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Mar

2025

Avoid These 12 Common Retirement Mistakes

12 Common Retirement Mistakes You Should Avoid

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

Part of planning for a secure future is knowing what retirement mistakes to avoid that could potentially cost you money. Some retirement planning mistakes are obvious; others you may not even know you’re making.

Being aware of the main pitfalls, or addressing any hurdles now, can help you get closer to your retirement goals, whether that’s traveling around the world or starting your own business.

Planning for Retirement

Knowing what not to do in retirement planning is just as important as knowing what you should do when working toward financial security. Avoiding mistakes when creating your retirement plan matters because of how those mistakes could affect you financially over the long term.

The investment choices someone makes in their 20s, for example, can influence how much money they have saved for retirement by the time they reach their 60s.

The younger you are when you spot any retirement mistakes you may have made, the more time you have to correct them. Remember that preparing for retirement is an ongoing process; it’s not something you do once and forget about. Taking time to review and reevaluate your retirement-planning strategy can help you to pinpoint mistakes you may need to address.

12 Common Retirement Planning Mistakes

There’s no such thing as a perfect retirement plan — everyone is susceptible to making mistakes with their investment strategy. Whether you’re just getting started or you’ve been actively pursuing your financial goals for a while, here are some of the biggest retirement mistakes to avoid — in other words, what not to do in retirement planning.

1. Saving Too Late

There are many retirement mistakes to avoid, but one of the most costly is waiting to start saving — and not saving automatically.

Time is a vital factor because the longer you wait to begin saving for retirement, whether through your 401(k) or an investment account, the less time you have to benefit from the power of compounding returns. Even a delay of just a few years could potentially cost you thousands or even hundreds of thousands of dollars in growth.

Here’s an example of how much a $7,000 annual contribution to an IRA that’s invested in mutual funds might grow by age 65. (Estimates assume a 7% annual return.)

• If you start saving at 25, you’d have $1,495, 267

• If you start saving at 35, you’d have $707,511

• If you start saving at 45, you’d have $307,056

As you can see, waiting until your 40s to start saving would cost you more than $1 million in growth. Even if you get started in your 30s, you’d still end up with less than half the amount you’d have if you start saving at 25. The difference underscores the importance of saving for retirement early on — and saving steadily.

This leads to the other important component of being an effective saver: Taking advantage of automatic savings features, like auto transfers to a savings account, or automatic contributions to your retirement plan at work. The less you have to think about saving, and the more you use technology to help you save, the more money you may be able to stash away.

2. Not Making a Financial Plan

Saving without a clear strategy in mind is also among the big retirement planning mistakes. Creating a financial plan gives you a roadmap to follow because it requires you to outline specific goals and the steps you need to take to achieve them.

Working with a financial planner or specialist may help you get some clarity on what your plan should include.

3. Missing Out on Your 401(k) Match

The biggest 401(k) mistake you can make is not contributing to your workplace plan if you have one. But after that, the second most costly mistake is not taking advantage of 401(k) employer matching, if your company offers it.

The employer match is essentially free money that you get for contributing to your plan. The matching formula is different for every plan, but companies typically match anywhere from 50% to 100% of employee contributions, up to 3% to 6% of employees’ pay.

A common match, for example, is for an employer to match 50% of the first 6% the employee saves. If the employee saves only 3% of their salary, their employer will contribute 50% of that (or 1.5%), for a total contribution rate of 4.5%. But if the employee saves 6%, they get the employer’s full match of 3%, for a total of 9%.

Adjusting your contribution limit so you get the full match can help you avoid leaving money on the table.

4. Bad Investing Strategies

Some investing strategies are designed to set you up for success, based on your risk tolerance and goals. A buy-and-hold strategy, for example, might work well for you if you want to purchase investments for the long term.

But bad investment strategies can cause you to fall short of your goals, or worse, cost you money. Some of the worst investment strategies include following trends without understanding what’s driving them, or buying high and selling low out of panic.

Taking time to explore different investment strategies can help you figure out what works for you.

5. Not Balancing Your Portfolio

Diversification is an important investing concept to master. Diversifying your portfolio means holding different types of investments, and different asset classes. For example, that might mean a mix of stocks, bonds, and cash.

So why does this matter? One reason: Diversifying your portfolio is a form of investment risk management. Bonds, for instance, may act as a balance to stocks as they generally have a lower risk profile. Real estate investment trusts (REITs) may be a hedge against inflation and has low correlation with stocks and bonds, which might provide protection against market downturns. However, it’s important to understand that diversification does not eliminate risk.

Balancing your holdings through diversification — and rebalancing periodically — could help you maintain an appropriate mix of investments to better manage risk. When you rebalance, you buy or sell investments as needed to bring your portfolio back in line with your target asset allocation.

💡 Quick Tip: For investors who want a diversified portfolio without having to manage it themselves, automated investing could be a solution (although robo advisors typically have more limited options and higher costs). The algorithmic design helps minimize human errors, to keep your investments allocated correctly.

