investment

Fact checked by Vikki Velasquez

A traditional individual retirement account (IRA) is one of the most common ways to save for retirement due to its tax advantages. These accounts are also commonly used because they are easy to open and maintain. 

The tax advantages of a traditional IRA are simple. Yearly contributions are tax-deductible, and your investments grow tax-deferred while in the IRA. Then, withdrawals during retirement are taxed according to your income tax rate during retirement.

If you’re looking to open a traditional IRA, this guide will walk you through what you need to know to open and manage your traditional IRA, from choosing the right provider to understanding the rules that govern contributions and withdrawals.

Key Takeaways

• Opening a traditional IRA is straightforward and can be done through online brokers, robo-advisors, or financial institutions.
• Contributions to a traditional IRA are tax-deductible, and your investments grow tax-deferred.
• Choose the right IRA provider based on fees, investment options, and customer service.
• Stay informed about contribution limits, required minimum distributions (RMDs), and potential early withdrawal penalties.

1. Understand What a Traditional IRA Is

Before you start the process of opening a traditional IRA, it’s important to understand what this type of account offers. A traditional IRA is a retirement account that allows you to make tax-deductible contributions, with investments growing tax-deferred until you start making withdrawals in retirement.

Keep in mind the IRS imposes rules and limits on the contributions you can make each year, otherwise a penalty may be applied.

2. Consider Your Investing Style

One benefit of traditional IRAs is that they can be invested in various investments, such as mutual funds, stocks, and bonds, similar to a brokerage account. Company-sponsored 401(k) plans often limit your investment options, and if these options do not agree with your investment priorities, you may be dissatisfied with your investment outcomes. 

On the other hand, with the wide variety of investment options available through a traditional IRA, you will have to decide how much time and energy you can and want to devote to managing your IRA. 

Opening a traditional IRA with a robo-advisor instead of a traditional broker is a great option for individuals who want to take a more passive approach to investing. Opening a traditional IRA at a brokerage with the help of a financial advisor could also be a compelling option for more hands-free investors. However, these services both charge fees, which can be unappealing to some people. 

“If you don’t have the time and energy, or if the idea of parsing through different investment options makes you anxious or nervous, I think it makes a ton of sense, at a minimum, to consider using a robo-advisor, because robo-advisors are usually way cheaper than the typical 1% in-person advisor fee,” said Taylor Jessee, CFP, CPA, founder of Impact Financial.  

Note

Mutual funds and ETFs are popular investment choices in long-term retirement accounts like traditional IRAs because of their low risk over extended investment periods. Therefore, independently investing in an IRA may seem more approachable than independently investing in a brokerage account. 

3. Choose an IRA Provider

Once you have decided whether to open your traditional IRA with a robo-advisor or a traditional broker, you will need to decide which provider to open your account with. 

Not all robo-advisor and traditional broker providers are created equal. These are some key considerations when comparing different products:

• Fees or commissions: Some brokers or robo-advisors impose fees or commissions on traditional IRAs. Research fee schedules and rates to find the right account for yourself. 
• Investment options: Traditional IRAs can generally be invested in stocks, bonds, mutual funds, and ETFs. However, if you are interested in alternative investments or real estate products, you should make sure that your account provider offers those options.
• Account or investment minimums: Some traditional IRA providers may have an account or investment minimums. Research this factor in advance to avoid any potential friction in your contribution schedule. 
• Customer support: Quality customer service can be key to an enjoyable and successful investment experience. 
• Educational resources: The availability and quality of investment education resources at your account provider can be a crucial factor when opening a traditional IRA, especially for inexperienced investors. 

4. Open a Traditional Account

Opening a traditional IRA is a straightforward process, often done entirely online. After selecting your provider, you’ll need to provide personal identification and financial information.

“Lots of mobile apps have it where you can open up an IRA or an investment account straight through your mobile phone,” Jessee said. “It’s not like how it was in the 70s, 80s, like before, the internet, where your only choice was to go to a stockbroker to open the account.”

Necessary materials vary by provider, but here are some common requirements: 

• Personal identification information (Social Security number and driver’s license or another form of personal identification) 
• Personal financial information (statement of assets or cash) 
• Employer information (if applicable)
• Beneficiary information

When you are actually opening the account, you will likely need to perform the following: 

• Create login credentials and answer security questions 
• Select account features
• Provide necessary information 
• Decide how to fund the account 

Nowadays, opening a traditional IRA account is a simple process. If you run into any roadblocks, customer service will likely be able to help you work through the issue. 

5. Fund Your IRA 

The final step to opening a traditional IRA is to fund the account. There are three main ways to fund a traditional IRA from an existing financial institution, and they are not unique from other kind of investment account: 

• Electronic funds transfer (EFT): It can be very convenient to transfer funds from an external account to your traditional IRA through an EFT. Creating this link between accounts can make it easier to fund your traditional IRA from that external account in the future. 
• Wire transfer: Wire transfers can also facilitate fund cash transfers from an existing financial account to your traditional IRA. These transfers are similar to EFTs but generally require more time than EFTs. 
• Check deposit: Checks from your existing financial institution can be mailed or deposited into your traditional IRA in person. 

Important

For 2024 and 2025, you can contribute up to $7,000 per year ($8,000 if you’re 50 or older). If your income is below the contribution limit, you may be able to contribute a lesser amount.

Important Considerations Before Opening a Traditional IRA

Before you open a traditional IRA, make sure that you understand the full terms of the account and how it compares to other retirement products. 

Choosing a Traditional IRA Over Other Retirement Accounts

A traditional IRA is just one mechanism to support retirement savings. When opening or considering opening a traditional IRA, you should consider other investment options to ensure that this is the right decision for you. 

You may want to explore other IRA options, like Roth IRAs, SIMPLE IRAs, and SEP IRAs, in order to determine if the tax advantages of the traditional IRA best suit your personal budget and career trajectory. For example, a SEP IRA is designed for self-employed individuals, and Roth IRAs have an annual income limit, while traditional IRAs do not. 

You may also want to contribute to a traditional IRA in addition to other retirement products. 

“The vast majority of employers these days offer a 401(k), so usually if you’re just starting out in your retirement savings journey, a 401(k) is almost always going to be the easiest and most efficient place to start,” Jessee said. “Once you check the box of putting money into your 401(k), then I think it can make sense to branch out and say, ‘I’m going to do a 401(k) and an IRA because I still have money that I want to save’.” 

Contribution Limits

Traditional IRAs, like Roth IRAs, have annual contribution limits. Therefore, you may want to consider investing sooner rather than later to maximize your return on investment during retirement. 

For 2024 and 2025, you can contribute up to $7,000 to your traditional IRA. To help older adults catch up on retirement savings, adults over age 50 can contribute up to $8,000 in 2024.

If your taxable compensation or total income for the year is less than $7,000, you can contribute up to the whole of this compensation. 

Early Withdrawal Penalties

Because traditional IRA investments are tax-advantaged and intended to remain in accounts until retirement, the IRS imposes early withdrawal penalties on these accounts. 

Withdrawals before the age of 59½ years old from a traditional IRA are subject to income tax in addition to a 10% penalty unless you have a specific extenuating circumstance. Exceptions to the 10% penalty include certain medical reasons, first home purchases, births, and adoptions. 

Similar restrictions apply to other kinds of retirement accounts, and considering this limitation may affect your retirement strategy. 

