Investopedia

Fact checked by Betsy Petrick

Roth IRAs are just one type of popular individual retirement account (IRA), the other being traditional IRAs. Unlike a traditional IRA, which is funded with tax-deferred contributions, a Roth IRA is funded with contributions made on an after-tax basis or through a 529 rollover (after 2024). Because of this, Roth IRAs are considered to be tax-advantaged, and there are strict contribution limits based on income level. Every year, these contributions and income levels can be adjusted, so it’s important to learn how much you can fund your account.

Key Takeaways

• Roth IRAs are funded with income that you’ve already paid taxes on.
• Individuals are only allowed to contribute up to $7,000 (or $8,000 if over 50 years old) for tax years 2024 and 2025.
• If your earnings exceed the income limit, you are not allowed to contribute to a Roth IRA.

Roth IRA Contribution Limits for Tax Year 2025

You can fund a Roth IRA up to your contribution limit until tax filing day of the following year. For instance, you can fund your Roth through April 15, 2025, and the contributions will count toward your 2024 limit. However, if you file your taxes before the deadline, the contributions you make after that point count toward the next year’s limit. Keep in mind if you file an extension on your taxes, you don’t get additional time to fund your Roth.

For 2024 and 2025, the IRS announced the full Roth IRA contribution limit is $7,000. People 50 years old and over can contribute an additional $1,000 if they meet income qualifications.

Roth IRA Contribution Limits for 2024 and 2025
Married and filing jointly (or qualifying widow(er))
You are single, head of household, or married, filing separately (but you didn’t live with your spouse at any time during the last year)
Filing Status	Contribution Limit
	$7,000 ($8,000 if age 50 or older)
	$7,000 ($8,000 if age 50 or older)

Roth IRA Phase-out Ranges

Not everyone can contribute to a Roth IRA since the IRS places income limitations on these accounts. Every year, the IRS publishes the phase-out ranges for contributing. These income limits are based on your modified adjusted gross income (MAGI) and tax-filing status. If you’re in the phase-out range, you can make partial contributions but not the maximum limit for the year.

To determine your MAGI, you can look at your adjusted gross income (AGI) and add the deductions that might have been taken out. Look at the income phase-out ranges below to see if you can make full or reduced contributions to your Roth IRA.

For example, if you’re a single filer and you make less than $150,000 MAGI in 2025, you can contribute the full amount. If you make $155,000, you can contribute a partial amount, and if you earn more than $165,000, you are ineligible for a Roth IRA.

Roth IRA Phase-out Ranges for 2024 and 2025
Married and filing jointly (or qualifying widow(er))
Married, filing separately (but you lived with your spouse at any time during the last year)
You are single, head of household, or married, filing separately (and you didn’t live with your spouse at any time during the last year)
Filing Status	2024 MAGI	2025 MAGI	Contribution Limit
	Less than $230,000	Less than $236,000	$7,000 ($8,000 if age 50 or older)
	$230,000 to $240,000	$236,000 to $246,000	Begin to phase out
	$240,000 or more	$246,000 or more	Ineligible for direct Roth IRA
	Less than $10,000	Less than $10,000	Begin to phase out
	$10,000 or more	$10,000 or more	Ineligible for direct Roth IRA
	Less than $146,000	Less than $150,000	$7,000 ($8,000 if age 50 or older)
	$146,000 to $161,000	$150,000 to $165,000	Begin to phase out
	$161,000 or more	$165,000 or more	Ineligible for direct Roth IRA

Roth IRA Catch-up Contributions

In a perfect world, you might be able to fund your Roth IRA to the maximum limit every single year, which could really help your retirement fund grow. Unfortunately, there are probably years that you missed out on funding your Roth to the max or contributing to it at all.

If you’re 50 or older, you can contribute more to your Roth IRA in an attempt to catch up a little. Usually, the IRS allows you to contribute an extra $1,000 each tax year in catch-up contributions if you’re eligible.

Note

You can usually find the updated contributions and phaseout ranges for the following year around the fourth quarter of the current year.

Withdrawing From a Roth IRA

With a Roth IRA, you can withdraw your contributions at any time. You don’t have to wait until retirement, and you’re not required to take minimum distributions once you reach retirement age. This is because you’ve already paid tax on the contributions, and it’s up to you what to do with the money in the account. That said, you can’t withdraw the earnings until you’re at least 59 ½ and you’ve owned the account for at least five years.

For example, someone who is 58 years old couldn’t withdraw their earnings but could withdraw earnings and contributions if they became disabled or was a first-time homebuyer. Once they reach 59 ½, they could withdraw funds penalty-free for any reason.

Those under 59 ½ or people who haven’t held their Roth IRA for at least five years do have the option of withdrawing earnings, but they’ll face a 10% penalty.

Important

Because of the Tax Cuts and Jobs Act (TCJA) of 2017, you can no longer convert your Roth IRA to and from another type of tax-advantaged account through recharacterization. Any loan conversions after 0ct. 15, 2018, cannot be recharacterized.

The Bottom Line

Contributing to a Roth IRA can be a smart strategy to save for retirement, but you’ve got to know the limits and withdrawal rules so you’re not hit with a surprise penalty. Fortunately, since you’ve already paid taxes on your contributions, you have more flexibility with the account before you retire. And, unlike traditional IRAs, you’re not required to take out minimum distribution payments, so you could leave the account to your heirs.

A Roth IRA is a beneficial retirement planning tool, and there are several reasons why you may want to implement it into your financial strategy. While there is no up-front tax break for investing in a Roth IRA, once you invest, you get the benefit of tax-free growth and tax-free withdrawals, when done properly, which can be especially advantageous if you end up in a higher tax bracket during retirement.

To open a Roth IRA account, you must first determine your eligibility. Next, you need to choose a Roth IRA provider, gather the necessary documentation, and decide which investments to include. Finally, you need to schedule your contributions.

