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Q: What is a Limit Order?

A limit order allows investors to buy or sell securities at a price they specify or better, providing some price protection on trades.

Dec

2023

What Is a Limit Order?

By Rebecca Lake | Growing Wealth, Investing, Terminology | No Comments

Table of Contents

What Is a Limit Order?
How Do Limit Orders Work?
Types of Limit Orders
How to Set a Limit Order
When a Trader Might Use a Limit Order
Pros and Cons of Using Limit Orders
Limit Orders vs Market Orders
Limit Orders vs Stop Orders
FAQ

What Is a Limit Order?

A limit order allows investors to buy or sell securities at a price they specify or better, providing some price protection on trades.

When you set a buy limit order, for example, the trade will only be executed at that price or lower. For sell limit orders, the order will be executed at the price you set or higher. By using certain types of orders, traders can potentially reduce their risk of losses and avoid unpredictable swings in the market.

How Do Limit Orders Work?

In the simplest terms, limit orders work as a sort of restriction that an investor can choose (to either buy or sell) with “limits” on a minimum or maximum price. An investor places an order to buy a stock at a minimum price, for instance, or places an order to sell at a maximum price, in an effort to maximize their returns.

There are two types of limit orders investors can execute: buy limit orders and limit sell orders. An important thing to know is that while a limit order specifies a desired price, it doesn’t guarantee the trade will occur at that price — or at all.

When you set a limit order, the trade will only be executed if and when the security meets the terms of the order — which may or may not happen, depending on the overall market conditions. So, when an investor sets a limit order, it’s possible to miss out on other investing opportunities.

Types of Limit Orders

As mentioned, there are two types of limit orders investors can execute: buy limit orders and limit sell orders.

What is a Buy Limit Order?

For buy limit orders, you’re essentially setting a ceiling for the trade — i.e. the highest price you’d be willing to pay for each share.If a trader places a buy limit order, the intention is to buy shares of stock. The order will be triggered when the stock hits the limit price or lower.

For example, you may want to buy shares of XYZ stock at $15 each. You could place a buy limit order that would allow the trade to be carried out automatically if the stock reaches that purchase price or better.

What is a Sell Limit Order?

For sell limit orders, you’re setting a price floor — i.e. the lowest amount you’d be willing to accept per share. If a trader places a limit order to sell, the order will be triggered when the stock hits the limit price or higher. So you could set a sell limit order to sell XYZ stock once its share price hits $20 or higher.

What is a Stop-Limit Order?

A stop-limit order is a combination of a stop order and a limit order. Stop-limit orders involve setting two prices. For example: A stock is currently priced at $30 and a trader believes it’s going to go up in value, so they set a buy stop order of $33.

When the stock hits $33, a market order to buy will be triggered. But with a stop-limit order, the trader can also set a limit price, meaning the highest price they’re willing to pay per share — say, $35 per share. Using a stop-limit order gives traders an additional level of control.

Stop-limit orders can also help traders make sure they sell stocks before they go down significantly in value. Let’s say a trader purchased stock XYZ at $40 per share, and now anticipates the price will drop. The trader doesn’t want to lose more than $5 per share, so they set a stop order for $35.

If the stock hits $35 — the stop price — the stock will be triggered to sell. However, the price could continue to drop before the trade is fully executed. To prevent selling at a much lower price than $35, the trader can set a limit order to only sell between $32 and $35.

How to Set a Limit Order

When placing a limit order with your brokerage firm, the broker or trading platform might ask for the following information:

• The stock or security

• Is it a buy or sell order

• Number of shares to buy or sell

• Stock order type (limit order, market order, or another type of order)

• Price

When setting up a limit order, the trader can set it to remain open indefinitely, (until the stock reaches the limit price), or they can set an expiration date.

Limit Order Example

Say a trader would like to purchase 100 shares of stock XYZ. The highest price they want to pay per share is $26.75. They would set up a limit buy order like this:

Buy 100 shares XYZ limit 26.75.

As noted above, the main upside of using limit orders is that traders get to name a desired price; they generally end up paying a price they expect; and they can set an order to execute a trade that can be executed even if they are doing other things.

In this way, setting limit orders can help traders seize opportunities they might otherwise miss because limit orders can stay open for months or in some cases indefinitely (the industry term is “good ‘til canceled,’ or GTC). The limit order will still execute the trade once the terms are met.

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When a Trader Might Use a Limit Order

There are several reasons why you might want to use a limit order.

• Price protection. When a stock is experiencing volatility, you may not want to risk placing a market order and getting a bad price. Although it’s unlikely that the price will change drastically within a few seconds or minutes after placing an order, it can happen, and setting a limit order can set a floor or a ceiling for the price you want.

• Convenience. Another occasion to use a limit order might be when you’re interested in buying or selling a stock but you don’t want to keep a constant eye on the price. By setting a limit order, you can walk away and wait for it to be executed. This might also be a good choice for longer-term positions, since in some cases traders can place a limit order with no expiration date.

• Volatility. Third, an investor may choose to set a limit order if they are buying or selling at the end of the market day or after the stock market has closed. Company or world news could be announced while the market is closed, which could affect the stock’s price when the market reopens. If the investor isn’t able to cancel a market order while the market is still closed, they may not be happy with the results of the trade. A limit order can help prevent that.

Limit orders can also be useful when the stock being traded doesn’t have a lot of liquidity. If there aren’t many people trading the stock, one order could affect the price. When entering a market order, that trade could cause the price to go up or down significantly, and a trader could end up with a different price than intended.

Pros and Cons of Using Limit Orders

Each type of order has pros and cons depending on the particular situation.

Pros of Limit Orders:

• The trader gets to name their price. One of the chief reasons traders rely on limit orders is to set baselines for profits and losses. They won’t end up paying a price they didn’t expect when they buy or get a price below their target when it’s time to sell.

• The trader can set the order and walk away. Day trading can be time consuming and it requires a significant amount of knowledge. Investors who use limit orders don’t have to continuously watch the market to get the price they want.

• Traders may pay less in fees. Commissions can take a bite out of your profits, something many investors would prefer to keep to a minimum. When trading illiquid stocks, sometimes the bid-ask spread is enough to cover broker fees.

• Insulate against volatility. Volatility can cause you to make emotional decisions. Limit orders can give traders more control over their portfolio and ward off panic-buying or selling.

• Ride the gaps. Stock prices can fluctuate overnight due to after hours trading. It’s possible to benefit from price differences from one day to another when using limit orders.

For example, if a trader places a buy limit order for a stock at $3.50, but the order doesn’t get triggered while the market is open, the price could change overnight. If the market opens at $3.30 the next morning, they’ll get a better price, since the buy limit order gets triggered if the stock is at or below the specified price.

Cons of Limit Orders:

• The order may never be executed. There may not be enough supply or demand to fulfill the order even if it reaches the limit price, since there could be hundreds or even thousands of other traders wanting to buy or sell at the specified price.