6. Using Retirement Funds Too Early

Although the retirement systems in the U.S. are generally designed to help protect your money until you retire, it’s still possible to take early withdrawals from personal retirement accounts like your 401(k) or IRA, or claim Social Security before you’ve reached full retirement age.

• Your 401(k) or IRA are designed to hold money you won’t need until you retire. Take money from either one before age 59 ½ and you could face a tax penalty. For example, 401(k) withdrawal penalties typically require you to pay a 10% early withdrawal tax on distributions. You’re also required to pay regular income tax on the money you withdraw, regardless of when you withdraw it.

Between income tax and the penalties, you might be left with a smaller amount of cash than you were expecting. Not only that, but your money is no longer growing and compounding for retirement. For that reason, it’s better to leave your 401(k) or IRA alone unless it’s absolutely necessary to cash out early.

And remember that if you change jobs, you can always roll over your 401(k) to another qualified plan to preserve your savings.

• Similarly, your Social Security benefits are also best left alone until you reach full retirement age, as you can get a much higher payout. Full retirement age is 67 for those born in 1960 or later.

That said, many retirees who need the income may feel compelled to take Social Security as soon as it’s available, at age 62 — but their monthly check will be about 30% lower than if they’d waited until full retirement age. If you can, wait to claim your benefits and you’ll typically get substantially more.

7. Not Paying Off Debt

Debt can be a barrier to your retirement savings goals, since money used to pay down debt each month can’t be saved and invested for the future.

So should you pay off debt or invest first? As you’ve seen, waiting to start saving for retirement can be a mistake if it potentially costs you growth in your portfolio. However, it’s critical to pay off debt, too. If you’d like to get rid of your debt ASAP, consider how you can still set aside something each payday for retirement.

Contributing the minimum amount allowed to your 401(k), or putting $50 to $100 a month in an IRA, can add up over time. As you get your debts paid off, you can begin to divert more money to retirement savings.

8. Not Planning Ahead for Future Costs

Another mistake to avoid when starting a retirement plan is not thinking about how your costs may change as you get older. Creating an estimated retirement budget can help you get an idea of what your day to day living expenses might be. But it’s also important to consider the cost of health care, specifically, long-term care.

Medicare can cover some health expenses once you turn 65, but it won’t pay for long-term care in a nursing home. If you need long-term care, the options for paying for it include long-term care insurance, applying for Medicaid, or paying out of pocket.

Thinking ahead about those kinds of costs can help you develop a plan for paying for them should you require long-term care as you age. How do you know if you’ll need long-term care? You can consider the longevity factors in your family, as well as your own health, and gender. Women tend to live longer than men do, almost 6 years longer, which often puts older women in a position of needing long-term care.

9. Not Saving Aggressively Enough

How much do you need to save for retirement? It’s a critical question, and it depends on several things, including:

• The age at which you plan to retire

• Your potential lifespan

• Your cost of living in retirement (i.e. your lifestyle)

• Your investment strategy

Each of these factors requires serious thought and possibly professional advice in order to come up with estimates that align with your unique situation. Investing in the resources you need to understand these variables may be one of the most important moves you can make, because the bottom line is that if you’re not saving enough, you could outlive your savings.

10. Making Unnecessary Purchases

If you need to step up your savings to keep pace with your goals, cutting back on spending may be necessary. That includes cutting out purchases you don’t really need to make — but also learning how to be a smarter spender.

Splurging on new furniture or spending $5,000 on a vacation might be tempting, but consider what kind of trade-off you could be making with your retirement. Investing that $5,000 into an IRA means you’ll miss the trip, but you’ll get a better return for your money over time.

11. Buying Into Scams

Get-rich-quick schemes abound, but they’re all designed to do one thing: rob you of your hard-earned money. Investment and retirement scams can take different forms and target different types of investments, such as real estate or cryptocurrency. So it’s important to be wary of anything that promises “free money,” “200% growth,” or anything else that seems too good to be true.

The Federal Trade Commission (FTC) offers consumer information on the most common investment scams and how to avoid them. If you think you’ve fallen victim to an investment scam you can report it at the FTC website.

12. Gambling Your Money

Gambling can be risky as there’s no guarantee that your bets will pay off. This is true whether you’re buying lottery tickets, sitting down at the poker table in Vegas, or taking a risk on a new investment that you don’t know much about.

Either way, you could be making a big retirement mistake if you end up losing money. Before putting money into crazy or wishful-thinking investments, it’s a good idea to do some research first. This way, you can make an informed decision about where to put your money.

Investing for Retirement With SoFi

Retirement planning isn’t an exact science and it’s possible you’ll make some mistakes along the way. Some of the most common mistakes are just not doing the basics — like saving early and often, getting your company matching contribution, paying down debt, and so on. But even if you do make a few mistakes, you can still get your retirement plan back on track.

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

Help build your nest egg with a SoFi IRA.

FAQ

Why is it important to start saving early?

Getting an early start on retirement saving means you generally have more time to capitalize on compounding returns. The later you start saving, the harder you might have to work to play catch up in order to reach your goals.

What is the first thing to do when you retire?

The first thing to do when you retire is review your budget and financial plan. Consider looking at how much you have saved and how much you plan to spend to make sure that your retirement is off to a solid financial start.

