Jan
23
2026
What Is the (P/E) Ratio? A Guide for Investors
What is a good price to earnings ratio? An exploration into the popular stock analysis tool.
Read more
Jan
21
2026
What Is Leverage In Finance
Table of Contents
In finance, leverage is the practice of borrowing funds to establish bigger positions. Leverage increases the potential for larger returns. But using leverage also increases the risk of loss.
In general, only qualified investors may use leverage when they invest, which they can typically access via a margin account. Margin is a type of loan from a brokerage. Trading on margin is a type of leverage.
As an investor, it’s critical to understand leverage and the additional risks involved if you plan to day trade or make other types of short-term investments.
Key Points
• In investing, leverage refers to the practice of borrowing money to place bigger trades, using a margin loan from a brokerage.
• Thus the use of leverage requires access to a margin account, which is subject to strict rules regarding account minimums and trade requirements.
• While leverage can amplify gains, it also magnifies losses and comes with additional risks and costs.
• Only qualified investors may open a margin account, owing to the higher risk of loss.
• Different types of leverage exist, including financial leverage used by businesses to raise capital, and operating leverage used to analyze fixed and variable costs.
What Is Leverage?
In finance, leverage refers to using a small amount of capital to establish bigger positions, using borrowed funds. This is called trading on margin, and it’s a strategy generally available only to qualified investors.
The use of margin is governed by rules from the Financial Industry Regulatory Authority (FINRA). A margin loan must be backed with cash and other securities, a minimum amount of cash must be maintained in the account, and the margin debt must be paid back with interest, whether investing online or through a traditional brokerage.
Trading With Cash vs. Margin
With a cash brokerage account, an investor can only purchase investments they can cover with cash. If an investor has $5,000 in cash, they can buy $5,000 worth of securities.
A margin account, however, allows qualified investors to borrow funds from the brokerage to purchase securities that are worth more than the cash they have on hand.
In the above example, an investor could borrow up to $5,000, which doubles the amount they can invest (depending on any account restrictions), and place a $10,000 trade.
Although leverage is about borrowing capital in an effort to increase returns when investing in stocks and other securities, if the trade moves in the wrong direction, though, you could suffer a loss — and you’d still have to repay the margin loan, plus interest and fees.
How Leverage Works
In leveraged investing, the leverage is debt that qualified investors use as a part of their investing strategy.
Leverage typically works like this: An investor wants to make a large investment, but doesn’t have enough liquid capital to do it. If they qualify, they use the capital they do have in conjunction with margin (borrowed money) to make a leveraged investment.
If they’re successful, the return on their investment is greater than it would’ve been had they only invested their own capital.
In the event that the investor lost money, they would still have to repay the money they’d borrowed, plus interest and fees.
Increase your buying power with a margin loan from SoFi.
Borrow against your current investments at just 4.75% to 9.50%* and start margin trading.
*For full margin details, see terms.
Example of Leverage
Let’s say an investor has $10,000 worth of cash and securities in their account. Generally speaking, and assuming they qualify for margin funds, the investor can borrow up to another $10,000, and place a $20,000 trade, though the brokerage firm could impose stricter limits or other restrictions.
That’s because the Federal Reserve’s Regulation T requires a 50% initial margin deposit, minimum, for trading on margin.
Thus, when using margin to buy stocks or other securities, an investor typically can borrow up to 50% of the value of the trade. The cash and securities are collateral for the loan, and the broker also charges interest on the loan, which adds to the cost — and to the risk of loss. (Margin rules can vary, however, depending on the securities being traded and other factors.)
Pros and Cons of Leverage
On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.
| Pros of Leverage | Cons of Leverage |
|---|---|
| Adds buying power | Increased risks and costs |
| Potential to earn greater returns | Leveraged losses are magnified |
| If you qualify, using leverage can be easy | Not all investors qualify for the use of leverage, i.e., margin |
Leverage vs Margin
Leverage is a type of debt. And as noted, margin is a type of leverage that can be used to make investment trades. It’s similar to a line of credit for a brokerage account that qualified investors can access.
Leverage can be used by businesses to expand operations or invest in new equipment or to fund an acquisition. Ideally, the use of leverage will generate additional revenue to cover the cost of the debt.