Key Takeaways

• Roth IRAs provide the benefit of tax-free growth: The money you invest is left over from income on which you paid tax, so you do not get a tax deduction for Roth IRA contributions. But once the money is invested, you get the advantage of tax-free growth. Depending on how early you start and the types of investments you use in your Roth, the compounding effects over time can generate substantial gains.  
• You can withdraw Roth IRA contributions tax-free at any time and age. Furthermore, you can withdraw Roth IRA earnings tax-free after you’ve owned that or any other Roth IRA for at least five years and you reach age 59½. Tax-free withdrawals in retirement can be especially beneficial to any Roth IRA account owner who ends up in a higher tax bracket than they were in pre-retirement.
• You are never required to take a distribution from your Roth IRA. Investing in a Roth can also be a great estate planning tool. Not only are required minimum distributions (RMDs) not required, but you can pass along the account tax-free to your beneficiaries someday. RMD rules do apply to any heirs, but their withdrawals would be tax-free. 

How to Open a Roth IRA

Step 1: Determine Your Eligibility

For the 2025 tax year, the modified adjusted gross income (MAGI) limit for Roth IRA contributions has increased. The amount you can contribute to a Roth IRA is limited or potentially phased out in the following tax filing situations:

• Married filing jointly or qualifying surviving spouse, with a modified AGI of at least $236,000 (up from $230,000 in 2024). You can’t make a Roth IRA contribution if your modified AGI is $246,000 (up from $240,000 in 2024) or more.
• Single, head of household, or married filing separately, and you didn’t live with your spouse at any time in 2025, and your modified AGI is at least $150,000 (up from $146,000 in 2024). You can’t make a Roth IRA contribution if your modified AGI is $165,000 (up from $161,000 in 2024) or more.
• Married filing separately is the same for 2025 as it was for 2024—you lived with your spouse at any time during the year, and your modified AGI is greater than $0. You can’t make a Roth IRA contribution if your modified AGI is $10,000 or more.

Income Limits for Roth IRA in 2024 and 2025

Filing Status	2024 Modified AGI	2025 Modified AGI	Contribution Limit
Married filing jointly or qualifying surviving spouse	Less than $230,000	Less than $236,000	Up to $7,000 (under age 50) Up to $8,000  (age 50 and over)
Married filing jointly or qualifying surviving Spouse	At least $230,000	At least $236,000	Reduced amount
Married filing jointly or qualifying surviving spouse	$240,000 or greater	$246,000 or greater	$0
Single, head of household, or married filing separately	At least $146,000	At least $150,000	Reduced amount
Single, head of household, or married filing separately	$161,000 or greater	$165,000 or greater	$0
Married filing separately (lived with spouse at any time during the year)	Greater than $0	Greater than $0	Reduced amount
Married filing separately (lived with spouse at any time during the year)	At least $10,000	At least $10,000	$0

Step 2: Choose a Roth IRA Provider

When deciding which brokerage is right for you, it is important to take a holistic look at the financial institution, including aspects such as:

• Fees: Are there yearly maintenance fees? Are there additional fees for trading investments within the Roth IRA? Are there additional fees for advice from a financial advisor?
• Investment options: Does the brokerage offer the types of investments that you are looking for—stocks, bonds, mutual funds, ETFs, alternative investment options?
• Customer service: What are the hours of customer service? Are questions answered by telephone, email, or online chat?
• Additional services: Does the brokerage offer other types of accounts that you may be interested in to help reach your financial goals, such as custodial accounts, educational savings accounts, or even banking options?
• Account amenities: Would you have access to planners, educational materials, or the ability to connect outside accounts to get an aggregate financial picture?

Best Roth IRA Brokers

Company	Fees	Account Minimum
Fidelity	$0 for stock/ETF trades, $0 plus $0.65/contract for options trades	$0
Charles Schwab	$0 for stock/ETF trades, $0.65 per contract for options	$0
Wealthfront	0.25% for most accounts; no trading commission or fees for withdrawals, minimums, or transfers	$500

Step 3: Gather the Necessary Documentation

To open a Roth IRA or any type of investment account, you need certain documents and information. 

• Identification, such as a driver’s license or state- or government-issued identification
• Social Security number
• Beneficiary information—it is important to have up-to-date beneficiary information on any account or asset that you have so that the person or people you intend will get the proceeds from the account upon your death and any tax benefit that may go along with that inheritance.
• Bank details to fund your account and feed any ongoing, automated contributions that you arrange

Step 4: Decide Which Investments to Include

As with any retirement account, you should choose investments in your Roth IRA that align with your risk threshold and financial goals. Because investments in your Roth IRA enjoy tax-free growth and tax-free withdrawal (when executed according to various rules, investments that have the potential to notch the most gains or generate high dividends are, generally speaking,  good choices. However, these types of investments should only be a part of your asset allocation if they also meet your risk tolerance and retirement timeline. 

Your risk tolerance indicates how much risk you are willing to take. 

• Higher-risk investments include growth-oriented stocks, stock mutual funds, and ETFs.
• Lower-risk investments include bonds, dividend stocks, income funds, money market accounts, and money market funds

Your retirement timeline also affects how aggressively you may want to invest. If you are relatively close to retirement, you may choose lower-risk investments to protect your principal amount, as you don’t have as much time to recover from unexpected drops in the market. If you have a few decades until you retire, holding higher-risk investments can lead to potentially higher returns over time while also giving you sufficient time to rebound from market pullbacks.

Step 5: Schedule Your Contributions

There are a few ways that you can invest in your Roth IRA account:

• Set up automatic investments from your bank or employer: A predetermined amount goes directly from your bank account or paycheck to your Roth account at set intervals until you have reached your maximum contribution level.
• Contribute on a yearly basis: Use money from a source such as an annual bonus or your tax refund to fund your Roth IRA each year.

It is also important to remember that a Roth IRA offers tax-free growth and tax-free withdrawals when done properly, so the younger you are when you start investing in a Roth IRA, the longer you have to take advantage of the compounding effects of the tax-free growth.

