How can someone qualify for withholding exemption?

To qualify as tax-exempt, you would have to have had all taxes refunded and have no liability in the previous year and expect the same status in the current tax year. Another consideration: Some forms of income may be tax-exempt, such as payments for in-home foster care of children or for workers’ compensation.

RETUPD Archives

Dec

2024

What Is Income Tax Withholding and How Does It Work?

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

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

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

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

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

Key Points

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

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

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

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

• Withheld taxes support federal programs and public services.

What is Income Tax Withholding?

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

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

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

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

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

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

Factors That Determine Tax Withholding

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

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

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

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

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

Recommended: How to Reduce Your Taxable Income

What Is State Income Tax Withholding?

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

• Alaska

• Florida

• Nevada

• New Hampshire

• South Dakota

• Tennessee

• Texas

• Washington

• Wyoming

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

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What Is the Purpose of Tax Withholding?

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

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

Tax and Employment Documents to Know

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

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

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

Calculating Income Tax Withholding

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

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

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

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

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

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

• Starting a new job or position

• Having a child

• Getting married or divorced

• Buying a house.

Can I Be Exempt from Tax Withholding?

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

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

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

The Takeaway

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

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

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FAQ

Does the government pay for income tax withholdings?

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

How can someone qualify for a withholding exemption?

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

Why has my employer withheld too much income tax?

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

Why has my employer withheld too little income tax?

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

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Dec

2024

Value-Weighted Index: Explanation and How to Calculate

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

Value weighted indexes, also called cap-weighted indexes, may be used by investors to gauge the performance of various sectors of the stock market. Indexes effectively measure a specific portion or subset of the market, which can help investors get a sense of the market’s performance.

Some of the most commonly known and used value weighted indexes include the S&P 500, Nasdaq Composite, or Wilshire 5000. While these indexes can help investors get an idea of the market’s performance, they do have flaws, which investors would do well to keep in mind.

Key Points

• Value weighted indexes aggregate stock performance using market capitalization.

• These indexes serve as benchmarks for evaluating performance in financial markets.

• Calculation involves multiplying stock price by shares outstanding, normalized by a divisor.

• Other index types include price weighted and fundamentally weighted indexes, each distinct.

• Value weighted indexes reflect market trends but can be skewed by large companies.

Value Weighted Index Explained

Value weighted indexes are often used in the investment world as a stock market evaluation tool. A value weighted index is a tool used to aggregate the performance of multiple stocks into a cohesive whole represented by a single number. In other words, it’s a way to simplify a subset of the market’s performance, and make it relatively easy to get an idea of what’s happening in the market.

Value weighted indexes multiply current share prices by the number of shares outstanding to get the market cap for each component, or asset, of the index. These individual market caps are then totaled to get the overall value of the index.

When value weighted cap indexes began, the typical method of combining these values was by using a weighted average. For instance, if a stock’s market cap represented 10% of the overall market it would be weighted at 10%.

However, that method quickly becomes complicated as stocks are removed and added from the index, and some companies may be acquired or merged. Because of this, almost all indexes calculate a divisor to normalize the business decisions made at each company so that the index represents performance as accurately as possible without being affected by individual company decisions.

Let’s examine how different constituencies use the indexes for their particular needs, including traders, investors, and fund managers.

How Traders Use Indexes

Traders may differ from “investors” in that they’re characterized by short-term decision making. Traders use indexes as a benchmark to judge performance. They try to use indexes that match with their market moves.

For example, a technology focused investor might use the Nasdaq Composite to measure how well they are meeting their investment goals. They might also use the market index to determine when to enter or exit trades by gleaning any information they can about how the overall market is moving.

How Investors Use Indexes

Investors may differ from “traders” in that they have long-term horizons or investment goals, and thus, may be a bit more conservative in their investing approach. But similar to traders, investors also use indexes as a benchmark to compare how they’re doing in comparison. But investors may also be looking for less-risky investments with broad diversification.

Exchange-traded funds, or ETFs, may align with their goals, and ETFs often seek to replicate the various indexes by holding shares in proportions to match the index. Index investing can be a relatively simple way to start investing for beginners, as it allows for a degree of built-in diversification, tends to align with market performance, and typically comes with the benefit of low transaction fees.

But further research is always required to ensure that a specific ETF aligns with an investor’s strategy. With that in mind, it may be worthwhile to review available resources to help you learn more about investing in ETFs.

How Mutual Fund Managers Use Indexes

Mutual funds pool investment resources from a number of investors to try and provide diversification across sectors, and often pursue more conservative investments. Mutual fund managers may, again, use value weighted indexes as a north star, and try to match a market index’s performance, or beat it with the goal of generating returns for investors. However, keep in mind that investors can always lose money, too.