About the author

Rebecca Lake

Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.

Photo credit: iStock/Morsa Images

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

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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

Mar

2025

The Average 401(k) Balance by Age

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

Table of Contents

Average 401(k) Balance: Overview
Average 401(k) Balance: Under Age 25
Average 401(k) Balance: Ages 25-34
Average 401(k) Balance: Ages 35 to 44
Average 401(k) Balance: Ages 45 – 54
Average 401(k) Balance: Ages 55 to 64
Average 401(k) Balance: Ages 65 and Older
How Much Should I Have in My 401(k)?
Tips for Catching Up If You’re Behind

Key Points

• Establishing the habit of investing in a retirement plan early, even small amounts, may help you benefit from compounding returns.

• Aim to contribute enough to your 401(k) to get the full employer match, so you don’t leave money on the table.

• Automating contributions can make it easier to consistently build retirement funds over time.

• If you’re over 50, making catch-up contributions can boost your retirement savings.

• Paying attention to asset allocations, investment performance, and fees can help you make regular adjustments to target your goals.

What’s the Average 401(k) Balance?

The average 401(k) balance for all ages is $134,128, according to Vanguard’s How America Saves Report 2024. However, the average 401(k) balance by age of someone in their 20s is very different from the balance of someone in their 50s and 60s. That’s why it’s helpful to know how much you should have saved in your 401(k) at different ages.

Seeing what others are saving in their 20s, 30s, 40s, 50s, and beyond can be a useful way to gauge whether you’re on track with your own retirement plans and what else you can do to maximize this critical, tax-deferred form of savings.

Average and Median 401(k) Balance by Age Group

Pinning down the average 401(k) account balance can be challenging, as only a handful of sources collect information on retirement accounts, and they each have their own methods for doing so.

Vanguard is one of the largest 401(k) providers in the U.S., with nearly 5 million participants. For this review of the average and median 401(k) balance by age, we use data from Vanguard’s How America Saves Report 2024.

It’s important to look at both the average balance amounts, as well as the median amounts. Here’s why: Because there are people who save very little, as well as those who have built up very substantial balances, the average account balance only tells part of the story. Comparing the average amount with the median amount — the number in the middle of the savings curve — provides a reality check as to how other retirement savers in your age group may be doing.

Age Group	Average 401(k) Balance	Median 401(k) Balance
Under 25	$7,351	$2,816
25-34	$37,557	$14,933
35-44	$91,281	$35,537
45-54	$168,646	$60,763
55-64	$244,750	$87,571
65+	$272,588	$88,488

Source: Vanguard’s How America Saves Report 2024

Average 401(k) Balance for Ages 25 and Under

• Average 401(k) Balance: $7,351

• Median 401(k) Balance: $2,816

• Key Challenges for Savers: Because they are new to the workforce, this age group is likely to be making lower starting salaries than those who have been working for several years. They may not have the income to put towards a 401(k). In addition, debt often presents a big challenge for younger savers, many of whom may be paying down student loan debt, credit card debt, or both.

• Tips for Savers: While being debt-free is a priority, it’s also crucial to establish the habit of saving now — even if you’re not saving a lot. The point is to save steadily, whether that’s by contributing to your 401(k) or an investment account, and to automate your savings.

By starting early, even small contributions have the potential to grow over time because of the power of compounding returns.

Average 401(k) for Ages 25 to 34

• Average 401(k) Balance: $37,557

• Median 401(k) Balance: $14,933

• Key Challenges for Savers: At this stage, savers may still be repaying student loans, which can take a chunk of their paychecks. At the same time, they may also be making big — and expensive — life changes like getting married or starting a family.

• Tips for Savers: You’ve got a lot of competing financial responsibilities right now, but it’s vital to make saving for your future a priority. Contribute as much as you can to your 401(k). If possible, aim to contribute at least the amount needed to get your employer’s matching contribution, which is essentially free money. And when you get a raise or bonus at work, direct those extra funds into your 401(k) as well.

Average 401(k) for Ages 35 to 44

• Average 401(k) Balance: $91,281

• Median 401(k) Balance: $35,537

• Key Challenges for Savers: While your late 30s and early 40s may be a time when salaries range higher, it’s also typically a phase of life when there are many demands on your money. You might be buying a home, raising a family, or starting a business, and it could feel more important to focus on the ‘now’ rather than the future.

• Tips for Savers: Even if you can’t save much more at this stage than you could when you were in your early 30s, you still may be able to increase your savings rate a little. Many 401(k) plans offer the opportunity to automatically increase your contributions each year. If your plan has this feature, take advantage of it. A 1% or 2% increase in savings annually can add up over time. And because the money automatically goes directly into your 401(k), you won’t miss it.

Average 401(k) for Ages 45 to 54

• Average 401(k) Balance: $168,646

• Median 401(k) Balance: $60,763

• Key Challenges for Savers: These can be peak earning years for some individuals. However, at this stage of life, you may also be dealing with the expense of sending your kids to college and helping ailing parents financially.