The Bottom Line

Regardless of what tax bracket you find yourself in during retirement, investing in a Roth IRA has perks. You do not get any immediate tax deductions for contributing to this type of account, but you do enjoy tax-free growth on your investments and, generally, tax-free withdrawals. If you find that you don’t want or need to take any withdrawals from your Roth IRA, then you can use it as an estate planning tool to pass assets to your named beneficiaries.

Reviewed by Charlene Rhinehart
Fact checked by Yarilet Perez

What Is Going Private?

A public company may choose to go private for several reasons. There are a number of short- and long-term effects to consider when going private, as well as a variety of advantages and disadvantages.

Here’s a look at the variables that companies must consider before deciding to go private.

Key Takeaways

• Going private means that a company does not have to comply with costly and time-consuming regulatory requirements, such as the Sarbanes-Oxley Act of 2002.
• In a “take-private” transaction, a private equity group purchases or acquires the stock of a publicly traded corporation.
• Private companies also do not have to meet Wall Street’s quarterly earnings expectations.
• With fewer requirements, private companies have more resources to devote to research and development, capital expenditures, and the funding of pensions.

Understanding a Public Company

There are advantages to being a public company. For example, the buying and selling of public company shares is a relatively straightforward transaction and a focus of investors seeking a liquid asset. There is also a certain degree of prestige to being a publicly traded company, implying a level of operational and financial size and success, particularly if the stock trades on a major market like the New York Stock Exchange.

However, there are also tremendous regulatory, administrative, financial reporting, and corporate governance bylaws to which public companies must comply. These activities can shift management’s focus away from operating and growing a company and toward adherence to government regulations.

For instance, the Sarbanes-Oxley (SOX) Act of 2002 imposes many compliance and administrative rules on public companies. A by-product of the Enron and WorldCom corporate failures in 2001 and 2002, respectively, SOX requires all levels of publicly traded companies to implement and execute internal controls. The most contentious part of SOX is Section 404, which requires the implementation, documentation, and testing of internal controls over financial reporting at all levels of the organization.

Public companies must also conduct operational, accounting, and financial engineering to meet Wall Street’s quarterly earnings expectations. This short-term focus on the quarterly earnings report, which is dictated by external analysts, can reduce prioritization of longer-term functions and goals such as research and development, capital expenditures, and the funding of pensions. In an attempt to manipulate the financial statements, a few public companies have shortchanged their employees’ pension funds while projecting overly optimistic anticipated returns on pension investments.

What It Means to Go Private

A “take-private” transaction means that a large private equity group, or a consortium of private equity firms, purchases or acquires the stock of a publicly traded corporation. Due to the large size of most public companies, which have annual revenues of several hundred million to several billion dollars, it is normally not feasible for an acquiring company to finance the purchase single-handedly. The acquiring private equity group typically needs to secure financing from an investment bank or related lender that can provide enough loans to help finance (and complete) the deal. The newly acquired target’s operating cash flow can then be used to pay off the debt that was used to make the acquisition possible.

Equity groups also need to provide sufficient returns for their shareholders. Leveraging a company reduces the amount of equity needed to fund an acquisition and increases the returns on capital deployed. Put another way, leveraging means the acquisition group borrows someone else’s money to buy the company, pays the interest on that loan with the cash generated from the newly purchased company, and eventually pays off the loan balance with a portion of the company’s appreciation in value. The rest of the cash flow and appreciation in value can be returned to investors as income and capital gains on their investment (after the private equity firm takes its cut of the management fees).

Once an acquisition is agreed to, management typically lays out its business plan to prospective shareholders. This go-forward prospectus covers the company and industry outlook and sets forth a strategy showing how the company will provide returns for its investors.

When market conditions make credit readily available, more private equity firms can borrow the funds needed to acquire a public company. When credit markets tighten, debt becomes more expensive, and there will usually be fewer “take-private” transactions.

Deciding to Go Private

Investment banks, financial intermediaries, and senior management often build relationships with private equity firms to explore partnership and transaction opportunities. As acquirers typically pay at least a 20% to 40% premium over the current stock price, they can entice CEOs and other managers of public companies—who are often heavily compensated when their company’s stock appreciates in value—to go private. In addition, shareholders—particularly those who have voting rights—often pressure the board of directors and senior management to complete a pending deal to increase the value of their equity holdings. Many stockholders of public companies are also short-term institutional and retail investors, and realizing premiums from a “take-private” transaction is a low-risk way of securing returns.

When considering whether to consummate a deal with a private equity investor, the public company’s senior leadership team must also balance short-term considerations with the company’s long-term outlook. In particular, they must decide:

• Does taking on a financial partner make sense for the long term?
• How much leverage will be tacked onto the company?
• Will cash flow from operations support the new interest payments?
• What is the future outlook for the company and industry?
• Are these outlooks overly optimistic, or are they realistic?

Management needs to scrutinize the track record of the proposed acquirer. Among the criteria to consider:

• Is the acquirer aggressive in leveraging a newly acquired company?
• How familiar is the acquirer with the industry?
• Does the acquirer have sound projections?
• Does the acquirer have hands-on investors, or will it give management leeway in the company’s stewardship?
• What is the acquirer’s exit strategy?

Advantages of Privatization

Going private, or privatization, frees up management’s time and effort to concentrate on running and growing a business, as there is no requirement to comply with SOX. Thus, the senior leadership team can focus more on improving the business’s competitive positioning in the marketplace. Internal and external assurance, legal professionals, and consulting professionals can work on reporting requirements for private investors.

Private equity firms have varying exit timelines for their investments, but holding periods are typically four to eight years. This horizon frees up management’s prioritization to meet quarterly earnings expectations and allows management to focus on activities that can create and build long-term shareholder wealth. For instance, managers might choose to retrain the sales staff and get rid of underperformers. The extra time and money that private companies enjoy once they’re free of reporting obligations can also be used for other purposes, such as implementing a process improvement initiative throughout the organization.

Disadvantages of Privatization

A private equity firm that adds too much leverage to a public company to fund the deal can seriously impair an organization if adverse conditions occur. For example, the economy could take a dive, the industry could face stiff competition from overseas, or the company’s operators could miss important revenue milestones.

