security trading. A few of the most common ones include:

Brokerage Accounts

Once an investor opens a brokerage account with a credentialed investment firm, they can start trading securities.

All a stock or bond investor has to do is fill out the required forms and deposit money to fund their investments. Investors looking to invest in higher-risk derivatives like options, futures, or currencies may have to fill out additional documentation proving their credentials as educated, experienced investors. They may also have to make larger cash deposits, as trading in derivatives is more complex and has more potential for risk.

Some qualified investors with a certain type of brokerage account can engage in margin trading, meaning that they trade securities using money borrowed from the broker. This is a high-risk strategy suitable only for experienced investors; most brokerages have strict rules about who can trade on margin.

Retirement Accounts

By opening a retirement account, through work or a bank or brokerage account, investors can invest in a range of securities, including stocks, mutual and index funds, bonds and bond funds, and annuities.

The type of securities you have access to will depend on the type of retirement account that you have. Workplace plans such as 401(k)s typically have fewer investment choices (but higher limits for tax-advantaged contributions) than IRAs, or Individual Retirement Accounts.

Risks and Considerations

There is always the risk of loss when investing in securities. That said, some securities are riskier than others.

Risk vs. Reward

•   Equities, or stocks, tend to be higher risk investments. Stock markets are known to be volatile and unpredictable. That said, stocks offer the potential for returns; the average historic return of the stock market is about 9% or 10% (or 6% to 7% after inflation).

•   Bonds, by contrast, are lower risk, and provide lower but steady returns versus stocks.

•   Derivatives, like options and futures trading, can be very high risk and these strategies are meant for experienced investors.

When choosing securities for an investment portfolio, it’s important to take into account the risk/reward profile of your investments, as well as whether your asset allocation reflects your risk tolerance. For example, if your portfolio is heavily weighted to stocks, that is likely to increase your risk exposure.

Types of Investments

Because many investors are less experienced at managing a portfolio for the long term, there are certain types of investments that can help investors to manage risk. This is especially true for those who are investing for retirement, and want to protect their savings while maximizing any potential growth. For example:

•   Target-date funds are a type of mutual fund that are geared to be long-term investments, held until a target retirement date is reached. So a 2045 fund is designed to provide a balanced portfolio of securities for investors with a target retirement date in roughly 20 years.

  The fund’s allocation of securities starts out more aggressive (tilted toward stocks), and automatically adjusts over time to become more conservative (tilted toward fixed income) to protect investors’ savings as they near retirement.

•   Robo-advisors are automated portfolios that investors can select based on their personal goals, time horizon, and risk tolerance — the difference being that investors don’t select the securities in these portfolios. A robo portfolio is generally a pre-set mix of ETFs, and the allocation (or mix of securities) is determined by a sophisticated algorithm.

  Because investors can’t change the securities themselves, this helps to prevent impulsive choices, and may mitigate risk over time.

Get Started With Securities Trading

To start trading securities, investors can set up a brokerage account or retirement account, and begin investing as they see fit.

Again, it’s best to start with the end in mind: Decide your investment goals, choose the amount you want to invest, do your due diligence in terms of researching various investment choices (bearing in mind risk levels and fees).

Once the account is funded, the investor can purchase a wide variety of securities in order to create an investment portfolio. Sometimes retirement account investment options can be more limited than a full-service brokerage account.

The Takeaway

There are many different types of securities that investors can purchase as part of their portfolio. Choosing which securities to invest in will depend on several factors, including your financial goals, current financial picture, and risk tolerance.

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 are the four main types of securities?

The four types of securities are: equity securities (such as stocks), debt securities (bonds and Treasuries), derivatives (higher-risk investments like options), and hybrid securities (such as convertible bonds).

What is a securities investment?

A securities investment is an investment in a security such as stocks, bonds, or derivatives. A security is a tradable type of investment that investors can buy and sell.

What’s the difference between securities and shares?

Stocks, also known as equity shares, are a type of security. The term “securities” refers to a range of different investments, one of which is stocks, or shares in a company.

Are securities an asset?

Yes, securities are a type of financial asset because they hold monetary value.

What are Treasury securities?

Treasuries are debt securities — e.g., bills, bonds, and notes — issued by the U.S. government. Treasuries are considered low risk because the U.S. has never defaulted on its debts.