• Tips for Savers: The good news is, that starting at age 50, the IRS allows you to start making catch-up contributions to your 401(k). For 2025, the regular contribution limit is $23,500, but individuals ages 50 and up can make an additional $7,500 in 401(k) catch-up contributions for a total of $31,000. For 2026, while those under age 50 can contribute up to $24,500, individuals who are 50 and up can contribute an additional $8,000 for a total of $32,500.

While money may be tight because of family obligations, this may be the perfect moment — and the perfect incentive — to renew your commitment to retirement savings because you can save so much more.

If you max out your 401(k) contributions, you may also want to consider opening an IRA. An individual retirement account is another vehicle to help you save for your future, and depending on the type of IRA you choose, there are potential tax benefits you could take advantage of now or after you retire.

Average 401(k) for Ages 55 to 64

• Average 401(k) balance: $244,750

• Median 401(k) balance: $87,571

• Key Challenges for Savers: As retirement gets closer, this is the time to save even more for retirement than you have been. That said, you may still be paying off your children’s college debt and your mortgage, which can make it tougher to allocate money for your future.

• Tips for Savers: In your early 60s, it may be tempting to consider dipping into Social Security. At age 62, you can begin claiming Social Security retirement benefits to supplement the money in your 401(k). But starting at 62 gives you a lower monthly payout for the rest of your life. Waiting until the full retirement age, which is 66 or 67 for most people, will allow you to collect a benefit that’s approximately 30% higher than what you’d get at 62. And if you can hold off until age 70 to take Social Security, that can increase your benefit as much as 32% versus taking it at 66.

In 2025 and 2026, those in their early 60s can also take advantage of an additional catch-up to their 401(k). Specifically, those aged 60 to 63 can contribute an additional $11,250 in catch-up contributions (instead of $7,500) to their 401(k) in 2025, and an additional $11,250 in 2026 (instead of $8,000), thanks to SECURE 2.0.

Average 401(k) for Ages 65 and Older

• Average 401(k) balance: $272,588

• Median 401(k) balance: $88,488

• Key Challenges for Savers: It’s critical to make sure that your savings and investments will last over the course of your retirement, however long that might be. You may be underestimating how much you’ll need. For instance, healthcare costs can rise in retirement since medical problems can become more serious as you get older.

• Tips for Savers: Draw up a retirement budget to determine how much you might need to live on. Be sure to include healthcare, housing, and entertainment and travel. In addition, consider saving money by downsizing to a smaller, less costly home, and continue working full-time or part-time to supplement your retirement savings. And finally, keep regularly saving in retirement accounts such as a traditional or Roth IRA, if you can.

Recommended: When Can I Retire?

How Much Should I Have in My 401(k)?

The amount you should have in your 401(k) depends on a number of factors, including your age, income, financial obligations, and other investment accounts you might hold. According to Fidelity’s research on how much is needed to retire , an individual should aim to save about 15% of their income a year (including an employer match) starting at age 25.

To get a sense of how this looks at various ages, the chart below shows the average 401(k) balance by age, according to Vanguard’s research, as well as Fidelity’s rule of thumb for what your target 401(k) balance should roughly be at that age. Note that these are just guidelines, but they can give you a goal to work toward.

Age Group	Average 401(k) Balance*	Approximate Target 401(k) Balance**
Under 25	$7,351	Less than 1x your salary
25-34	$37,557	1x your salary by age 30
35-44	$91,281	2x your salary by age 35 3x your salary by age 40
45-54	$168,646	4x your salary by age 45 6x your salary by age 50
55-64	$244,750	7x your salary by 55 8x your salary by 60
65+	$272,588	10x your salary by age 67

*Source: Vanguard’s How America Saves Report 2024
**Source: Fidelity Viewpoints: How Much Do I Need to Retire?

Tips for Catching Up If You’re Behind

If your savings aren’t where they should be for your stage of life, take a breath — there are ways to catch up. These seven strategies can help you build your nest egg.

1. Automate your savings.

Automating your 401(k) contributions ensures that the money will go directly from your paycheck into your 401(k). You may also be able to have your contribution amount automatically increased every year, which can help accelerate your savings. Check with your employer to see if this is an option with your 401(k) plan.

2. Maximize 401(k) contributions.

The more you contribute to your 401(k), the more growth you can potentially see. At the very least, aim to contribute enough to qualify for the full employer matching contribution if your company offers one.

3. Make catch-up contributions if you’re eligible.

As mentioned, once you turn age 50, you can contribute even more money to your 401(k). If you can max out the regular contributions each year, making additional catch-up contributions to your 401(k) may help you grow your account balance faster.

4. Consider opening an IRA.

If you’ve maxed out all your 401(k) contributions, you could open a traditional or Roth IRA to help save even more for retirement. For 2025, those under age 50 can contribute up to $7,000 to an IRA or up to $8,000 if they’re 50 and older. For 2026, they can contribute up to $7,500 to an IRA or up to $8,600 if they’re 50 or older.

5. Make sure you have the right asset allocations.

The younger you are, the more time you have to recover from market downturns, so you may choose to be a little more aggressive with your investments. On the other hand, if you have a low risk capacity, you may opt for more conservative investments.