If a privatized company has difficulty servicing its debt, its bonds can be reclassified from investment-grade bonds to junk bonds. This will make it harder for the company to raise debt or equity capital to fund capital expenditures, expansion, or research and development. Healthy levels of capital expenditures and research and development are often critical to the long-term success of a company as it seeks to differentiate its product and service offerings and make its position in the marketplace more competitive. High levels of debt can, thus, prevent a company from obtaining competitive advantages in this regard.

Obviously, private company shares don’t trade on public exchanges. In fact, the liquidity of investors’ holdings in a privatized company varies depending on how much of a market the private equity firm wants to take—that is, how willing it is to buy out investors who want to sell. In some cases, private investors may easily find a buyer for their portion of the equity stake in the company. However, if the privacy covenants specify exit dates, it can make it challenging to sell the investment.

Pros

• Management can concentrate on running and growing the business.

• Management can prioritize meeting quarterly earnings expectations.

• Management can focus on creating and building long-term shareholder wealth.

Cons

• Adverse conditions could impair the company if too much leverage funded the deal.

• High levels of debt can prevent the company from obtaining competitive advantages.

• Privacy covenants with specified exit dates can make it challenging for private investors to sell their investment.

What Are Some of the Best-Known Public Companies to Go Private?

Among the best-known public companies to go private are X (formerly Twitter), Heinz (which went public again as The Kraft Heinz Company (KHC)), Panera Bread, and Reader’s Digest.

What Is the Largest ‘Take-Private’ Deal in History?

Dell Technologies spent $67 billion to acquire EMC Corp., forming the world’s largest privately controlled tech company in 2016. Dell went public again (DELL) two years later.

Can a Private Company Go Public?

Yes, a privately held company can decide to go public. The process involves several important and sensitive steps that protect the company and potential investors, including selling shares for the first time, otherwise known as an initial public offering (IPO).

The Bottom Line

Going private is an attractive and viable alternative for many public companies. Being acquired can create significant financial gain for shareholders and CEOs, while fewer regulatory and reporting requirements for private companies can free up time and money to focus on long-term goals.

As long as debt levels are reasonable, and the company continues to maintain or grow its free cash flow, operating and running a private company frees up management’s time and energy from compliance requirements and short-term earnings management and may provide long-term benefits to the company and its shareholders.

Reviewed by Ebony Howard
Fact checked by Vikki Velasquez

The Youth Advantage

If you’re a young investor, you face a bewildering array of investment options. But whatever your choices are, time is on your side. Your long time horizon allows you to exploit the power of compounding to meet your financial goals.

You probably have several goals in mind: You need to build a small nest egg to deal with emergencies. You want to invest in the medium term for big purchases like a home. You want to start the process of building wealth for your retirement years way down the road.

Here are some solid suggestions for dealing with all of those goals.

Key Takeaways

• Young investors have the most valuable resource on their side: time.
• Compound interest and dividend reinvestment are proven tools for maximizing long-term investing.
• Buying your own home is a solid investment choice if you plan to stay in it for longer than five years.
• Company 401(k) plans are excellent choices, especially if your employer offers a matching contribution.
• If you’re self-employed, IRAs open up a huge range of investment choices.

Saving for Retirement

If you’re young, your greatest financial assets are time⁠ and compound interest. Early on, your primary investment objective for long-term savings should be growth. With 40 years or so to go before retirement, you can afford to take reasonable risks.

Consider focusing on equities such as stocks and stock mutual funds or exchange-traded funds (ETFs)⁠. You might also consider real estate, either in the form of a personal residence or a real estate investment trust (REIT), a mutual fund that invests in real estate holdings.

Above all, make a plan and stick to it. As your income rises, increase the amount you put away for the future.

Important

Real estate and stocks both tend to outpace inflation over time. Real estate values rarely grow as quickly as stock prices but they experience fewer booms and busts.

401(k)s and IRAs

If you have a full-time job, you probably have access to a 401(k) retirement plan. If you are self-employed, you can invest in an Individual Retirement Account (IRA).

Both come with immediate tax benefits and the potential for serious wealth accumulation over time.

Retirement Plan Choices

Employer-sponsored retirement plans can come with a voluntary contribution by your employer. This might be, for example, a 50% match on the first 5% of your contributions. That can result in tens of thousands of extra dollars in your pocket at retirement.

If you’re self-employed, you can open an individual retirement account (IRA).

The benefits of an employer-sponsored 401(k) and an IRA are similar:

• If you choose a traditional account, the amount you contribute each year is tax-free that year. You won’t pay taxes on the money until you withdraw it, presumably after you retire.
• If you choose a Roth account, you’ll pay income taxes on the money you contribute in that year but the entire account will be tax free when you withdraw it.

Traditional or Roth?

Most financial experts advise younger people to use a Roth account. All of those years of growth should result in a bigger pile of non-taxed income when you retire.

Ultimately, the Roth account’s tax-free growth makes it unbeatable over time. Since you pay income taxes on the money when you pay it in, it’s a little more pain now for a lot more gain over time.

Not all employers offer a Roth alternative with their 401(k) plans.

IRAs, traditional and Roth, are available at most banks and other financial institutions.

Investing

You’re not going to want to put every spare penny into an account you can’t use for 40 or more years. If you’re saving for a down payment on a house, or any other shorter-term goal, you can do better than stashing your money in a savings account that barely matches the inflation rate.

Investing in exchange-traded funds (ETFs) that mimic the holdings in a benchmark like the S&P 500 Index is one good option.

You can choose an ETF with a mix of stocks across industries, giving you a diverse portfolio without a huge outlay of cash. The fees are lower than you’ll pay for a managed mutual fund.

Moreover, if you allow the dividends and interest to accumulate, you can reach your financial goal in a few years rather than a few decades.

Index-linked ETFs typically outperform risky strategies like individual stock-picking or day trading, especially over time.

Buying a Home

Traditional financial wisdom dictates that a house is one of the best long-term investments. but your returns depend on several variables. The duration of your residence and the state of the housing market at the time you buy and sell are big factors, as are current interest rates and comparable rental prices in your town.