“Investments don’t have to just be retirement,” said Kevin Lao, CFP, founder of Imagine Financial. “It could also be investing into yourself, investing into education, investing into a skill or a trade because that’s going to add value to your earning potential, and more earning potential in your 30s, 40s, and 50s will pay more dividends than just saving 10% or 50% of your salary for the next 30 to 35 years.”

Warning

Be aware of early withdrawal penalties on traditional IRAs.

Required Minimum Distributions (RMDs)

Required minimum distributions are the amount of money that you must withdraw from your traditional IRA after you reach age 73 (age 72 if you reached that age before Dec. 31, 2022). 

Required minimum distributions for traditional IRAs vary depending on marital status, spouse age, and beneficiaries. For specific information, consult the IRS website. 

If You Are Rolling Over a 401(k)

If you are specifically rolling over a 401(k) from a former employer to a traditional IRA, you will likely want to roll over your retirement plan distribution. By rolling over, you generally will not have to pay tax on your investments until you withdraw from your new plan, and you will not incur any penalties if your distribution is given to you before age 73. 

“The traditional IRA is more for folks that are doing a rollover,” Lao said. “Let’s say [you] have a 401(k) plan from a previous employer, and [you]’ve built up a couple million dollars and want a little bit more control over [your] investments, but don’t want to go through the whole corporate bureaucracy of tapping into [your] 401 k plan… [You] can roll those funds into a traditional IRA and control the investments a little bit more.”

To complete a distribution rollover, you will need to deposit the distribution within 60 days of receiving it, and generally, you can only complete one rollover per year. To learn more about specific situations, consult the IRS website. 

Can I Open a Traditional IRA on My Own?

Yes. Traditional IRAs can be easily opened through many different brokers and robo-advisors by providing personal identification and financial information. To ensure that you are opening an account that fits your personal goals and investment style, you may want to compare different accounts’ fees or commissions, investment options, account or investment minimums, customer support, and educational resources. 

How Much Money Do You Need To Open a Traditional Ira?

The amount of money required to open a traditional IRA depends on the provider. Many brokers and financial institutions allow you to open an IRA with no minimum deposit, but some may require an initial contribution, often ranging from $100 to $1,000.

Can I Open a Traditional Ira at a Bank?

Yes, you can open a traditional IRA at many banks. However, bank IRAs typically offer fewer investment options (like certificates of deposit or savings accounts) compared to brokerage firms or robo-advisors, which offer a wider range of stocks, bonds, and mutual funds.

The Bottom Line

You can open a traditional IRA in a few simple steps. When opening a traditional IRA, evaluating your investment style, provider fees, and contribution limits in advance is crucial. This accessible retirement tool offers tax-deductible contributions and tax-deferred growth through diverse investment options.

To effectively manage your IRA after opening it, regularly review your investment strategy, take advantage of employer-sponsored plans, and stay informed about retirement savings options to maximize your long-term benefits.

Reviewed by Somer Anderson
Fact checked by Timothy Li

The U.S. central bank, the Federal Reserve (the Fed), has a dual mandate: to work to achieve low unemployment, and to maintain stable prices throughout the economy. During a recession, unemployment rises, and prices sometimes fall in a process known as deflation.

The Fed, in the case of steep economic downturns, may take dramatic steps to suppress unemployment and bolster prices, both to fulfill its traditional mandate and to provide emergency support to the U.S. financial system and economy.

Key Takeaways

• The Federal Reserve has a dual mandate from Congress to maintain full employment and price stability in the U.S. economy.
• To help accomplish this during recessions, the Fed employs various monetary policy tools to suppress unemployment rates and reinflate prices.
• These tools include open market asset purchases, reserve regulation, discount lending, and forward guidance to manage market expectations.
• Most of these tools were deployed in a big way starting in the spring of 2020 in response to the economic challenges imposed by a global pandemic.

The Impact of a Recession

At the onset of a recession, some businesses begin to fail, typically due to some combination of real economic shocks or economic bottlenecks caused by the incompatibility of production and consumption activities resulting from previously distorted interest rate and credit conditions. These businesses lay off workers, sell assets, and sometimes default on their debts or even go bankrupt. All of these things put downward pressure on prices and the supply of credit to businesses in general, which can spark a process of debt deflation. 

Deflation, in the form of falling prices, is not generally a harmful process for the economy or a problem for most businesses and consumers by itself. It is, however, widely feared by central banks and the broader financial sector, especially when it involves debt deflation because it increases the real value of debts and thus the risk to debtors. Banks and related institutions are typically among the largest debtors in any modern economy. To protect its constituent banks from defaulting on their overextended debts, the Federal Reserve does not hesitate to take action in the name of stability.

The Federal Reserve has a number of tools to attempt to re-inflate the economy during a recession in pursuit of these goals. These tools largely fall into a handful of categories, which we will look at below.

Open Market Operations

The Fed can lower interest rates by buying debt securities on the open market in return for newly created bank credit. Flush with new reserves, the banks that the Fed buys from are able to lend money to each other at a lower federal funds rate, the rate at which banks lend to each other overnight. The Fed hopes that a drop in interest rates spreads throughout the financial system, reducing rates charged to businesses and individuals.

When this works, the lower rates make it cheaper for companies to borrow, allowing them to continue going into more debt rather than defaulting or being forced to lay off staff. This helps to both keep employees in their current jobs and suppress the rise in unemployment when a recession hits. Lower interest rates also enable consumers to make more purchases on credit, keeping consumer prices high.

There are times when interest rates won’t go any lower because banks simply hold on to the newly injected reserve credit for their own use as liquid reserves against their debt obligations. In these cases, the Federal Reserve may choose to simply continue open market operations, buying bonds and other assets to flood the banking system with new credit. This is known as quantitative easing (QE)—the direct purchase of assets by the Federal Reserve to inject more money into the economy and expand the money supply. 

The Fed has used quantitative easing on several occasions since 2008, including in March 2020, when the central bank launched an initial $700 billion QE plan aimed at propping up the debts of the financial system on top of most of the nearly $4 trillion in QE that it created during the Great Recession.   

Important

The Fed purchases mostly Treasury securities in its normal open market operations but extends this to include other government-backed debt when it comes to quantitative easing.

Lowering Capital Requirements

The Fed also can regulate banks to ensure that they are not required to hold capital against potential debt redemption. Historically, the Fed was charged with regulating the banks to make sure they maintained adequate liquid reserves to meet redemption demands and remain solvent. During recessions, the Fed could also lower requirements to allow banks greater flexibility to run their reserves down, at the risk that this may increase banks’ financial vulnerability.

However, after the 2007–08 financial crisis, the Fed’s campaign of quantitative easing resulted in banks holding massive ongoing balances of reserves in excess of the required reserve ratio. In part because of this, as of March 2020, the Fed eliminated all reserve requirements for banks. This leaves the Fed no further room to use this tool to loosen credit conditions for any impending recessions.

Note

The Fed does not currently require banks to hold any minimum reserves against their liabilities, but many banks hold large excess reserves with the Fed anyway.

Discount Lending

The Fed can directly lend funds to banks in need through what is called the discount window. Historically, this type of lending was carried out as an emergency bailout loan of last resort for banks out of other options—and it came with a hefty interest rate to protect the interests of taxpayers, given the risky nature of the loans.