Mutual funds are also generally aligned with an index that parallels the investment philosophy of the fund, be that stocks, bonds, commodities, etc. So, there may be mutual funds that specialize or focus on investing in certain market segments, and use those as indexes to try and match.

How Hedge Funds Use Indexes

Hedge funds pool investment resources in a similar way to mutual funds, but typically follow a far more aggressive investment strategy and managers stick to an active investing style. Though they may be a bit more aggressive and less risk-averse, like other types of funds, hedge fund managers may use indexes as a benchmark to meet or beat in an attempt to generate returns for investors. Remember: There’s a potential for losses, too.

Pros and Cons of Value Weighted Indexes

Value weighted indexes have their pros and cons, of course. Here’s a quick rundown of what the advantages and disadvantages of using value weighted indexes may be for investors.

thumb_up

Pros:

• Tend to offer a comprehensive market perspective

• Are often comprised of less volatile, more mature companies

• Often include a broad-based, well-diversified list of companies and have low transaction costs

thumb_down

Cons:

• The largest companies in the index may overwhelm performance

• May help generate market bubbles, with overpriced assets

• May encourage buying-high, selling-low investor behavior

How Market Value Weighted Index Is Calculated

Theoretically, the calculation of a value weighted index and the weights assigned to each component are easy to calculate. But as with most things, reality is a little more complicated.

To calculate a value weighted index, the first step is to multiply the price and shares outstanding (both of which are in near constant flux) of each component to get the market capitalization for each stock. For example, if you were trying to calculate a value weighted index comprising only three companies (which would not be indicative of a true index, but for simplicity’s sake, will work for an example), you’d first figure out the market capitalization of each company.

Market Capitalization = Price per share x Shares Outstanding

In this hypothetical example, here’s how that might look:

• Company 1: 50 shares outstanding at a current price of $10 = $500

• Company 2: 100 shares outstanding at a current price of $5 = $500

• Company 3: 75 shares outstanding at a current price of $15 = $1,125

Adding those up, the entire market value of this index is $2,125. To calculate the weights of each company in the index, you divide the value of the given company by the overall value of the index:

• Company 1: $500 ÷ $2,125 = weight of 23.5%

• Company 2: $500 ÷ $2,125 = weight of 23.5%

• Company 3: $1,125 ÷ $2,125 = weight of 53%

So, our total weight between the three companies is 100%, and Company 3 carries the highest weighting.

But remember: Due to complications with adding and removing companies from the index, dividends paid, buybacks, mergers, etc., there must be some normalizing done to the formula to remove large fluctuations caused by anything other than core performance.

This function is accomplished by the divisor, which oftentimes performs double duty by scaling the index values much smaller, say in the thousands rather than in the trillions, resulting in the following formula.

Index Value = ∑_𝑖𝑝_𝑖𝑞_𝑖 / Divisor

Other Forms of Weighted Market Indexes

Value weighted indexes aren’t the only index-based securities measuring tool. Investors can utilize the following market index assessment options as well.

The Price Weighted Index

Price weighted indexes are another form of weighted market index, and a good example is the Dow Jones Industrial Average.

A price weighted index weights each component based on its stock price. Therefore a company trading at $200 will have a higher weighting than a stock trading at $5. This is despite the revenue, employment, or market capitalization of the respective companies.

The Fundamentally Weighted Index

A fundamentally weighted market index weighs companies based on some other financial criteria such as revenues, earnings, dividend rates, or other factors. Fundamentally weighted indexes allow tremendous flexibility in creating an index to match an investing criteria and strategy.

Unweighted Index

The term “unweighted” simply means that no weight is applied when measuring a stock against an index. Instead, the measurement gives equal weight to each index component. It is common to see unweighted versions of major indexes compared to the weighted indexes to get deeper market insights on, for example, how broad-based a market rally truly is.

The Takeaway

Value weighted indexes can be useful as performance benchmarks and to provide a quick overview of market conditions. By observing the index performance, investors may be better informed on entry and exit opportunities, as well as to measure their own investing performance.

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Photo credit: iStock/tdub303

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

SOIN21030

Jun

2024

Guide to IRA Accounts With Limited Margin

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

An IRA account with limited margin is a retirement account that allows investors to trade securities with unsettled cash. It’s a more lenient structure versus a cash account, where you must wait for trades to settle before using the money for further trading. But an IRA account with limited margin isn’t a true margin account in that you can’t use leverage.

Nonetheless, an IRA account with limited margin offers a few advantages, including the ability to defer or avoid short-term capital gains tax, and you’re protected against good faith violations. That said, there are still restrictions, so before setting one up, it may be beneficial to learn more about how these accounts work.

What Is an IRA Account With Limited Margin?