• The stock may never reach the limit price. For example, if a stock is currently priced at $20, a trader might set a limit order to buy at $15. If the stock goes down to $16 and then back up to $20, the order won’t execute. In this case, they would miss out on potential gains.

• The market can change significantly. If a trader sets a shorter-term limit order they might miss out on a better price. For example, if a stock a trader owns is currently priced at $150, the trader may choose to set a sell limit order at $154 within four weeks. If the company then makes a big announcement about a new product after that period, and the stock’s price spikes to $170, the trader would miss out on selling at that higher price.

• It takes experience to understand the market and set limit orders. New investors can miss out on opportunities and experience unwanted losses, as with any type of investment.

Limit Order vs Market Order

Limit orders differ from market orders, which are, essentially, orders to buy a security immediately at its given price. These are the most common types of orders. So, while a market order is executed immediately regardless of terms, limit orders only execute under certain circumstances.

Limit orders can also be set for pre-market and after-hours trading sessions. Market orders, by contrast, are limited to standard trading hours (9:30am to 4pm ET).

Remember: Even though limit orders are geared to a specific price, that price isn’t guaranteed. First, limit orders are generally executed on a first-come-first-served basis. So there may be orders ahead of yours that eliminate the availability of shares at your limit price.

And it bears repeating again: There is also the potential for missed opportunities: The limit order you set could trigger a trade. But then the stock or other security might hit an even better price.

In other words, time is a factor. In today’s market, computer algorithms execute the majority of stock market trades. In this high-tech trading environment, it can be hard as an individual trader to know when to buy and sell. By using certain types of orders, like limit orders, traders can potentially limit their losses, lock in gains, and avoid swings in the market.

Though limit orders are commonly used as a part of day trading strategies, they can be useful for any investor who wants some price protection around their trades. For example, if you think a stock is currently undervalued, you could purchase it at the current market price, then set a sell limit order to automatically sell it when the price goes up. Again, the limit order can stay open until the security meets your desired price — or you cancel the order.

However, speculating in the market can be risky and having experience can be helpful when deciding how and when to set limit orders.

Limit Orders vs Stop Orders

There is another type of order that can come into play when you’re trying to control the price of a trade: a stop order. A stop order is similar to a limit order in that you set your desired price for a stock, say, and once the stock hits that price or goes past it, a market order is triggered to execute the purchase or sale.

The terms of a limit order are different in that a trade will be executed if the stock hits the specified price or better. So if you want to sell XYZ stock for $50 a share, a sell limit order will be triggered once the stock hits $50 or higher.

A stop order triggers a market order once XYZ stock hits $50, period. By the time the order is executed, the actual stock price could be higher or lower.

Thus with a stop order there’s also no guarantee that you’ll get the specified price. A market order is submitted once the stop price is hit, but in fast-moving markets the actual price you pay might end up being higher or lower.

Stop orders are generally used to exit a position and to minimize losses, whereas limit orders are used to capture gains. But two can also be used in conjunction with each other with something called a stop-limit order.

When to Consider a Market Order vs a Limit Order

If you’re trying to parse out when a market order or a limit order is the best tool to use, consider the following.

A trader might want to use a market order if:

• Executing the trade immediately is a priority

• The stock is highly liquid

• They’re only trading a small number of shares

• The stock has a narrow bid-ask spread (about a penny)

A trader might want to use a limit order if:

• They want to specify their price

• They are trading an illiquid stock

• They want to set a long-term trade (or even walk away for their lunch break and still have the trade execute)

• They feel a stock is currently over- or undervalued

• The stock has a large bid-ask spread

• They are trading a larger number of shares

Is a Limit Order Bad?

Limit orders are not necessarily good or bad. As mentioned, they can offer advantages to investors who understand how to use them.

For example, limit orders can offer more control and flexibility than using market orders. And they can work well in a number of different trading situations. If the stock being traded is highly volatile, for instance, a limit order can help traders retain control and avoid paying an unexpected price.

Each time a trader does research on a stock and decides to buy or sell shares, they also consider their goals and the current market conditions to decide whether to place a market or a limit order.

What Happens If a Limit Order Is Not Filled?

A limit order can only be filled if the stock’s price reaches the limit price or better. If this doesn’t happen, then the order is not executed and it expires according to the terms of the contract. An order can be good just for a single trading day, for a certain period of time, or in some cases it’s possible to leave the limit order open-ended using a GTC (good ‘til canceled) provision.

So if you placed a buy limit order, but the stock does not reach the specified price or lower, the purchase would not be completed and the order would expire within the specified time frame.

And if you’re using a sell limit order, but the security never reaches the specified sell price or higher, the shares would remain in your trading account and the order would expire.

Limit Orders and Price Gaps

Price gaps can occur when stocks close at one price then open at a different price on the next trading day. This can be attributed to after-market or pre-market trading that occurs after the regular market hours have ended. After-hours trading can impact stock price minimally or more substantially, depending on what’s spurring trades.

For example, say news of a large tech company’s planned merger with another tech giant leaks after hours. That could send the aftermarket trading markets into a frenzy, resulting in a radically different price for both company’s stocks when the market reopens. Pricing gaps don’t necessarily have to be wide but large pricing swings are possible with overnight trading.

Limit orders can help to downplay the potential for losses associated with pricing gaps. Placing a buy limit order or limit sell order may not close the gap entirely. But it could help to mitigate the losses you may experience when gaps in pricing exist. Whether the gap is moving up or down can determine what type of limit order to place and where to cap your limit price.

The Takeaway

Limit orders can be an effective and efficient way for investors to set price caps on their trades, and also give them some protection against market swings. Limit orders offer other advantages as well, including giving traders the ability to place longer- or shorter-term trades that will be executed even if they’re not continuously watching the market. This can potentially protect investors against losses and potentially lock in gains.

That said, limit orders are complicated because they don’t guarantee that the trade will be executed at the set price. The stock (or other security) could hit the limit price — and there might not be enough supply or demand to complete the trade. There is also the potential for some missed opportunities, if the price you set triggers a trade, and subsequently the stock or other security hits an even better price.

Investors can also consider combining a limit order with a stop order. A stop-limit order can provide even more protection against potential losses.

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FAQ

Can I specify the price for a limit order?

Yes, investors can specify the price for a limit order. In fact, the price typically is the limit in a limit order, representing either a price ceiling or a price floor.

How long does a limit order stay active?

Generally, a limit order will stay active indefinitely, unless an investor cancels it or specifies otherwise. That means that if the limit is never reached, the order will not execute, and the limit order will remain active until the limit is reached.

Can I cancel a limit order once it’s placed?

Investors can cancel standing limit orders as long as conditions haven’t arrived that’s led to the order being actively executed. The cancelation process will depend on the specific exchange an investor is using, however.

What happens if the market price doesn’t reach my limit price?

If the market price of a stock does not reach the limit price — either a price floor or price ceiling — then the limit order will not execute, and the limit order will remain active until it does.

Can I place a limit order outside of regular trading hours?