Either way, you want to save and invest your money wisely. Consider using a mix of investment vehicles, such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds, to help diversify your portfolio. Just be aware that investing always involves some risk.

6. Pay Attention to Fees.

Fees can erode your investment returns over time and ultimately reduce the size of your nest egg. As you choose investments for your 401(k), consider the cost of different funds. Specifically, look at the expense ratio for any mutual funds or ETFs offered by the plan. This reflects the cost of owning the fund annually, expressed as a percentage. The higher this percentage, the more you’ll pay to own the fund.

7. Conduct an Annual Financial Checkup.

It can be helpful to check in with your goals periodically to see how you’re doing. For example, you might plan an annual 401(k) checkup at year’s end to review how your investments have performed, what you contributed to the plan, and how much you’ve paid in fees. This can help you make smarter investment decisions for the upcoming year.

The Takeaway

The average and median 401(k) balances and the target amounts noted above reflect some important realities for different age groups. Some people can save more, others less — and it’s crucial to understand that many factors play into those account balances. It’s not simply a matter of how much money you have, but also the choices you make.

For instance, starting early and saving regularly can help your money grow. Contributing as much as possible to your 401(k) and getting an employer match are also smart strategies to pursue, if you’re able to. And opening an IRA or an investment account are other potential ways to help you save for the future.

With forethought and planning, you can put, and keep, your retirement goals on track.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

FAQ

What is a good 401(k) balance?

A good 401(k) balance is different for everyone and depends on their age, specific financial situation, and goals. The general rule of thumb is to have 401(k) savings that’s equivalent to your salary by age 30, three times your salary by age 40, six times your salary by age 50, 8 times your salary by age 60, and 10 times your salary by age 67.

How much do most people retire with?

According to the Federal Reserve’s most recent Survey of Consumer Finances, the average 401(k)/IRA account balance for adults ages 55 to 64 was $204,000. Keep in mind, however, that when it comes to savings, one rule of thumb, according to Fidelity, is for an individual to have 8 times their salary saved by age 60 and 10 times their salary saved by age 67.

About the author

Rebecca Lake

Photo credit: iStock/kate_sept2004

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.

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

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

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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CN-Q425-3236452-62

Mar

2025

What Is a Protective Put? Definition, Graphs, & Example

Understanding Protective Puts: A Comprehensive Guide

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

A protective put is an investment strategy that uses options contracts to help reduce the risk that comes with owning a particular security or commodity. In it, an investor buys a put option on the security or commodity.

Typically, put options are used by investors who want to benefit from a price decline in a given investment. But in a protective put strategy, the investor owns the underlying asset, and is positioned to benefit if the price of the asset goes up.

The investor purchases the protective put, in this case, to help limit their potential losses if the price of the stock they own goes down.

An investor may use a protective put on various investments, including equities, ETFs, and commodities. But if the investment they own does go up, the investor will have to deduct the cost of the put-option premiums from their returns.

Key Points

• A protective put strategy involves buying a put option on an asset that’s owned to limit potential losses.

• The strike price of and premium paid for the put options can significantly affect the strategy’s effectiveness and cost.

• Advantages include setting a loss limit and maintaining upside potential, while disadvantages involve premium costs.

• In a real scenario, an investor buys a put option to hedge against a stock price decline.

• Compared to other strategies, a protective put offers downside protection and upside participation.

What Is a Protective Put?

Investors typically purchase protective puts on assets that they already own as a way of limiting or capping any future potential losses.

The instrument that makes a protective put strategy work is the put option. A put option is a contract between two investors. The buyer of the put acquires the right to sell an agreed-upon number of a given asset security at a given price during a predetermined time period.

Definition and Basic Concepts

There is some key options trading lingo to know in order to fully understand a protective put.

• The price at which the purchaser of the put option can sell the underlying asset is known as the “strike price.”

• The amount of money the buyer pays to acquire this right is called the “premium.”

• And the end of the time period specified in the options contract is the expiration date, or “expiry date.”

• In a protective put strategy, the strike price represents the predetermined price at which an investor can sell the underlying asset if the put option is exercised. However, the true floor price, the minimum amount the investor would effectively receive, is the strike price minus the premium paid for the option. This also accounts for the cost of protection.

For complete coverage in a protective put strategy, an investor might buy put option contracts equal to their entire position. For large positions in a given stock, that can be expensive. And whether or not that protection comes in handy, the put options themselves regularly expire — which means the investor has to purchase new put options contracts on a regular basis.

Setting Up a Protective Put

To set up a protective put, an investor must first own the underlying asset they want to protect. The investor purchases a put option contract for the same asset. This put option allows the investor to sell the asset at a predetermined price, known as the strike price, within a specific time frame.

Setting up a protective put involves:

• Determining the Level of Protection Needed: Investors should evaluate how much of their position they want to protect. A full protective put strategy involves buying put option contracts to cover the entire position. However, for cost-saving purposes, some investors may choose partial coverage.