An IRA account that may have limited margin — often called simply a limited margin IRA — presents a more flexible option to invest for retirement than a traditional IRA. These types of IRAs may allow you to trade with unsettled funds, meaning that if you close a position you don’t have to wait the standard two days after you trade, you can use those funds right away.

There may also be tax benefits. In a traditional IRA margin account, capital gains taxes are deferred until funds are withdrawn. This is similar to a regular IRA, where you don’t pay taxes on contributions or gains until you withdraw your money.

You may also be able to use limited margin in a Roth IRA, and there may be even more tax benefits when using limited margin in a Roth IRA. You don’t pay any capital gains because Roth accounts are tax-free, since Roth contributions are made with after-tax money.

As noted, an IRA account with limited margin may allow investors to trade with unsettled cash. However, a limited margin IRA is just that — limited. It is not a true margin account, and does not allow you to short stocks or use leverage by borrowing money to trade with margin debits. In that sense, it is different from margin trading in a taxable brokerage account.

You may be able to use limited margin in several IRA types. In addition to having margin IRAs with traditional and Roth accounts, rollover IRAs, SEP IRAs, and even small business SIMPLE IRAs are eligible for the margin feature. While mutual funds are often owned inside an IRA, you cannot buy mutual funds on margin.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

How Does Limited Margin Work?

Limited margin works by allowing investors to trade securities without having to wait for funds to settle. You can think of it like an advance payment from positions recently sold.

The first step is to open an IRA account and request that the IRA margin feature be added. Once approved, you might have to request that your broker move positions from cash to margin within the IRA. This operational task will also set future trades to the margin type.

IRAs with limited margin will state your intraday buying power — you should use this balance when day trading stocks and options in the IRA.

An advantage to trading in limited margin IRAs is that you can avoid or defer capital gains tax. Assuming you earn profits from trading, that can be a major annual savings versus day trading in a taxable brokerage account. If you trade within a pre-tax account, such as a traditional or rollover IRA, then you simply pay income tax upon the withdrawal of funds. When using Roth IRA margin, your account can grow tax-free forever in some cases.

The drawback with an IRA with limited margin versus day trading in a taxable account is you are unable to borrow money from your broker to create margin debits. You are also unable to sell securities short with an IRA with limited margin account. So while it is a margin account, you do not have all the bells and whistles of a full margin account that is not an IRA.

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Who Is Eligible for an IRA With Limited Margin?

Some brokerage firms have strict eligibility requirements such as a minimum equity threshold (similar to the minimum balances required in full margin accounts). When signing up, you might also be required to indicate that your investment objective is the “most aggressive.” That gives the broker a clue that you will use the account for active trading purposes.

Another restriction is that you might not be able to choose an FDIC-insured cash position. That’s not a major issue for most investors since you can elect a safe money market fund instead.

IRA Margin Calls

An advantage to having margin in an IRA is that you can more easily avoid margin calls by not having to wait for cash from the proceeds of a sale to settle, but margin calls can still happen. If the IRA margin equity amount drops below a certain amount (often $25,000, but it can vary by broker), then a day trade minimum equity call is issued. Until you meet the call, you are limited to closing positions only.

To meet the IRA margin call, you just have to deposit more cash or marginable securities. Since it is an IRA, there are annual contribution limits that you cannot exceed, so adding funds might be tricky.

💡 Quick Tip: One of the advantages of using a margin account, if you qualify, is that a margin loan gives you the ability to buy more securities. Be sure to understand the terms of the margin account, though, as buying on margin includes the risk of bigger losses.

Avoiding Good Faith Violations

A good faith violation happens when you purchase a security in a cash account then sell before paying for the purchase with settled cash. You must wait for the funds to settle — the standard is trade date plus two days (T+2 settlement) for equity securities. Only cash and funds from sale proceeds are considered “settled funds.” Cash accounts and margin accounts have different rules to know about.

A good faith violation can happen in an IRA account without margin. For example, if you buy a stock in the morning, sell it in the afternoon, then use those proceeds to do another round-trip trade before the funds settle, that second sale can trigger a good faith violation. Having margin in an IRA prevents good faith violations in that instance since an IRA with limited margin allows you to trade with unsettled funds.

Pros and Cons of Limited Margin Trading in an IRA

Can IRA accounts have margin? Yes. Can you use margin in a Roth IRA? Yes. Should your IRA have the limited margin feature added? It depends on your preferences. Below are the pros and cons to consider with IRAs with limited margin.

Pros	Cons
You are permitted to trade with unsettled cash.	You cannot trade using actual margin (i.e. leverage).
You can avoid good faith violations.	You cannot engage in short selling or have naked options positions.
	You take on more risk with your retirement money.