It’s possible to place limit orders outside of regular trading hours, depending on the rules of a given exchange, and market conditions dictate. The order itself, of course, won’t execute until the market opens, assuming that the limit is reached.

Are there any fees associated with limit orders?

There may or may not be fees associated with limit orders, and it’ll depend on the specific exchange or brokerage an investor is using. Note that some brokerages may charge higher fees for limit orders than market orders — but some may charge no fees at all.

Are limit orders guaranteed to be executed?

No, there is no guarantee that a limit order will be executed, as it will only execute if the limit price is reached. If the limit is not reached, the order will remain active but not execute.

Dec

2023

Understanding the Coupon Rate of a Bond

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

A bond’s coupon rate represents the annual interest rate paid by the issuer, as determined by current market interest rates and based on the bond’s face value. Bond issuers typically pay coupon rates on a semiannual basis.

The coupon rate of a bond can tell an investor how much interest they can expect to collect on a yearly basis. The bond coupon rate is not the same as the bond yield, which investors who buy bonds on the secondary market use to estimate the total rate of return at maturity.

Investment-quality bonds can help with diversification in a portfolio while providing a consistent stream of interest income. Understanding the coupon rate and what it means is important when choosing bonds for your portfolio.

What Is the Coupon Rate?

Bonds represent a debt where the bond issuer borrows money from investors and agrees to pay interest at regular intervals in exchange for the use of their capital. Both governments and non-government entities, like corporations, may issue bonds to raise capital to fund various endeavors.

The coupon rate of a bond is usually a fixed interest rate, typically paid out twice per year. That said, there are some variable-rate bonds, as well as zero-coupon bonds (more on those below). Investors often use the term “coupon rate” when discussing fixed-income securities, including bonds and notes.

Recommended: How Does the Bond Market Work

The Role of Coupon Rates in Bond Investments

Investors can buy individual bonds, bond funds, or bond options, which are derivatives similar to stock options.

The coupon interest rate tells you what percentage of the bond’s face value, or par value, you’ll receive yearly. The rate won’t change during the life of the bond, which is why some bonds are worth more than others on the secondary market.

Coupon rates are typically lower for investment-grade bonds and higher for junk bonds, due to their higher risk.

Example of a Bond’s Coupon Rate

Assume you purchase a bond with a face value of $1,000. The bond has a coupon rate of 4%. This means that for each year you hold the bond until maturity, you’d receive $40, regardless of what you paid for the bond.

If you buy a bond on the secondary market, the story changes somewhat. That’s because bonds trade either at a premium to the par value (higher than the face value), or at a discount to par (lower than the face value). Because the coupon rate of the bond stays the same until maturity, it may represent a higher or lower percentage of the par value — this is called the yield.

History of the Term Coupon

Bond holders used to get literal coupons as a way of collecting their interest payments. This is no longer the case, as interest is paid on a set schedule to the investor directly.

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Calculating the Coupon Rate

The bond coupon rate formula is fairly simple:

Bond coupon rate = Total annual coupon payment/Face or par value of the bond x 100

To apply the coupon rate formula you’d need to know the face or par value of the bond and the annual interest or coupon payment. To find this payment, you’d multiply the amount of interest paid by the number of periodic payments made for the year. You’d then divide that by the par value and divide the result by 100.

Recommended: How to Buy Bonds: A Guide for Beginners

Step-by-Step Calculation of the Coupon Rate

Say you have a bond with a face value of $1,000, which pays $25 in interest to you twice per year.

• To find the annual coupon payment you’d multiply $25 by two to get $50.

• You’d then divide the $50 annual coupon payment by the $1,000 par value of the bond. 50 / 1000 = 0.05

• Then multiply the result by 100 (0.05 x 100) to find that your bond has a coupon rate of 5%.

The Impact of Market Interest Rates on Coupon Rates

How is the coupon rate determined? This is where current market interest rates come into play.

How Interest Rate Fluctuations Affect Bonds

Interest rates can influence coupon rates. An interest rate is the rate a lender charges a borrower. Individual lenders determine interest rates, often based on movements in an underlying benchmark rate. When discussing bond coupon rates and interest rates, it’s typically in the context of changes to the federal funds rate. This is the rate at which commercial banks lend to one another overnight.

Movements in the federal funds rate directly influence other types of interest rates, including coupon rates and bond prices on the secondary market.

When interest rates rise, based on changes to the federal funds rate, that can cause bond prices to fall. When interest rates decline, bond prices typically rise. When bond prices change that doesn’t impact the coupon rate, which stays the same. But a bond’s price is an important consideration for investors who trade on the secondary market because it impacts the yield to maturity.

Strategies for Investors in a Changing Rate Environment

Bond prices can move up or down based on the coupon rate, relative to movements in interest rates.

When interest rates are higher than the bond’s coupon rate, that bond’s price may fall in order to offset a less attractive yield. If interest rates drop below the bond’s coupon rate, the bond’s price may rise if it becomes a more attractive investment opportunity.

When comparing coupon rates and bond prices, it’s important to understand the relationship between the bond’s face value and what it trades for on the secondary market. If a bond is trading at a price above its face value, that means it’s trading at a premium to par. Conversely, if a bond is trading at a price below its face value, that means it’s trading at a discount to par.

An investor who purchases a bond with the intent to hold it until it reaches maturity does not need to worry about bond price movements. Their end goal is to collect the annual interest payments and recover their principal on the assigned maturity date, making it a relatively safe investment as long as the issuer fulfills their obligation.

Investors looking to buy bonds and resell them before they mature, however, may pay attention to which way bond prices are moving relative to the coupon rate to determine whether selling would yield a profit or loss.

Understanding Coupon Rate vs. Yield

Coupon rate tells investors how much interest a bond will pay yearly until maturity. But there are other metrics for evaluating bonds, including yield to maturity and interest rates. Understanding the differences in what they measure matters when determining whether bond investments are a good fit and what rate of return to expect.

Coupon Rate vs. Yield to Maturity

A bond’s yield to maturity or current yield reflects the interest rate earned by an investor who purchases a bond at market price and holds on to it until it reaches maturity. A bond’s maturity date represents the date at which the bond issuer agrees to repay the investor’s principal investment. Longer maturity dates may present greater risk, as they leave more room for the bond issuer to run into complications that could make it difficult to repay the principal.

When evaluating yield to maturity of a bond, you’re looking at the discount rate at which the sum of all future cash flows is equal to the price of the bond. Yield to maturity can be quoted as an annual rate that’s different from the bond coupon rate. In figuring yield to maturity, there’s an assumption that the bond issuer will make coupon and principal payments to investors on time.

The coupon rate is the annual interest earned while yield to maturity reflects the total rate of return produced by the bond when all interest and principal payments are made.

Coupon Rate vs Interest Rate

While coupon rate and interest rate seem similar, they are distinct. The coupon rate is set by the issuer of the bond, and the amount paid to the bondholder is tied to the face value.

