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Q: Do You Pay Taxes on Mutual Funds?

Mutual fund investors generally have to pay taxes on any income or capital gains the mutual fund distributes, including dividends, interest, and realized capital gains from the sale of securities within the fund.

Q: How Much Tax Do You Pay on Mutual Funds?

The amount of tax you pay on mutual fund investments depends on the type of fund, the type of income or capital gains the fund generates, and your individual tax situation.

Dec

2024

Guide to Taxes and Mutual Funds

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

Mutual fund investors pay taxes on the income or capital gains they see from their investments. But the specific tax treatment of mutual fund investments depends on several variables, which can breed confusion. For a long time, mutual funds have been a popular investment vehicle for millions of investors, largely because they offer an easy way to purchase no-fuss, diversified assets with relative ease. This out-of-the-box diversification and risk mitigation is something that individual stocks can’t match.

Read on to learn how taxes on mutual funds work, what investors should expect or anticipate when dealing with mutual funds and the IRS, and some strategies for tax-efficient investing.

Key Points

• Mutual fund investors must pay taxes on income or capital gains distributed by the fund, including dividends, interest, and realized capital gains.

• The tax treatment of mutual fund investments varies depending on the type of fund and the income or capital gains it generates.

• Shareholders may owe taxes on mutual fund holdings even without selling shares, due to realized gains from distributions.

• The amount of tax paid depends on the type of fund, income or capital gains, and the investor’s tax situation.

• Strategies to minimize taxes include investing in tax-efficient funds, using tax-deferred accounts, and employing a buy-and-hold strategy to avoid short-term capital gains taxes.

Quick Mutual Fund Overview

A mutual fund is a pooled investment vehicle that allows individuals to invest in a professionally managed portfolio of stocks, bonds, and other securities. Mutual funds are managed by professional portfolio managers who use the pooled capital to buy and sell securities according to the fund’s stated investment objective. When investors buy into a mutual fund while online investing, they’re purchasing a spectrum of assets all at once.

Mutual funds can be actively managed, where the portfolio manager actively buys and sells securities in the fund, or passively managed, where the fund tracks an index. Mutual funds are a popular way for individuals to diversify their portfolios and access professional investment management.

Recommended: How to Buy Mutual Funds Online

Do You Pay Taxes on Mutual Funds?

Mutual fund investors generally need to pay taxes on any income or capital gains the mutual fund distributes, including dividends, interest, and realized capital gains from the sale of securities within the fund.

It’s worth noting that mutual funds can be structured in different ways, and the tax treatment of mutual fund investments can vary depending on the specific type of mutual fund. For example, some mutual funds are classified as tax-exempt or tax-deferred, which means that they are not subject to certain taxes or that taxes on the income or gains from the fund are deferred until later.

When a mutual fund distributes income or capital gains to its investors, it must provide them with a Form 1099-DIV, which reports the distribution amount and any associated taxes. Investors are then responsible for reporting this income on their tax returns and paying any taxes that are due.

How Are Mutual Funds Taxed?

Mutual funds are taxed based on the income and capital gains they generate and distribute to their investors. This income and capital gains can come from various sources, such as dividends on stocks held by the fund, interest on bonds held by the fund, and profits from the sale of securities within the fund.

The tax treatment of mutual fund investments can vary depending on the type of fund and the type of income or capital gains it generates. Here are some general rules to keep in mind:

Paying Tax on “Realized Gains” from a Mutual Fund

It may come as a surprise that shareholders may owe taxes on their mutual fund holdings even if they don’t sell shares of the fund. That’s because shareholders still generate income from those holdings, which are often called “realized” gains.

Mutual funds are often actively managed, meaning that a portfolio manager regularly makes decisions about what the fund contains by buying and selling investments — a process that can net profits. Those profits, or gains, are then passed back to shareholders as distributions (or as dividends) or reinvested in the fund.

When shareholders are awarded distributions from funds, they see a “realized” gain from their investment. For that reason, shareholders may end up owing tax on investments that they have not sold or may have lost value over the year.

Paying Capital Gains on Mutual Funds

Most investors likely know that when they sell shares of a mutual fund, they’ll need to pay taxes on the earnings. Specifically, they’ll pay capital gains tax on the profit from selling an investment. The capital gains tax rate will vary depending on how long an investor holds the investment (short-term versus long-term).

Because funds contain investments that may be sold during the year, thereby netting capital gains, investors may be responsible for capital gains taxes on their mutual fund distributions. As each fund is different, so are the taxes associated with their distributions. So reading through the fund’s prospectus and any other available documentation can help investors figure out what, if anything, they owe.

How Much Tax Do You Pay on Mutual Funds?

The amount of tax you may need to pay on mutual fund investments depends on the type of fund, the type of income or capital gains the fund generates, and your individual tax situation.

Here are some general rules to keep in mind:

• Dividends: Dividends paid by mutual funds are taxed at different rates, depending on whether the payouts are ordinary or qualified dividends. Qualified dividends are taxed at a lower rate than ordinary dividends; they’re taxed at the long-term capital gains rate, which ranges from 0% to 20%. In contrast, ordinary dividends are taxed at an investor’s ordinary income tax rate.

• Interest: The tax on the interest income from mutual funds depends on whether the payout comes from tax-exempt bonds, federal debt, or regular fixed-income securities. Depending on the type of asset, the interest may be taxed at ordinary income tax rates or exempt from certain taxes.