However, in recent decades, the practice of discount lending by the Fed has shifted toward making these risky loans at much lower interest rates to favor the interests of the financial sector as much as possible. It has also rolled out a host of new lending facilities similar to discount lending, targeted at supporting specific sectors of the economy or the prices of specific asset classes.

As of March 2020, the Fed dropped its discount rate to a record low 0.25% to give extraordinarily favorable terms to the riskiest of borrowers. However, by March 2025, a series of assertive rate increases enacted by the Fed to cool high inflation had returned the discount rate to 4.5%.

Note

With discount lending, the Fed is acting in its function as a lender of last resort for banks.

Expectations Management

Expectations management is also known as forward guidance. Much of the economic research and theory on financial markets and asset prices acknowledge the role that market expectations play in the financial sector and the economy more broadly, and this is not lost on the Fed. Doubt as to whether the Fed will act to bail out banks and keep asset prices inflated can lead to pessimism among investors, banks, and businesses on top of the real problems facing the economy. 

Fighting Inflation and the Specter of a Recession

Inflation occurs when prices rise in the economy and the purchasing power of the dollar erodes. The Fed targets around 2% inflation per year, and during a recession, inflation may indeed remain well below this target, allowing the central bank to maintain expansionary monetary policy.

However, expansionary monetary policy also can eventually lead to inflation. If the economy is operating near capacity and there are not enough workers to fill all the jobs available, or if wages are rising faster than productivity growth, then more people will want to borrow money to fund additional consumption.

The supply of labor will not expand quickly enough to accommodate the increased demand for labor, leading to rising wages relative to productivity growth and a wage-price spiral in which firms are forced to raise wages to match the cost of borrowing. The availability of cheap credit to individuals and firms may also lead to increased borrowing, spending, and investing, which can lead to both economic growth and higher prices. These factors, when combined, can cause an inflationary rise in asset prices in the economy.

In periods of high inflation, central banks must aggressively fight price pressures by raising interest rates and/or implementing contractionary policies such as reducing bank reserve requirements or selling off assets. When inflation rises above the target level for too long, this can push the economy into stagflation, a situation in which high unemployment and high inflation occur at the same time.

This dual problem is untenable for the central bank, which can end it only by tightening policy aggressively to bring price pressures down and slash aggregate demand in the economy. This, however, can trigger another recession.

What Tools Does the Federal Reserve Have to Fight a Recession?

The Fed has several monetary policy tools it can use to fight off a recession. It can lower interest rates to spark demand and increase the amount of money in circulation via open market operations, including quantitative easing, through which additional types of assets may be purchased by the Fed. Other measures include making loans to troubled financial institutions or buying assets from them directly. These policies can be particularly useful during a financial crisis or economic slump, when firms and investors may be unwilling to lend as they worry about their future.

Why Does the Fed Raise Interest Rates When Unemployment Falls?

The Fed does not always raise interest rates in response to low unemployment. However, low unemployment can lead to an overheated economy. Higher interest rates reduce demand by making borrowing more expensive, which slows economic growth and damps price pressures in the economy. Interest rates should rise when unemployment falls because consumers are likely to start borrowing more and spending more with high employment and faster wage growth. 

What Is Loose Money?

Loose money (or easy money) refers to expansionary monetary policy by the Fed. When money is “loose,” it means it is abundant and easy to obtain. When money is “tight,” it is scarce and more expensive to borrow. During a recession, loose monetary policy can help the economy recover by sparking aggregate demand because individuals and firms are able to borrow more to spend and invest.

What Is the Difference Between Fiscal Policy and Monetary Policy?

Monetary policy is enacted by a country’s central bank and seeks to influence the money supply in a nation. Fiscal policy is enacted by a country’s government through spending and taxes to influence a nation’s economic conditions. To help fight a recession, fiscal policy may aim to lower taxes and increase federal spending to increase aggregate demand.

The Bottom Line

During recessions, the Fed generally seeks to credibly reassure market participants through its actions and public announcements that it will prevent or cushion its member banks and the financial system from suffering too-heavy losses, using the tools discussed above.

Reviewed by Somer Anderson

Gross profit margin and operating profit margin are two metrics used to measure a company’s profitability. Gross profit margin includes the direct costs involved in production, while operating profit margin accounts for operating expenses like overhead.

Both metrics are important in assessing the financial health of a company.

Key Takeaways

• Gross profit margin and operating profit margin are two metrics used to measure a company’s profitability.
• Gross profit margin includes the direct costs involved in production.
• Operating profit margin accounts for operating expenses like overhead.

Gross Profit Margin

Gross profit margin shows how well a company generates revenue from direct costs like direct labor and materials used in production. Gross profit is first calculated by subtracting the cost of goods sold from total revenue. Gross profit margin is the difference divided by total revenue and shown as a percentage.

$begin{aligned} &text{Gross Profit Margin} = frac { text{Revenue} – text{COGS}}{ text{Revenue}} times 100 \ &textbf{where:} \ &text{COGS} = text{Cost of goods sold} \ end{aligned}$​Gross Profit Margin=RevenueRevenue−COGS​×100where:COGS=Cost of goods sold​

Important

The cost of goods sold (COGS) is the amount a company spends to produce the goods or services it sells.

Operating Profit Margin

Operating profit is derived from gross profit. Operating profit or operating income takes gross profit and subtracts all overhead, administrative, and operational expenses. Operating expenses include rent, utilities, payroll, employee benefits, and insurance premiums. The operating profit calculation excludes interest on debt and the company’s taxes.

Operating profit margin is calculated by dividing operating income by total revenue. Like gross profit margin, operating profit margin is expressed as a percentage.

$begin{aligned} &text{Operating Profit Margin} = frac { text{Operating Income} }{ text{Revenue}} times 100 \ end{aligned}$​Operating Profit Margin=RevenueOperating Income​×100​

Comparing Gross Profit Margin and Operating Profit Margin

Below is a portion of an income statement for JCPenney. In this example, JCPenney earned only $3 million in operating income after earning $2.67 billion in revenue.

Although the gross profit margin appeared healthy at 38%, after taking out expenses and selling, general, and administrative expenses (SG&A), the operating profit margin tells a different story. The disparity between the numbers shows the importance of using multiple financial metrics in analyzing a company’s profitability.

• Total revenue is highlighted in green as $2.67 billion, while the COGS is beneath revenue, coming in at $1.7 billion.
• Gross profit margin was 36%, or $begin{aligned} frac { $2.67 text{ Billion} – $1.7 text{ Billion COGS} }{ $2.67 text{ Billion} } = .36 times 100 = 36$$2.67 Billion$2.67 Billion−$1.7 Billion COGS​=.36×100=36%​
• Operating income, which is further down the statement, totaled $3 million for the period and is further down the statement, highlighted in blue.
• Operating profit margin was 0.11%, or $begin{aligned} frac { $3 text{ Million} }{ $2.67 text{ Billion} } = .0011 times 100 = .11$$2.67 Billion$3 Million​=.0011×100=.11%​
• Although JCPenney had a 36% gross profit margin, after taking out operating expenses and overhead, listed as SG&A, the company earned less than 1% in operating profit margin.

What Expenses Are Included in COGS?

Cost of goods sold (COGS) is the cost to manufacture the products or finished goods a company sells. Costs included in the measure are directly tied to the production of the products, including the labor, materials, and manufacturing overhead.