The Takeaway

An IRA account with limited margin allows people investing in individual retirement accounts to trade securities a bit more freely versus a cash account. The main benefit to having an IRA with limited margin is that you can buy and sell stocks and options without waiting for lengthy settlement periods associated with a non-margin account.

But remember: Unlike a normal margin account, this type doesn’t allow you to use leverage. That means a margin-equipped IRA doesn’t permit margin trading that creates margin debit balances. You are also not allowed to have naked options positions or engage in selling shares short.

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FAQ

Is an IRA a cash or a margin account?

An IRA can either be a cash account or a limited margin account. While a cash account only lets you buy and sell securities with a traditional settlement period, a limited margin IRA might offer same-day settlement of trades. You are not allowed to borrow funds or short sell, however.

Is day trading possible in an IRA?

Yes. You can day trade in your IRA, and it can actually be a tax-savvy practice. Short-term capital gains can add up when you day trade in a taxable brokerage account. That tax liability can eat into your profits. With a limited margin IRA that offers same-day settlement, however, you can buy and sell stocks and options without the many tax consequences of a non-IRA. The downside is that, in the case of losses, you cannot take advantage of the $3,000 capital loss tax deduction because an IRA is a tax-sheltered account. Another feature that is limited when day trading an IRA is that you cannot borrow funds to control more capital. A final drawback is that you are limited to going long shares, not short.

Can a 401(k) be a margin account?

Most 401(k) plans do not allow participants to have the margin feature. An emerging type of small business 401(k) plan — the solo brokerage 401(k) — allows participants to have a margin feature. Not all providers allow it, though. Also, just because the account has the margin feature, it does not mean you can borrow money from the broker to buy securities.

Photo credit: iStock/Drazen_

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

May

2024

A Beginner’s Guide to Investing in CDs

By Janet Siroto | Growing Wealth, invest, Investing | Comments Off

A certificate of deposit (or CD) has many of the same low-risk benefits as a savings account, but a CD holds your money for a fixed time period in exchange for a higher rate of interest than the standard savings account.

You may be familiar with CDs as part of your savings strategy (say, keeping money secure and earning interest until you are ready to buy a house), but they can also be used as a part of a portfolio’s cash allocation. CDs generally pay a higher interest rate than you can get with other cash accounts. Owing to their lower risk profile and modest but steady returns, allocating part of your portfolio to CDs can offer diversification that may help lower your risk exposure in other areas.

Here’s a closer look at the ins and outs of investing in CDs.

Key Points

• Certificates of deposit (CDs) offer higher interest rates than regular savings accounts by locking funds for a fixed period.

• CDs are available through banks, credit unions, and brokerages, with varying terms and minimum deposits.

• Early withdrawal from a CD incurs penalties, typically costing several months’ interest.

• Investment strategies like CD laddering, barbells, and bullets help manage liquidity and returns.

• CDs are insured up to $250,000, providing a safe investment option with predictable returns.

How to Buy CDs

Investors can buy CDs at many, if not most financial institutions, such as banks, credit unions, or brokerages. Not all institutions might offer CDs, and others may have limited options, but generally, if you’re looking to buy CDs, you might want to start at your bank, where you might hold a savings account.

Again, a certificate of deposit is similar to a savings account in that you can stash your money for a long period of time, but CDs possess some distinct features you need to understand in order to gauge whether they’re a good fit with your plan. Here are some aspects of CDs to keep in mind.

1. A Fixed Deposit for a Set Time Period

Investors purchase a CD for a fixed amount of money: e.g., $1,000, $5,000, or more. Some banks have a required minimum deposit; others don’t. Generally, you cannot increase the amount of your savings (although you can always buy another CD). Some banks offer jumbo CDs, which might require a minimum $100,000 deposit.

Unlike a savings account, which is open-ended (and allows you to access your cash at any time), you typically purchase a CD for a set period of time during which you can’t withdraw the funds without a penalty. Typical CD terms can vary from one month to five years, so check with the institution that issues the CD.

2. Guaranteed Interest Rates and Insurance

Because investing in CDs is less liquid than a savings account, the interest rate tends to be higher. CD rates are quoted as an annual percentage yield (APY). The APY is how much the account will earn in one year, including compound interest. Banks generally compound interest daily or monthly.

When the period is up, also known as the CD maturity date, the CD holder can receive the original investment, plus any interest earned. The interest rate can vary considerably, depending on the institution. Also, longer-term CDs tend to offer higher rates than shorter-term ones.

The money in a CD is protected by the same federal insurance (FDIC) that covers all deposit products, whether at a bank, credit union, or other institution.