Photo credit: iStock/paulaphoto

SoFi Invest®

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 https://sofi.app.link/investchat. 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.
Mutual Funds (MFs): 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 clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.

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.

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.

SOIN-Q125-076

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Mar
14
2025
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Types of Budgeting Strategies and Methods

By | Budgeting & Goals, money | No Comments

Budgets come in all shapes and sizes, from the old-fashioned, “write down everything you spend” approach to using apps that automatically track and categorize your expenses. There is likely at least one method out there that can help you gain insight and manage your finances effectively. Once a budget is up and running, it can help you wrangle your spending and reach your savings goals, too.

Below, we break down seven popular budgeting strategies, including their benefits and potential drawbacks so you can choose the best fit for your needs and lifestyle.

Key Points

•   Budgets can provide insight into your spending habits and help you better manage your money.

•   Line-item budgets track detailed monthly expenses, aiding in precise financial control.

•   The 50/30/20 budget rule splits income into needs, wants, and goals, promoting balanced financial management.

•   The envelope system uses cash for categories, making it easier to manage and reduce spending, while the zero-sum budget assigns every dollar a purpose.

•   Tech tools, including those provided by financial institutions, can also play a role in effective budget management.

Line-Item Budget

A line-item budget is what you may first imagine when you think of a “typical” type of budgeting. They’re commonly used by small businesses, but individuals can also benefit from keeping close tabs on cash flowing in and out of their checking accounts.

You can set up a basic line-item budget using pen and paper, or you might find it easier to use a spreadsheet on your computer. Either way, you’ll want to list income and expenses vertically in the first column, then make columns for each month of the year. It’s also a good idea to set spending targets for each category. As you log actual spending numbers into your budget, you can see how they line up to your targets.

Benefits and Drawbacks of Line-Item Budgeting

Pros:

•   For new budgeters, this method is relatively easy to create and intuitive.

•   Due to its detail, a line-time budget can be a good starting place for tracking expenses.

•   This method is well-suited for someone who needs more control over their spending.

Cons:

•   It can be time-consuming to set up and requires a high level of commitment to stick with.

•   It may feel restrictive for those who prefer more flexible spending.

•   It does not easily accommodate unexpected expenses.

Recommended: How to Make a Budget in Excel

Proportional Budgets

A proportional budget divides your after-tax income into several broad spending categories (or buckets) and allocates a set percentage for each. This budgeting strategy helps ensure you cover all of your needs, wants, and savings goals without having to account for every penny you spend.

How to Divide Your Income Proportionally

•   50/30/20 Rule (50% needs, 30% wants, 20% savings)

•   60/40 Rule (60% expenses, 40% savings/extras)

•   Custom variations based on individual priorities and financial situations

Proportional budgeting offers a structured yet flexible financial plan. You might try one method of allocating funds for a month or two, then adjust the proportions to better fit your living expenses and goals. (Read on for more details on how to set up a 50/30/20 and 60/40 proportional budget.)

Paying Yourself First

The “pay yourself first” approach is a simple budgeting method that prioritizes savings before anything else. Rather than wait to see what’s left over after covering all of your expenses, you siphon off a predetermined amount for savings as soon as your paycheck hits your bank account. This keeps the money out of sight and (hopefully) out of mind, so you’re less likely to spend it on something else.

Prioritizing Savings With the Pay Yourself First Method

Some tips for using this method effectively:

•   Put savings on auto pilot: Consider setting up an automated transfer from checking to savings for a set amount on the same day each month, perhaps the day after you get paid.

•   Set up a split direct deposit. Another way to automate savings is to ask your employer to do a split direct deposit, where most of your paycheck goes into checking but a portion goes directly into your savings account.

•   Watch your spending. You may need to adjust nonessential (discretionary) spending to ensure you can cover all of your fixed expenses, like rent, utilities, and debt payments, once saving has been deducted.

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Envelope Budget

Also known as “cash stuffing,” the envelope budgeting method involves dividing your expenses into categories (such as rent, groceries, transportation) and assigns an envelope to each one. You then decide how much you can spend on each category and stuff your envelopes with the allotted amount.

You use your envelope money to spend throughout the month. Once an envelope is empty, no more spending is allowed in that category until the next month.

To update this approach for today’s digital world, many budgeting apps allow you to create digital “envelopes” and follow the same principals as the original envelope system.