• Selecting the Strike Price: The strike price represents the minimum price at which the asset can be sold if the put option is exercised. Higher strike prices provide more protection but come with higher premiums. Lower strike prices reduce premium costs but offer less downside protection.

• Choosing the Expiration Date: The expiration date of the put option determines the duration of the protection. Shorter-term options are generally less expensive but require frequent renewal if protection is still needed. Longer-term options, while more costly, may offer stability for investors seeking extended coverage.

• Purchase the Put Option: Once the strike price and expiration date are chosen, the investor buys the put option from the market. The cost of this purchase is the premium, which varies based on market conditions, volatility, and the specific terms of the contract.

By following these steps, investors can effectively set up a protective put to help manage downside risk while maintaining the opportunity for upside gains if the asset increases in value.

Uses of Protective Puts

Protective puts are primarily used by investors to mitigate downside risk while maintaining the potential for upside gains. This strategy can be applied across a variety of scenarios to suit individual investment goals and market conditions.

• Portfolio Protection: Investors holding significant positions in a stock, commodity, or index can use protective puts to safeguard their portfolio against sudden price declines. By setting a strike price near the current value, they establish a “floor” that limits losses in the event of a market downturn.

• Market Volatility Management: Protective puts can help investors reduce uncertainty during periods of heightened market volatility. If a stock begins to trade below the strike price of the contract, they can choose to exercise their option to sell the stock at that higher strike price.

• Strategic Planning: Protective puts can also be part of a larger investment strategy, allowing investors to take calculated risks in other areas of their portfolio. With downside risk managed, they can explore opportunities for higher returns elsewhere without jeopardizing their core holdings.

• Hedging Concentrated Positions: Investors with concentrated positions in a single stock or sector can use protective puts to hedge against adverse price movements. This is particularly useful for individuals or institutions holding stock grants, company shares, or positions they are reluctant to sell.

Overall, protective puts provide a flexible means of managing risk, ensuring investors can participate in potential market gains while limiting their exposure to significant losses.

Recommended: How to Sell Options for Premiums

Calculating and Choosing Strike Prices and Premiums

When implementing a protective put strategy, selecting the right strike price and premium is critical. These choices directly affect the level of protection, the cost of the hedge, and the potential returns. Understanding how to calculate and balance these factors helps investors tailor their strategy to their goals and risk tolerance.

Calculating Strike Prices

Investors should consider the following factors when choosing a strike price:

• Risk Tolerance: A strike price closer to the asset’s current market price offers maximum protection but comes at a higher cost. Conversely, a lower strike price provides less protection but reduces the premium paid.

• Market Outlook: If an investor expects minor fluctuations, they may opt for a lower strike price to balance cost and protection. For significant downside risks, a strike price near the current price may be preferable.

• Investment Goals: Whether the focus is on preserving capital or limiting minor losses, the strike price should align with the investor’s specific financial objectives.

Premium Considerations

The premium is the cost of purchasing the put option. It represents the upfront expense for securing downside protection and affects the overall profitability of the strategy. Key considerations include:

• Cost vs. Protection: Higher premiums may provide greater protection but can erode potential returns. Investors should weigh the cost of the premium against the likelihood and impact of a price decline.

• Option Moneyness: Options can be in the money (ITM), at the money (ATM), or out of the money (OTM). ITM options have higher premiums but provide immediate protection, while OTM options are cheaper but only activate under significant price drops.

• Time Decay: The time until expiration impacts the premium. Longer-term options, which are typically more expensive, provide extended protection, whereas shorter-term options have lower premiums but require frequent renewal.

By carefully calculating strike prices and evaluating premium considerations, investors can design a protective put strategy that aligns with their risk profile and financial objectives. Striking the right balance between cost and protection is essential to maximize the benefits of this strategy.

Real-World Examples and Scenarios

Protective puts are widely used by investors to manage risk across various market conditions. Examining real-world examples provides a practical understanding of how this strategy works and its potential outcomes in different scenarios.

Scenario Analysis

A protective put strategy can help an investor manage risk by limiting potential losses while maintaining exposure to gains. For example, if an investor owns 100 shares of XYZ stock, currently trading at $100 per share, and buys a protective put option (also for 100 shares) with a $95 strike price for a premium of $2 per share, the position will perform differently depending on the stock’s movement.

Let’s say the stock price drops to $85 near the expiration date. The investor can exercise the put option, selling the shares at the $95 strike price instead of the lower market price. Let’s say the stock price drops from $100 to $85. Without a protective put, the investor would face a $15 per share loss ($1,500 total for 100 shares). However, with a put option at a $95 strike price, they can sell at $95 instead of $85, recovering $10 per share. After subtracting the $2 premium paid, the net gain from the put is $8 per share ($800 total). This offsets part of the stock’s decline, reducing the total loss to $700 instead of $1,500.

On the other hand, if the stock price rises to $110, the put option will expire worthless, and the investor will lose the premium paid, which amounts to $200 (100 shares × $2). The stock’s price increase results in a $1,000 unrealized gain, and after deducting the $200 premium, the investor still sees a net gain of $800.