It’s probably cheaper to rent in most cases if you plan on living in the home for less than five years. It usually takes at least five to seven years to accumulate enough equity in a home to justify buying one rather than renting.

Saving for College

There are several savings vehicles to consider for your money if you’re still trying to get through school or haven’t started yet.

529 Plans

Nearly every state has this type of college savings plan. The funds can be allocated among various investment choices and will grow tax-free until they’re withdrawn to pay tuition and other higher education expenses.

The contribution limits for these plans vary from state to state but are generally quite high.

If you’re struggling to get near your college savings goal you should know that parents and grandparents can also contribute to your plan, and enjoy some tax benefits.

Coverdell Education Savings Accounts

This type of college savings account is another option for those who want to take a self-directed approach to their investments. This is a federal program that allows tax-free distribution of the accumulated funds.

The annual contribution limit as of 2024 is $2,000 per beneficiary per year. That’s not much, given the current cost of tuition, but it can be helpful, especially if you want to purchase a specific investment that’s not offered inside a 529 Plan.

U.S. Savings Bonds

Savings bonds are worth considering if you want to keep your money safe. The interest earned on U.S. Savings Bonds is tax-free if it’s used for higher education expenses. The returns are modest but this is the gold standard of safe investing.

Short-Term Investments

The alternatives for your short-term cash are pretty much the same regardless of your age.

Money market funds, savings accounts, and short-term certificates of deposit (CDs) provide safety and liquidity for your idle cash.

The amount you keep in these investments will depend on your financial situation but most experts recommend keeping enough to cover at least three to six months of living expenses in an emergency fund.

What Are the Easiest Investments for Young People?

Exchange-traded funds (ETFs) and mutual funds are a way to keep pace with the overall growth of the stock market. It’s less risky than picking stocks on your own.

That said, the popularity of ETFs has led to the creation of highly specialized funds that track everything from gold prices to video game companies.

The more popular and less risky ETFs track benchmarks like the S&P 500 Index, the Nasdaq 100, and the total stock market.

Why Should You Start Investing When You’re Still Young?

It’s said that the only true miracle is compound interest. Young people may earn less money but investing in your 20s will give your savings several decades to grow.

Tax-advantaged retirement accounts give you even more reason to start young.

What Are the Best Short-Term Investments for Young People?

Investing is a challenge for younger people because they tend to have little disposable income and big first-time expenses. The interest paid on regular savings accounts is insignificant.

Your better bet is short-term investments such as money market funds and certificates of deposit (CDs). You’ll get a slightly better return and still be able to access your money at relatively short notice.

The Bottom Line

The most important financial step you can take is to start young. Where you invest matters less than the decision to invest regularly. The right investments for you will depend largely upon your personal investment objectives, risk tolerance, and time horizon.

Reviewed by Khadija Khartit
Fact checked by Suzanne Kvilhaug

Dividend Stock Ratios

Dividend stock ratios are used by investors and analysts to evaluate the dividends a company might pay out in the future. Dividend payouts depend on many factors such as a company’s debt load; its cash flow; its earnings; its strategic plans and the capital needed for them; its dividend payout history; and its dividend policy. The four most popular ratios are the dividend payout ratio; dividend coverage ratio; free cash flow to equity (FCFE) ratio; and net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio.

Mature companies no longer in the growth stage may choose to pay dividends to their shareholders. A dividend is a cash distribution of a company’s earnings to its shareholders, which is declared by the company’s board of directors. A company may also issue dividends in the form of stock or other assets. Generally, dividend rates are quoted in terms of dollars per share, or they may be quoted in terms of a percentage of the stock’s current market price per share, which is known as the dividend yield.

Key Takeaways

• Dividend stock ratios are an indicator of a company’s ability to pay dividends to its shareholders in the future.
• The four most popular ratios are the dividend payout ratio, dividend coverage ratio, free cash flow to equity ratio, and net debt to EBITDA ratio.
• A low dividend payout ratio is considered preferable to a high dividend ratio because the latter may indicate that a company could struggle to maintain dividend payouts over the long term.
• Investors should use a combination of ratios to evaluate dividend stocks.

Understanding Dividend Stock Ratios

Some stocks have higher yields, which may be very attractive to income investors. Under normal market conditions, a stock that offers a dividend yield greater than that of the U.S. 10-year Treasury yield is considered a high-yielding stock. As of March 28, 2025, the U.S. 10-year Treasury yield was 4.27%. Therefore, any company that had a trailing 12-month dividend yield or forward dividend yield greater than 4.27% was considered a high-yielding stock.

However, prior to investing in stocks that offer high dividend yields, investors should analyze whether the dividends are sustainable for a long period. Investors who are focused on dividend-paying stocks should evaluate the quality of the dividends by analyzing the dividend payout ratio, dividend coverage ratio, free cash flow to equity (FCFE) ratio, and net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio.

Important

Income investors should check whether a high-yielding stock can maintain its performance over the long term by analyzing various dividend ratios.

Dividend Payout Ratio

The dividend payout ratio may be calculated as annual dividends per share (DPS) divided by earnings per share (EPS) or total dividends divided by net income. The dividend payout ratio indicates the portion of a company’s annual earnings per share that the organization is paying in the form of cash dividends per share. Cash dividends per share may also be interpreted as the percentage of net income that is being paid out in the form of cash dividends.

Generally, a company that pays out less than 50% of its earnings in the form of dividends is considered stable, and the company has the potential to raise its earnings over the long term. However, a company that pays out more than 50% may not raise its dividends as much as a company with a lower dividend payout ratio. Additionally, companies with high dividend payout ratios may have trouble maintaining their dividends over the long term.

When evaluating a company’s dividend payout ratio, investors should only compare a company’s dividend payout ratio with its industry average or similar companies.

Dividend Coverage Ratio

The dividend coverage ratio is calculated by dividing a company’s annual EPS by its annual DPS or dividing its net income less required dividend payments to preferred shareholders by its dividends applicable to common stockholders.