Leverage vs Margin |
|
|---|---|
| Leverage | Margin |
| A loan from a bank for a specific purpose | A loan from a brokerage for investing in financial instruments |
| Can be used by businesses or individuals | Only qualified investors have access to margin trading |
| Leverage may be used to expand business operations or achieve other goals | Can be used to increase investment buying power |
| Borrowed capital generally must be repaid according to the terms of the loan. | Margin loans must be repaid with interest, and fees. |
Types of Leverage
So far, we’ve mostly discussed leverage as it relates to the financial markets for investors. But there are other types of leverage, too.
Financial Leverage
Financial leverage is used by businesses and organizations as a way to raise money or access additional capital without having to issue additional shares or sell equity. For instance, if a company wants to expand operations, it can take on debt to finance that expansion.
The main ways that a company may do so is by either issuing bonds or by taking out loans. Much like in the leverage example above, this capital injection gives the company more spending power to do what it needs to do, with the expectation that the profits reaped will outweigh the costs of borrowing in the long run.
Operating Leverage
Operating leverage is an accounting measure used by businesses to get an idea of their fixed versus variable costs. When calculating operating leverage, a company looks at its fixed costs as compared to variable costs to get a sense of how the costs of borrowing are affecting its profitability.
Understanding operating leverage helps to evaluate whether a company’s borrowing is profitable (called the debt-to-equity ratio).
Using Borrowed Money to Invest
While many investors utilize margin, it’s also possible to borrow money from an outside source (not your broker or brokerage) to invest with. This may be appealing to some investors who don’t have high enough account balances to meet the thresholds some brokerages have in place to trade on margin.
If an investor doesn’t meet the margin requirements, looking for an outside loan — a personal loan, a home equity loan, etc.— to meet that threshold may be an appealing option.
But, as mentioned, investors will need to consider the additional costs associated with borrowing funds, such as applicable interest rates. So, before doing so, it may be a good idea to consult a financial professional.
Leverage in Personal Finance
The use of leverage also exists in personal finance — not merely in investing. People often leverage their money to make big purchases like cars or homes with auto loans and mortgages.
A mortgage is a fairly simple example of how an individual may use leverage. They’re using their own money for a down payment to buy a home, and then taking out a loan to pay for the rest. The assumption is that the home will accrue value over time, growing their investment.
Leverage in Professional Trading
Professional traders tend to be more aggressive in trying to boost returns, and as such, many consider leverage an incredibly important and potent tool. While the degree to which professional traders use leverage varies from market to market (the stock market versus the foreign exchange market, for example), in general most pro traders are well-versed in leveraging their trades.
This may allow them to significantly increase returns on a given trade. And professionals are given more leeway with margin than the average investor, so they can potentially borrow significantly more than the typical person to trade. Of course, they also have to stomach the risks of doing so, too — because while it may increase returns on a given trade, there is always the possibility that it will not.
Leveraged Products
There are numerous financial products and instruments that investors can use to gain greater exposure to the market, all without increasing their investments, like leveraged ETFs.
Leveraged ETFs
ETFs, or exchange-traded funds, can have leverage baked into them. ETFs are typically baskets of stocks, bonds, or other assets that mirror a relevant index, such as the S&P 500.
Leveraged ETFs, or LETFs, use derivatives so that investors may potentially double (2x), triple (3x) or short (-1) the daily gains or losses of the index. Financial derivatives are contracts whose prices are reliant on an underlying asset.
Leveraged ETFs are highly risky, owing to their use of derivative products.
Volatility and Leverage Ratio
A leverage ratio measures a company’s debt profile, and gives a snapshot of how much debt a company currently has versus its cash flow. Companies can use leverage to increase profitability by expanding operations, etc., but it’s a gamble because that profitability may not materialize as planned.
Knowing the leverage ratio helps company lenders understand just how much debt they’ve taken on, and can also help investors understand whether a company is a potentially risky investment given its debt obligations.
The leverage ratio formula is: total debt / total equity.
Volatility is another element in the mix, and it can be added into the equation to figure out just how volatile an investment may be. That’s important, given how leverage can significantly amplify risk.
The Takeaway
Leverage can help investors, buyers, corporations and others do more with less cash by using borrowed funds. But there are some important considerations to keep in mind when it comes to leverage. In terms of leveraged investing, it has the potential to magnify gains — but also to magnify losses, and increase total costs.
Utilizing leverage and margin as a part of an investing or trading strategy has its pros and cons, and investors should give the risks serious consideration.
If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.
FAQ
What is leverage in simple terms?
In simple terms, the concept of leverage means to use a small amount of force to create a larger outcome. As it relates to finance or investing, this can mean using a small amount of capital to make large or outsized trades or investments.