What Are Overhead Costs?

Overhead costs include all of the expenses to run a business, like rent, insurance, and utilities.

How Often Do Companies Report Earnings?

Publicly traded companies must submit quarterly reports to the U.S. Securities and Exchange Commission (SEC). They must also file annual reports.

The Bottom Line

The gross profit margin can show a company’s financial health. However, when accounting for additional operating costs like rent or payroll, the operating profit margin may be lower than the gross profit margin. The difference between the numbers proves how important it is for investors and analysts to use multiple financial metrics in analyzing a company’s financial position.

Reviewed by Ebony Howard
Fact checked by Yarilet Perez

What Is Marginal Propensity to Save?

Marginal propensity to save (MPS) is used by economists to quantify the relationship between changes in income and changes in savings. It refers to the proportion of an increase in disposable income that a household saves rather than uses for consuming goods and services.

Key Takeaways

• Marginal propensity to save (MPS) is an economic measure of how savings change, given a change in disposable income.
• It is calculated by dividing the change in savings by the change in disposable income.
• A larger MPS indicates that small changes in disposable income lead to large changes in savings, while a small MPS indicates that large income changes lead to small savings changes.

Understanding Marginal Propensity to Save

The marginal propensity to save is the portion of each extra dollar of a household’s income that’s saved. The MPS indicates what the overall household sector does with extra income—specifically, the percent of extra income that is saved.

As saving and consumption complement each other, the MPS reflects key aspects of a household’s saving and consumption habits. The MPS reflects leakage, the portion of disposable income that’s not put back into the economy through purchases of goods and services. The higher the changes in disposable income for an individual, the higher the MPS, as the ability to satisfy needs increases with income.

Disposable income is the amount of income left over after paying bills and other recurring expenses, income that is not intended to be used for living expenses. Disposable income can increase for various reasons, such as a pay raise without an increase in expenses or paying off a car loan, mortgage, or credit card.

In other words, each additional dollar is less likely to be spent as an individual becomes wealthier. Studying MPS helps economists determine how wage growth might influence savings.

MPS is expressed as a percentage. For example, if the marginal propensity to save is 10%, it means that out of each additional dollar not used for expenses, $0.10 is saved.

How Marginal Propensity to Save Is Calculated

MPS is most often used in Keynesian economic theory. It is calculated simply by dividing the change in savings observed given a change in income: 

MPS = ΔS/ΔY

Where:

• Δ represents change
• ΔS is the change in savings
• ΔY is the change in income

If income changes by a dollar, then saving changes by the value of the marginal propensity to save. The marginal propensity to save is actually a measure of the slope of the savings line when graphed. The graph is created by plotting the change in income on the horizontal x-axis and the change in savings on the vertical y-axis. The slope of the savings line is depicted by the change in savings and the change in income, or a change in the y-axis, divided by the change in the x-axis.

So, if consumers saved $0.20 for every $1 increase in income, the MPC would be 0.20 (0.20 / $1). The value of the marginal propensity to save always varies between zero and one, where zero indicates that changes in income had no effect on savings whatsoever.

Example

Assume an engineer has a $100,000 change in income from the previous year due to a pay raise and bonus. The engineer decides that they want to spend $50,000 of the increase in income on a new car and save the remaining $50,000. The resulting marginal propensity to save is 0.5, which is calculated by dividing the $50,000 change in savings by the $100,000 change in income.

Therefore, for each additional $1 of income, the engineer’s savings account increases by $0.50.

What Is MPC and MPS?

Marginal propensity to save (MPS) is a measurement of a consumer’s increase in savings relative to a change in income. Marginal propensity to consume (MPC) is the opposite of MPS, a measurement of an increase in spending in proportion to an increase in income.

How do You Calculate MPC to Save?

Marginal propensity to consume (MPC) is a measurement of a consumer’s increase in consumption regarding an increase in disposable income.

What Is Meant by Marginal Propensity to Save?

Marginal propensity to save is the measured proportion of savings following an increase in income.

The Bottom Line

Marginal propensity to save is a measurement of a worker’s proportional increase in savings following an increase in income. It is a metric generally used by economists to describe and quantify consumer saving tendencies.

Reviewed by Ebony Howard
Fact checked by Suzanne Kvilhaug

Jersey is a 45-square-mile island located in the English Channel, off the coast of France. It is a British Crown Dependency, which means that although it is not part of the United Kingdom, it is a possession of the British Crown. Jersey maintains full political and financial autonomy, allowing it to operate independently of the UK. Known for its low taxes, Jersey has long been considered a tax haven, particularly for wealthy individuals and corporations looking to reduce their tax liabilities. Let’s discuss why.

Key Takeaways

• Jersey has been considered a tax haven since the 1920s.
• The island has a maximum 20% personal income tax rate, with no wealth, inheritance, or capital gains taxes.
• Jersey’s corporate tax rate is zero for most businesses, except for financial services (10%) and certain utilities, rentals, and development projects (20%).
• Jersey’s tax structure has made it an attractive destination for international financial services and high-net-worth individuals.

Jersey Tax History

Jersey first gained a reputation as a tax haven in the 1920s, when wealthy British citizens began moving to the island, or, in many cases, simply transferring their wealth there, in order to benefit from the absence of wealth and inheritance taxes.

In 1928, Jersey introduced a 2.5% income tax, which was later raised to 20% during the German Occupation of the Channel Islands in World War II. Since then, the island has maintained a 20% income tax rate, and it still does not impose inheritance, wealth, or capital gains taxes.

As deposits from wealthy individuals filled the nation’s coffers, the revelation that almost any tax could be avoided in Jersey brought the banking business to roost on the island. That gave birth to one of the most popular offshore destinations for U.S. dollars, rubles, yen, and other global currencies.

Note

Jersey became a location for international smuggling in the 17th century. In the early 18th century, the merchant Jean Martel, whose Cognac brandy is prized to this day, smuggled Jersey knitted stockings to France as his brandy was smuggled to England.

Financial Regulation

No registration of offshore trust accounts is required by the companies that administer individual financial accounts on the island. While the Jersey Financial Services Commission (JFSC) insists that trusts face strict regulation of fund sources, ownership, beneficiaries, and anti-money laundering provisions, large degrees of privacy surround the accounts.

JFSC officials who entered into cooperative agreements fostering disclosure with the United States and the United Kingdom contend that the confidentiality associated with the trusts equates with standards afforded to any other financial accounts.

To combat tax fraud or money laundering, banks require significant documentation regarding the source and nature of deposits, such as sales contracts from real estate or business transactions and proof of income from employers.

Individual Income Taxes

A maximum income tax rate of 20% applies to people who establish residency in Jersey. Those prospective residents who are high-net-worth individuals must meet and sustain a minimum income of £1,250,000, or about $1,617,875 as of March 2025. Income that exceeds the minimum is subject to an additional 1% tax. Compared to the UK, where the top income tax rate is 45%, Jersey provides significant tax savings for those meeting the residency requirements.

Corporate Tax Structure

In 2008, Jersey introduced a landmark tax policy by eliminating corporate taxes for most companies operating on the island. The only exceptions to this are financial services firms, which are taxed at 10%, and businesses in the utilities, rental, and development sectors, which face a 20% tax rate.