The dividend coverage ratio indicates the number of times a company could pay dividends to its common shareholders using its net income over a specified fiscal period. Generally, a higher dividend coverage ratio is more favorable.

While the dividend coverage ratio and the dividend payout ratio are reliable measures to evaluate dividend stocks, investors should also evaluate the free cash flow to equity (FCFE) ratio.

Free Cash Flow to Equity (FCFE) Ratio

The FCFE ratio measures the amount of cash that could be paid out to shareholders after all expenses and debts have been paid. The FCFE is calculated by subtracting net capital expenditures, debt repayment, and change in net working capital from net income and adding net debt.

Investors typically want to see that a company’s dividend payments are paid in full by FCFE.

Net Debt to EBITDA Ratio

The net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio is calculated by dividing a company’s total liability less cash and cash equivalents by its EBITDA. The net debt to EBITDA ratio measures a company’s leverage and its ability to meet its debt.

Generally, a company with a lower ratio, when measured against its industry average or similar companies, is more attractive. If a dividend-paying company has a high net debt to EBITDA ratio that has been increasing over multiple periods, the ratio indicates that the company may cut its dividend in the future.

Fast Fact

A company that pays out more than 50% of its earnings in the form of dividends may not raise its dividends as much as a company with a lower dividend payout ratio. Thus, investors prefer a company that pays out less of its earnings in the form of dividends.

What Is a Dividend Payout Ratio?

A dividend payout ratio is the total amount of dividends that a company pays to shareholders relative to its net income. Put simply, it’s the percentage of earnings paid to shareholders via dividends. The amount not paid to shareholders is retained by the company to pay off debt or to reinvest in its core operations.

A dividend payout ratio is also known as a payout ratio.

What Is a Dividend Coverage Ratio?

A dividend coverage ratio measures the number of times that a company can pay dividends to its common shareholders using its net income over a specified fiscal period.

The dividend coverage ratio is also known as the dividend cover.

What Is a Free Cash Flow to Equity (FCFE) Ratio?

A free cash flow to equity (FCFE) ratio measures how much cash is available to a company’s equity shareholders after all expenses, reinvestment, and debt are paid. FCFE is a measure of equity capital usage and is often used by analysts to try to determine the value of a company.

What Is a Net Debt to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Ratio?

A net debt to EBITDA ratio measures leverage, calculated as a company’s interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA. It’s a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. However, if a company has more cash than debt, the ratio can be negative.

The Bottom Line

Each ratio provides valuable insights as to a stock’s ability to meet dividend payouts. However, investors who seek to evaluate dividend stocks should not use just one ratio because there could be other factors that indicate the company may cut its dividend. Investors should use a combination of ratios, such as those outlined above, to better evaluate dividend stocks.

Reviewed by Amy Drury
Fact checked by Michael Rosenston

What Are Momentum Indicators?

Momentrum indicators are technical analysis tools used to determine the strength or weakness of a stock’s price trend. Momentum measures the rate of the rise or fall of stock prices. Common momentum indicators include the relative strength index (RSI) and moving average convergence divergence (MACD).

Understanding Momentum Indicators

Momentum measures the rate of the rise or fall in stock prices. From the standpoint of trending, momentum is a very useful indicator of strength or weakness in the issue’s price. History has shown us that momentum is far more useful during rising markets than during falling markets; the fact that markets rise more often than they fall is the reason for this. In other words, bull markets tend to last longer than bear markets.

RSI

The relative strength index was created by J. Welles Wilder Jr. in the late 1970s; his “New Concepts in Trading Systems” (1978) is now an investment-lit classic. On a chart, RSI assigns stocks a value between 0 and 100. Once these numbers are charted, they can be compared to thresholds to see if the stock is oversold or overbought. Other indicators can be used along with RSI to strengthen this conclusion. To reach the best evaluation, experts generally chart the RSI on a daily time frame rather than hourly. However, sometimes shorter hourly periods are charted to indicate whether it is a good idea to make a short-term asset purchase. 

There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the trader whether or not an assets’s price action is created by those over-buying or over-selling it. The well-known formula for the relative strength index is as follows:

$begin{aligned} &textbf{RSI} = 100 – left(frac{100}{1 + RS}right)\ &textbf{RS} = frac{text{Average of x days’ up closes}}{text{Average of x days’ down closes}}\ &textbf{where:}\ &RSI= text{relative strength index} end{aligned}$​RSI=100−(1+RS100​)RS=Average of x days’ down closesAverage of x days’ up closes​where:RSI=relative strength index​

At the bottom of the RSI chart, settings of 70 and 30 are considered standards that serve as clear warnings of, respectively, overbought and oversold assets. A trader with today’s simple-to-use software may choose to reset the indicators’ parameters to 80 and 20. This helps the trader to be sure when making the decision to buy or sell an issue and not pull the trigger too fast.

Ultimately, RSI is a tool to determine low-probability and high-reward setups. It works best when compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, you may find that the crossovers indicating a shift in direction will occur very closely to the times when the RSI is either in the 20/30 or 70/80 range, the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI forecasts sooner than almost anything else an upcoming reversal of a trend, either up or down.

A Demonstration

It is important to recognize that many traders view the RSI value of 50 to be a support and resistance benchmark. If an asset has a difficult time breaking through the 50-value level, the resistance may be too high at that particular time, and the price action may fall off again until there is enough volume to break through and continue on to new levels. An asset falling in price may find support at the 50 value and bounce off this level again to continue an upward rise in price action.

Reviewed by Charlene Rhinehart
Fact checked by Yarilet Perez

CAGR vs. IRR: An Overview

The compound annual growth rate (CAGR) measures the return on an investment over a certain period of time. The internal rate of return (IRR) also measures investment performance. While CAGR is easier to calculate, IRR can cope with more complicated situations.

The most important distinction between CAGR and IRR is that CAGR is straightforward enough that it can be calculated by hand. In contrast, more complicated investments and projects, or those that have many different cash inflows and outflows, are best evaluated using IRR. To back into the IRR, a financial calculator, Excel, or portfolio accounting system is ideal.