• Capital gains: When a mutual fund sells securities for a profit, it may realize a capital gain, which is subject to tax. The tax rate on capital gains depends on how long the securities were held and your tax bracket. Short-term capital gains (on securities held for one year or less) are taxed at the same rate as ordinary income. In comparison, long-term capital gains (on securities held for more than one year) are generally taxed at the lower capital gains tax rate.

How to Minimize Taxes on Mutual Funds

Here are a handful of ways to potentially lower taxable income associated with mutual funds:

Know the Details Before You Invest

Do your homework! The holdings in each fund and how they’re managed will ultimately play a significant role in the tax liabilities associated with each fund. Before investing in a specific mutual fund, it’s worth digging through the prospectus and other documents to understand what to expect.

For example, an investor can typically find out ahead of time if a mutual fund makes capital gains distributions or how often a fund pays out dividends. Those types of income-generating events will need to be declared to the IRS come tax time.

Some investors may look for tax-efficient funds specifically designed to help mutual fund investors avoid taxes.

Use a Tax-deferred Account

Some brokerage or investment accounts — including retirement accounts like IRAs and 401(k) plans — are tax-deferred. That means they grow tax-free until the money they contain is withdrawn. In the short term, using these types of accounts to invest in mutual funds can help investors avoid any immediate tax liabilities that those mutual funds impose.

Recommended: Are Mutual Funds Good for Retirement?

Hang Onto Your Funds to Try and Avoid Short-term Capital Gains

If the goal is to minimize an investor’s tax liability, avoiding short-term capital gains tax is important. That’s because short-term capital gains taxes are steeper than the long-term variety. An easy way to ensure that an investor is rarely or never on the hook for those short-term rates is to subscribe to a buy-and-hold investment strategy.

This can be applied as an overall investing strategy in addition to one tailor-made for avoiding additional tax liabilities on mutual fund holdings.

Talk to a Financial Professional

Of course, not every investor has the same resources, including time, available to them. That’s why some investors may choose to consult a financial advisor specializing in these services. They usually charge a fee, but some may offer free consultations. For some investors, the cost savings associated with solid financial advice can outweigh the initial costs of securing that advice.

How Do You Report Mutual Funds on Your Taxes?

If you own mutual funds, you will generally need to report any income or capital gains you receive from the fund on your tax return.

Mutual funds are required to provide their investors with a Form 1099-DIV, which reports the amount of any dividends, interest, and capital gains distributions the fund paid out during the year. Make sure to keep this form for your records and use it to help complete your tax return.

You will then need to report any dividends, interest, and capital gains distributions you received from your mutual fund on your tax return, specifically on IRS Form 1040 or Schedule D (Form 1040).

The Takeaway

Mutual fund taxes are generally unavoidable, but with a little planning, you may be able to minimize the amount you get taxed. Employing some of the above strategies can help you minimize your mutual taxes. For example, those investing for long-term financial goals, like retirement, can use tax-deferred accounts as their primary investing vehicles. And by using those accounts to invest in mutual funds and other assets, they can help offset their short-term tax liabilities.

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FAQ

Do you pay taxes when you sell mutual funds?

Yes, you may be required to pay taxes when you sell mutual funds. The specific taxes you may be required to pay will depend on several factors, including the type of mutual funds you are selling, how long you have held the funds, and the type of gains you have earned from the sale.

Are mutual funds taxed twice?

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends. Later, when the investor sells shares of the mutual fund for a gain, they’ll have to pay capital gains taxes on those earnings.

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

SOIN-Q424-019

Dec

2024

What Is Income Tax Withholding and How Does It Work?

By Susan Guillory | Life & Career, money | Comments Off

“What happened?!” may be your response when you look at your paycheck and see all of those deductions, whittling your hard-earned cash down to a (much) lower figure than you expected.

And perhaps, if you look more closely, you’ll notice a line on your paystub that shows a major amount of money subtracted and think, What is withholding tax? And why do they take so much?

Federal and state withholding taxes, also known as “taxes withheld,” are funds that your employer takes out and sends to the government to help federal programs. These taxes have a purpose, and in the long run, you’ll probably be glad they are deducted from your check rather than owed as a mega lump sum on Tax Day.

Read on to learn more about tax withholding, including factors that impact how much gets deducted and how to calculate your withholding taxes.

Key Points

• Income tax withholding deducts money from your paychecks to cover your estimated tax liability, preventing large year-end bills.

• Factors that affect tax withholding include income, filing status, claimed allowances, and extra withholding requests.

• You can adjust your W-4 form to balance withholding, avoiding overpayment or tax debt.

• Withholding exemptions are available for those with no tax liability.

• Withheld taxes support federal programs and public services.

What is Income Tax Withholding?

Many people think their taxes are due mid-April, but the Internal Revenue Service (IRS) actually requires you to pay as you go, meaning you need to pay most of your tax during the year, as you receive income, rather than at the end of the year. When you see those federal and possibly state and local taxes being whisked out of each paycheck, that’s exactly what is happening.

A withholding tax is an amount, based on your salary, that your employer sets aside and then pays directly to the government on your behalf. It’s a credit against the full amount of personal income tax you will owe for the year. By doing this, your employer is helping you avoid a surprise tax bill come April. Tax withholding also helps ensure you won’t owe interest or a penalty for paying too little tax during the course of the year.