As of 2025, there were 20 banks, with deposits of over $160 billion, licensed to operate in Jersey. Among the banks that conduct business in Jersey are Citibank, the U.S. consumer division of Citigroup Inc., and UBS AG.

Other Taxes

While no taxes are levied against capital gains or capital transfers, a 5% tax on goods and services was implemented in June 2011. Additionally, a stamp duty of up to 0.75% applies to the transfer of immovable property within the nation’s borders, and its individual parishes collect property taxes.

Jersey offers a VAT-free environment, meaning goods and services are not subject to value-added taxes, unlike in the UK and much of Europe, where VAT rates can reach 20% or more. This tax advantage significantly reduces the cost of living and business operations, making the island particularly attractive to high-net-worth individuals, luxury shoppers, and companies looking to minimize consumption tax burdens. 

What Makes Jersey’s Taxes Attractive?

What makes Jersey’s taxes attractive is the fact that they’re low for individuals (20% maximum tax rate) and nonexistent for many corporations or relatively low for the exceptions, such as financial services firms (10%).

Which Taxes Does Jersey Not Levy?

Jersey does not charge taxes on wealth, inheritance, or capital gains. This makes it an attractive place for individuals and corporations seeking to minimize their tax liabilities.

When Did Jersey’s Income Tax Rate Go to 20%?

During the Second World War and the German Occupation of Jersey, the rate was raised from 2.5% to 20%, where it has stayed to this day.

The Bottom Line

The largest Channel Island, Jersey is home to a tax structure that for years has attracted new financial accounts, residents, and corporations.

Known as a tax haven, its 20% income tax rate has been in place since the 1940s. And, with some exceptions (e.g., banks and other financial services companies), it eliminated corporate taxes in 2008.

Reviewed by Andy Smith
Fact checked by Yarilet Perez

Net present value (NPV) assesses the profitability of an investment on the basis that a dollar in the future isn’t worth the same as a dollar today.

NPV calculations are useful when you’re evaluating investment opportunities but the process is by no means perfect. It’s a useful starting point but it’s not a definitive metric that an investor can rely on for all investment decisions.

Key Takeaways

• Net present value (NPV) is a calculation that discounts a future stream of cash flows back into the present day.
• The NPV calculation helps investors decide how much they would be willing to pay today for a stream of cash flows in the future.
• A disadvantage of using NPV is that it can be challenging to accurately arrive at a discount rate that represents the investment’s true risk premium.
• Another disadvantage is that a company may select a cost of capital that’s either too high or too low leading it to miss a profitable opportunity.

Net Present Value (NPV)

Money loses value over time due to inflation but a dollar today can be invested and earn a return. Its future value could possibly be higher than a dollar received at the same point down the road.

NPV seeks to determine the present value of future cash flows of an investment above its initial cost. The discount rate element of the formula discounts the future cash flows to the present-day value. The investment is considered worthwhile if subtracting the initial cost of the investment from the sum of the cash flows in the present day is positive.

An investor could receive $100 today or a year from now. Most investors wouldn’t be willing to postpone receiving $100 today but what if they could choose to receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might be worthwhile unless another investment could yield a rate greater than 5% over the same period.

An investor would choose to receive $100 today, not $105 in a year with the 5% rate of return if they knew they could earn 8% from a relatively safe investment over the next year. The 8% is the discount rate in this case.

Important

An alternative to net present value (NPV) is the payback period or payback method. More attractive investments generally have shorter payback periods.

Disadvantages of Net Present Value (NPV)

There are some disadvantages to using the NPV calculation.

Selecting a discount rate

Accurately pegging a percentage number to an investment to represent its risk premium isn’t an exact science. If the investment is safe with a low risk of loss, 5% might be a reasonable discount rate to use. But what if the investment harbors enough risk to warrant a 10% discount rate? NPV calculations require the selection of a discount rate so they can be unreliable if the wrong rate is used.

The investment won’t have the same level of risk throughout its entire time horizon, either, and this makes matters even more complex.

Let’s go back to our example of a five-year investment. How should an investor calculate NPV if the investment had a high risk of loss for the first year but a relatively low risk for the last four years? The investor could apply different discount rates for each period but this would make the model even more complex and require the pegging of five discount rates.

Determining the cost of capital and cash flows

The cost of capital is the rate of return required to make an investment worthwhile. It helps determine whether the return on the investment is worth the risk.

A company must set an appropriate cost of capital when it decides whether to invest. It may determine that an investment isn’t worth the risk and miss and opportunity if it aims too high. It may be making investment decisions that aren’t worthwhile, however, if the cost of capital is too low.

It can be difficult to determine the cash flows from an investment when it doesn’t have a guaranteed return. This can sometimes be the case for companies that invest in new equipment or decisions that are based on business expansion. A company can estimate the kind of cash flows these investment decisions may have but there’s a chance they could be off by a significant percentage.

Investment size

A higher NPV doesn’t necessarily mean a better investment. The NPV will be higher for a project if there are two investments or projects up for decision and one project is larger in scale because NPV is reported in dollars. A larger outlay will therefore result in a larger number. It’s important to assess the returns from an investment in percentage terms to get an accurate picture of which investment provides a better return.

How Does Inflation Work?

Inflation involves a consistent escalation of prices, particularly for consumer goods, over an extended time. A $500 purchase in December 2024 might require $525 out of pocket in June 2025. It’s referred to as disinflation when increases pause. Deflation is a drop in prices that’s steady on ongoing like inflationary increases.

What Is a Payback Period?

The payback period is the amount of time it takes for an investor to reach the breakeven point and recover their initial investment cost.

How Is Cash Flow Measured?

Cash flow is the difference between money coming into a business or account and money leaving the business or account as it’s spent. The difference can be positive or negative. Negative cash flow isn’t sustainable indefinitely. Positive cash flow can be reduced by investments into growth or other opportunities.

The Bottom Line

Net present value calculates the value of future cash flow into the present day. It can be a tool for investors to help determine how much they’re willing to pay now for cash inflows in the future. Basing your investment decisions on NPV comes with some risks, however, particularly if you’re only considering this one factor. It can be tricky to calculate and can be affected and skewed by a company’s cost of capital.

Always seek expert help if you’re uncertain about an investment rather than rely too heavily on this metric.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.

Find profits in these types of companies that do well during recessions

Reviewed by Michael J Boyle
Fact checked by Kirsten Rohrs Schmitt

During a recession, equities markets are usually hammered as companies’ earnings take a hit from reduced consumer demand. But there are companies that do well in bad times. Knowing which types of companies do well even when the economy is in poor health can help shield your investment from the worst of a market downturn, and it may offer the opportunity to find profit even as the broader market languishes.

Key Takeaways

• Investors can safeguard their portfolios, and potentially even make money, during a market downturn by identifying recession-resistant companies.
• Recession-resistant companies generally deliver stable revenue regardless of economic conditions.
• Most of these companies sell consumer essentials, provide critical repair services, manufacture proprietary products, or provide required services that consumers cannot easily eliminate.

How to Spot a Recession-Resistant Company

When looking to minimize downside risk during a recession, investors should look for companies that sell products or offer services consumers cannot easily cut. These include companies such as utilities, insurance, healthcare, consumer essentials and food. Discounters also fare well as consumers look for bargains.

Inelasticity of Demand

What all recession-proof companies have in common is that demand for their products and services is relatively inelastic. Customers have little flexibility even when budgets are tight.

