How an Employer 401(k) Match Works

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Whether your retirement plans involve writing your memoir from a lovely little seaside cottage, a heated game of bocce against your (*ahem* sore loser) neighbor, or hitting up every farmers market in a 50-mile radius, a 401(k) is one savings strategy you can use to save money to get you there.

Simply put, a 401(k) is a mechanism for saving retirement funds by making pre-tax contributions through deductions from payroll. Some plans offer a 401(k) employer match, which can be the equivalent of getting “free money” from an employer.

A Quick Breakdown on 401(k) Plans

A 401(k) is an investment plan many employers offer their employees as a way to save for retirement. Employees can contribute either a percentage of or predetermined amount from each paycheck and, in some cases, the contributions can be matched by the employer up to a certain amount.

These deferred wages, also called “elective deferrals,” aren’t typically subject to federal income tax withholding, and are not listed as taxable income on the employee’s annual return.

If someone is self-employed, they can contribute to a one participant 401(k) plan plan with the same rules and requirements as an employer-sponsored 401(k) plan. Similarly, 457(b) plans can be used for public sector employees, and 403(b) plans for public schools and certain tax-exempt organizations.

Advantages of Participating in a 401(k)

A few advantages to participating in a 401(k) :

1. Investment gains and elective deferrals to 401(k) plans are not subject to federal income tax until they’re distributed, which is typically when:

•   The participant reaches the age of 59½
•   The participant becomes disabled, deceased, or otherwise has a severance from employment
•   The plan terminates and no subsequent plan is established by the employer
•   The participant incurs a financial hardship

2. Elective deferrals are 100% vested. The participant owns 100% of the money in their account, and the employer cannot take it back or forfeit it for any reason.

3. Participants choose how to invest their 401(k). The plans are mainly self-directed, meaning participants decide how they’d like to invest the money in their account. This could mean mutual funds or exchange-traded funds (ETFs) which invests in a wide array of sectors and companies, but typically doesn’t include investing in individual companies and stocks.

Investment tactics might vary from person to person, but by understanding their goals, investors can decide whether their portfolio will have time to withstand market ups and downs with some high-risk, high-reward investments, or if they should shift to a more conservative allocation as they come closer to retirement.

What About 401(k) Vesting Schedules?

“Vesting ” means “ownership” in a retirement plan. The employee will vest, or own, some percent of their account balance. In the case of a 401(k), being 100% vested means they’ve met their employer’s vesting schedule requirements to ensure complete ownership of their funds.

Vesting schedules, determined by 401(k) plan documents, can lay out certain employer vesting restrictions that range from immediate vesting to 100% vesting after three years to a schedule that increases the vested percentage based on years of service. Either way, all employees must be 100% vested if a plan is terminated by the employer or upon reaching the plan’s standard retirement age.

How Does a 401(k) Match Work?

A 401(k) match is an employee benefit that allows an employer to contribute a certain amount to their employee’s 401(k) plan. The match can be based on a percentage of the employee’s contribution, up to a certain portion of their total salary or a set dollar amount, depending on the terms of the plan.

Not all employers offer this benefit, and some have prerequisites for participating in the match, such as a minimum required contribution or a cap up to a certain amount.

Meeting with an HR representative or a benefits administrator is a one way to get a better idea of what’s possible. Learning the maximum percent of salary the company will contribute is a start, then the employee can set or increase their contribution accordingly to maximize the employer match benefit.

Benefits of a 401(k) Employer Match

According to a report from Fidelity Investments , the average employer 401(k) match reached a record high of 4.7% in 2019 and “boosted the average total savings rate to an all-time high of 13.5%.”

Many employees are taking advantage of this benefit. Some reasons they could benefit:

It’s Basically “Free Money”

An employer match is one part of the overall compensation package and another way to maximize the amount of money an employer pays their employees. Those employees could be turning their backs on free money by not contributing to an employer-matched 401(k) plan.