3. Early Withdrawal Penalties

CDs can offer higher yields because customers are promising the bank that they will deposit their money for a set period of time. As a result, investing in CDs means the money is usually locked up until it reaches its maturity date. Withdrawing the money before the CD matures may trigger a penalty, which could effectively eliminate any interest rate gains.

The penalty for an early withdrawal on a CD is often stated in terms of interest: e.g. you would owe 60 days’ worth of interest, 150 days’ worth of interest, and so on. The penalty is usually charged according to the simple interest rate on your account, not the compound interest you might have earned over time.

Before purchasing a CD, it’s best to look at its disclosure statement, which should tell you the interest rate, how often interest is paid, the maturity date of the CD, and any early withdrawal penalties.

Note: There are penalty-free or no penalty CDs. These allow you to withdraw funds before the maturity date without a fee, but they typically have lower interest rates than other CDs.

4. Terms Vary Widely

It’s important to shop around for the best CD rates and terms. Brick-and-mortar banks may pay lower rates, while online banks and credit unions may pay higher rates. Because the interest rates on CDs are based on the federal funds rate, similar to mortgages and other financial products, it’s also a good idea to see whether the Federal Reserve is about to raise or lower interest rates before deciding whether it’s a good time to invest in CDs.

CD Investing Strategies

CDs can be incorporated as part of your financial plan in various ways. They can act as short-term savings vehicles — a way to secure your money for a down payment or a large purchase within five years, say. Or they can be part of a longer-term strategy. Here are some examples.

CD Ladder

A CD ladder uses a combination of shorter-term and longer-term CDs to maximize different rates of return and deliver several years of steady income.

Hypothetically, say you want to invest $10,000 over a 10-year period. You could create a CD ladder by purchasing five CDs of different maturities all at once, and reinvesting them as follows:

• Deposit $2,000 in a 1-year CD. When that CD matures, roll over the money plus interest into a 5-year CD.

• Deposit $2,000 in a 2-year CD. When that CD matures, again roll over those funds into another 5-year CD.

• Do the same for a 3-year, 4-year, and 5-year CD. As each one matures, you roll over the funds, plus any accumulated interest, into a 5-year CD.

The result will be five different CDs that mature one year apart, allowing you to withdraw your funds plus interest. This strategy ensures some diversification of interest rates, so your money isn’t locked into a flat rate for the full 10 years. It can be reassuring to know that, if you need access to cash, you can expect one of the CDs to be on the verge of maturing at regular intervals.

CD Barbell

The CD barbell is like a CD ladder, but without buying any mid-length CDs: Here you invest a certain amount in a short-term CD (say, a 1-year CD), and the rest in a 5-year CD as a way to hedge your bets.

The barbell strategy allows you to take advantage of both short- and long-term rates. When the short-term CD matures, you can either reinvest at the short-term rate, if that makes sense, or shift the money over to a longer-term CD.

CD Bullet

Instead of buying a few CDs of different maturities at the same time, the bullet strategy allows you to invest different amounts at different times, as a way of saving for a specific goal like a down payment.

This strategy could allow you to invest one amount in a CD to start, save up more for a year or two and buy another CD that matures at the same time as the first, and so on. Then you have, say, three CDs that mature at the same time, with interest, allowing you to withdraw the lump sum from each one for your goal.

For example:

• You could invest $5,000 in a 5-year CD today.

• Then, in two years, invest $3,000 in a 3-year CD.

• Last, save up money for another two years and buy a $2,000 1-year CD.

• All three CDs mature at the same time, and you can withdraw all the money, plus compound interest.

Benefits of Investing in CDs

Investing in CDs can offer some investors specific benefits.

Peace of Mind

CDs are generally considered one of the safer options for investors. Like traditional savings accounts or high-yield savings accounts, CDs are insured for up to $250,000 per depositor, per account ownership category, per insured institution, when they are purchased through an FDIC-insured bank or an NCUA-insured credit union. In the very rare instance of the CD-issuing bank failing, your deposits would be covered up to $250,000.

Predictability

CD interest rates are usually fixed and will deliver a predictable yield at the end of their term. The same is not necessarily true of traditional savings accounts, which may lower the amount they pay if interest rates drop. The ability to calculate exactly how much you’ll be paid at the end of the CD’s term makes it easier to know how that CD will fit into a financial plan.

A Variety of Options

Thousands of banks and credit unions across the country offer a diverse selection of CDs, which come with many interest rate options and with maturity lengths from a month to a decade.

There also may be different styles of CDs to choose from (you’ll learn about bump-up and add-on CDs in a moment). But, as always, be sure to check the terms.

Drawbacks of Investing in CDs

Of course, like any other investment, CDs can come with their share of potential downsides.