But the prevailing interest rate set by the government is what determines the coupon rate. If the central bank, i.e. the Federal Reserve, sets the interest rate at 6%, that will influence what lenders are willing to accept in the form of the coupon rate.

Also, the price of a bond on the secondary market hinges on the coupon rate. A higher-coupon bond is more desirable than a lower-coupon bond, so its price will be higher.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Variable-Rate and Zero-Coupon Bonds

Not all coupon rates are fixed. Investors can also consider whether buying variable-rate bonds or zero-coupon bonds might make sense.

Fixed vs. Variable Coupon Rates and Investment Impact

Although bonds typically offer fixed-income payments, some bonds do offer coupon rates that adjust periodically. For that reason these bonds are sometimes called floating-rate or adjustable-rate bonds.

In these cases, the coupon rate adjusts according to a formula that’s linked to an interest rate index such as the SOFR (Secured Overnight Financing Rate), the new benchmark in the U.S. that has largely replaced the LIBOR (London Interbank Offered Rate).

Although these are income-producing bonds, and there is always the possibility that they could offer a higher yield under the right conditions, they are not technically fixed-income instruments, which is something for investors to bear in mind. In addition they come with the risk of default.

Zero-Coupon Bonds Explained

Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond. The upside of choosing zero bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.

Zero-coupon bonds typically have longer maturity dates, which may make them suitable when investing for long-term goals. This type of bond may experience more price fluctuations compared to other types of bonds sold on the secondary market. Investors may still have to pay taxes on the imputed interest generated by the bond, though it’s possible to avoid that by investing in zero-coupon municipal bonds or other tax-exempt zero-coupon bond options.

The Takeaway

Investing in bonds can help you create a well-rounded portfolio alongside stocks, and other securities, which is why knowing the coupon rate of a bond is important. The coupon rate is the interest rate paid by the issuer, and it’s fixed for the life of the bond — which makes it possible to create a predictable income stream, whether you buy the bond at issuance or on the secondary market.

As you get closer to retirement, bonds can be an important part of your income and risk management strategy, whether you’re investing through an IRA, a 401(k), or a brokerage account.

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Dec

2023

How to Calculate the Debt-to-Equity Ratio

By Samuel Becker | Growing Wealth, Investing | No Comments

The debt-to-equity ratio (D/E) is one of many financial metrics that helps investors determine potential risks when looking to invest in certain stocks.

Companies also use debt, also known as leverage, to help them accomplish business goals and finance operating costs. Calculating a company’s debt-to-income ratio requires a relatively simple formula investors can use on their own or with a spreadsheet.

What Is the Debt-to-Equity Ratio?

The debt-to-equity ratio is one of several metrics that investors can use to evaluate individual stocks. At its simplest, the debt-to-equity ratio is a quick way to assess a company’s total liabilities vs. total shareholder equity, to gauge the company’s reliance on debt.

In other words, the D/E ratio compares a company’s equity — how much value is locked up in its shares — to its debts. Among other things, knowing this figure can help investors gauge a company’s ability to cover its debts. For example, if a company were to liquidate its assets, would it be able to cover its debt? How much money would be left over for shareholders?

Investors often use the debt-to-equity ratio to determine how much risk a company has taken on, and in return, how risky it may be to invest in that company. After all, if a company goes under and can’t cover its debts, its shares could wind up worthless.

💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.

What Is Leverage?

To understand the debt-to-equity ratio, it’s helpful to understand the concept of leverage. A business has two options when it comes to paying for operating costs: It can either use equity, or it can use debt, a.k.a. leverage.

The company can use the funds they borrow to buy equipment, inventory, or other assets — or to fund new projects or acquisitions. The money can also serve as working capital in cyclical businesses during the periods when cash flow is low.

While it’s potentially risky to use leverage — a company might have to declare bankruptcy if it can’t pay its debt — borrowed funds can also help a company grow beyond the limitation of its equity at critical junctures.

The term “leverage” reflects the hope that the company will be able to use a relatively small amount of debt to boost its growth and earnings. Wise use of debt can help companies build a good reputation with creditors, which, in turn, will allow them to borrow more money for potential future growth.

Understanding Different Types of Debt

Not all debt is considered equally risky, however, and investors may want to consider a company’s long-term versus short-term liabilities. Generally speaking, short-term liabilities (e.g. accounts payable, wages, etc.) that would be paid within a year are considered less risky.

A company’s ability to cover its long-term obligations is more uncertain, and is subject to a variety of factors including interest rates (more on that below).

The Debt-to-Equity Ratio Formula

Calculating the debt-to-equity ratio is fairly straightforward. You can find the numbers you need on a listed company’s balance sheet.

To calculate the D/E ratio, take the company’s total liabilities and divide it by shareholder equity. Here’s what the debt to equity ratio formula looks like:

D/E = Total Liabilities / Shareholder Equity

How to Calculate the Debt-to-Equity Ratio

In order to calculate the debt-to-equity ratio, you need to understand both components.

Total Liabilities

This component includes a company’s current and long-term liabilities. Current liabilities are the debts that a company will typically pay off within the year, including accounts payable. Long-term liabilities are debts whose maturity extends longer than a year. Think mortgages on buildings or long-term leases.

Equity

The equity component includes two portions: shareholder equity and retained earnings. Shareholder equity is the money investors have paid in exchange for shares of the company stock. Retained earnings are profits that the company holds onto that aren’t paid out in the form of dividends to shareholders.

Excel Formula for Debt-to-Equity Ratio

Using excel or another spreadsheet to calculate the D/E is relatively straightforward. First, using the company balance sheet, pull the total debt amount and the total shareholder equity amount, and enter these numbers into adjacent cells (e.g. E2 and E3).

Then, in cell E4 enter the formula “=E2/E3”, and this will give you the D/E ratio.

Debt-to-Equity Example

To look at a simple example of a debt to equity formula, consider a company with total liabilities worth $100 million dollars and equity worth $85 million. Divide $100 million by $85 million and you’ll see that the company’s debt-to-equity ratio would be about 1.18. In other words, the company has $1.18 in debt for every dollar of equity.

When using a real-world debt to equity ratio formula, you’ll probably be able to find figures for both total liabilities and shareholder equity on a company’s balance sheet. Publicly traded companies will usually share their balance sheet along with their regular filings with the Securities and Exchange Commission (SEC).

Putting the D/E in Context

Remember that arriving at this ratio is just that: a single number that reveals a certain aspect of a company’s potential performance, but doesn’t tell the whole story. It’s essential to compare a company’s D/E ratio to that of other companies in its industry.

In addition, there are many other ways to assess a company’s fundamentals and performance — by using fundamental analysis and technical indicators. Experienced investors rarely rely on one measure to evaluate a stock.

What Is a Good Debt-to-Equity Ratio?

Once you’ve calculated a debt-to-equity ratio, how do you know whether that number is good or bad?

As a general rule of thumb, a good debt-to-equity ratio will equal about 1.0. However, the acceptable rate can vary by industry, and may depend on the overall economy. A higher debt-to-income ratio could be more risky in an economic downturn, for example, than during a boom.