That said, how much is deducted from your paycheck can vary depending on a variety of factors. You are able to designate what portion of your check goes toward your taxes on the IRS W-4 form (more on that in a bit).

• If you allocate too much, that means more than necessary is taken out, and you will likely receive a tax refund when you file your taxes.

• If you set aside too little, you will probably owe a balance or have what’s known as a “tax bill” due during tax season to make up the difference.

Your federal withholding tax rate depends on your income and tax bracket.

Factors That Determine Tax Withholding

There are several factors that determine just how much tax is withheld from your paycheck, whether it arrives as a paper check or via direct deposit. These include:

• How much you earn: Generally, the more you earn, the higher the rate at which taxes are withheld

• Your filing status: For instance, you might file your taxes as single, married filing jointly, or married filing separately.

• How many (if any) withholding allowances you claim: Typically, if you claim a higher number of allowances, your withholding will be lower. This means more cash will flow your way on each payday, but you might owe taxes when you file. If you have a lower number of allowances, more money is taken out for taxes, and you could wind up getting a refund when your tax return is processed.

• Whether you decide to have additional money withheld: Some individuals may ask their employers to withhold, say, an extra $100 or more per pay period if they find they typically owe taxes at year’s end.

Recommended: How to Reduce Your Taxable Income

What Is State Income Tax Withholding?

If you live in a state that levies income tax, you will also see tax withholding for that type of tax on your paycheck. There are just nine states that don’t tax earned income. In other words, you will not pay state taxes if you live in:

• Alaska

• Florida

• Nevada

• New Hampshire

• South Dakota

• Tennessee

• Texas

• Washington

• Wyoming

The concept of tax withholding works in the same way at the state level as it does at the federal: A certain portion is put toward your future state tax bill, and you may either owe or get a refund, depending on how much you paid in.

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What Is the Purpose of Tax Withholding?

As briefly mentioned above, tax withholding saves you from owing a huge bundle of taxes in April. If people were left to their own devices to set aside money for taxes, well, that might not always be a success. Every time you receive your paycheck, there are bills to pay, dinners out and movies to tempt you, and vacations to plan and take. As a result it can be hard to save money from your salary.

In addition to helping you avoid a surprise tax bill, tax withholding is also a way for the government to maintain its pay-as-you-go income tax system. If you pay too little in taxes throughout the year, you can get hit with an underpayment penalty and interest payments (on top of that surprise tax bill).

Tax and Employment Documents to Know

When you are first hired at a company, you typically fill out a W-4 form. This form is designed to help your employer estimate how much tax you’ll owe by the end of the year. To do this, the form asks you about your family, potential deductions you might claim, and any additional income you earn outside your W-2 job. Based on your answers, your employer will determine how much tax to withhold from your paychecks.

Then when tax time rolls around, you will receive IRS Form W-2. This includes information on how much income you earned in a given tax year, as well as how much you paid in federal, state, and other taxes.

You’ll use this W-2 to file your taxes, and it will determine whether you receive a tax refund, owe more taxes, or break even.

Calculating Income Tax Withholding

It can take a bit of tweaking to find that balance between overpaying in federal withholding and having to pay more when you file your taxes.

Some people like getting a tax refund because it’s a lump sum they can put toward debt or invest. But realize that overpaying is a bit like giving the government a free loan throughout the year.

While there may be fast ways to get a tax refund, perhaps you’d rather just hold onto that money in the first place. If you better balance what is taken out of your paychecks, you could take the excess you would have paid and put it in a high-yield savings account or invest it for the future.

If you’re wondering what is a withholding tax allowance that’s right for you, there’s help. The IRS has a Tax Withholding Estimator you can use based on your current situation. In general, the more allowances or exemptions you have, the less will be withheld from your pay; the fewer the exemptions, the more will be withheld.

While you aren’t asked to fill out a new W-4 each year, you may request one if you think you need to adjust the withholding amount.

Some of the times it might be wise to adjust how much income tax is withheld include:

• Starting a new job or position

• Having a child

• Getting married or divorced

• Buying a house.

Can I Be Exempt from Tax Withholding?

To be exempt from tax withholding means that no federal taxes will be withheld from your pay. You might also have no state or local taxes (if applicable) deducted. Here are the ways in which someone might qualify to be exempt from such taxes:

• If all of your federal income tax was refunded because you have no tax liability and you expect the same thing to happen this year, then you may be exempt from withholding taxes. (But note, Social Security and some other taxes may still be withheld as part of other types of payroll deductions.)

• Certain types of income are considered exempt. For instance, money paid to foster parents for their taking care of children in their homes may be tax-free. Payments from workers’ compensation is another example of funds that may be tax-exempt.

The Takeaway

Paying taxes may not be fun, but it’s important to remember that this money is put toward things we all enjoy, like smooth roads and education programs. And federal withholding from your paycheck keeps you from having a giant bill when you file taxes.

When it comes to tax withholding, it’s important to understand how much is being withheld from each paycheck and whether you need to modify your W-4 to find a better balance between overpaying and owing more money come Tax Day.

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FAQ

Does the government pay for income tax withholdings?

Money that is withheld from your earnings, known as income tax withholding, goes to the government. These dollars help pay for federal programs that benefit citizens and keep our country running, from education to transportation to security.

How can someone qualify for a withholding exemption?

To qualify as tax-exempt, you would have to have had no tax liability in the previous year and expect the same status in the current tax year. Also keep in mind that some forms of income may be tax-exempt, such as payments for in-home foster care of children or for workers’ compensation.