Reducing Taxable Income

According to FINRA , “with pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year. But your take-home pay will go down by less than a dollar.”

If a participant contributed $1,500 a year to a 401(k), they’d only owe taxes on their current salary minus that amount, which could save some serious money as that salary grows.

The Most Common Employer Match Formulas

Not all employer matches are created equal.

According to a recent report from Vanguard , “How America Saves,” among the 150 distinct match formulas administered through their employer-matched 401(k) plans in 2018:

•  70% of plans used a single-tier match formula, with the most commonly cited being $0.50 on the dollar on the first 6% of pay.
•  21% of plans used multi-tier match formulas, e.g., dollar-on-dollar on the first 3% of pay and $0.50 on the dollar on the next 2% of pay.

A Sample Employer Match 401(k) Scenario

For the sake of breaking a few things down, here’s a retirement saving scenario that can illuminate how 401(k) matching works in real life:

Let’s say a person is 30 years old, with a salary of $50,000, contributing 3% of their salary (or $1,500) to a 401(k). Let’s also say they keep making $50,000 and contributing 3% every year until they’re 65. They will have put $52,500 into their 401(k) in those 35 years.

Now let’s say they opt into an employer match with a dollar-for-dollar up to 3% formula. Putting aside the likelihood of an increase in the value of the investments, they’ll have saved $105,000— with $52,500 in free contributions from their employer.

That’s a no-cost way to increase retirement savings by 100%.

How Much Should a Participant Contribute?

The average 401(k) employee contribution amount, according to Fidelity , reached a record level of $2,370 in 2019. Still, there’s no across-the-board amount that will work for everyone.

When deciding how much to contribute to a 401(k) plan, many factors might be considered to take advantage of a unique savings approach:

•   If a company offers a 401(k) employer match, the participant might consider contributing enough to meet whatever the minimum match requirements are.
•   If a participant is closer to retirement age, they’ll probably have a pretty good idea of what they already have saved and what they need to reach their retirement goals. An increase in contributions can make a difference, and maxing out their 401(k) might be a solid strategy.

A retirement calculator can also be helpful in determining what the right contribution amount is for a specific financial situation.

Are There 401(k) Contribution Limits?

In addition to the uncertainty that can come with choosing how much to contribute to a 401(k), there’s the added pressure of potential penalties for going over the maximum 401(k) contribution limit.

Three common limits to 401(k) contributions :

1. Elective deferral limits: Contribution amounts chosen by an employee and contributed to a 401(k) plan by the employer. In 2020, participants can contribute up to $19,500.

2. Catch-up contribution limits: After the age of 50, participants can contribute more to their 401(k) with catch-up contributions. In 2020, participants can make up to $6,500 in catch-up contributions.

3. Employer contribution limits: An employer can also make contributions and matches to a 401(k). The combined limit (not including catch-up contributions) on employer and employee contributions in 2020 is $57,000.

If participants think their total deferrals will exceed the limit for that particular year, the IRS recommends notifying the plan to request the difference (an “excess deferral ”) “be paid out of any of the plans that permit these distributions. The plan must then pay the employee that amount by April 15 of the following year (or an earlier date specified in the plan).”

Getting Started With Investing

Real, human advisors are a great outlet for discussing financial situations and potentially finding a retirement planning strategy that works for each investor (remember that beachside cottage?).

Opening a SoFi Invest® account lets you get started with as little as $1 and comes with complimentary access to financial advisors who are held to the highest fiduciary standards, meaning they’re required to act on your best interests. Try an exploratory conversation at no cost.

Start saving for retirement with SoFi Invest.



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.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Third Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third party trademarks referenced herein are property of their respective owners.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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.

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How to Choose a 401(k) Beneficiary: Rules & Options

multicultural family

Choosing a 401(k) beneficiary ensures that any unused funds in your account are dispersed according to your wishes after you pass away. Whether you’re married, single, or in a domestic partnership, naming a beneficiary simplifies the estate process and makes it easier for your heirs to receive the money.