If the stock price remains stable at $100 until the expiration date, the investor will hold onto the shares without any price changes, but the $200 premium will be a loss. In this case, the protective put serves as a precautionary measure, providing peace of mind during the holding period, but without any real financial benefit.

These examples show how a protective put works to limit losses while allowing participation in upside potential. Although the premium represents a cost, this strategy is useful in managing risk, particularly in uncertain or volatile markets.

The Impact of Time Decay and Volatility

Time decay and volatility play significant roles in the pricing and effectiveness of a protective put strategy, impacting both the cost of the put option and its potential for profit or loss.

Time decay refers to the gradual reduction in the value of an options contract as it approaches its expiration date. As with all options, the protective put’s premium tends to decrease over time due to time decay, even if the underlying asset’s price stays stable. As the expiration date nears, the value of the put option typically declines due to time decay. This can impact an investor who wants to sell the option before it expires. However, if the investor holds on through expiration, its final value will depend on whether the underlying asset’s price falls below the strike price.

Volatility impacts the value of options by affecting their premiums. Higher volatility increases the potential for large price movements in the underlying asset, which can raise the cost of the protective put. Conversely, during periods of low volatility, premiums tend to be lower, making puts more affordable, but also potentially reducing the need for protection if the asset’s price remains relatively stable.

Advantages and Disadvantages of Protective Puts

As with most investing strategies, there are both upsides and downsides to using protective puts.

Pros of Using Protective Puts

Protective puts allow investors to set a limit on how much they stand to lose in a given investment. Here’s why investors are drawn to them:

• Protective puts offer protection against the possibility that an investment will lose money.

• The protective put strategy allows an investor to participate in nearly all of an investment’s upside potential.

• Investors can use at-the-money (ATM), out-of-the-money (OTM) options, in-the-money (ITM) options, or a mix of these to tailor their risks and costs.

Cons and Potential Risks

Buying protective put options comes at a cost. There is limited upside potential, expenses involved, and may come with other tradeoffs that can impact your investing goals.

• An investor using protective puts will see lower returns if the underlying stock price rises, because of the premiums paid to buy the put options.

• If a stock doesn’t experience much movement up or down, the investor will see diminished returns as they pay the option premiums.

• Options with strike prices close to the asset’s current market price can be prohibitively expensive.

• More affordable options that are further away from the stock’s current price offer only partial protection and may result in further losses.

Alternative Strategies to Protective Puts

In addition to protective puts, investors have several other strategies to manage risk, such as covered calls and collar strategies.

A covered call involves selling a call option against a stock you own, which generates income through the premium received. This can help offset potential losses, though it caps the upside potential.

A collar strategy combines buying a protective put and selling a covered call on the same asset, limiting both downside risk and upside potential. This can be a cost-effective way to manage risk while still participating in some upside potential.

Comparing with Other Options Strategies

Each alternative strategy comes with its own set of trade-offs. While a covered call generates income through premiums, it limits the upside, as the stock is “capped” if it rises above the strike price of the sold call.

The collar strategy offers protection like a protective put but may be more cost-effective due to the income from the sold call, though it also limits potential gains. Investors should choose the strategy that aligns with their risk tolerance, investment goals, and market outlook.

When to Choose Alternative Strategies

Investors might prefer alternative strategies when looking to reduce the cost of protection or when expecting limited movement in the underlying asset. A covered call can be useful in a flat or slightly bullish market, while a collar strategy may be ideal for those seeking cost-effective protection without the full expense of a protective put. These strategies can also be suitable for investors who are more focused on income generation than on maximizing returns from significant price movements.

The Takeaway

Protective put options are risk-management strategies that use options contracts to guard against losses. This options-based strategy allows investors to set a limit on how much they stand to lose in a given investment.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

Explore SoFi’s user-friendly options trading platform.

Photo credit: iStock/igoriss

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.

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

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

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOIN-Q125-123

Mar

2025

What Is Buy to Cover & How Does It Work?

By Dan Miller | Growing Wealth, invest, Investing | Comments Off

Buy to cover refers to when an investor purchases a stock or other security to close out a short position.

A short sale is when a trader borrows shares, betting the price will drop. A buy to cover order is a way to “cover” the short positions, so they can be returned to the lender.

Taking a short position requires a margin account, and buy to cover helps to prevent a margin call (when the broker requires that funds be deposited in the margin account).

Key Points

• Buy to cover involves purchasing shares to close a short position.

• Taking a short position requires a margin account, because the shares are borrowed, with the expectation the price will drop, and the shares can be bought at the lower price.

• A short sale strategy aims to profit from the difference between the higher selling price and the lower buying price.

• If the stock price rises, a margin call may occur, requiring additional funds or liquidation. A buy to cover order “covers” the shares needed to close out the short position.

Buy to Cover Meaning

Traditionally, you buy a stock with a bullish outlook, and sell to close out your position. In an ideal situation, you buy low and sell high, securing the difference between the purchase price and the sale price as your profit.

What Is a Short Position?

A short position is different. If you think a stock is currently overpriced, you might sell the stock before you have actually purchased it, via a short sale. Within the world of options trading, this requires temporarily borrowing the shares, usually from your broker or dealer.