1. Enjoys Inelastic Demand

Many recession-resistant companies sell products and services that are relatively inelastic. That is, customers have little flexibility about buying their products or services, even when budgets are tight.

Utility companies are one good example. They provide gas for heating and cooking, electricity and water. These companies generally fare well during recessions as consumers cannot easily stop consuming those services.

Their prices also do not come under pressure the way consumer products do if demand weakens, as most utility rates are set by agreement with various government agencies.

To get a sense of how this stability translates into share price, we can look at the Great Recession (2007-2009), when stock values took a beating. The Dow Jones Industrial Average slid more than 35% from 12,650 in early January 2008 to 8,000 one year later. It did recover somewhat by early 2010, but regained less than half its losses, crawling back to 10,000 in early January 2010.

But utilities held their value even as the market imploded. Some even made money for investors.

Pacific Gas and Electric Company (PCG), for example, was trading at about $25 in early January 2008. One year later, while the broader market lost about 35%, PCG was trading slightly higher at just over $26 per share.

American Water Works (AWK) was similarly trading at around $21 in early 2008, climbed slightly to just below $22 by the end of the year and further still to $23 by January 2010.

These may not look like stellar performances, but given that the broader market was in steep decline, holding steady is an accomplishment. It also shows that these companies tend to enjoy fairly stable earnings regardless of what is happening in the economy.

2. Provides Critical Repair Services

Companies that provide nonessential services are typically the first to suffer in a recession. A consumer can choose to cut their own grass or paint their own house, for example.

But some companies provide critical services that cannot be easily cut.

Waste management is one example: It takes more than a recession for people to cancel garbage collection and just let uncollected trash pile up.

So it’s not surprising that shares in Waste Management Inc (WM) also held firm during the 2008 recession, and even gained ground. In early 2008, WM shares were trading at about $29, but then climbed to nearly $34 by the end of the year even as the market lost over a third of its value.

Auto repair and parts companies are another example: Consumers generally have no choice to repair their cars if they break down, even if it’s financially challenging to do so.

AutoZone, Inc. (AZO) also fared well during the 2008 recession. The company’s share price was around $120 in early January 2008, before the recession hit in earnest. One year later, it had climbed to $132, and then further to $155 by January of 2010.

3. Sells Proprietary or Specialized Products

Pharmaceutical and healthcare companies with drug patents also enjoy relatively inelastic demand for their products. Consumer buying habits remain stable regardless of price, especially if the product is something they have to buy.

Insulin is a good example. Diabetics who need insulin to survive have no choice but to pay, whatever the cost.

Indeed, the S&P Pharmaceuticals Select Industry Index did take a hit at the onset of the 2008 crisis, slipping just 8% from 1,660 in early January 2008 to 1,530 one year later, but by January of 2010 the index had not only recovered but jumped to over 1,900.

4. Sells Discounted Products

In tough economic times, discounters also do better as people look for bargains.

Before the 2008 recession, Dollar Tree Inc (DLTR) was trading at $9.24, but by January of 2009 its share price had climbed some 54% to $14.24, and a further 16.5% to $16.50 by January of 2010.

How are Companies Negatively Impacted by Recessions?

For most companies, tough economic times mean slowing or even negative earnings growth as consumers spend less, resulting in less demand for the goods and services companies sell. This falling demand may prompt businesses to cut spending, which may impact companies they buy goods and services from, which in turn have to cut their own costs.

In some cases, cost-cutting measures may mean layoffs, which feeds the cycle as laid-off employees have less money to spend, further decreasing demand.

How Do Companies Manage During a Recession?

When consumers cut spending, companies earn less and may have to cut their own spending. This can include reducing or cancelling investments, slowing new hiring or even cutting costs through layoffs.

What Kinds of Companies Are Recession-Resistant?

While most companies are hurt by recessions, some can weather them better than others. Companies that are most likely to fare better during recessions are those that provide an essential product or service to consumers such as gas, electricity, heat and healthcare. Also, companies producing consumer essentials such as toothpaste and toilet paper tend to hold up better during recessionary times.

The Bottom Line

While most companies are negatively impacted by recessions as consumers cut spending, there are companies that weather tough times better than others. Consumers can easily cut spending in many areas, but there are some things consumers cannot easily eliminate from their budgets.

Companies that provide goods and services that people need tend to do well regardless of economic conditions. These include utilities (as people need to heat and power their homes), insurance (car insurance, for example, is required) and healthcare (such as insulin: a diabetic cannot simply stop taking it even if the price creates financial hardship). These companies offer a safe haven to shield investors from the worst of a downturn, and may even offer positive returns.

Fact checked by Vikki Velasquez

What Is a Traditional IRA?

A traditional individual retirement account (IRA) is a retirement savings account that lets you invest pre-tax income to save for retirement. The key feature of this account is its tax advantages: contributions to a traditional IRA are tax-deductible, meaning you don’t pay taxes on the money you contribute in the year you make the deposit. Taxes are paid when you withdraw funds during retirement, ideally when you’re in a lower tax bracket.

You don’t need to be sponsored by an employer to open a traditional IRA. It’s an individual account that you can open with various financial institutions such as Vanguard, Fidelity, or Charles Schwab.

Key Takeaways

• Traditional IRAs allow you to invest pre-tax income toward your retirement.
• Contributions to a traditional IRA may be tax-deductible.
• Taxes are paid upon withdrawal of funds, typically during retirement.
• Early withdrawals may be subject to penalties, with some exceptions.
• Alternatives to traditional IRAs include Roth IRAs, SIMPLE IRAs, and SEP-IRAs.

How Traditional IRAs Work

Traditional IRAs allow you to direct your contributions to a variety of investment options such as stocks, bonds, or mutual funds. These investments grow tax-deferred, meaning you won’t owe any taxes on dividends, interest, or capital gains as long as the funds remain in the account.

Once you reach your retirement age and begin to withdraw funds, they are subject to ordinary income taxes. If you withdraw money before age 59½, you’ll typically incur a 10% early withdrawal penalty, in addition to paying the relevant income taxes on the distribution.

Tax Treatment of Traditional IRAs

Contributions to a traditional IRA are made from pre-tax income. In some cases, contributions may be tax-deductible. Typically, investors without access to employer-sponsored retirement plans are more likely to be able to deduct contributions to a traditional IRA.

Contribution Limits for Traditional IRAs

If you are under age 50, you may contribute a total of $7,000 to traditional and Roth IRAs in 2024 and 2025. If you are age 50 and above, you may contribute an additional $1,000 in catch-up contributions for a total of $8,000 per year. These limits include all contributions, meaning that the total contribution to all IRA accounts cannot exceed $7,000 or $8,000, depending on your age.

Note

In 2024, you may make IRA contributions until April 15, 2025.

Early Withdrawals: Rules, Penalties, and Exceptions

Traditional IRA withdrawals are subject to income tax for the year in which they are disbursed. Additionally, the IRS levies a 10% early withdrawal penalty for investors who take a distribution before age 59½.