There’s room on 401(k) beneficiary forms for both a primary and contingent beneficiary. Before making any decisions on a beneficiary and a backup, it can help to familiarize yourself with 401(k) beneficiary rules and options.

Why It’s Important to Name 401(k) Beneficiaries

If you die without a beneficiary listed on your 401(k) account, the distribution of the account may have to go through the probate process. While some plans with unnamed beneficiaries automatically default to a surviving spouse, others do not. If that’s the case—or if there is no surviving spouse—the 401(k) account becomes part of the estate that goes through probate as part of the will review.

401(k) may house a substantial amount of your retirement savings. How you approach choosing a 401(k) beneficiary depends on your personal situation. For married individuals, it’s common to choose a spouse. Some people choose to name a domestic partner or your children as beneficiaries.

Another option is to choose multiple beneficiaries, like multiple children or siblings. In this scenario, you can either elect for all beneficiaries to receive equal portions of your remaining 401(k) account, or assign each individual different percentages.

For example, you could allocate 25% to each of four children, or you could choose to leave 50% to one child, 25% to another, and 12.5% to the other two.

In addition to choosing a primary beneficiary, you must also choose a contingent beneficiary. This individual only receives your 401(k) funds if the primary beneficiary passes away. If the primary beneficiary is still alive, the contingent beneficiary doesn’t receive any funds.

401(k) Beneficiary Rules and Restrictions

Really, an individual can choose anyone they want to be a 401(k) beneficiary, with a few limitations. There are only a few restrictions and requirements on who may be named a beneficiary.

•  Minor children cannot be direct beneficiaries. They must have a named guardian oversee the inherited funds on their behalf, which will be chosen by a court if not specifically named. Choosing a reliable guardian helps to ensure the children’s inheritance is managed well until they reach adulthood.

•  A waiver may be required if someone other than a spouse is designated. Accounts that are ruled by the Employee Retirement Income Security Act (ERISA) have 401(k) spouse beneficiary rules. A spousal waiver is required if you designate less than 50% of your account to your spouse. Your plan administrator can tell you whether or not this rule applies to your specific 401(k).

How to Name Multiple 401(k) Beneficiaries

You are allowed to have multiple 401(k) beneficiaries, both for a single account and across multiple accounts. You must name them for each account, which gives you flexibility in how you want to pass on those funds.

When naming multiple beneficiaries, it’s common practice to divide the account by percentage, since the dollar amounts may vary based on what you use during your lifetime and investment performance.

However, also consider how the funds will be taxed for each individual . Spouse and non-spouse beneficiaries have different rules for an inherited 401(k). Spouses usually have more options available, but they differ depending on the spouse’s age and your age at the time of passing. In many cases, the spouse may roll over the funds into a specific spousal or inherited IRA.

Non-spouse beneficiaries may face higher tax consequences, but may be able to extend or stretch any required distributions over their life span to reduce their taxable income. They can also take out the money as a lump sum, which will be subject to income tax, but not the 10% early withdrawal penalty.

What to Do After Naming Beneficiaries

Once you’ve selected one or more beneficiaries, take the following steps to notify your heirs and to continually review and update your decisions as you move through various life stages.

Inform Your Beneficiaries

Naming your beneficiaries on your 401(k) plan makes sure your wishes are legally upheld, but you’ll make the inheritance process easier by telling your beneficiaries about your accounts. They’ll need to know where and how to access the account funds, especially since 401(k) accounts can be distributed outside of probate, making the process much faster than other elements of your estate plan.

For all of your accounts, including a 401(k), it’s a good idea to keep a list of financial institutions and account numbers. This makes it easier for your beneficiaries to access the funds quickly after your death. Plus, there may be rules on the pace at which the funds must be dispersed after your death—in some cases, your beneficiary may need to spread out withdrawals of the entire account over the 10 years following your death.