Illiquidity

One of the main drawbacks of a CD is that most of them are relatively illiquid, meaning you can’t access the funds whenever you like. An investor’s money is tied up until the maturity date, and early withdrawals may trigger penalties in the form of lost interest payments or, in some cases, lost principal.

Though there are some CDs that offer penalty-free withdrawals, investors must often accept lower interest rates in trade.

When choosing a CD, it’s best to carefully consider a maturity date you know you will be able to meet. An emergency fund can help you avoid the temptation to tap CD investments when the unexpected happens.

Inflation Risk

Despite the fact that CDs tend to offer higher returns than traditional savings accounts, they can still be subject to the same inflation risk. When inflation is high, CD returns may be unable to outpace it. That means the money sitting in the CD may lose purchasing power before reaching maturity.

Taxes

When investors withdraw money from CDs after the maturity date, they pay no taxes on the principal withdrawn, but the money earned is taxable on state and federal levels as interest income.

The taxes will reduce the amount of money a CD investor will actually get to take home. It’s a good idea to carefully consider taxes when shopping for a CD and deciding on an APY.

Opportunity Cost

Money that’s tied up in a CD can’t be put to work anywhere else — a problem known as opportunity cost. CD interest rates may be higher than some other bank products, but stocks, bonds, and other investments may offer much higher returns. That said, higher returns are often associated with higher risk.

CD investors may be opting to avoid risk or using the accounts to diversify a portfolio that already holds a mix of stocks and bonds.

Types of CDs to Invest In

Above, you learned about the basic structure of a traditional CD, but there are a few other types that may offer features that are more desirable. In some cases, these may come with tradeoffs or additional risk factors, so be sure to weigh the pros and cons and terms of each.

1. Liquid CDs

If you’d prefer a CD that allows you to access your savings before the maturity date without paying a penalty, a liquid CD may offer a solution. These CDs don’t charge a penalty for early withdrawals, but they may offer lower interest rates as a result.

2. Bump-up CDs

Some investors dislike the idea of locking up their cash at a fixed rate, when in theory rates could rise, and you’d lose out on the higher rate of return. A bump-up CD may help address that concern by allowing you a chance to “bump up” to a higher rate.

3. Add-on CDs

If you don’t have the specific amount required to open a CD, another option could be to open an add-on CD, which allows you to make additional deposits.

4. Variable Rate CDs

Like a variable rate loan, a variable rate CD doesn’t pay a fixed interest rate. Having a variable rate may give you higher or lower rates at some points, but the point is that the rate isn’t guaranteed, so you have to be willing to take your chances.

5. Uninsured CDs

If you’re willing to forgo federal insurance on your deposits, you might be able to get a higher interest rate.

In all cases, be sure to check the terms of the CD you’re about to buy, in case there are restrictions or caveats that might make a certain CD less desirable. For example, there are some CDs offered by foreign banks, but denominated in US dollars, which may offer competitive rates but they are not federally insured.

6. Brokered CDs

A brokered CD is a lot like a traditional CD but is purchased through a broker, typically using a brokerage account. This setup can provide access to a wide range of CDs from different financial institutions.

It is also possible to trade brokered CDs on the secondary market. Finding a buyer may be difficult, however, which could mean accepting a lower price for the sale. Brokered CDs may come with additional fees.

The Takeaway

Although CDs are sometimes dismissed as simple savings vehicles, in fact investing in CDs can offer a steady if modest rate of return, and some peace of mind — factors that may appeal to some investors, especially over time. It’s also possible to use different strategies like a CD ladder to create an income stream or maximize different interest rates over time.

If, however, the idea of locking up your money for a set period of time doesn’t suit your needs, you might consider a high-yield checking and savings account instead.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 3.60% APY on SoFi Checking and Savings.

🛈 While SoFi does not offer Certificates of Deposit (CDs), we do offer alternative savings vehicles such as high-yield savings accounts.

FAQ

Where do you go to invest in CDs?

Investors can purchase CDs at many financial institutions, such as banks, credit unions, or brokerages, although not all institutions will offer them.

How much does a $10,000 CD make in a year?

The ultimate yield on a $10,000 CD in a year will depend on the associated interest rate and compounding frequency, which can vary. But assuming the interest rate is 3.00%, an investor could earn $300 after one year if compounded annually.

Are CDs considered low-risk?

CDs are generally considered to be lower-risk investments, especially compared to assets like stocks.

How much money do you need to invest in a CD?

There are minimums to purchase a CD, which vary, but a ballpark figure is around $500, depending on where you buy them.

SoFi Checking and Savings is offered through SoFi Bank, N.A. Member FDIC. The SoFi® Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

Annual percentage yield (APY) is variable and subject to change at any time. Rates are current as of 11/12/25. There is no minimum balance requirement. Fees may reduce earnings. Additional rates and information can be found at https://www.sofi.com/legal/banking-rate-sheet

Eligible Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Eligible Direct Deposit”) via the Automated Clearing House (“ACH”) Network every 31 calendar days.