What is an ordinary example of leverage?
An example of leverage could be a mortgage, or home loan, in which a borrower makes a relatively small down payment and borrows money to purchase a home. They’re making a big financial move with a fraction of the funds necessary to facilitate the transaction, borrowing the remainder.
Why do people want leverage?
Leverage allows investors or traders to make bigger moves or take larger positions in the market with only a relatively small amount of capital. This could lead to larger returns — or larger losses.
Photo credit: iStock/StockRocket
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
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.
S&P 500 Index: The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an investment product, but a measure of U.S. equity performance. Historical performance of the S&P 500 Index does not guarantee similar results in the future. The historical return of the S&P 500 Index shown does not include the reinvestment of dividends or account for investment fees, expenses, or taxes, which would reduce actual returns.
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.
Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®
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 emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
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-Q425-039
Read moreJan
15
2026
Investing vs. Speculation: Understanding the Core Differences
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.
The primary differences between investing and speculating are the degree of risk and the time frame involved. Investing is typically a longer-term strategy that involves less risk than speculating — which is a short-term, high-risk approach to profiting from quick changes in price.
Whether you’re interested in investing or speculating can also determine the types of assets you might invest in, as well as the strategies you might use.
Table of Contents
Key Points
• The fundamental differences between investing and speculating involve the time frame (long-term vs. short-term) and the degree of risk (lower vs. higher risk).
• Investing typically involves buying researched assets with the goal of long-term price appreciation.
• Speculation is a short-term, high-risk strategy focused on profiting from quick price changes.
• Traditional investors rely on tools like fundamental analysis to evaluate a business’s health and employ a buy-and-hold strategy, whereas speculators focus on technical analysis and market timing for immediate gains.
• Investment carries a reasonable likelihood of profit over time, while speculation is associated with higher volatility and the risk of loss.
Defining Investing and Speculation
Speculating usually describes scenarios when there’s a high chance the investment will deliver losses, but also cases where the investment could result in a high profit. High-risk, potentially high-reward investments may include commodities, derivatives, futures, and more.
In contrast, investing generally refers to transactions where an individual has researched an asset, and puts money into it with the hope that prices will rise over time.
There are no guarantees, of course, and all types of investing include some form of risk. Individuals may find ways to speculate or invest with an online investing platform or through a regular broker.
Examples of Investments and Speculative Investments
Assets that are thought of as more traditional types of investments include publicly traded stocks, mutual funds, exchange-traded funds (ETFs), bonds (e.g. U.S. Treasurys, municipal bonds, high-grade corporate bonds), and real estate.
Even some so-called alternative investments would be considered more long-term and less speculative: e.g., jewelry, art, collectibles.
Assets that are almost always considered speculative include: junk bonds, options, futures, forex and foreign currencies, and investments in startup companies.
Sometimes it isn’t as simple as saying that all investments in the stock market, or types of ETFs or mutual funds, hold the same amount of risk, or are definitely classified as investments. Even within certain asset classes, there can be large variations in risk exposure.
The Traditional Approach to Investing
When it comes to the more traditional approach to investing, individuals typically buy and hold assets in their investment portfolios or retirement accounts (e.g., when they open an IRA), with the aim of seeing long-term gains.
Traditional forms of investing focus on the performance of the underlying business or organization, not on the day-to-day or hour-by-hour price movements of an asset — which is more common with speculation.
For this reason, some traditional investors tend to rely on various forms of analysis (e.g., the fundamental analysis of stocks), as well as analytical tools and metrics to gauge the health of a company, asset, or market sector.
Recommended: Stock Market Basics
Speculation: A High-Risk, High-Reward Game
The difference between speculating and investing can be nuanced and a matter of opinion. (After all, some investors view investing in stocks as a form of gambling.) But when traders are speculating, they are typically seeking profits in a relatively short period of time: e.g., hours, days, or weeks.
In the case of commodities or futures trading, the time horizon might be longer, but the aim of making a big profit fairly quickly is at the heart of most speculation.
Speculators may also use leverage, a.k.a. margin trading, to boost their buying power and amplify gains where possible (although using leverage can also lead to steep losses).