Revise After Major Life Changes

Managing your 401(k) beneficiaries isn’t necessarily a one-time task. It’s important to regularly review and update your decisions, especially as major life events occur. The most common events include marriage, divorce, birth, and death.

Common Life Stages

Before you get married, you may decide to list a parent or sibling as your beneficiary. But you’ll likely want to update that to your spouse or domestic partner, should you have one. At a certain point, you may also wish to add your children, especially once they reach adulthood and can be named as direct beneficiaries.

Divorce

It’s particularly important to update your named beneficiaries if you go through a divorce. If you don’t revise your 401(k) account, your ex-spouse could end up receiving those benefits—even if your will has been changed.

Death of a Beneficiary

Should your primary beneficiary die before you do, your contingent beneficiary will receive your 401(k) funds if you pass away. Any time a major death happens in your family, take the time to see how that impacts your own estate planning wishes. If your spouse passes away, for instance, you may wish to name your children as beneficiaries.

Second Marriages and Blended Families

Also note that the spouse rules apply for second marriages as well, whether following divorce or death of your first spouse. Your 401(k) automatically goes to your spouse if no other beneficiary is named. And if you assign them less than 50%, you’ll need that spousal waiver. Financial planning for blended families takes thought and communication, especially if you remarry later in life and want some or all of your assets to go to your children.

Manage Your Account Well

borrow from your 401(k), this can cause issues if you pass away with an outstanding balance. The loan principal will likely be deducted from your estate, which can limit how much your heirs actually receive.

Also try to streamline multiple 401(k) accounts as you change jobs and open new employer-sponsored plans. There are several ways to rollover your 401(k), which makes it easier for you to track and update your beneficiaries. It also simplifies things for your heirs after you pass away, because they don’t have to track down multiple accounts.

How to Update 401(k) Beneficiaries

Check with your 401(k) plan administrator to find out how to update your beneficiary information. Usually you’ll need to just fill out a form or log into your online retirement account.

Typically, you need the following information for each beneficiary:

•  Type of beneficiary
•  Full name
•  Birth date
•  Potentially their Social Security number

Although your named beneficiaries on the account supersede anything written in your will, it’s still smart to update that document as well. This can help circumvent legal challenges for your heirs after you pass away.

The Takeaway

A financial plan at any age should include how to distribute your assets should you pass away. The best way to manage your 401(k) is to formally name one or more beneficiaries on the account. This helps speed up the process by avoiding probate.

A named beneficiary trumps anything stated in your will. That’s why it’s so important to regularly review these designations to make sure the right people are identified to inherit your 401(k) assets.

Preparing for retirement? SoFi Invest® offers both traditional and Roth IRAs to help you reach your goals.

Find out how SoFi can help you with a financial plan for retirement.


SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Digital Assets—The Digital Assets platform is owned by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, http://www.sofi.com/legal.

External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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.

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How Tax on Mutual Funds Works

For a long time, mutual funds have been a popular investment vehicle for millions of investors, largely because they offer an easy way to purchase no-fuss, diversified assets with relative ease. This out-of-the-box diversification and risk-mitigation is something that individual stocks can’t match.

Though technology has made it easier than ever to buy securities like mutual funds online, one area of confusion persists. When it comes to tax on mutual funds, and calculating capital gains on mutual funds, many investors don’t know where to start.

Discussing tax on mutual funds and other investments can be tricky, but it doesn’t have to be. Read on to learn how tax on mutual funds works, what investors should expect or anticipate when it comes to dealing with mutual funds and the IRS, and some simple strategies for tax-efficient investing.

Quick Mutual Fund Overview

First, it makes sense to review the basics. Mutual funds are similar to exchange-traded funds (ETFs) in that they’re not singular investments. Instead, they’re a collection (or a “basket”) of many different investments like stocks, bonds, and short-term debt. When an investor buys into a mutual fund, they’re essentially purchasing a spectrum of assets all at once.