Then, once the stock (hopefully) goes down, you purchase the shares at the lower price and return them to the lenderclosing out your position and pocketing the difference between the higher and lower price.

Buying to cover is the after-the-fact purchase of shares that you previously shorted, to cover the trade and avoid a margin call. When you do a short sale by selling first, you will eventually need to repay your short sale by purchasing shares.

What Is a Buy to Cover Limit?

When placing a buy to cover order, there are two ways that you can close your position. The first is a market order, in which you simply close the position at the first available market price.

The other method involves using a buy to cover limit order, in which you set a maximum price at which you’re willing to purchase the share.

One advantage of the latter approach is that you know exactly the price that you’ll get for your shares. This can help you when planning your overall strategy. A drawback, however, is that if the market moves against you, your order may not get filled.

How Does Buy to Cover Work?

A buy to cover order works much in the same way as a traditional buy order. The main difference is the order in which you make your buy and sell transactions.

In a traditional buy order, you purchase shares that you intend to later sell. With a buy to cover order, you’re buying shares to cover a sale that you previously made.

Also, a traditional buy order can be executed using cash; a short sale requires a margin account.

Example of a Buy to Cover Stock

Here’s a buy to cover stock example to help illustrate how the process works:

• You believe that stock ABC is overpriced at $50.

• You sell short 100 shares of ABC, borrowing $5,000 on margin from your broker.

• After a few days, stock ABC’s price has dropped to $45.

• You issue a buy to cover order for 100 shares of ABC, paying $4,500.

• Your profit is $500 — the difference between the amount you receive from the short sale and the amount you pay to close the position, less any fees.

Sell Short vs Buy to Cover

“Selling short” and “buying to cover” are complementary actions within a short-selling strategy. If you think that a particular stock or investment is likely to go down in price, you can use a short sale to first sell shares that you’ve borrowed on margin, generally from your broker or dealer.

When you’re ready to close out your short sale transaction, you can place a buy- o cover order. This will purchase the shares that you sold originally, either at the market price or with a buy to cover limit order at a particular price.

If the stock declines in price as you expected, this strategy may yield a profit from selling high and then buying low.

Buy to Cover and Margin Trades

Using a buy to cover order is intricately tied in with both short selling and margin trading. When you sell short, you are using margin trading to borrow shares to sell that you don’t yet own.

When you are ready to close out your position, you issue a buy-to-cover order, purchasing the shares you need to correspond to the shares that you earlier sold on margin. If the stock price rises instead of falling, you may face a margin call, requiring additional funds or the liquidation of your position.

The Takeaway

A buy to cover is a purchase order executed to close out a short sale position in options trading. In a traditional sale, you purchase a stock first and then later sell the shares. When you sell short, you place a buy-to-cover order to close your position.

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, 10.50%*

Photo credit: iStock/Ridofranz

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.

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

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

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOIN-Q125-111

Mar

2025

What Is Compliance Testing for 401(k)?

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

To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.

401(k) compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.

Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.

Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.

401(k) Compliance Testing Explained

Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. 401(k) compliance testing is the responsibility of the company that offers the plan.

How 401(k) Compliance Testing Works

Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.

There are three nondiscrimination testing standards employers must apply to qualified retirement plans.

• The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan

• The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees

• Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees

The Actual Deferral Percentage (ADP) Test

The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance testing measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.

To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.

A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:

• 125% of the ADP for the group of non-highly compensated employees

• The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%

The Actual Contribution Percentage (ACP) Test

Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.

This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:

• 125% of the ACP for the group of non-highly compensated employees

• The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%

Companies may run both the ADP and ACP tests using prior year or current-year contributions.

Top-Heavy Test

The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:

• An officer making over $215,000 for 2023 and over $220,000 for 2024

• A 5% owner of the business OR

• An employee owning more than 1% of the business and making over $150,000 for the plan year

Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.

Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.

Why 401(k) Compliance Testing Is Necessary

401(k) compliance testing ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.

If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.

Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.

Highly Compensated Employees

The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:

• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received,

• Received compensation from the business of more than $150,000 in 2023 and $155,000 in 2024 or $135,000 (if the preceding is 2022) and was in the top 20% of employees when ranked by compensation

If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.

Non-Highly Compensated Employees

Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.

Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.

How to Fix a Non-Compliant 401(k)

The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:

• Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards

• Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test

Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.

Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:

• Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.

• Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.

Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.

The Takeaway

A 401(k) is a key way for employees to help save for retirement and reach their retirement goals. It’s important for employers to conduct IRS-mandated 401(k) compliance testing in order to ensure that their 401(k) plans are administered in a fair and equal manner that benefits all employees.

If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings, you may want to consider opening an Individual Retirement Account (IRA) to help save for retirement. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions.

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

Easily manage your retirement savings with a SoFi IRA.

FAQ

What is top-heavy testing for 401(k)?

Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.

What happens if you fail 401(k) testing?

If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.

What is a highly compensated employee for 401(k) purposes?

The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the year. Income limits are set by the IRS and updated periodically.

About the author

Rebecca Lake

Photo credit: iStock/tumsasedgars

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.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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

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