The Psychology of Investing vs Speculating
The psychology of a typical investor is quite different from that of a speculative investor, and again revolves around the higher tolerance for risk in pursuit of a potentially bigger reward in a very short time frame.
| Long-Term Investing | Speculating |
|---|---|
| Taking calculated or minimal risks | Willing to take on high-risk endeavors |
| Pursuit of reasonable gains | Pursuit of very high returns |
| Willing to invest for the long term | Willing to invest only for the short term |
| Uses a mix of traditional investments and strategies (e.g., stocks, bonds, funds) | Uses single strategies and may prefer derivatives or alternative investments |
| Infrequent use of leverage/margin | Frequent use of leverage/margin |
Historical Perspectives on Investing and Speculation
The history of investing and speculating has long been entwined. In the earliest days of trading thousands of years ago, most markets were focused on the exchange of tangible commodities like livestock, grain, etc.
That said, some investors might put their money into global voyages or even wars with the hope of acquiring great wealth. Although the time frame for these investments was long-term, the risk of loss was very high. Thus, many early investors could be described as speculators.
Investing in forms of debt as a way to make money was also common, eventually leading to the bond market as we know it today.
The concept of investing in companies and focusing on longer-term gains took hold gradually. As markets became more sophisticated over the centuries, and a wider range of technologies, strategies, and financial products came into use, the division between investing and speculating became more distinct.
Recommended: What Causes a Stock Market Bubble?
Speculation History: Notable Market Bubbles and Crashes
The history of investing is rife with market bubbles, manias, and crashes. While the speculative market around tulip bulbs in 17th-century Holland is one extreme example, there have been many similar financial events in just the last 20 or 30 years — including the dot-com bubble and the Great Financial Crisis of 2008-09. Most of these were driven by speculation.
What marks a bubble is a well-established series of stages driven by investor emotions like exuberance (i.e., greed) followed by panic and loss. That’s because many investors tend to be irrational, especially when in pursuit of a quick profit that seems like “a sure thing.”
Some classic examples of financial bubbles that changed the course of history:
• The South Sea Bubble (U.K., 1711 to 1720) — The South Sea company was created in 1711 to help reduce national war debt. The company stock peaked in 1720 and then crashed, taking with it the fortunes of many.
• The Roaring Twenties (U.S., 1924 to 1929) — The 1920s saw a rapid expansion of the U.S. economy, thanks to both corporations’ and consumers’ growing use of credit. Stock market speculation reached a peak in 1929, followed by the infamous crash, and the Great Depression.
• Japanese Bubble Economy (1984 to 1989) — The Japanese economy experienced a historic two-decade period of growth beginning in the 1960s, that was further fueled by financial deregulation and widespread speculation that artificially inflated the worth of many corporations and land values. By late 1989, as the government raised interest rates, the economy fell into a prolonged slowdown that took years to recover from.
• Dot-Com Bubble (1995 to 2002) — Sparked by rapid internet adoption, the dot-com boom and bust saw the growth of tech companies in the late 1990s, when the Nasdaq rose 800%. But by October 2002 it had fallen 78% from that high mark.
Key Differences Between Investing and Speculating
What can be confusing for some investors is that there is an overlap between investing in the traditional sense, and speculative investing in higher-risk instruments. And some types of investing fall into the gray area between the two.
For example, options trading, commodities trading, or buying IPO stock are considered high-risk endeavors that should be reserved for more experienced investors. What makes these types of investments more speculative, again, is the shorter time frame and the overall risk level.
Time Horizon: Long-term Goals vs Quick Gains
As noted above, investors typically take a longer view and invest for a longer time frame; speculators seek quick-turn profits within a shorter period.
That’s because more traditional investors are inclined to seek profits over time, based on the quality of their investments. This strategy at its core is a way of managing risk in order to maximize potential gains.
Speculators are more aggressive: They’re geared toward quick profits, using a single strategy or asset to deliver an outsized gain — with a willingness to accept a much higher risk factor, and the potential for steep losses.
Fundamental Analysis vs. Market Timing
As a result of these two different mindsets, investors and speculators utilize different means of achieving their ends.
Investors focused on more traditional strategies might use tools like fundamental analysis to gauge the worthiness of an investment.
Speculators don’t necessarily base their choices on the quality of a certain asset. They’re more interested in the technical analysis of securities that will help them predict and, ideally, profit from short-term price movements. While buy-and-hold investors focus on time in the market, speculators are looking to time the market.
Real-World Implications of Investment vs Speculation
To better understand the respective value and impact of investing vs. speculating, it helps to consider the real-world implications of each strategy.