There are exceptions for which the 10% penalty tax does not apply. These include but are not limited to:

• Birth or adoption expenses for a new child (up to $5,000)
• Death or disability of the account holder
• Expenses for recovery from a federally recognized disaster (up to $22,000)
• Cases of domestic abuse
• Qualified higher education expenses
• Emergency family expenses (typically up to $1,000 per year)
• First-time homebuying expenses (up to $10,000)
• Unreimbursed medical expenses equal to greater than 7.5% of the taxpayer’s AGI
• Health insurance costs while unemployed

Required Minimum Distributions

The IRS requires investors to take regular distributions from traditional IRAs once they reach a certain age. If you turn 72 before Dec. 31, 2022, you’ll need to take these required minimum distributions (RMDs) by age 72; if you turn 72 after that date, you’ll need to take RMDs by age 73.

Tip

The amount of these minimum withdrawals is calculated based on the account balance at the end of the previous year and your life expectancy.

Having a Traditional IRA and a 401(k)

If you have an employer-sponsored retirement plan like a 401(k), you may also invest in IRAs. However, if you have a 401(k) as well as an IRA, depending on your income, you may be unable to deduct IRA contributions.

Pros and Cons of Contributing to a Traditional IRA

Benefits of a Traditional IRA

• Ability to set up a traditional IRA separate from (and in addition to) employer-sponsored retirement accounts like 401(k)s
• May provide tax advantages at retirement if you expect to be in a lower tax bracket then than you are now
• Contributions may be tax-deductible

Drawbacks of a Traditional IRA

• Lower annual contribution limit compared to 401(k) accounts
• Must pay taxes on distributions in the year they are made
• Early withdrawal penalties in most cases for individuals under 59½ 

Traditional IRAs vs. Other IRAs

Traditional IRA vs. Roth IRA

Traditional and Roth IRAs are very similar, except that Roth IRAs make use of post-tax income for contributions. This means that Roth IRA distributions are generally not taxed. The 10% early withdrawal penalty tax is only levied on distributions of Roth IRA earnings; investors may typically withdraw their contributions without penalty so long as the fund has been active for at least five years.

Traditional IRA vs. SIMPLE IRA

SIMPLE IRAs allow both employees and employers to contribute. These accounts are offered by employers who may be unable to provide other retirement plans.

Traditional IRA vs. SEP-IRA

Simplified Employee Pension Plan IRAs (SEP-IRAs) function similarly to traditional IRAs, except they provide employers a way to contribute toward an employee’s retirement. The contribution limits are higher for a SEP-IRA than a traditional IRA, but typically only employers are allowed to make contributions.

Here’s a comparison of how the four main types of IRAs compare with one another: 

	Traditional IRA	Roth IRA	SIMPLE IRA	SEP-IRA
Account holders are…	Individuals	Individuals	Employees	Employees (or self-employed individuals)
Contributions come from…	Pre-tax income	Post-tax income	Pre-tax income	Pre-tax income
Annual contribution limits (2024 and 2025)	$7,000	$7,000	$16,000 (for 2024) $16,500 (for 2025)	$69,000 or 25% of compensation up to $345,000 (for 2024) $70,000 (or 25% of their compensation up to $350,000 (for 2025)
Income cap	None	2024 phaseout range: single filers, $146,000-$161,000; joint filers, $230,000-$240,000 2025 phaseout range: single filers, $150,000-$165,000; joint filers, $236,000-$246,000	None	None
Who is eligible?	Anyone earning at least the contribution amount	Anyone earning at least the contribution amount	Employers not offering other retirement accounts	Individuals 21+ earning at least $750 annually from a business they’ve worked for during at least 3 of the previous 5 years

How To Open a Traditional IRA

Opening a traditional IRA is a straightforward process:

1. Select an IRA provider. Major providers include TIAA, Vanguard, Fidelity, and more.
2. Apply through the provider. You’ll need to provide personal information and financial details and specify the type of IRA you want to open.
3. Fund the account. Make a contribution from an existing bank account or set up a rollover from a previous retirement account.
4. Select investment options. Specify any investments you would like the account to target. This may mean particular stocks, mutual funds, bonds, and so on, or it may be a broader breakdown of stocks vs. bonds.

Is a Traditional IRA Right for You?

Traditional IRAs are a good option if you’re looking to contribute pre-tax dollars to a retirement account separate from an employer-sponsored plan. They are particularly appropriate if you anticipate being in a lower tax bracket at the time of retirement when you will pay taxes on distributions.

What Happens if I Contribute More Than the Annual Limit to a Traditional IRA?

Over contributing to a traditional IRA incurs a 6% penalty tax. In order to correct the situation, you must withdraw any excess contributions or apply them to the next year’s limit.

How Much Tax Will I Pay on a Traditional IRA?

The amount of tax you pay on a traditional IRA depends on your income tax bracket when you withdraw the funds. Contributions to a traditional IRA are made with pre-tax income, and taxes are deferred until you begin taking distributions. At the time of withdrawal, the amount you take out is taxed as ordinary income. If you withdraw funds before age 59½, you may face a 10% early withdrawal penalty.

At What Age Can You No Longer Open a Traditional IRA?

There is no maximum age for opening a traditional IRA. As long as you have earned income (such as from a job or self-employment), you can contribute to a traditional IRA at any age.

The Bottom Line

Traditional IRAs are individual-directed retirement accounts that use pre-tax dollars for investment. They have lower contribution limits than 401(k)s but do not require employer sponsorship. While investors can direct how their contributions are invested, often the best approach is to determine an appropriate level of risk, target a broad range of assets through a mutual fund or similar option, and hold for the long term.

Reviewed by Ebony Howard
Fact checked by Vikki Velasquez

408(k) Plan vs. 401(k) Plan: An Overview

408(k) and 401(k) are sections of the Internal Revenue Code that outline employer-sponsored retirement plans. Both sections provide guidelines for plans that give employees a means of saving for retirement in a special account.

That’s where these two retirement savings plans diverge. While section 401(k) has become synonymous with a widely available retirement savings vehicle, section 408(k) sets the guidelines for what is called the simplified employee pension (SEP) IRA.

Key Takeaways

• 408(k)s and 401(k)s are retirement savings plans.
• Employee contributions are not permitted as part of the 408(k) contribution limits.
• An SEP is available to companies of any size and self-employed individuals.
• Up to 25% of an employee’s pay may be contributed to an SEP.
• 401(k)s are the most common type of plan.

408(k)s

A simplified employee pension plan is an individual retirement account and/or annuity that meets the contribution requirements set by the Internal Revenue Code. It can be created by a business of any size. Only the employer can contribute to the plan, and every employee receives the same percentage of their earnings as contribution amounts.

Those who are self-employed may contribute to SEP IRAs. Employers can also make tax-deductible contributions on behalf of eligible employees—including the business owner—to their SEP IRAs. The employer is allowed a tax deduction for plan contributions that do not exceed the statutory limit.

401(k)s

A 401(k) is the most common type of retirement savings account offered. It is an employer-sponsored savings plan in which the employer and employee can make contributions. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis in traditional 401(k)s and a potentially tax-free basis in a Roth 401(k).

Important

401(k) plans are slightly more complex than 408(k)s, as they generally contain several investment options chosen by the employer. In an SEP IRA, employees choose their investments.