Why has my employer withheld too much income tax?

If your employer withheld too much income tax, then you will likely get a refund at tax time. You can update your withholding on your W-4 form; the more allowances you have, the less money will be withheld to cover your tax liability.

Why has my employer withheld too little income tax?

If you wound up owing the IRS money at tax time, the issue could be that you have too many exemptions or allowances claimed on your W-4 form, meaning your employer is not withholding enough money from your paycheck. You may want to adjust your W-4, knowing that the lower your number of allowances, the more money your employer with withhold and send to the IRS on your behalf.

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Dec

2024

Delayed vs Real-Time Stock Quotes

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

Stock quotes, which may be seen on financial news networks or websites, are typically reported in real time, or with a delay. The main difference between the two is that real-time quotes are the most up-to-date, while delayed quotes lag behind real-time quotes by several minutes, in most cases.

For the average investor who isn’t making changes to their portfolio, real-time quotes may be more precise than they need. For those investors, delayed stock quotes may suffice. Here’s what you need to know about the difference between real-time stock quotes and delayed quotes.

Key Points

• Real-time stock quotes provide immediate price information, reflecting current market conditions.

• Delayed stock quotes are typically behind by up to 20 minutes.

• Active traders benefit from real-time quotes for precise, up-to-the-minute data.

• Long-term investors may find delayed quotes sufficient, as they do not focus on minute-by-minute changes.

• Real-time data can be costly, prompting some providers to offer delayed quotes to conserve resources.

What Are Real-Time Stock Quotes?

Real-time stock quotes relay price information for various securities in real-time, or instantaneously. In other words, a real-time stock quote is the actual and immediate stock price at any given point in time. The quotes reflect demand for a stock or assets on stock markets around the world.

How Real-Time Quotes Work

Stock quotes include ticker symbols that denote the stock of a specific company or firm, and the price of a stock’s current (real-time) valuation. Those values are determined by trading activity — supply and demand, in other words. Those values also fluctuate during the trading day.

The letters and numbers comprising a quote — either real-time or delayed — reflect different types of investments or commodities and their prices — the price at which they’re currently trading. Typically the ticker symbol is similar in some way to the company name, and you can use it to look up the stock price.

For example, the ticker AAPL is Apple; XOM is the ticker for ExxonMobil; JNJ is the ticker for Johnson & Johnson; UDMY is Udemy; LULU is Lululemon.

Those symbols, when displayed on a ticker tape, are generally followed by or attached to their current trading price.

Real-time quotes are provided by many sources, including financial news networks and websites. Many online investing brokerages also offer their clients access to them as well. Real-time stock quotes provide traders and active investors with more accurate information.

What Are Delayed Quotes?

Delayed stock quotes are valuations of securities that are not in real-time — they’re delayed, as the name indicates. Depending on the source of the quote, the information relating to stock or share prices can be delayed by several minutes, or even up to 20 minutes.

For instance, it’s not unusual that you might login to your investment brokerage and see delayed stock quotes relaying information about the value of your current investments. There will likely be a note telling you how delayed the data is (15 minutes, for example), so that you know the pricing isn’t in real-time.

Most people should be able to tell if a quote is delayed, too, if the price remains static for minutes at a time. Real-time quotes, on the other hand, can fluctuate second-by-second, depending on the security and the source.

For investors engaged in day trading, delayed quotes wouldn’t be sufficient; these investors require up-to-the-minute (or to the second) price quotes in order to execute their strategies. But for the majority of buy-and-hold investors, knowing the very latest price of a security may not matter to their long-term plans.

How Delayed Quotes Work

Delayed stock quotes work the same way that real-time quotes do, in that they reflect current market conditions and data relating to security values. But the reporting is delayed for a variety of reasons.

The most common reason that you may come across a site or information source with delayed stock quotes is that fetching and reporting real-time quotes is costly and resource-consuming. As such, companies may opt to report delayed quotes instead.

Real-Time vs Delayed Stock Quotes

Real-time streaming stock quotes change second to second, and can showcase the volatility of stock prices. When stock exchanges are open, trading is constant, and the dynamics of supply and demand for specific stocks change their prices rapidly. So, watching real-time streaming stock quotes means seeing those price fluctuations occur in real time, as the name implies. That can have implications for how traders and investors make decisions.

That can have implications for how traders and investors make decisions when online investing.

Using real-time stock quotes can be useful for active traders or investors, or high-frequency traders — professionals who are making numerous stock trades every day or week and may be managing other people’s portfolios, too. For these traders, knowing stock prices down to the minute helps inform their decision to buy or sell. That real-time price, ultimately, determines their stock trading profit (or loss).

There’s also after-hours trading to keep in mind, too. Stock markets have trading hours — the New York Stock Exchange (NYSE) and NASDAQ are open between 9:30 am and 4 pm, for example. At other times, investors may still be able to swap securities, but prices are much more volatile after-hours, and because it’s difficult to get real-time quotes after-hours, values can change dramatically before stock markets reopen.

Investors can also execute a market-on-open trade, during which a transaction completes as soon as the markets do open.

While security prices do fluctuate, they generally don’t fluctuate all that much over a relatively short interval (15 minutes, for example). And since the average investor may not be all that interested in minute-by-minute price fluctuations, using a delayed stock quote could provide all the information they need.