How to Effectively Use the Envelope Budgeting System

Here’a how to get started with the envelope system:

•   Consider the types of expenses you have and sort them into categories. You can be highly specific (such as “eating out”) or more broad (like “discretionary spending”).

•   Decide how much you will spend on each category, or envelope, per month and portion out the money.

•   Once an envelope is empty, you’ll want to stop spending in that category.

•   If you have remaining funds in an envelope at the end of the month, you could roll over the funds into the same envelope for the next month, move them to a different envelope, or put them in a savings account.

This budgeting method can work well for those who need a tangible way to control their spending. However, it may not be practical unless you’re using a digital tool.

Zero-Sum Budgeting

The idea here is to spend every dollar that you have. That doesn’t mean going on a shopping spree, however. Instead, you assign a specific purpose to each dollar that you earn, whether it’s expenses, savings, debt repayment, or discretionary spending.

It’s called a zero-sum budget because the goal is to have income minus expenses equal zero, meaning there is no unaccounted-for money. This budgeting strategy not only ensures all of your needs are met, but that you also have room in your budget for future needs and fun.

Balancing Income and Expenses With Zero-Sum Budgeting

To create a zero-sum budget:

1.    Go through the past three to six months of financial statements to determine your average monthly take-home income and typical expenses.

2.    Assign dollars to each of your non-negotiable bills, such as rent, insurance, student loan payments, and groceries.

3.    Assess how much money you have left for saving, paying more than minimum on debts, and discretionary spending, then assign where your remaining money is going to go.

Though this approach requires meticulous tracking, it can be ideal for those who want complete control over their finances and ensure they are using their money efficiently.

50/30/20 Budget

The 50/30/20 budget is type of proportional budget that divides your monthly income into three buckets:

•   50% for “needs:” This includes essential expenses like housing, food, transportation to work, as well as minimum payments due on debt.

•   30% for “wants:” This is anything that you buy for personal enjoyment, such as eating out, traveling, and shopping for clothes (beyond basic needs). You may also hear these called discretionary expenses.

•   20% for goals: This category includes saving for short-term goals like building an emergency fund, saving for long-term goals like retirement, as well as paying more than minimum on debts.

This budgeting method can be a great fit for someone who likes a simple framework or just beginning to budget. However, others may crave more structure, such as pre-assigned spending limits for individual categories.

60/40 Budget

Another type of proportional budget, the 60/40 budget divides your monthly income into only two buckets:

•   60% for expenses: This includes fixed costs like rent, utilities, and nonessential bills (like streaming services or a gym membership). The idea is that 60% of your budget goes to regular spending, rather than out-of-the-ordinary expenses like concert tickets or a vacation.

•   40% for everything else: This represents the rest of your income and it goes towards savings goals and spending that is outside your usual lifestyle.

Adjusting for Savings and Spending Needs

You can take the 40% bucket and allocate it however you wish. One allocation you might consider is:

•   20% for retirement/other long-term goals

•   10% for short-term savings goals, such as building an emergency fund, saving for a vacation, or making a major purchase.

•   10% for “fun” spending, like going out to dinner, seeing a show, or other occasional splurges.

The simplicity of the plan can be a positive for people who don’t like complicated, time-consuming budgets, but it may not provide enough guidance for those who really need to take control of their finances.

Sticking to a Budget

Whatever approach you pick, a budgeting method only works if you stick with it. Here’s a look at some ways to make it sustainable.

Overcoming Mental Barriers

Having financial discipline and sticking to a budget can be difficult. If you are struggling with discipline, you might try these tactics:

•   Acknowledge the issue that is holding you back. Out loud. You can only fix a problem if it’s been identified.

•   Create space for yourself to succeed. For example, you might put a 20-minute block on your calendar to look over your budget every week.

•   Anchor the task of budgeting to another activity that you do regularly and enjoy (such as making coffee on Sunday morning). This way, you’ll start to associate the two tasks and think about them in tandem.

Setting Realistic Expectations

A common pitfall when setting a budget is to be too restrictive in your spending targets right out of the gate. While it’s great to be ambitious, it’s unlikely that you’ll make sweeping changes in your spending just because you set lofty targets. And in fact, missing big targets could be disheartening.

Instead, try to set yourself up for success by choosing realistic goals for the upcoming months. You can gradually decrease spending and increase saving as you get used to budgeting.