The Impact of Speculation on Markets
It’s important to remember that speculation occurs in many if not all market sectors. So speculation isn’t bad, nor does it always add to volatility — although in certain circumstances it can.
For example, some point to IPO shares as an example of how speculative investors, who are looking for quick profits, may help fuel the volatility of IPO stock.
Speculation does add liquidity to the markets, though, which facilitates trading. And speculative investors often inject cash into companies that need it, which provides a vital function in the economy.
Strategic Approaches to Investment
Whether an investor chooses a more traditional route or a more speculative one, or a combination of these strategies, comes down to that person’s skill, goals, and ability to tolerate risk.
Diversification and Asset Allocation
For more traditional, longer-term investors, there are two main tools in their toolkit that help manage risk over time.
• Diversification is the practice of investing in more than one asset class, and also diversifying within that asset class. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and potentially improve returns.
• Asset allocation is the practice of balancing a portfolio between more aggressive and more conservative holdings, also with the aim of growth while managing risk.
When Does Speculation Make Sense?
Speculation makes sense for a certain type of investor, with a certain level of experience and risk profile. It’s not so much that speculative investing always makes sense in Cases A, B, or C. It’s more about an investor mastering certain speculative strategies to the degree that they feel comfortable with the level of risk they’re taking on.
The Takeaway
The main way to differentiate between investment and speculation is through the lens of risk exposure. If an asset is purchased that carries a reasonable probability of profit over time without significant risk, it’s an investment. If an asset carries a higher likelihood of significant fluctuation and volatility in a short period of time, it is speculation.
A long-term commitment to a broad stock market investment, like an equity-based index fund, is generally considered an investment. Historical data shows us that the likelihood of seeing gains over long periods, like 20 years or more, is reasonable — although there is always the risk of loss.
Compare that with a trader who purchases a single stock with the expectation that the price will surge that very day or week — which is far more difficult to predict and has a much lower probability of success.
Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.
FAQ
Is speculation the same as gambling?
Not exactly. Gambling involves placing a bet or wager on a certain event or outcome, with the hope of winning money. Speculation involves some skill and the use of technical analysis in order to make a profit. But both involve the risk of total loss.
What is the psychology of investing vs speculating?
An investment mindset tends to be more risk-averse and focused on long-term goals. The psychology of a speculator tends to be comfortable with risk in order to use short-term strategies that may or may not be profitable.
What are the tools for investing vs speculating?
Investors often use fundamental analysis tools to gauge the health of a business. Speculators use different forms of technical and trend analysis to take advantage of price movements.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.
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.
Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. This should not be considered a recommendation to participate in IPOs and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation. New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For more information on the allocation process please visit IPO Allocation Procedures.
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.
Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®
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 emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
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.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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.
SOIN1023133
Jan
12
2026
Short-Term vs Long-Term Investments
Unsure of the difference between long-term and short-term investments? We examine the characteristics of each and when to use them.
Read moreJan
09
2026
Safe Harbor 401(k) Plan: What Is It? Is It for You?
Safe harbor 401(k) plans enable companies to avoid the annual IRS testing that comes with traditional 401(k) plans. With a safe harbor 401(k), an employer makes mandatory contributions to all employees’ retirement accounts, and those funds vest immediately.
Often a perk used to attract top talent, safe harbor 401(k) plans are a way for highly compensated employees, like company executives and owners, to save more than a traditional 401(k) plan would normally allow.
Keep reading to learn more about safe harbor rules, why companies use these plans, along with the benefits, drawbacks, and relevant deadlines.
Key Points
• Like a traditional 401(k), a safe harbor 401(k) lets employees deposit tax-deferred funds from their paychecks into a retirement savings account.
• Employers are required to contribute to employees’ safe harbor 401(k) accounts.
• Employer contributions in a safe harbor 401(k) vest immediately. There is no waiting period.
• Highly-paid employees can contribute more to a safe harbor 401(k) than a traditional 40(k).
• Safe harbor 401(k) plans allow companies to skip the annual nondiscrimination regulatory testing required by the IRS for traditional 401(k)s.
What Is a Safe Harbor 401(k) Plan?
A 401(k) safe harbor plan is similar to a traditional 401(k) plan — but with a twist. In both cases, eligible employees can use the plan to contribute pre-tax funds to a retirement account and employers may contribute matching funds.