Paying Tax on Mutual Funds

Like other types of investments, investors must pay tax on any income or profits they realize from their mutual fund holdings. Not every fund is the same, so it follows that the taxable income shareholders receive (or don’t receive) from a fund isn’t the same.

Since it’s up to investors to know when to pay taxes on stocks and report the amount of taxable income they’ve received from the sales of their investments and distributions (on IRS Form 1099-DIV) the most proactive thing an investor can do to get an idea of what type of tax liability a specific mutual fund may present is to research the fund before any shares are purchased. In other words, do your homework.

There are a number of online resources—including but not limited to Morningstar and Kiplinger Mutual Fund Finder —that allow investors to conduct that research, with some also providing rating systems to help streamline the process.

Paying Tax on “Realized Gains” from a Mutual Fund

capital gains taxation rate will vary.

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

How to Minimize Taxes on Mutual Funds

When it comes to mutual funds, taxes are going to be a part of the equation for investors—there’s no way around it. But that doesn’t mean that investors can’t make some smart moves to minimize what they owe. Here are a handful of ways to potentially lower taxable income associated with mutual funds:

Know the Details Before You Invest

IRAs and 401(k)s—are tax-deferred. That means that they grow tax-free until the money contained in them is withdrawn. In the short-term, using these types of accounts to invest in mutual funds can help investors avoid any immediate tax liabilities that those mutual funds impose.

Hang Onto Your Funds to Avoid Short-term Capital Gains

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

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

Talk to a Financial Professional

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

The Takeaway

Getting taxed on capital gain on a mutual fund is unavoidable, but with a little help from a tax professional, you can minimize the amount you get taxed.

Some of the above strategies can work in concert: Investors who are investing for long-term financial goals, like retirement, can use tax-deferred accounts as their primary investing vehicles. And by using those accounts to invest in mutual funds and other assets, they can help offset their short-term tax liabilities.

While it’s possible to buy some mutual funds with an online brokerage account, many have restrictions on the types of funds investors can buy, as they’re specially-tailored toward specific financial goals, like retirement. With a SoFi Invest® account, investors can get started building a portfolio, and even gain access to complimentary advice.

Find out how SoFi Invest can help you get your money in the market.


Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Digital Assets—The Digital Assets platform is owned by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, http://www.sofi.com/legal.

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Investing With the Business Cycle

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A “business cycle” refers to the periodic expansion and contraction of a nation’s economy. Also known as an “economic cycle,” it tracks the different stages of growth and decline in a country’s gross domestic product, or economic activity.

business cycles . Each business cycle is dated from peak to peak or trough to trough of economic activity.

During the expansion phase of the business cycle, GDP increases and the economy grows. This phase tends to be significantly longer than the contraction phase. Since 1945, the average expansion has been 65 months, while the average contraction has lasted 11 months, according to a congressional research report. Features of expansion periods include:

•  GDP growth rate of 2-3%
•  Inflation around 2%
•  Unemployment between 3.5-4.5%
•  Bullish stock market
•  Increased demand for goods and services
•  Interest rates move higher
•  Job creation
•  Stock prices usually increase
•  Increased wages
•  Increased real estate values

As economic growth slows down, an economic contraction begins as the nation enters a recession. GDP growth dips below 2% in this phase.

Companies that have taken out loans may struggle to repay them, so they have to lay off workers and slow down production. As workers lose jobs, they have to cut down on spending. This creates a cycle of economic decline. Features of contraction periods include:

•  GDP growth falls below 2%
•  Decreased demand for goods and services
•  Interest rates move lower, making it easier to borrow money
•  Loss of jobs, increased unemployment
•  Reduced wages because people need jobs so they’re willing to work for less, and companies can’t pay as much
•  Stock prices usually decline
•  Real estate values plateau or decline

Stage 1: Recession

One definition of a recession is two consecutive quarters with a decline in real GDP. A recession could actually be defined more broadly as a period where there is significant decline in economic activity throughout the entire economy.