Considering Irregular Expenses

No matter what type of budget you choose, there will always be the issue of irregular expenses. Irregular expenses may be expected (like annual membership fees or holiday gifts) or unexpected (like car repairs). Some solutions:

•   Turn irregular expenses into monthly expenses. To account for occasional or seasonal expenses, add up the total expected cost for the year, divide that number by 12, then factor it into your monthly budget.

•   Set up an emergency fund for unexpected expenses. It’s a good idea to have three to six months’ worth of living expenses set aside in a separate savings account to cover any unexpected costs or financial bumps in the road.

Staying Out of the Weeds

To avoid getting overwhelmed by the details when budgeting, consider these tips:

•   Steer clear of strategies that feel complicated or require hours of effort. You need a budget you will stick with, and that is likely one that suits your style and feels manageable.

•   Test-drive a couple of budgets to see which works best.

•   Recognize that a budget is never going to be perfect. And that’s okay! If you forget a category or overspend here and there, it may feel like a failure when it’s not.

Tips for Maintaining Motivation

These strategies can help ensure you stick with your budget long-term:

•   Set clear, meaningful goals: Budgeting can feel easier when you have a purpose behind it. Instead of just tracking expenses, consider setting specific goals like saving for a vacation or buying a car.

•   Make it fun: If budgeting feels like a chore, you’re less likely to stick with it. You might use an app that makes tracking finances fun or gamify the experience by setting challenges, such as a no-spend challenge or the 52-week savings challenge.

•   Celebrate your successes: Even small wins, like saving an extra $50 a month, deserve recognition. Reward yourself in non-financial ways, such as a relaxing day off or a favorite activity.

Leveraging Technology

Budgeting apps and tools can simplify financial management and automate tracking, making it easier to stick with a budget.

Apps to Simplify Budgeting

Your bank may offer a free spending tracker as part of their mobile app. If not, consider downloading a separate budgeting app. Some popular options include:

•   Goodbudget: A digital version of the envelope system, this app helps you divide up your salary into spending categories, then tracks your spending and helps you stick to the plan.

•   YNAB (You Need A Budget): YNAB helps you create a budget then monitors your spending and charts your progress as you work towards your goals.

•   PocketGuard: This tool connects to all of your financial accounts and syncs transactions in real-time, helping you stick to your budget.

The Takeaway

Budgeting is a system that can help you track and manage your money better, which in turn can optimize your spending and saving. There are many different budgeting methods. Popular ones include the 50/30/20 budget rule, the zero-sum system, and the envelope technique. Take some time experimenting to find the system that works best for you. A good budget and the right banking partner can help you along the path to financial wellness.

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FAQ

What’s the best budget plan?

The best budget plan is one that works for you. To find the best fit, consider your goals and personal preferences. Some people want to control their spending and like a really detailed budget, such as a line-item budget. Other people are more focused on making sure they allocate funds towards savings, in which case a 50/30/20 rule could be a good option.

What are the simplest ways to budget?

A simple way to start budgeting is to look at the past several months of financial statements, then determine the average amount of money you have coming and going out of your bank account each month. If you see that monthly outflows are close to (or, worse, exceed) monthly inflows, you’ll want to comb through your nonessential expenses and find places to cut back. Any funds you free up can be funnelled into saving and, if you have debt, paying it down.

What is the 50/30/20 rule budget?

The 50/30/20 rule is a simple budgeting framework that recommends putting 50% of your money toward needs (like housing, food, and utilities); 30% toward wants (including entertainment and dining out); and 20% towards goals (savings, investments, and debt repayment beyond the minimum).

This budgeting method can work well for beginners and those who are looking for a simple approach to personal finance. However, you may need to adjust percentages based on your needs and goals.

What tools can help with sticking to a budget?

All you really need to start budgeting is a pen and a notebook, where you keep track of income and expenses. But tech tools can simplify and streamline the process. Spreadsheets, like Microsoft Excel or Google Sheets, are easy to update and offer built-in formulas for automatic calculations. Budgeting apps, on the other hand, can link to outside accounts, track spending in real time, and categorize expenses automatically, which can save time.

How can budgeting methods be adapted for families?

You can adapt any budgeting method for a family by coming up with your total monthly household income and expenses. Plan for essential costs like housing, food, and childcare first, then set aside savings for emergencies and future expenses. You can involve children by teaching financial literacy through allowances and savings goals.

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