But with a traditional 401(k) retirement plan, companies must submit to annual nondiscrimination regulatory testing by the IRS to ensure that the company plan doesn’t treat highly compensated employees (HCEs) more favorably than others. HCEs are generally defined as earning at least $160,000 in the 2025 and 2026 tax years, and being in the company’s top 20% in pay, or owning more than 5% of the business. The testing process is complex and can be a burden for some companies.
An alternative is to set up a safe harbor 401(k) plan with a safe harbor match. This allows a company to skip the annual IRS testing — and avoid imposing restrictions on employee saving — by providing the same 401(k) contributions to all employees, regardless of title, salary, or even years spent at the company. And those funds must vest immediately.
This is an important benefit, because in many cases, employer contributions to traditional 401(k) plans vest over time, requiring employees to stay with the company for some years in order to get the full value of the employer match. Often, if you leave before the employer contributions or match have vested, you may forfeit them.
For smaller companies, it may be worth making the extra safe harbor match contributions in order to avoid the time and expense of the IRS’s annual nondiscrimination testing. For larger companies, giving all employees the same percentage contribution could be expensive. But the upside is that highly paid employees can then make much larger 401(k) contributions without running afoul of IRS rules, a real perk for company leaders. In addition, 401(k) safe harbor plans are typically less expensive to set up than traditional plans.
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Traditional 401(k) vs Safe Harbor 401(k) Plans
While safe harbor 401(k)s and traditional 401(k) plans are similar in many ways, there are some important differences that employers should be aware of.
For instance, with traditional 401(k) plans, contributions from highly compensated employees can’t comprise more than 2% of the average of all other employee contributions, in addition to other restrictions. However, with safe harbor 401(k) plans, those limits don’t apply.
Comparing Plan Features and Benefits
Here is a side-by-side comparison of a safe harbor 401(k) vs. a traditional 401(k)
| Safe Harbor 401(k) | Traditional 401(k) |
|---|---|
| Employer contributions are required. | Employer contributions are optional. |
| Employer contributions are vested immediately. | Employer contributions may vest over time. |
| Highly-paid employees can contribute up to the $23,500 maximum in tax year 2025 and up to $24,500 in 2026. | Highly-paid employees can be limited in how much they can contribute. |
| Companies do not have to do annual nondiscrimination testing. | Companies must do annual nondiscrimination testing. |
Choosing the Right Plan for Your Business
A safe harbor plan may be beneficial for some smaller companies that can’t afford the expense of nondiscrimination testing. In addition, the plan is simpler with less administrative tasks.
A company might also choose a safe harbor 401(k) if it has some key high-earning employees that make up a large share of the workforce.
However, if your company is able to easily manage the nondiscrimination testing process, you may want to opt for a traditional 401(k). A traditional 401(k) could also be a good option for business owners who want to try to retain employees over the long-term. They could set up a vesting schedule for employer contributions that requires employees to be with the company for three years before becoming fully vested, for instance.
Setting Up a Safe Harbor 401(k) Plan
For employers interested in using a safe harbor 401(k), there are some general rules and guidelines they will need to follow.
Requirements, Contribution Formulas, and Deadlines
To fulfill the safe harbor 401(k) requirements, the employer must make qualifying 401(k) contributions (a.k.a. the safe harbor match) that vest immediately. The company contributes to employees’ retirement accounts in one of three ways:
• Non-elective: The company contributes the equivalent of 3% of each employee’s annual salary to a company 401(k) plan, regardless of whether the employee contributes.
• Basic: The company offers 100% matching for the first 3% of an employee’s 401(k) plan contributions, plus a 50% match for up to 5% of an employee’s contributions.
• Enhanced: The company offers a 100% company match for all employee 401(k) contributions, up to 4% of a staffer’s annual salary.
Companies that opt for a safe harbor 401(k) plan have to adhere to strict compliance filing deadlines. These are the dates worth knowing.
October 1: That’s the deadline for filing for a safe harbor 401(k) for the current calendar year. This deadline meets the government criteria of a company needing to have a safe harbor 401(k) in operation for at least three months in a 12 month period, for the first year operating a safe harbor plan.
December 1: By this date, all companies — whether they’re rolling out a brand new safe harbor plan or are administering an existing one — must issue a formal notice to employees that a safe harbor 401(k) will be offered to company staffers.
January 1: The date that all safe harbor 401(k) plans are activated. For companies that currently have no 401(k) plan at all, they can roll out either a traditional 401(k) plan or a safe harbor 401(k) plan at any point in the year, for that calendar year.
Advantages of Implementing a Safe Harbor 401(k) Plan
Safe harbor 401(k)s offer some distinct upsides for business owners and employees alike.