Recommended: Investing During a Recession

For example, if a company, such as a manufacturer, requires a lot of capital to operate, it may need to take on a lot of debt to finance its operations. A company like this may have a debt equity ratio of about 2.0 or more.

Other companies that might have higher ratios include those that face little competition and have strong market positions, and regulated companies, like utilities, that investors consider relatively low risk.

Companies that don’t need a lot of debt to operate may have debt-to-equity ratios below 1.0. For example, the service industry requires relatively little capital.

Modifying Debt-to-Equity Ratio

As noted above, it’s also important to know which type of liabilities you’re concerned about — longer-term debt vs. short-term debt — so that you plug the right numbers into the formula.

For example, if you have two companies, each with $2.5 million in shareholder equity, and $2.5 million in debt, their D/E ratios would be the same: 1.0.

But let’s say Company A has $2 million in long-term liabilities, and $500,000 in short-term liabilities, whereas Company B has $1.5 million in long-term debt and $1 million in short term debt. The long-term D/E ratio for Company A would be 0.8 vs. 0.6 for company B, indicating a higher risk level.

Depending on the industry they were in and the D/E ratio of competitors, this may or may not be a significant difference, but it’s an important perspective to keep in mind.

What Does a Company’s Debt-to-Equity Ratio Say About It?

A debt-to-equity-ratio that’s high compared to others in a company’s given industry may indicate that that company is overleveraged and in a precarious position. Investors may want to shy away from companies that are overloaded on debt.

Not only that, companies with a high debt-to-equity ratio may have a hard time working with other lenders, partners, or even suppliers, who may be afraid they won’t be paid back.

In some cases, creditors limit the debt-to-equity ratio a company can have as part of their lending agreement. Such an agreement prevents the borrower from taking on too much new debt, which could limit the original creditor’s ability to collect.

It is possible that the debt-to-equity ratio may be considered too low, as well, which is an indicator that a company is relying too heavily on its own equity to fund operations. In that case, investors may worry that the company isn’t taking advantage of potential growth opportunities.

Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with equity.

What Does It Mean for a Debt-to-Equity Ratio to Be Negative?

There could be several reasons for a negative debt-to-equity ratio, including:

• Interest rates are higher than the returns

• A negative net worth (more liabilities than assets)

• A financial loss after a large dividend payout

• Dividend payments that surpass investor’s equity in the firm

So, what does this mean for investors?

Negative D/E ratios may tell investors that the company indicates investment risk and shows that the company is not financially stable. Therefore, investing in such a company may result in a loss for investors.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

Which Industries Have High Debt-to-Equity Ratios?

The depository industry (banks and lenders) may have high debt-to-equity ratios. Because banks borrow funds to loan money to consumers, financial institutions usually have higher debt-to-equity ratios than other industries.

Other industries with high debt-to-equity ratios include:

• Non-depository credit institutions

• Insurance providers

• Hotels, rooming houses, camps, and other lodging places

• Transportation by air

• Railroad transportation

Effect of Debt-to-Equity Ratio on Stock Price

The debt-to-equity ratio can clue investors in on how stock prices may move. As a measure of leverage, debt-to-equity can show how aggressively a company is using debt to fund its growth.

The interest rates on business loans can be relatively low, and are tax deductible. That makes debt an attractive way to fund business, especially compared to the potential returns from the stock market, which can be volatile. And sometimes an aggressive strategy can pay off.

For example, if a company takes on a lot of debt and then grows very quickly, its earnings could rise quickly as well. If earnings outstrip the cost of the debt, which includes interest payments, a company’s shareholders can benefit and stock prices may go up.

The opposite may also be true. A highly leveraged company could have high business risk. If earnings don’t outpace the debt’s cost, then shareholders may lose and stock prices may fall.

Having to make high debt payments can leave companies with less cash on hand to pay for growth, which can also hurt the company and shareholders. And a high debt-to-equity ratio can limit a company’s access to borrowing, which could limit its ability to grow.

Debt-to-Equity (D/E) Ratio vs the Gearing Ratio

The debt-to-equity ratio belongs to a family of ratios that investors can use to help them evaluate companies. These ratios are collectively known as gearing ratios.

Here’s a quick look at other gearing ratios you may encounter:

Equity Ratio

This ratio compares a company’s equity to its assets, showing how much of the company’s assets are funded by equity.

Debt Ratio

This looks at the total liabilities of a company in comparison to its total assets. On the surface, this may sound like the debt ratio formula is the same as the debt-to-equity ratio formula. However, the total debt ratio formula includes short-term assets and liabilities as part of the equation, which the debt-to-equity ratio discounts. Also, this ratio looks specifically at how much of a company’s assets are financed with debt.

Time Interest Earned

This ratio helps indicate whether a company has the ability to make interest payments on its debt, dividing earnings before interest and taxes (EBIT) by total interest. Most of the information needed to calculate these ratios appears on a company’s balance sheet, save for EBIT, which appears on its profit and loss statement.

How Businesses Use Debt-to-Equity Ratios

Businesses pay as much attention to debt-to-equity as individual investors. For example, if a company wants to take on new credit, they would likely want their debt-to-equity ratio to be favorable.

Banks and other lenders keep tabs on what healthy debt-to-equity ratios look like in a given industry. A debt-to-equity ratio that seems too high, especially compared to a company’s peers, might signal to potential lenders that the company isn’t in a good position to repay the debt.

Publicly traded companies that are in the midst of repurchasing stock may also want to control their debt-to-equity ratio. That’s because share buybacks are usually counted as risk, since they reduce the value of stockholder equity. As a result the equity side of the equation looks smaller and the debt side appears bigger.

How Can the Debt-to-Equity Ratio Be Used to Measure a Company’s Risk?

While acceptable D/E ratios vary by industry, investors can still use this ratio to identify companies in which they want to invest. First, however, it’s essential to understand the scope of the industry to fully grasp how the debt-to-equity ratio plays a role in assessing the company’s risk.

Many companies borrow money to maintain business operations — making it a typical practice for many businesses. For companies with steady and consistent cash flow, repaying debt happens rapidly. Also, because they repay debt quickly, these businesses will likely have solid credit, which allows them to borrow inexpensively from lenders.

Therefore, even if such companies have high debt-to-equity ratios, it doesn’t necessarily mean they are risky. For example, companies in the utility industry must borrow large sums of cash to purchase costly assets to maintain business operations. However, since they have high cash flows, paying off debt happens quickly and does not pose a huge risk to the company.

On the other hand, companies with low debt-to-equity ratios aren’t always a safe bet, either. For example, a company may not borrow any funds to support business operations, not because it doesn’t need to but because it doesn’t have enough capital to repay it promptly. This may mean that the company doesn’t have the potential for much growth.

IPOs and Debt-to-Equity Ratios

Many startups make high use of leverage to grow, and even plan to use the proceeds of an initial public offering, or IPO, to pay down their debt. The results of their IPO will determine their debt-to-equity ratio, as investors put a value on the company’s equity.