Although we do our best to recognize all Eligible Direct Deposits, a small number of employers, payroll providers, benefits providers, or government agencies do not designate payments as direct deposit. To ensure you're earning the APY for account holders with Eligible Direct Deposit, we encourage you to check your APY Details page the day after your Eligible Direct Deposit posts to your SoFi account. If your APY is not showing as the APY for account holders with Eligible Direct Deposit, contact us at 855-456-7634 with the details of your Eligible Direct Deposit. As long as SoFi Bank can validate those details, you will start earning the APY for account holders with Eligible Direct Deposit from the date you contact SoFi for the next 31 calendar days. You will also be eligible for the APY for account holders with Eligible Direct Deposit on future Eligible Direct Deposits, as long as SoFi Bank can validate them.

Deposits that are not from an employer, payroll, or benefits provider or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, Wise, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Eligible Direct Deposit activity. There is no minimum Eligible Direct Deposit amount required to qualify for the stated interest rate. SoFi Bank shall, in its sole discretion, assess each account holder's Eligible Direct Deposit activity to determine the applicability of rates and may request additional documentation for verification of eligibility.

See additional details at https://www.sofi.com/legal/banking-rate-sheet.
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.

SOBK0224018

May

2024

Mutual Funds vs Index Funds: Key Differences

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

Mutual funds and index funds are similar in many ways, but there are some key differences that investors need to understand to effectively implement them into an investment strategy. Those differences might include investing style, associated fees and taxes, and how they work.

The choice between an index fund and an actively managed mutual fund can be a hard one, especially for investors who are unsure of the distinction. The differences between index funds and other mutual funds are actually few — but may be important, depending on the investor.

Key Points

• Index funds aim to mirror the performance of a specific market index, using a passive investment strategy.

• Mutual funds are actively managed by fund managers who select securities to potentially outperform the market.

• The costs associated with mutual funds are generally higher due to active management fees.

• Index funds typically have lower expense ratios, making them a cost-effective option for investors.

• The choice between index and mutual funds depends on individual investment goals and preferences for active versus passive management.

What’s the Difference between Index Funds and Mutual Funds?

Index funds and mutual funds are similar in many ways, but they do differ in some others, such as how they work, associated costs, and investment style.

How They Work

Index funds are a type of mutual fund, interestingly enough. Index funds are distinguished by their investing approach: Index funds invest in an index, and only change the securities they hold when the index changes, or to realign their holdings to better match the index they invest in.

Rather than rely on a portfolio manager’s instincts and experience, an index fund tracks a particular index. There are benchmark indexes across all of the different asset classes, including stocks, bonds, currencies, and commodities. As an example, the S&P 500® Index tracks the stocks of 500 of the leading companies in the United States.

An index fund aims to mirror the performance of a given benchmark index by investing in the same companies with similar weights. With these funds, it’s not about beating the market, it’s about tracking it, and as such, index funds typically follow a passive investment strategy, known as a buy-and-hold strategy.

A mutual fund is an investment that holds a collection — or portfolio — of securities, such as stocks and bonds. The “mutual” part of the name has to do with the structure of the fund, in that all of its investors mutually combine their funds in this one shared portfolio.

Mutual funds are also called ’40 Act funds, as they were created in 1940 by an act of Congress that was designed to correct some of the investment abuses that led to the Stock Market Crash of 1929. It created a regulatory framework for offering and maintaining mutual funds, including requirements for filings, service charges, financial disclosures, and the fiduciary duties of investment companies.

To get people to invest, the portfolio managers of a given mutual fund offer a unique investment perspective or strategy. That could mean investing in tech stocks, or only investing in the fund manager’s five best ideas, or investing in a few thousand stocks at once, or only in gold-mining stocks, and so on.

Fees and Taxes

There may be different associated costs with index funds and mutual funds as well.

Mutual-fund managers generally charge investors a management fee, which comes from the assets of the fund. Those fees vary widely, but an active manager will generally charge more, as they have to pay the salaries of analysts, researchers, and the stock pickers themselves. Passive managers of index funds, on the other hand, simply have to pay to license the use of an index.

An actively-managed mutual fund may charge an expense ratio (which includes the management fee) of 0.5% to 0.75%, and sometimes as high as 1.5%. But for index funds, that expense ratio is typically much lower — often around 0.2%, and as low as 0.02% for some funds.

Investing Style

The two also differ on a basic level in that index funds are a passive investing vehicle and mutual funds are typically actively managed. That means that investors who want to take a hands-off approach may find index funds a more suitable choice, whereas investors who want a guiding hand in their portfolio may be more attracted to mutual funds.