Benefits for Employers and Employees
By creating a safe harbor 401(k) plan, a business owner can potentially attract and maintain highly skilled employees. Employees are attracted to higher retirement plan contributions and the ability to optimize retirement plan contribution amounts, ensuring more money for long-term retirement savings.
Plus, a safe harbor 401(k) plan can also help business owners save money on the compliance end of the spectrum. For example, companies save on regulatory costs by avoiding the costs of preparing for a nondiscrimination test (and the staff hours and training that goes with it).
There are some additional upsides to offering a safe harbor 401(k) retirement plan, for higher paid employees and regular staff too.
• Playing catch up. If a company owner, or high-level managers, historically haven’t stowed enough money away in a company retirement plan, a safe harbor 401(k) plan can help them catch up. The same may be true, although to a lesser degree, for regular employees.
• The spread of profit. Suppose a company has a steady and robust revenue stream and is managed efficiently. In that case, company owners may feel comfortable “spreading the wealth” with not only high-profile talent but rank-and-file employees, too.
• Encourage retirement savings. If a company is seeing weak contribution activity from its rank-and-file employees, it may feel more comfortable going the safe harbor route and at least guaranteeing minimum 401(k) contributions to employees while rewarding higher-value employees with more lucrative 401(k) plan contributions.
Disadvantages of Safe Harbor Plans
Safe harbor 401(k) plans have their downsides, too. Here are some drawbacks to consider.
Financial Implications for Employers
The matching contribution requirements for safe harbor 401(k)s can add up to a hefty expense, depending on employee salaries. And because employees are vested immediately, there’s no incentive to stay with the company for a certain period.
In addition, if a company introduces a safe harbor 401(k) plan, it must commit to it for one calendar year, no matter how the plan is performing internally. Even after a year, 401(k) plan providers (which administer and manage the retirement plans) may charge a termination fee if a company decides to pull the plug on its safe harbor plan after one year.
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Safe Harbor 401(k) Contribution Limits and Match Types
There are some different rules for employer contribution limits and matching with a safe harbor 401(k) vs. a traditional 401(k).
Understanding Contribution Limits
Just like traditional 401(k) plans, the maximum employee contribution limit for a safe harbor plan is $23,500 in 2025 and $24,500 in 2026. If you are over 50, you would be eligible for an additional $7,500 catch-up contribution in 2025 and $8,000 in 2026, if your plan allows it.
For both 2025 and 2026, those aged 60 to 63 may contribute an additional $11,250 (instead of $7,500 and $8,000) to their 401(k) plan.
But in a safe harbor plan, a company owner can reserve the maximum $23,500 in 2025 for their annual plan contribution, $24,500 for 2026, and also boost contribution payments to valued team members up to an individual profit-sharing maximum amount of 100% of their compensation, or $70,000 (77,500 for those over age 50 with the standard catch-up and $81,250 with the SECURE 2.0 catch-up for those 60 to 63) — whichever is less — for 2025.
For 2026, the total allowed is 100% of compensation or $72,000, whichever is less. (For those 50 and up the cap is $80,000 with the standard catch-up, and $83,250 with the SECURE 2.0 catch-up for those ages 60 to 63 only.) Employer rules about catch-up provisions may vary, so be sure to ask.
Regular employees are allowed the standard maximum contribution limit of $23,500 in 2025, $24,500 in 2026; plus anyone over age 50 can contribute an extra “catch-up” amount of $7,500 in 2025 and $8,000 in 2026. Those are the same maximum contribution ceilings as regular 401(k) plans. For 2025 and 2026, those aged 60 to 63 may contribute an additional $11,250 instead of $7,500 and $8,000 respectively, thanks to SECURE 2.0.
Different Types of Employer Matching Contributions
As mentioned earlier, with a safe harbor 401(k), an employer must make qualifying 401(k) contributions that vest immediately in one of these ways:
• Non-elective: The company contributes the equivalent of 3% of each employee’s annual salary to a company 401(k) plan.
• Basic: The company matches 100% for the first 3% of an employee’s 401(k) plan contributions, plus a 50% match for the following 2% of their contributions.
• Enhanced: The company provides a 100% company match for all employee 401(k) contributions, up to 4% of a staffer’s annual salary.
IRS Compliance Testing and Safe Harbor Provisions
To help understand the benefit of safe harbor plans, it helps to see what employers with traditional 401(k) plans face in terms of following IRS rules and submitting to the annual nondiscrimination tests.