Key Takeaways

• The most important distinction between CAGR and IRR is that CAGR is straightforward enough that it can be calculated by hand.
• The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, its ending value, and the time period.
• IRR considers multiple cash flows and periods—reflecting the fact that cash inflows and outflows often constantly occur when it comes to investments.

CAGR

The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, its ending value, and the time period. Online tools, including CAGR calculators, will spit out the CAGR when entering these three values.

An example of a CAGR calculation follows.

• Initial Value = 1,000
• Final Value = 2,200
• Time period (n) = 4

[(Final Value) / (Initial Value)] ^ (1/n) – 1

In the above case, the CAGR is 21.7%.

The CAGR is superior to an average returns figure because it takes into account how an investment is compounded over time. However, it is limited in that it assumes a smoothed return over the time period measured, only taking into account an initial and a final value when, in reality, an investment usually experiences short-term ups and downs. CAGR is also subject to manipulation, as the variable for the time period is input by the person calculating it and is not part of the calculation itself.

The CAGR helps frame an investment’s return over a certain period of time. It has its benefits, but there are definite limitations that investors need to be aware of.

Important

In situations with multiple cash flows, the IRR approach is usually considered to be better than CAGR.

IRR

IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. The IRR is also a rate of return (RoR) metric, but it is more flexible than CAGR. While CAGR simply uses the beginning and ending values, IRR considers multiple cash flows and periods—reflecting the fact that cash inflows and outflows often constantly occur when it comes to investments.

IRR can also be used in corporate finance when a project requires cash outflows upfront but then results in cash inflows as an investment pays off. Consider the following investment:

Investment Example
Time Period	Cash Flow
0	-1,000
1	400
2	500
3	600
4	700

In the above case, using the Excel function “IRR,” the rate is 36.4%.

The IRR is classified as a discount rate that utilizes net present value (NPV), making all cash flows equal to zero in a discounted cash flow (DCF) analysis. In most situations, the higher the IRR, the better the investment option.

IRR is often used by companies when they must choose which project is best among many options. A project that has an IRR above its cost of capital is one that will be profitable.

Special Considerations

In reality, investments experience volatility. There is never a continuously smooth market cycle that experiences linear growth. When running a business or expecting any sort of cash inflow, it is important for a business or investor to understand this so that they can successfully manage their cash.

For example, if a company makes an investment that provides $5,000 a month, which covers their debt payments and working capital, they may expect by using CAGR that every month for the life of the project or investment will result in a continuous cash stream of $5,000. However, some months may result in market or business volatility, where the investment return will be less than $5,000, or even zero. This would impact their ability to make debt payments or fund working capital.

What Is the Compound Annual Growth Rate (CAGR)?

The compound annual growth rate (CAGR) is the rate of return that an investment would need to have every year in order to grow from its beginning balance to its ending balance, over a given time interval. The CAGR assumes that any profits were reinvested at the end of each period of the investment’s life span.

What Is Internal Rate of Return (IRR)?

Internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. It is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow (DCF) analysis. IRR is the annual rate of growth that an investment is expected to generate, with the ultimate goal of identifying the rate of discount.

Why Is IRR Harder to Calculate than CAGR?

The formula for IRR can’t be easily calculated analytically because finding the discount rate that makes the net present value (NPV) of all cash flows equal to zero often requires repeatedly adjusting the discount rate until the NPV reaches zero—a time-consuming, tedious trial-and-error process.

CAGR is easier to calculate because it uses a simple formula based on the beginning value, the ending value, and the time period.

The Bottom Line

It is more conservative and accurate to use IRR than CAGR when seriously evaluating any investment options, as it will take into consideration true market volatility and the realities of the financial world.

Reviewed by Ebony Howard
Fact checked by Yarilet Perez

Tax- and business-friendly laws make the Commonwealth of the Bahamas a tax haven for foreign investors. Bahamian citizens and resident aliens pay no taxes on personal income, inheritance, gifts, or capital gains. To raise revenue, the government uses other forms of taxes instead, including value-added tax (VAT), property taxes, stamp taxes, import duties, and license fees.

The Bahamas, a parliamentary democracy since 1729, has a reputation for stability that attracts foreign financial institutions, making it an international center for banking. The Bahamas is also one of the wealthiest countries in the New World, with a per-capita GDP of $35,897 as of 2023. Its official language is English.

Key Takeaways

• Citizens of the Bahamas do not pay taxes on income, inheritance, gifts, or capital gains.
• The Bahamian government uses revenue from sources like VAT and stamp taxes.
• There are strict laws prohibiting illicit financial activity such as money laundering.

Understanding Tax Havens

A tax haven is a jurisdiction that offers favorable tax conditions to individuals and businesses. This involves providing low or no tax rates on income, capital gains, or other types of transactions.

Tax havens generally have certain characteristics in common, including political stability, economic opportunity, and tax treaties with other nations. The scope of illicit financial activities used to illegally evade taxes does not fall under the purview of tax havens.

Ease of International Transactions

More than 250 banks and trust companies representing 25 countries are licensed to do business in the Bahamas. Bahamian laws protect the right to privacy of bank clients. Strict Bahamian laws also prohibit any illicit financial activity, such as money laundering. The Central Bank of The Bahamas regulates foreign financial entities by providing a secure environment for banks specializing in private banking, mutual fund administration, and portfolio management.

Financial institutions doing business in the Bahamas include those of the United States, Canada, Switzerland, the United Kingdom, Brazil, and Japan. Major international accounting firms, including Deloitte & Touche, KPMG, and PricewaterhouseCoopers International Ltd have offices in Nassau.

Convenience of Creating Offshore Businesses

The Bahamas offers foreign companies seeking a tax haven the convenience of easily setting up a business entity. One example of business entities for foreign individuals and businesses is the international business company (IBC).

Bahamian IBCs do not have to pay corporate tax unless the revenue is derived locally. IBCs are also exempt from stamp and estate duties and other taxes for 20 years from their incorporation date. The benefits of IBCs established in the Bahamas also include exemptions from corporate reporting requirements and shareholder privacy. IBCs are required to list one director, and a copy of the register of directors and officers must be open to the public.