Think about it this way: If an investor were looking to rebalance their portfolio — something they may only do two or three times per year — a real-time stock quote isn’t going to give them much more actionable information than a delayed stock quote to help them make an informed decision.

Delayed stock quotes also don’t relay the second-by-second volatility of the market, which can be hard for some investors to digest.

Why Do Stock Quotes Get Delayed?

As mentioned, delayed stock quotes are lagging because they require resources to gather and report. The information is out there, and is collected by firms that supply quotes and pricing information to other companies. Depending on the individual security and the source of the information, a delay is likely the result of a company opting to supply delayed quotes rather than real-time quotes to consumers in order to save on costs.

As such, a small percentage of quote-providers offer consumers real-time market information — and often only to those who pay for it. That’s not to say that real-time data isn’t available for free, but the gathering and reporting can be costly, which is why some providers use delayed quotes.

How Real-Time Quotes Affect Your Investment Strategy

One big question investors may have: How do these two different types of stock quotes actually affect someone’s investment strategy? That depends largely on whether you’re into active investing, and how often they’re swapping positions in their portfolio.

Real-time stock quotes are mainly used by day traders, or active investors who are executing trades on a daily or hourly basis. In those cases, the relatively small fluctuations in price due to market volatility, which occurs in real time, can determine whether a trade is profitable or not.

Real-time stock quotes are mainly used by day traders, or active investors who are executing trades on a daily or hourly basis.

For example, if a trader was trying to time a trade to execute at a specific price, a delayed quote might be useless. The time lag could cause them to miss their window, and bobble the trade.

How Delayed Quotes Affect Your Investment Strategy

As noted, if investors are only rebalancing their portfolios every so often, real-time quotes won’t matter all that much to their investing strategies. They aren’t trying to turn a profit from day-trading, in other words, and are taking a longer-term approach to their investing.

As such, for long- or medium-term investors who may only occasionally buy or sell securities, delayed quotes will do the trick. If you’re not checking on your portfolio every day and are only considering asset allocation every few months, there isn’t much of an advantage to looking at real time quotes over delayed ones.

Real-time quotes do provide more information than delayed quotes, though, in that they’re more precise. That can help you if you’re weighing decisions regarding either short-term vs long-term investments.

Deciding Which Stock Quote is Right for You

Most investors may not give much thought to real-time versus delayed stock quotes, unless they are active traders, as discussed. Whether or not you need up-to-the-minute quotes really depends on whether you’re doing a lot of trading, and doing that trading within tight time frames in which seconds or minutes matter. So, real-time quotes can give you more insight as to when it’s time to buy, sell, or hold.

Accordingly, if you’re more of a passive investor, you can probably stick to delayed stock quotes to get a broader idea of a security’s value.

The Takeaway

Real-time stock prices are updated to the second; delayed stock prices might be updated every 15 minutes, every hour, or every day, depending on the provider and the security involved.

For investors who aren’t looking to profit from small price fluctuations, it won’t make much of a difference if the quotes they’re using are delayed or not. That said, it’s never a bad idea to use real-time trading data, if an investor has access to it.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is a delayed stock quote?

A delayed stock quote is a quote that does not relay real-time value information regarding stock or security values. Instead, the information is delayed by around 15 or 20 minutes, in many cases.

What are real-time stock quotes?

Real-time stock quotes reflect the current market value of a security in real time — meaning up-to-the-minute, or second. Real-time quotes fluctuate constantly based on supply and demand for a security on the market.

Are real-time quotes better than delayed quotes?

Real-time quotes aren’t necessarily better than delayed quotes, but they do reflect more current information which can be better for active investors or day traders.

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

SOIN-Q424-037

Dec

2024

Benefits of ETFs — Pros & Cons in Investment Portfolio

By Inyoung Hwang | Growing Wealth, Investing | Comments Off

Exchange-traded funds (ETFs) are funds that can be used to build a relatively simple and low-cost diverse portfolio. There are many investing benefits to ETFs, which is why they’ve grown in popularity both for DIY investors and for more traditional money managers. However, there are cons investors should be aware of, too.

Key Points

• ETFs offer diversified exposure across various assets, potentially reducing large swings in overall portfolio value.

• They tend to be cost-effective due to lower management fees compared to mutual funds.

• ETFs provide flexibility with real-time trading, similar to stocks.

• Tax efficiency is enhanced in ETFs because of fewer capital gains distributions.

• However, ETFs can have hidden costs like bid-ask spreads and brokerage fees.

What Are the Benefits of ETFs?

Exchange-traded funds (ETFs) have become increasingly popular in recent years, especially with the rise of online investing allowing people to buy and sell them quickly.

As an investment tool, ETFs have become popular: there were almost 10,000 ETFs in the world with trillions of dollars in assets under management (AUM) at the end of 2023. In the U.S., there was more than $7 trillion in AUM in ETFs.

Here are some of the benefits of ETFs, which has helped spur their popularity.

ETFs Trade Similar to Stocks

ETFs are traded on stock exchanges and can be bought and sold throughout the day, like individual stocks. The market determines the price for a share of an ETF and changes throughout the day. This means investors can buy and sell ETFs efficiently, making them a convenient investment option.

Portfolio Diversification

An additional benefit of an ETF is that you don’t need a lot of money to invest in many different things. One share of an ETF offers investors a way to diversify their portfolio by investing in a basket of assets, such as stocks, bonds, or commodities, rather than just a single asset. This can help to reduce the overall risk of an investment portfolio.