Navigating Non-Discrimination Testing
Each year, a company must conduct Actual Deferral Percentage (ADP), Actual Contribution Percentage (ACP), and Top Heavy tests to confirm there is no compensation discrimination.
If the company fails one of the tests, it could mean considerable administrative hassle, plus the expense of making corrections, and potentially even refunding 401(k) contributions.
Before explaining the details of each test, here’s a refresher on how the IRS defines highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).
To be an HCE:
• The employee must own more than 5% of the company at any time during the current or preceding year (directly or through family attribution).
• The employee is paid over $160,000 in compensation from the employer for both 2025 and 2026. The plan can limit these employees to the top 20% of employees who make the most money.
Employees who don’t fit these criteria are considered non-highly compensated. The nondiscrimination tests are designed to assess whether top employees are saving substantially more than the rank-and-file staffers.
• The Actual Deferral Percentage (ADP) test measures how much income highly paid employees contribute to their 401(k), versus staff employees.
• The Actual Contribution Percentage (ACP) test compares employer retirement contributions to HCEs versus the contributions to everyone else.
According to the IRS, the terms of the ADP test — which compares the amounts different employees are saving in their 401(k)s — are met if the ADP for highly compensated employees (HCE) doesn’t exceed the greater of:
• 125% of the deferral percentage for ordinary, i.e., non-highly compensated employees (NHCEs)
Or the lesser of:
• 200% of the deferral percentage for the NHCEs
• or the deferral percentage for the NHCEs plus 2%.
The ACP test is met if the deferral percentage for highly compensated employees doesn’t exceed the greater of:
• 125% of the deferral percentage for the NHCEs,
Or the lesser of:
• 200% of the deferral percentage for the group of NHCEs
• or the deferral percentage for the NHCEs plus 2%.
Last, the top-heavy test measures the value of the assets in all company 401(k) accounts, total. If the 401(k) balances of “key employees” account for more than 60% of total plan assets, the 401(k) would fail the top heavy test. The IRS defines key employees somewhat differently than highly compensated employees, although both groups are similar in that they earn more than ordinary staff.
As you can see, maintaining a traditional 401(k) plan, and meeting these requirements each year, can be a burden for some companies. Fortunately, by setting up a safe harbor 401(k) plan, a company can avoid the annual nondiscrimination tests and still provide a 401(k) savings plan for employees.
The Takeaway
Companies that don’t want the regulatory obligations of a traditional 401(k) plan, and would like to prioritize talent acquisition and employee retention may want to consider safe harbor 401(k) plans.
However, a business owner needs to weigh the pros and cons of a safe harbor 401(k) plan because, in some cases, it can be expensive for a company to maintain.
But no matter what type of 401(k) an employer decides to go with, having a retirement plan in place, with different savings and investment options, can help employees — and business owners themselves — save for the future.
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FAQ
Is a safe harbor 401(k) worth it?
Whether a safe harbor 401(k) is worth it depends on the goals of the business owner. A safe harbor 401(k) allows a company to skip the expense of nondiscrimination testing. And by creating a safe harbor 401(k) plan, a business owner may be able to attract and maintain highly skilled employees because of the higher contributions. However, the matching employer contribution requirements can add up to a high expense. A business owner needs to weigh the pros and cons of these plans.
Can I cash out my safe harbor 401(k)?
You can withdraw safe harbor 401(k) funds without penalty at age 59 ½ or if you leave your job. However, hardship withdrawals for immediate and heavy financial need may be allowed in certain circumstances. You can learn more at irs.gov.
Why would a company use a safe harbor 401(k)?
A company might use a safe harbor 401(k) to avoid the expense of nondiscrimination testing and to simplify the administration of a 401(k) plan. They might also use a safe harbor 401(k) to help attract and keep highly skilled employees.
What is an example of a safe harbor 401(k) match?
If an employer with a safe harbor 401(k) chooses to offer non-elective matching contributions, that means they contribute at least 3% of each employee’s annual salary. So if an employee makes $70,000 a year, for example, the employer would contribute $2,100 to their safe harbor 401(k) account.
About the author
Ashley Kilroy
Ashley Kilroy is a seasoned personal finance writer with 15 years of experience simplifying complex concepts for individuals seeking financial security. Her expertise has shined through in well-known publications like Rolling Stone, Forbes, SmartAsset, and Money Talks News. Read full bio.
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