Mutual Funds vs. Index Funds: Key Differences
Mutual Funds	Index Funds
Overseen by a fund manager	Track a market index
May have higher associated costs	Typically has lower associated costs
Active investing	Passive investing

Index vs Mutual Fund: Which is Best for You?

There’s no telling whether an index or mutual fund is better for you — it’ll depend on specific factors relevant to your specific situation and goals.

When deciding how to invest, everyone has their own unique approach. If an investor believes in the expertise and human touch of a fund manager or team of professionals, then an actively managed fund like a mutual fund may be the right fit. While no one beats the market every year, some funds can potentially outperform the broader market for long stretches.

But for those individuals who want to invest in the markets and not think about it, then the broad exposure — and lower fees — offered by index funds may make more sense. Investing in index funds tends to work best when you hold your money in the funds for a longer period of time, or use a dollar-cost-average strategy, where you invest consistently over time to take advantage of both high and low points.

The Takeaway

Index funds and mutual funds are similar investment vehicles, but there are some key differences which include how they’re managed, costs associated with them, and how they function at a granular level.

The choice between index funds and other mutual funds is one with decades of debate behind it. For individuals who prefer the expertise of a hands-on professional or team buying and selling assets within the fund, a mutual fund may be preferred. For investors who’d rather their fund passively track an index — without worrying about “beating the market” — an index fund might be the way to go.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.

Invest in alts to take your portfolio beyond stocks and bonds.

FAQ

Do index funds outperform mutual funds?

Actively-managed funds, such as mutual funds, tend to underperform the market as a whole over time. That’s to say that most of the time, a broad index fund may be more likely to outperform a mutual fund.

Do people prefer index funds over mutual funds, or mutual funds over index funds?

The types of funds that investors prefer to invest in depends completely on their own financial situation and investment goals. But some investors may prefer index funds over mutual funds due to their hands-off, passive approach and lower associated costs.

Are mutual funds riskier than index funds?

Mutual funds may be riskier than index funds, but it depends on the specific funds being compared — mutual funds do tend to be more expensive than index funds, and tend to underperform the market at large, too.

An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

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.

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

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.

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

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

SOIN0224025

What Is Income Tax Withholding and How Does It Work?

What is Income Tax Withholding?

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

Factors That Determine Tax Withholding

What Is State Income Tax Withholding?

What Is the Purpose of Tax Withholding?

Tax and Employment Documents to Know

Calculating Income Tax Withholding

Can I Be Exempt from Tax Withholding?

The Takeaway

FAQ

Does the government pay for income tax withholdings?

How can someone qualify for a withholding exemption?

Why has my employer withheld too much income tax?

Why has my employer withheld too little income tax?

Value-Weighted Index: Explanation and How to Calculate

Value Weighted Index Explained

How Traders Use Indexes

How Investors Use Indexes

How Mutual Fund Managers Use Indexes

How Hedge Funds Use Indexes

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Pros and Cons of Value Weighted Indexes

Pros:

Cons:

How Market Value Weighted Index Is Calculated

Other Forms of Weighted Market Indexes

The Price Weighted Index

The Fundamentally Weighted Index

Unweighted Index

The Takeaway

Guide to IRA Accounts With Limited Margin

What Is an IRA Account With Limited Margin?

How Does Limited Margin Work?

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 10.50%* and start margin trading.

Who Is Eligible for an IRA With Limited Margin?

IRA Margin Calls

Avoiding Good Faith Violations

Pros and Cons of Limited Margin Trading in an IRA

The Takeaway

FAQ

Is an IRA a cash or a margin account?

Is day trading possible in an IRA?

Can a 401(k) be a margin account?

A Beginner’s Guide to Investing in CDs

How to Buy CDs

1. A Fixed Deposit for a Set Time Period

2. Guaranteed Interest Rates and Insurance

3. Early Withdrawal Penalties

4. Terms Vary Widely

CD Investing Strategies

CD Ladder

CD Barbell

CD Bullet

Benefits of Investing in CDs

Peace of Mind

Predictability

A Variety of Options

Drawbacks of Investing in CDs

Illiquidity

Inflation Risk

Taxes

Opportunity Cost

Types of CDs to Invest In

1. Liquid CDs

2. Bump-up CDs

3. Add-on CDs

4. Variable Rate CDs

5. Uninsured CDs

6. Brokered CDs

The Takeaway

FAQ

Where do you go to invest in CDs?

How much does a $10,000 CD make in a year?

Are CDs considered low-risk?

How much money do you need to invest in a CD?

Mutual Funds vs Index Funds: Key Differences

What’s the Difference between Index Funds and Mutual Funds?

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