Key Differences

Here are some features that distinguish the 408(k) SEP IRA from the 401(k):

• In general, only employers can contribute to an SEP IRA: Unlike a 401(k), employee contributions are not permitted as part of SEP contribution limits.
• Some SEP IRAs permit separate, personal IRA contributions: If your company’s SEP IRA plan permits it, employees can make non-SEP IRA contributions to the same account, up to $7,000 for 2025 (and 2024), plus an additional $1,000 for those age 50 or older.
• Employer contributions under an SEP IRA must be equal: Each eligible employee must get the same percentage of the salary contributed to the plan.
• Employees, not employers, manage an SEP account: Overall, 401(k) plans are a bit more complex than SEPs, with many investment options set up by the employer (or its plan managers), including mutual funds that contain stocks, bonds, and commodities. With an SEP IRA, the employer does not set up investment options. Instead, the employee manages the SEP IRA, choosing their investments. Employers essentially put money (not real property, which is forbidden) into employee individual retirement accounts (IRAs). This saves the employer from paying administration costs as they would with a 401(k).
• Self-employed contributions are tax-deductible: Only self-employed participants can deduct a certain amount of their contributions to their retirement funds.
• 408(k)s have minimum earnings for eligibility: The minimum compensation threshold is $750 for 2025 and 2024.

Similarities

• Maximum allowable compensation: No matter how much an employee earns, the annual compensation limit for determining contributions is $350,000 in 2025.
• Contribution limits: Employers can contribute as much as 25% of an employee’s salary but no more than $70,000 for 2025 ($69,000 for 2024). However, no catch-up contributions are allowed in SEP IRAs, as they are funded only with employer contributions.
• Contributions are not taxed: Employer contributions to your plans are not taxed. You pay taxes on withdrawals.
• Eligibility: SEP IRAs are available for employees of companies of any size or those who are self-employed and would typically not have access to a retirement plan.
• Contribution deadlines follow IRA deadlines. For example, 2025 contributions to an SEP IRA may be made until April 15, 2026. With a 401(k), the deadline is the calendar year (i.e., Dec. 31) for individual contributions, but April 15 for employer contributions.
• Penalty for early withdrawal. Both accounts are inaccessible without a penalty until the account holder reaches the qualifying age of 59½.

What Is a 408(k) Withdrawal Plan?

A 408(k) plan is an SEP IRA. If you have an SEP IRA, it’s best to make a withdrawal plan that meets your financial needs and accounts for paying any taxes on the withdrawals. You aren’t required to take distributions until age 73. After you turn 73, you must begin taking withdrawals that meet or exceed the required minimum distribution amounts.

Is a 408(a) the Same as a Traditional IRA?

A 408(a) is commonly known as a Roth IRA, so it is not a traditional IRA. This individual retirement account lets you make post-tax contributions and tax-free distributions after 59½.

What Are the 2 Types of 401(k) Plans?

The types of IRAs are traditional, Roth, SIMPLE, and Safe Harbor IRAs.

The Bottom Line

408(k) and 401(k) plans are both retirement savings plans, but they have significant differences and similarities. Differences include who can contribute, who manages the account, and whether catch-up contributions are allowed.

Reviewed by Charlene Rhinehart
Fact checked by Suzanne Kvilhaug

What Is a Liquidity Ratio?

A liquidity ratio is a measurement of a company’s ability to pay off its current debts with its current assets.

There are various types of liquidity ratios, including the current ratio and the quick ratio. Usually, a liquidity ratio greater than 1 is a positive sign. But a very high liquidity ratio isn’t necessarily a good thing.

Companies can increase their liquidity ratios quickly in a few different ways, including using sweep accounts, cutting overhead expenses, and paying off liabilities.

Read on to learn more about liquidity ratios and how a company can increase them.

Key Takeaways

• Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
• Liquidity ratios measure the ability of a company to pay off its short-term obligations with its current assets.
• Two of the most common liquidity ratios are the current ratio and the quick ratio.
• A higher liquidity ratio indicates a company is in a better position to meet its obligations, but can also indicate that a company isn’t using its assets efficiently.
• A satisfactory ratio can differ depending on the ratio type.

Understanding Liquidity Ratios

A company calculates a liquidity ratio by dividing its current assets by its short-term liabilities.

A liquidity ratio can be a valuable metric for market analysts and potential investors. That’s because it can help them to determine if a company is financially healthy enough to pay off its short-term debts and other current liabilities.

A low liquidity ratio could signal a company that is in financial trouble. However, a very high liquidity ratio may show that a company is too focused on liquidity, to the detriment of efficiently utilizing its capital to grow and expand its business.

The Current and Quick Ratios

As mentioned above, two commonly reviewed liquidity ratios are the current ratio and the quick ratio.

Current Ratio

The current ratio provides a good indication of a company’s ability to cover its short-term liabilities. It’s a measure of all current assets that can be turned into cash quickly and used to pay all short-term obligations.

For this ratio, current assets include cash, cash equivalents, inventory, marketable securities, and certain other short-term investments.

Quick Ratio

The quick ratio refines the current ratio, measuring the most liquid assets a company has to cover liabilities, including cash, receivables, and marketable securities.

As a result, it is more conservative than the current ratio because it excludes inventory and some other current assets from the calculation.

As you might imagine, liquidity ratios can differ somewhat depending on which assets are used in the ratio formula.

Important

Creditors analyze liquidity ratios when deciding whether or not to extend credit to a company.

Increasing Liquidity Ratios

• One way to quickly improve a company’s liquidity ratio is to use sweep accounts that transfer funds into higher interest rate accounts when they’re not needed, and back to readily accessible accounts when necessary.
• Paying off liabilities also quickly improves the liquidity ratio. So does cutting back on short-term overhead expenses such as rent, labor, and marketing.
• A company can also increase its liquidity ratio by using long-term rather than short-term financing to acquire inventory or finance projects. Removing short-term debt from the balance sheet allows a company to save some liquidity in the near term and put it to better use.
• To increase a company’s liquidity ratio for the long term, take a look at accounts receivable and payable. Ensure that you’re invoicing customers as quickly as possible, and that they’re paying on time. When it comes to accounts payable, you’ll want to ensure the opposite—longer pay cycles are more beneficial to a company that’s trying to improve its liquidity ratio. You can often negotiate longer payment terms with certain vendors.

Why Do Liquidity Ratios Matter?

They matter because they give management and potential investors a way to gauge how easily and quickly a company could meet its short-term obligations, and without having to borrow money to do so. It’s a sign of a company’s short-term financial health. A company with solid liquidity, as demonstrated by liquidity ratios, should be able to weather periods when the economy weakens. It may also use some quickly available cash to take advantage of opportunities for growth.

When Is a Liquidity Ratio Too High?

It’s not an exact science, but a ratio that’s way above 1, for example 4, means that a company has enough in current assets to pay off its immediate obligations four times over. Some companies may feel that one time over is enough. In that case, it may be that cash isn’t being used properly and opportunities to grow value are missed.

How Do Liquidity Ratios Clarify a Company’s Potential for Default?

The more easily that a company can pay all of its short-term liabilities, the less chance there is that the company will default on them. Measuring how quickly current assets can be sold and the cash used to pay all of these bills is the role of liquidity ratios. By presenting a metric, such ratios demonstrate whether there’s a risk of default. A liquidity ratio of 1 indicates that all short-term debts can be covered by current assets.

The Bottom Line

Liquidity ratios, which measure a firm’s capacity to pay its short-term financial obligations with current assets, can be increased by paying off some liabilities, reducing costs, using long-term financing, and efficiently managing receivables and payables.

That said, a liquidity ratio that’s overly high does not always indicate stronger financial health, as it could mean that a company is not using its assets effectively to grow the value of the business.