So in the case of deciding whether to invest in IPO stock, it’s important for investors to consider debt when deciding whether they want to buy IPO stock.

The Limitations of Debt-to-Equity Ratios

Debt-to-equity ratio is just one piece of the puzzle when it comes to evaluating stocks. Whether the ratio is high or low is not the bottom line of whether one should invest in a company. A deeper dive into a company’s financial structure can paint a fuller picture.

A company’s accounting policies can change the calculation of its debt-to-equity. For example, preferred stock is sometimes included as equity, but it has certain properties that can also make it seem a lot like debt. Specifically, preferred stock with dividend payment included as part of the stock agreement can cause the stock to take on some characteristics of debt, since the company has to pay dividends in the future.

If preferred stock appears on the debt side of the equation, a company’s debt-to-equity ratio may look riskier. If it’s included on the equity side, the ratio can look more favorable.

In some cases, companies can manipulate assets and liabilities to produce debt-to-equity ratios that are more favorable. Additionally, investors may want to keep an eye on interest rates. If they’re low, it can make sense for companies to borrow more, which can inflate the debt-to-equity ratio, but may not actually be an indicator of bad tidings.

Finally, the debt-to-equity ratio does not take into account when a debt is due. A debt due in the near term could have an outsized effect on the debt-to-equity ratio.

As a result of temporary imbalances like these, investors may want to compare debt-to-equity ratios from various time periods to get an idea of a company’s normal wage, or whether fluctuations are signaling more noteworthy movement within the company.

Investing in Businesses With SoFi

Investors can use the debt-to-equity ratio to help determine potential risk before they buy a stock. As an individual investor you may choose to take an active or passive approach to investing and building a nest egg. The approach investors choose may depend on their goals and personal preferences.

Investors who want to take a more hands-on approach to investing, choosing individual stocks, may take a look at the debt-to-equity ratio to help determine whether a company is a risky bet.

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

What is a good debt-to-equity ratio?

Generally speaking a D/E ratio of about 1.0 doesn’t raise any red flags, but it’s important to consider the needs of the company, its industry, and its competitors, as any of these factors might justify a higher debt-to-equity ratio.

How do you interpret debt-to-equity ratio?

Taking a broader view of a company and understanding the industry its in and how it operates can help to correctly interpret its D/E ratio. For example, utility companies might be required to use leverage to purchase costly assets to maintain business operations. But utility companies have steady inflows of cash, and for that reason having a higher D/E may not spell higher risk.

What is considered a bad debt-to-equity ratio?

A D/E ratio of about 1.0 to 2.0 is considered good, depending on other factors like the industry the company is in. But a D/E ratio above 2.0 — i.e., more than $2 of debt for every dollar of equity — could be a red flag. Again, context is everything and the D/E ratio is only one indicator of a company’s health.

SOIN0723012

Dec

2023

What Is a Red Herring in Investing & How Does It Work?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

What Is a Red Herring?

A red herring is a preliminary prospectus filed by a company that’s planning an initial public offering, or IPO. While a red herring prospectus includes coverage of the company’s operations, total estimated IPO amount, management and competitive market standing, it doesn’t reveal the share price or number of shares to be issued.

The SEC reviews the red herring prospectus, and all subsequent iterations, to make sure that all information is accurate before allowing the company to transition to the final investment prospectus phase.

A red herring prospectus has both investment and regulatory implications for companies heading toward an IPO, and any investors who may be interested in obtaining IPO stock.

Key Points

• A red herring in an IPO is a preliminary prospectus filed by a company that provides information on operations, estimated IPO amount, management, and market standing.

• A red herring is not final, and investors must take into considerations that the filing doesn’t include the share price for the IPO or the number of shares to be issued.

• The SEC reviews a red herring prospectus to make sure that all information is accurate before allowing the company to transition to the final investment prospectus phase.

• Red herrings offer investors some insight into the pros and cons potentially associated with trading IPO shares of the company in question.

IPOs, Explained

An initial public offering is the process through which a private company goes public, with shares of the company’s stock available to the investing public. The term “initial public offering” simply refers to a new stock issuance on a public exchange, which allows corporations to raise money through the sale of company stock.

Red Herring Prospectus

When a company transitions from a private company to public stock issuance, they must file a prospectus, a formal document sharing the new company’s structure, the purpose of the issue, underwriting, board of directors, and other relevant details with the Securities and Exchange Commission (SEC).

That prospectus, while not final, may help potential investors make investment decisions based on the information included in the prospectus. A prospectus doesn’t just cover stocks — it’s also required for bonds and mutual funds.

While all stocks include some degree of risk, IPO shares are particularly high-risk investments. Despite the media hype around many IPOs, which often focuses on big wins, the history of IPOs shows plenty of losses as well, owing to the volatility of these shares.

The risks associated with IPO stock is a significant reason why investors are typically asked to meet certain requirements in order to trade IPO shares through a brokerage.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

[ipo_launch]

How a Red Herring Works

Prospectuses are dynamic and change regularly, as new information about a company comes forth. So, an investment prospectus will likely have multiple drafts before a final draft is released after SEC review.

In a red herring document, the prospectus is incomplete and noted as such, with the word “Red Herring” included on the prospectus cover. That disclaimer lets readers know not only that the prospectus is incomplete, but also that the company has filed for an upcoming IPO. The term “red herring” refers to both the initial prospectus and the subsequent drafts.

Additionally, a stock cannot complete its IPO until it fulfills the S-1 registration statement process, which is a primary reason why a red herring prospectus doesn’t include a stock price or the number of shares traded.

The SEC will review a red herring prospectus prior to its release to ensure that all information is accurate and that the document does not include any intentional discrepancies, falsehoods, or misleading information.

Recommended: A Guide to Tech IPOs

Once regulators clear the registration statement, the company can go ahead and transition out of the red herring IPO phase and enter into the final investment prospectus phase. The time between the approval of the registration process and the time that it reaches its “effective date” (which clears the stock for public trading) is 15 days.

In clearing the IPO for stock market trading, the SEC confirms the necessary information is included in the final prospectus, and that the information is accurate and compliant, based on U.S. securities law. Once the company gets through that hurdle they can continue moving through the IPO process.

💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.

Red Herring Pros and Cons

Any investor looking to invest in an IPO stock should understand the benefits and investment risks when it comes to red herrings and in investing in IPOs.

Red Herring Advantages

• Useful overall information on the company. While investors won’t find any information on pricing or share amounts, they can review company history, operational strategies, management team, potential IPO amount, and market performance, among other company particulars.

• Some financial data points. Red herring IPOs may provide valuable information about how a company plans to use proceeds from an IPO stock offering. Knowing, for example, that a company plans to use stock proceeds to grow the company or to pay down debts gives investors a better indication of company direction, which they can use to make more informed investment decisions.