During this stage, GDP, profits, sales, and economic activity decline. Credit is tight for both consumers and businesses due to the policies set during the last business cycle. This leads to shifts in monetary policy that lead to a recovery phase. It’s a vicious cycle of falling production, falling incomes, falling employment, and falling GDP.

The intensity of a recession is measured by looking at the three D’s:

•  Depth: The measure of peak to trough decline in sales, income, employment, and output. The trough is the lowest point the GDP reaches during a cycle. Before World War II, recessions used to be much deeper than they are now.
•  Diffusion: How far the recession spreads across industries, regions, and activities.
•  Duration: The amount of time between the peak and the trough.

A more severe recession is called a depression. Depressions have deeper troughs and last longer than recessions. The only depression that has happened thus far was the Great Depression, which lasted 3.5 years, beginning in 1929.

Stage 2: Early Cycle

Following a recession, there tends to be a sharp recovery as growth begins to accelerate. The stock market tends to rise the most during this stage, which generally lasts about one year. Interest rates are low, so businesses and consumers can borrow more money for growth and investment. GDP begins to increase.

Just as a recession is a vicious cycle, a recovery is a virtuous cycle of rising income, rising employment, rising GDP, and rising production. And similar to the three D’s, a recovery period, which includes Stages 2-4, is measured using three P’s: how pronounced, pervasive, and persistent the expansion is.

Stage 3: Mid-Cycle

This is generally the longest phase of the business cycle, with moderate growth throughout. On average the mid-cycle phase lasts three years. Monetary policies shift toward a neutral state: Interest rates are higher, credit is strong, and companies are profitable.

Stage 4: Late Cycle

At this stage, economic activity reaches its highest point, and while growth continues, its pace decelerates. Monetary policies become tight due to rising inflation and low unemployment, making it harder for people to borrow money. The GDP rate begins to plateau or slow.

Companies may be engaging in reckless expansions, and investors are overconfident, which increases the price of assets beyond their actual value. Late cycles last a year and a half on average.

What Industries Do Well During Each Stage?

Historically certain industries have prospered during each stage of the business cycle.

When money is tight and people are concerned about the economy, they cut back on certain types of purchases, such as vacations and fancy clothes. Also, when people anticipate a coming recession, they tend to sell stocks and move into safer assets, causing the market to decline.

Basically, industries do better or worse depending on supply and demand, and the demand for certain products shifts throughout the business cycle. In general, the following industries perform well during each stage of the business cycle:

Recession

•  Healthcare
•  Consumer staples
•  Utilities
•  Bonds

Early Cycle

•  Information technology
•  Financial sector
•  Industrial sector
•  Consumer sector
•  Stocks and bonds
•  Real Estate
•  Household durables

Mid-Cycle

•  Information technology
•  Stocks
•  Energy and materials
•  Media

Late Cycle

•  Commodities such as oil and gas
•  Bonds can be a safe haven
•  Index funds

Who Should Invest With the Business Cycle?

Business cycle investing is an intermediate-term strategy, since it isn’t as short-term as day trading but not as long-term as buy and hold strategies. Each stage of the business cycle can last for a few months to a few years.

the best strategy for beginner investors.

However, more experienced investors might choose to shift at least a portion of their portfolio along with the business cycle. Business cycle investing can also be a good option for younger investors because they will have more opportunities to take advantage of the ups and downs of future cycles.

Understanding the business cycle can also help people make decisions such as when to buy a home or search for a job. It’s usually best to purchase a home, start a business, or look for a job in the early to mid-stages of the cycle.

The Takeaway

No business cycle is identical but history shows there can be a rough pattern to which industries do better as the economy expands and contracts. Investors can take cues from which stage of the business cycle the economy is in in order to allocate money to different sectors.

One great way to invest and keep track of the market is using an online investing app like SoFi Invest®. The investing platform features both active and automated investing.

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