Accessible Across Markets

There is also a range of ETFs on the market now: stocks, bonds, commodities, real estate, and hybrids that offer a mix. ETFs also vary in how they target certain assets — aggressively or defensively, specific to one asset class or broad. So investors should be able to find what they want and build a diverse portfolio.

Lower Costs

Most ETFs are passively managed and track a benchmark index, meaning portfolio managers don’t actively manage the fund to try to beat the market or an index. Passive investing, as opposed to active investing, may be more cost-effective because there tends to be less overhead and fewer investment fees.

Because there is often less overhead, ETFs generally charge investors a lower operating expense ratio than actively managed mutual funds. The operating expense ratio is the annual rate the fund charges to pay for portfolio management, administration, and other costs.

There are other costs investors need to consider, like commissions for trades and a bid/ask spread.

Tax Efficiency

ETFs tend to be more tax efficient than mutual funds because they typically generate fewer capital gains and capital gains taxes. This is because passively managed ETFs tend to have lower turnover than actively managed mutual funds, which means they sell fewer assets and, thus, result in fewer capital gains.

Transparency

ETFs generally disclose their holdings daily, so investors can see exactly what assets the ETF holds. This can be helpful for investors who want to know what they are investing in.

Flexibility

ETFs can be used as a part of various investment strategies, including as part of a long-term buy-and-hold strategy or as a short-term trading tool. This makes them a flexible investment option for a wide range of investors.

Moreover, investors can trade thematic ETFs — funds focusing on a specific trend or niche industry, like robotics, artificial intelligence, or gender equality. However, there are pros and cons to thematic ETFs. While they allow investors to make more targeted investments, the shares of these funds can be volatile. Because they’re so focused, these ETFs may also diminish the most important benefit of ETFs: broad, diverse exposure.

Disadvantages of ETFs

While ETFs offer many benefits to investors, there are also some potential disadvantages to consider. These disadvantages include the following:

Lack of Personalization

Because ETFs are not actively managed, they do not consider an investor’s specific financial goals or risk tolerance. A lack of personalization means that ETF investors may be unable to tailor their investment portfolio to their particular financial needs.

Tracking Error

ETFs are usually designed to track the performance of a particular index or basket of assets. However, the performance of the ETF may not precisely match the performance of the underlying index due to various factors, such as the fund’s expenses or the timing of when it buys and sells assets. This is known as a tracking error.

Short-Term Trading Costs

ETFs can be traded on the market throughout the day, making them attractive to short-term traders. However, the commission costs of trading ETFs can add up over time, which can eat into investment returns.

Limited Choices

While many ETFs are available, the range of options may be limited compared to other investment vehicles, such as mutual funds. Thus, investors may be unable to find an ETF that perfectly matches their investment needs.

Counterparty Risk

Certain ETFs may use financial instruments, such as futures contracts or swaps, to gain exposure to specific assets. These instruments carry counterparty risk, which means that there is a risk that the counterparty will not fulfill its obligations under the contract. This can expose ETF investors to additional risks.

Complexity

Some ETFs use complex investment strategies, such as leveraged or inverse ETFs, which can be difficult for some investors to understand. Complex investing strategies can make it challenging for investors to fully understand the risks and potential returns of these types of ETFs.

Market Risk

ETFs, like all investments, are subject to market risk, meaning the value of an ETF can go up or down depending on the performance of the underlying assets.

What to Consider When Investing in ETFs

When investing in ETFs, it is essential to consider the following factors:

• Investment objective: Determine your investment goals and how ETFs fit into your overall investment strategy. This can help you choose an ETF that aligns with your financial goals and risk tolerance.

• Asset class: Consider which asset classes you want to invest in and whether an ETF that tracks those assets is available. For example, if you want to invest in large-cap domestic stocks, look for an ETF that tracks a particular large-cap domestic stock index.

• Diversification: ETFs offer a way to diversify your investment portfolio by investing in a basket of assets rather than just a single asset. Consider the level of diversification an ETF offers and whether it aligns with your investment goals.

• Expenses: ETFs typically have lower fees than mutual funds because they are not actively managed. However, it is still important to compare the expenses of different ETFs to ensure you are getting the best value for your money.

• Tax considerations: ETFs tend to be more tax efficient than mutual funds because they generate fewer capital gains. However, it is still important to consider the tax implications of investing in an ETF and whether it aligns with your overall financial plan.

Investing With SoFi

ETFs are becoming increasingly more popular and ubiquitous in the financial markets, with some being more targeted in focus than others. So, being aware of an ETF’s investments can be important for an investor who chooses to put dollars into this financial vehicle. But, as with any investment, they have their pros and cons, which investors should familiarize themselves with before investing.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

What is the benefit of investing in an exchange-traded fund?

Exchange-traded funds (ETFs) offer investors a convenient and cost-effective way to diversify their portfolios by investing in a basket of assets. ETFs are also typically more tax efficient than mutual funds and offer investors the ability to buy and sell their shares on a stock exchange.

Are ETFs a good investment?

Depending on their investment goals and risk tolerance, ETFs may be a good investment for some investors. ETFs offer a convenient and cost-effective way to diversify a portfolio and provide access to a wide range of asset classes. However, it is important for investors to consider the specific ETF they are considering and how it fits into their overall investment plan.

Why are ETFs better than stocks?

For some investors, ETFs may be a better investment option than individual stocks because they offer diversification by investing in a basket of assets rather than just a single stock.