• Risk factors. Under a section known as “Risk Factors”, a soon-to-be publicly-traded company lists any potential risk factors that could curb performance and growth. Legal or compliance problems, abundant market competition, and frequent management turnover are just some of the potential risks included in a red herring IPO prospectus – and investors should factor those risks into any potential investment decision.

Red Herring Disadvantages

• No pricing data. The biggest drawback of red herring IPO prospectus is the fact that the documents don’t provide any guidance on IPO stock pricing or number of shares available. These are obviously critical components of any investment decision, but investors must wait until the registration statement process is fully complete before that data is available.

• Shifting information. IPO company information can and does change from document version to version. Investors need to be diligent and stay apprised of all information on red herring prospectuses, from version to version, if they’re interested in an IPO stock.

• Uncertainty. If government regulators cite deficiencies in a red herring prospectus they may half the IPO process until they’re addressed.

Red Herring Example

A red herring prospectus when filed with the SEC may have the words “Red Herring” stamped on the document as a reminder to prospective investors that the information in the document is subject to change, and that the securities (i.e. shares of stock, or bonds) are not available for sale until the SEC has approved the final prospectus.

The statement typically included in a new company’s prospectus may say:

The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.

The Takeaway

The red herring prospectus is the first version of a new IPO company S-1 prospectus, and may be the first detailed impression that institutional investors and the investing public gets of an initial public offering.

By providing all the necessary information on a new publicly traded company (minus the opening share price and the number of shares available), a red herring prospectus can introduce investors to a new stock, which can provide much of the information necessary for investors to decide whether they’re interested in the company, and willing to assume the risks involved in trading IPO shares (if eligible).

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

How does a red herring document differ from the final prospectus?

The red herring document is usually shorter than the final filing with the SEC. In addition the final document contains the number of shares in the IPO, as well as the IPO price.

Are there any legal or regulatory requirements associated with red herring documents?

Yes. The SEC must validate all claims and data included in the red herring to ensure that it does not include any false information, or anything that might violate existing laws and regulations. Once the red herring passes muster,

Can investors rely on the information provided in a red herring document when making investment decisions?

Investors may use the red herring document to inform their basic understanding of the company that is seeking an IPO, but it may not be enough to guide an actual decision to buy shares.

Are there any risks or limitations associated with red herring documents that investors should be aware of?

Red herring documents are an important part of a new company’s IPO process, and as such they contain key information about the company, but investors need to be aware that the details are not finalized, and the terms may change before the final prospectus is filed.

Photo credit: iStock/Riska

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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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. IPOs offered through SoFi Securities are not a recommendation 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 SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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.

SOIN0723109

Dec

2023

Solo 401(k): The Retirement Plan Built for the Self-Employed

Navigating Solo 401(k) Plans: A Complete Guide for the Self-Employed

By Rebecca Lake | invest, Investing, Preparing for Retirement | Comments Off

Being self-employed offers many perks, including freedom and flexibility. What it doesn’t offer is an employer-sponsored retirement plan. But when you don’t have access to a 401(k) at work, opening a solo 401(k) can make it easier to stay on track with retirement planning.

Before you establish a solo 401(k) for yourself, it’s important to understand how these plans work and the pros and cons involved.

What Is a Solo 401(k)?

A solo 401(k) is a type of 401(k) that’s designed specifically with self-employed individuals in mind. This retirement savings option follows many of the same rules as workplace 401(k) plans in terms of annual contribution limits, tax treatment, and withdrawals. But it’s tailored to individuals who run a business solo or only employ their spouses.

It’s one of several self-employed retirement options you might consider when planning a long-term financial strategy.

Definition and Overview

A solo 401(k) is a tax-advantaged retirement account that’s for self-employed individuals and business owners who have zero employees, or no employees other than their spouse. This type of 401(k) plan is also known by a few other names:

• Solo-k

• Uni-k

• One-participant plan

Traditional solo 401(k) contributions are made using pre-tax dollars. However, it’s possible to open a Roth solo 401(k) instead. In the case of a Roth solo 401(k), you’d make contributions using after-tax dollars and be able to withdraw the money tax-free in retirement.

A self-employed 401(k) plan works much the same as a regular 401(k). For instance, you may be able to take loans from your savings if needed. Catch-up contributions are also allowed. The biggest difference is that there is no matching contribution from an outside employer.

You can start investing in a solo 401(k) for yourself through an online brokerage. There’s some paperwork you’ll need to fill out to get the process started, but once your account is open you can make contributions year-round.

At the end of the year, the IRS requires solo 401(k) plan owners to file a Form 5500-EZ if the account has $250,000 or more in assets.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Contribution Limits in Solo 401(k) Plans

Much like workplace 401(k)s, there are annual contribution limits that apply to solo 401(k) plans.

The IRS caps total contributions to a solo 401(k) account at $66,000 for 2023 and $69,000 for 2024. That doesn’t include catch-up contributions for those age 50 and over, which are an additional $7,500 for each year.

As both the employee and employer of your own business, you can contribute both elective salary deferrals and employer nonelective contributions (you are both the employer and the employee in this scenario). Each has different contribution caps.

Annual Contribution Limits

As an employee, you can contribute up to 100% of your earned income up to the annual contribution limit: $22,500 in 2023 and $23,000 in 2024, plus an additional $7,500 for those age 50+ in elective salary deferrals.
In addition, you can make employer nonelective contributions. These come directly from the “employer” (aka you) and are not deducted from the employee’s (your) salary. As an employer, you can contribute up to 25% of your self-employment income (business income – ½ self-employment tax and elective salary deferrals), in pre-tax dollars.

Setting Up a Solo 401(k) Plan

If you’re interested in setting up a solo 401(k) for yourself, you can do so through an online brokerage. Here’s a step-by-step guide for how to open a solo 401(k).

Steps to Establish Your Plan

1. Choose a Plan Administrator

A plan administrator is the person responsible for managing your solo 401(k). It’s their job to make sure the plan is meeting reporting and other requirements established by the IRS. If you’re self-employed, you can act as your own plan administrator or you could choose your accountant instead.

2. Choose a Brokerage

Once you know who’s going to manage the plan, the next step is deciding where to open it. A number of brokerages offer solo 401(k) plans so you may want to spend some time comparing things like:

• Account setup process

• Investment options

• Fees

You may be able to start the solo 401(k) account setup process online, though some brokerages require you to call and speak to a representative first. And you may need to finalize your account opening by mailing or faxing in any supporting documents the brokerage needs to complete the application.

3. Fill Out a Solo 401(k) Application

Before you can start a 401(k) account for yourself, you’ll need to give your brokerage some information about your business. A typical solo 401(k) application may ask for your:

• First and last name

• Employer Identification Number (EIN)

• Plan administrator’s name and contact information

• Social Security number

• Mailing address

• Citizenship status

• Income information

You’ll also need to disclose any professional associations or affiliations that might result in a conflict of interest with the brokerage. In completing the application, you’ll be asked to name one or more beneficiaries. You may also be asked to provide bank account information that will be used to make your initial contribution to the plan.