Is an ETF better than a mutual fund?

Whether an ETF is better than a mutual fund depends on the specific circumstances of the investor and their investment goals. ETFs tend to have lower fees than mutual funds because they are not actively managed and may also be more tax efficient due to their lower turnover. However, mutual funds offer a more comprehensive range of investment options and may be more suitable for some investors.

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.

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.

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.

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

¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN-Q424-028

Dec

2024

Guide to Investment Risk Pyramids

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

An investment risk pyramid is an illustration used to help investors understand the risk/reward profile of various assets. The investment risk pyramid uses a base, middle, and top to rank investments by the likelihood of losing money or seeing big returns. The tool is useful when getting started with investing.

Building a portfolio is no easy task. It requires due diligence and an assessment of your risk tolerance and return goals. The investment risk pyramid may help you determine what approaches work best for you.

What Are Investment Pyramids?

Investment pyramids are practical tools for gauging how risky certain asset types are. The pyramid model has been used in many areas for a long time, and it’s useful when learning what your risk tolerance is.

An investment risk pyramid has three levels grouped by risk/return profile. The least-risky securities are found in the large base; growth and moderately risky assets are in the middle; then the most speculative strategies are at the top.

Again, this can be helpful to investors who are looking to buy and sell stocks or other securities, and also get a sense of how much associated risk they’re introducing or jettisoning from their portfolio.

How Investing Pyramids Work

There are many investing risk need-to-knows, and the pyramid of investment risk works by helping investors understand the connection between their asset allocation and their risk tolerance.

The visual should ultimately lead individuals to better grasp what percentage of their investable assets should go to which types of investments based on risk level and return potential.

Using a risk pyramid investment strategy provides a basic framework for analyzing portfolio construction. The investment risk pyramid is structured so that it suggests people hold a higher percentage of lower-risk assets, and relatively little in the way of ultra-high-risk, speculative assets.

Base of the Pyramid

Managing investment risk is among the most fundamental aspects of investing, and risk is controlled by ensuring an allocation to some safe securities. The base of the investment risk pyramid, which is the bulk of total assets, contains low-risk assets and accounts. Investments such as government bonds, money markets, savings and checking accounts, certificates of deposit (CDs), and cash are included in the base.

While these securities feature relatively low risk, you might lose out to inflation over time if you hold too much cash, for example.

Middle of the Pyramid

Let’s step up our risk game a bit by venturing into the middle of the investment risk pyramid. Here we will find medium-risk assets. In general, investments with some growth potential and a lower risk profile are in this tier. Growth and income stocks and capital appreciation funds are examples.

Other holdings might include real estate, dividend stock mutual funds, and even some higher-risk bond funds.

Top of the Pyramid

At the top of the investment risk pyramid is where you’ll find the most speculative asset types and even margin investing strategies. Options, futures, and collectibles are examples of high-risk investments.

You will notice that the top of the pyramid of investment risk is the smallest – which suggests only a small portion of your portfolio should go to this high-risk, high-reward niche.

Sample Investment Pyramid

Here’s what a sample investment risk pyramid might contain:

Top of the pyramid, high risk: Speculative growth stocks, put and call options, commodities, collectibles, cryptocurrency, and non-fungible tokens (NFTs). Generally, just a small percentage of an overall portfolio should be allocated to the top of the pyramid.

Middle of the pyramid, moderate risk: Dividend mutual funds, corporate bond funds, blue-chip stocks, and variable annuities. Small-cap stocks and foreign funds can be included, too. A 30-40% allocation could make sense for some investors.

Base of the pyramid, low risk: U.S. government Treasuries, checking and savings accounts, CDs, AAA-rated corporate bonds. This might comprise 40-50% of the portfolio.

Pros and Cons of Investment Pyramids

The investment risk pyramid has advantages and disadvantages. Let’s outline those to help determine the right investing strategy for you.

Pros

The investment risk pyramid is useful as a quick introduction to asset allocation and bucketing. Another upside is that it is a direct way to differentiate asset types by risk.

Cons

While the investment risk pyramid is helpful for beginners, as you build wealth, you might need more elaborate strategies beyond the pyramid’s simplicity. Moreover, in the end, you determine what securities to own – the pyramid is just a suggestion.

Examples of Low-Risk Investments

Let’s describe some low-risk investments in more detail since these are including the investment risk pyramid’s biggest tier.

Bonds

Bonds are essentially a loan you make to the government or other entity for a set amount of time. In return for lending your money, the debtor promises to pay you back at maturity along with periodic coupon payments, like interest.

Lower-risk bonds include short-term Treasury bills while riskier bonds are issued by speculative companies at a higher yield.

Cash

Cash feels like a low-risk asset, but ideally you would store it in an interest-bearing savings account in order to keep up with inflation.

Also consider that holding too much cash can expose you to inflation risk, which is when cash loses value relative to the cost of living.

Bank Accounts

You can earn a rate of return through a bank account with FDIC insurance. Keeping an emergency fund in a checking account can be a prudent move so you can pay expenses without having to sell assets like stocks and bonds or take on debt.

Examples of High-Risk Investments

At the top of the pyramid, you will find assets and strategies that may generate large returns, but also expose you to serious potential losses. Margin trading is a method often employed by some investors to try and increase their returns.