4. Choose Your Investments

Once you’ve returned your solo 401(k) account application and it’s been approved, you can choose your investments. The type of investments offered can depend on the brokerage and the plan. But typically, you may be able to choose from:

• Target-date funds

• Index funds

• Actively managed funds

• Exchange-traded funds (ETFs)

Whether you have access to individual stocks, bonds, CDs, or alternative investments such as commodities can depend on the platform that’s offering the plan.

5. Decide How Much to Contribute

You may choose to schedule automatic investments or make them manually according to a schedule that works for you.

Choosing Between Traditional and Roth Solo 401(k)s

You can opt for a traditional solo 401(k), which is made with pre-tax dollars, or a Roth solo 401(k), which is made with after-tax dollars. Which plan is better for you may depend on what you expect your income to be in retirement.

If you believe your income will be higher in retirement than it is now, in general, a Roth could be a better choice since you can take the distributions tax-free at that time. But if you think your income may be less in retirement than it is now, you might be better off with a traditional solo 401(k), which allows you to take the tax deduction now and have your distributions taxed in retirement.

Advantages and Disadvantages of Solo 401(k) Plans

When considering retirement account options, it can be helpful to look at the pros and cons to determine what works best for your personal situation.

Benefits of Having a Solo 401(k)

There are different reasons why opening a 401(k) for self employed individuals could make sense.

• Bigger contributions. Compared to other types of self-employed retirement plans, such as a SEP IRA or SIMPLE IRA, solo 401(k) contribution limits tend to be more generous. Neither a SEP IRA or SIMPLE IRA, for instance, allows for catch-up contributions.

• Roth contributions. You also have the option to open a Roth solo 401(k). If you anticipate being in a higher tax bracket when you retire, you may prefer being able to withdraw contributions tax-free with a Roth.

• Flexible withdrawal rules. A solo 401(k) can also offer more flexibility with regard to early withdrawals than a SEP IRA, SIMPLE IRA, traditional IRA, or Roth IRA. If your solo 401(k) plan allows it, you could take out a loan in place of an early withdrawal. This could help you to avoid early withdrawal penalties and taxes. An IRA-based plan wouldn’t allow for loans.

Considerations and Potential Drawbacks

There are also a few potential downsides of investing in a solo 401(k).

• Eligibility restrictions. If you run a small business and you have at least one employee other than a spouse, you won’t be able to open a solo 401(k) at all.

• Complicated reporting. Calculating contributions and filing can be more complicated with a solo 401(k) vs. a SEP IRA or SIMPLE IRA. If your plan has more than $250,000 in assets you’ll need to file Form 5500-EZ with the IRS each year.

• Administrative costs. Depending on where you open a solo 401(k) plan, the cost of maintaining it year to year may be higher compared to other self employed retirement plans. And an early 401(k) withdrawal can trigger taxes and penalties.

It’s important to consider the range of investment options offered through a solo 401(k). What you can invest in at one brokerage may be very different from another. The individual cost of those investments can also vary if some mutual funds or exchange-traded funds offered come with higher expense ratios than others.

💡 Quick Tip: Did you know that you must choose the investments in your IRA? Once you open a new IRA and start saving, you get to decide which mutual funds, ETFs, or other investments you want — it’s totally up to you.

Withdrawals and Loan Provisions

There are certain requirements for withdrawals and/or loans from a solo 401(k).

Rules for Withdrawing Funds

You can make withdrawals from a solo 401(k) without penalty at age 59 ½ or older. Distributions may be allowed before that time in the case of certain “triggering events,” such as a disability, but you may owe a 10% penalty as well as income taxes on the withdrawal.

Loan Options and Conditions

Some solo 401(k) plans may be set up to allow loans. If yours does, you could take out a loan in place of an early withdrawal. This could help you to avoid early withdrawal penalties and taxes. Just be sure to find out the loan terms and conditions, which can vary by plan.

Testing and Compliance for Solo 401(k)s

Unlike workplace 401(k)s, solo 401(k)s have no testing compliance requirements involved.

Alternatives to Solo 401(k) Plans

Instead of a solo 401(k), self employed individuals can consider another type of retirement account. Here’s how different options stack up.

Comparing a Solo 401(k) to a SEP IRA and Other Retirement Options

A SEP IRA is designed for small businesses. However, unlike a solo 401(k), a SEP IRA allows no catch-up contributions and there is no Roth version of the plan.

A SIMPLE IRA is for businesses with no more than 100 employees. It has much lower contribution limits than a solo 401(k) and once again, there is no Roth option.

Pros and Cons of a Solo 401(k)

A solo 401(k) has advantages and disadvantages. Here’s a side-by-side comparison of the benefits and drawbacks.

Solo 401(k) Pros	Solo 401(k) Cons
Catch-up contributions may allow older investors to save more for retirement versus a SEP IRA or SIMPLE IRA.	Only self-employed individuals who have no employees or just employee their spouses can contribute.
It’s possible to choose between a traditional solo 401(k) or Roth solo 401(k), based on your investing goals and tax situation.	Annual reporting requirements may be more complicated for a solo 401(k) compared to other self employed retirement plans.
Solo 401(k) plans may allow for loans, similar to workplace plans.	Early withdrawals from a solo 401(k) are subject to taxes and penalties.

The Takeaway

A solo 401(k) can be a worthwhile investment vehicle for self-employed people who want to save for retirement. It has more generous contribution limits than some other retirement options. In addition, there is a Roth version of the plan, and a solo 401(k) plan may also offer flexibility in terms of early withdrawals. For individuals who are self-employed, opening a solo 401(k) is one potential way to start saving for their golden years.

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FAQ

Can I contribute 100% of my salary to a solo 401(k)?

As an employee, you can contribute up to 100% of your earned income to a solo 401(k) up to the annual contribution limit, which is $22,500 in 2023, and $23,000 in 2024, plus an additional $7,500 for those age 50 and up in elective salary deferrals.

Is a solo 401(k) taxable income?

You will pay taxes with a solo 401(k), but the type of plan you open determines when you’ll pay those taxes. If you have a traditional 401(k), your contributions are tax-deferred, and they reduce your taxable income for the year in which you make them. However, you will pay taxes on distributions when you take them in retirement. If you have a Roth 401(k), you pay taxes on your contributions when you make them, but your distributions in retirement are tax-free.

What is the average return on a solo 401(k)?

The return on a solo 401(k) depends on the investments in your portfolio. However, in general, a solo 401(k) invested in a mix of bonds, stocks, and cash assets can have an average rate of return ranging between 3% and 8%. But again, it depends on what your investments are, and how much you allocate to those different assets. You may want to compare your plan’s performance to plans with similar funds to get a general sense of what the average return might be.

Who qualifies for a solo 401(k)?

To be eligible for a solo 401(k), you must be self-employed or a small business owner with no employees other than a spouse. To open a solo 401(k) you will need an Employee Identification Number (EIN), which is available from the IRS.

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