Margin Trading

Margin trading is using borrowed funds in an attempt to amplify returns. A cash account vs. margin account has key differences to consider before you go about trading. Trading with leverage offers investors the possibility of large short-term gains as well as the potential for outsize losses, so it is perhaps best suited for sophisticated investors.

Options

Options on stocks and exchange-traded funds (ETFs) are popular these days. Options, through calls and puts, are derivative instruments that offer holders the right but not the obligation tobuy shares at a specific price at a predetermined time. These are risky since you can lose your entire premium if the option contract strategy does not work out for the holder.

Collectibles

Collectibles, such as artwork or wine, are alternative investment types that may provide some of the benefits of diversification, but it’s hard to know what various items are worth since they are not valued frequently. Consider that stocks and many bonds are priced at least daily.

Collectibles might also go through fad periods and booms and bust cycles, which can add to the risk factors in this category.

Discovering Your Risk Tolerance

The investment risk pyramid is all about helping you figure out your ability and willingness to accept risk. It is a fundamental piece of being an investor. You should consider doing more research and even speaking with a financial advisor for a more detailed risk assessment along with an analysis of what your long-term financial goals are.

The Takeaway

Using an investment risk pyramid can make sense for many investors. It’s an easy, visual way to decide which asset classes you might want to hold in your portfolio, so that the percentage of each (i.e. your asset allocation) is aligned with your risk tolerance.

The other helpful aspect of the investment risk pyramid is that it presumes a bigger foundation in lower-risk investments (the bottom tier), with gradually smaller allocations to moderate risk and higher-risk assets, as you move up the pyramid. This can be helpful for a long-term strategy. In a nutshell, the investment risk pyramid helps you figure out how to allocate investments based on your risk tolerance and return objectives.

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.

Get one of the most competitive margin loan rates with SoFi, from 4.75% to 9.50%*

FAQ

What are the levels of an investment pyramid?

The levels of an investment risk pyramid are low-risk at the base, moderate-risk in the middle, and high-risk at the top. The risk/return investment pyramid helps investors understand how to think about various assets they may want to own.

What does investment risk refer to?

Investment risk can be thought of as the variance in return, or how great the chance is that an investment will experience sharp losses. While the risk investment pyramid helps you build a portfolio, you should also recognize that a diversified stock portfolio performs well over time, while cash generally loses out due to the risk of inflation.

What are some examples of high-risk investments?

High-risk investments include speculative assets like options, trading securities on margin, and even some collectibles that might be hard to accurately value since they are based on what someone might be willing to pay for them. The low-risk to high-risk investments pyramid can include virtually any asset.

Photo credit: iStock/MicroStockHub

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.

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.

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.

¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN-Q324-024

Guide to Taxes and Mutual Funds

Quick Mutual Fund Overview

Do You Pay Taxes on Mutual Funds?

How Are Mutual Funds Taxed?

Paying Tax on “Realized Gains” from a Mutual Fund

Paying Capital Gains on Mutual Funds

How Much Tax Do You Pay on Mutual Funds?

How to Minimize Taxes on Mutual Funds

Know the Details Before You Invest

Use a Tax-deferred Account

Hang Onto Your Funds to Try and Avoid Short-term Capital Gains

Talk to a Financial Professional

How Do You Report Mutual Funds on Your Taxes?

The Takeaway

FAQ

Do you pay taxes when you sell mutual funds?

Are mutual funds taxed twice?

What Is Income Tax Withholding and How Does It Work?

What is Income Tax Withholding?

Increase your savings with a limited-time APY boost.*

Factors That Determine Tax Withholding

What Is State Income Tax Withholding?

What Is the Purpose of Tax Withholding?

Tax and Employment Documents to Know

Calculating Income Tax Withholding

Can I Be Exempt from Tax Withholding?

The Takeaway

FAQ

Does the government pay for income tax withholdings?

How can someone qualify for a withholding exemption?

Why has my employer withheld too much income tax?

Why has my employer withheld too little income tax?

Delayed vs Real-Time Stock Quotes

What Are Real-Time Stock Quotes?

How Real-Time Quotes Work

What Are Delayed Quotes?

How Delayed Quotes Work

Real-Time vs Delayed Stock Quotes

Why Do Stock Quotes Get Delayed?

How Real-Time Quotes Affect Your Investment Strategy

How Delayed Quotes Affect Your Investment Strategy

Deciding Which Stock Quote is Right for You

The Takeaway

FAQ

What is a delayed stock quote?

What are real-time stock quotes?

Are real-time quotes better than delayed quotes?

Benefits of ETFs — Pros & Cons in Investment Portfolio

What Are the Benefits of ETFs?

ETFs Trade Similar to Stocks

Portfolio Diversification

Accessible Across Markets

Lower Costs

Tax Efficiency

Transparency

Flexibility

Disadvantages of ETFs

Lack of Personalization

Tracking Error

Short-Term Trading Costs

Limited Choices

Counterparty Risk

Complexity

Market Risk

What to Consider When Investing in ETFs

Investing With SoFi

FAQ

What is the benefit of investing in an exchange-traded fund?

Are ETFs a good investment?

Why are ETFs better than stocks?

Is an ETF better than a mutual fund?

Guide to Investment Risk Pyramids

What Are Investment Pyramids?

How Investing Pyramids Work

Base of the Pyramid

Middle of the Pyramid

Top of the Pyramid

Sample Investment Pyramid

Pros and Cons of Investment Pyramids

Pros

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with a limited-time APY boost.*

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