Flexibility in Legal Structure

Bahamian law allows foreign investors to establish businesses as sole proprietors as well. Investors need to obtain a business license and register their businesses. Foreign sole proprietors also enjoy the same tax exemptions as foreign individuals and business entities. Investors must get approval from the Bahamas Investment Authority for business ventures, as some business areas are reserved for Bahamian citizens.

Protection From Real Estate Taxes

Foreign investors can also buy property in the Bahamas without restrictions. The government levies a graduated stamp tax on all real estate transactions. The stamp tax is between 2.5 and 10%. The U.S. Department of State also flagged a number of economic incentives including “incentives for investment including…property tax abatement”.

No Capital Gains Taxes

The absence of capital gains tax in the Bahamas makes it an appealing destination for investors. Capital gains tax is typically levied on the profit made from the sale of assets such as stocks, real estate, or other investments. In the Bahamas, the government does not impose any tax on the capital gains realized from these transactions.

Strong Confidentiality and Privacy

The Bahamas has historically promoted confidentiality and privacy in financial matters. Strong legal measures have made it illegal for financial institutions to disclose client information without proper authorization, and corporate entities are offered a degree of anonymity for shareholders and directors. In many cases, entities can transact, invest, or shelter funds within Bahama’s financial structure in privacy without personally identifiable information (PII) being disclosed.

Note that there may be circumstances in which personal data may be released. For example, the Bahamas passed the Data Protection Act in 2003, though there is a list of exceptions where disclosure of personal data is warranted. Some of these exceptions include protecting the international relations of the Bahamas, protecting from injury or health of someone, or complying with the opinion of the Minister of National Security.

Political Stability

Investors are drawn to tax havens with political stability. Locations with unpredictable legislative tendencies or higher risk of geopolitical strife increase the risk an investor faces by putting their money into the hands of that country (and its government).

The Bahamas is a parliamentary democracy and a constitutional monarchy with a political system that closely resembles that of the United Kingdom. The country gained independence from British rule in 1973. The country has regular elections, a multi-party system, and a commitment to democratic principles. In all, it’s a low-risk environment ripe for investments.

Does the Bahamas Have Corporate Income Tax?

No, the Bahamas does not impose corporate income tax on profits earned by businesses operating within its jurisdiction.

Are There Personal Income Taxes in the Bahamas?

No, individuals in the Bahamas are not subject to personal income tax on their earnings.

How Does the Absence of Capital Gains Tax in the Bahamas Benefit Investors?

Without capital gains taxes, investors are able to more freely buy and sell securities without tax implications. This means a greater portion of capital is retained by investors, allowing them to further invest, perpetuating investment growth.

How Has the Bahamas Encouraged Financial Transparency?

There have been international efforts to combat tax evasion and enhance financial transparency. In response, the Bahamas has taken steps to align with some of these global standards. The Bahamas are aligning with some initiatives such as the Common Reporting Standard (CRS) developed and approved by the OECD.

The Bottom Line

The Bahamas is recognized as a tax haven because of its favorable financial environment. This includes the absence of corporate and personal income taxes, no capital gains tax, and a historically strong commitment to banking secrecy. The Bahamas is also known for being politically stable.

Housing, food, cars, and entertainment top the list

Reviewed by Brandon Renfro

Consumer goods are products manufactured and sold for final consumption by the purchaser.

According to the U.S. Bureau of Labor Statistics, an American household earning an average annual income of $101,805 before taxes spent about $77,280 on consumer expenditures in 2023 (the latest data available). Housing costs accounted for about a third (33%) of the total expenditures. Transportation accounted for 17%, and food accounted for nearly 13%.

Key Takeaways

• Non-durable consumer goods are consumed immediately or have a life span of fewer than three years. Take, for example, food and clothing.
• Durable consumer goods have a life span of over three years—for example, cars and furniture.
• On average, American households spend a third of their expenditures on housing.

What Are Consumer Goods?

Consumer goods are also known as retail goods and include food, clothing, electronics, jewelry, personal hygiene products, household cleaning products, furniture, books, magazines, tools, and outdoor equipment. The purchasers of consumer goods do not resell the goods but will use them daily. Expenditures on consumer goods account for nearly one-third of total consumer spending annually.

Consumer goods include durable and non-durable consumer goods. Durable consumer goods are products with a lifespan greater than three years, such as cars, furniture, and appliances. Non-durable consumer goods are consumed immediately, like food and clothing.

Important

In the United States, measuring the amount of money spent on consumer goods is key to calculating the country’s gross domestic product (GDP), which measures the size of the economy and growth rate.

Consumer Spending

A subcategory of consumer goods, consumer staples, are products that people consider essential. They’re what people buy the most. These products include beverages, food, household items, and tobacco. Other consumer goods that people buy regularly include cleaning products, personal hygiene items, and clothing.

According to the U.S. Bureau of Labor Statistics, an American household earning an average income of $101,805 before taxes in 2023 (the latest available data) allocated annual spending on average to:

• Food at home: $6,053
• Food away from home: $3,933
• Apparel and services: $2,041
• Vehicle purchases: $5,539
• Gasoline: $2,449
• Personal care products and services: $950
• Entertainment (including pets): $3,635

What Affects Consumer Spending?

Consumer spending can reflect fluctuations in economic conditions. Expenditures for jewelry, electronics, and automobiles are typically subject to the greatest fluctuations. These are areas where consumers tend to cut back their expenses substantially during difficult economic times when they have less disposable income remaining after paying for basic expenses such as food, housing, and utilities.

Why Is Consumer Spending Used as an Economic Indicator?

Consumer spending, which includes consumer goods and other expenditures like housing and transportation, is reported monthly and considered a leading economic indicator. The goods and services purchased in the United States help gauge the economy’s strength.

How Can the U.S. Government Boost Consumer Spending?

During periods when the overall economy and consumer spending are sluggish, the U.S. government sometimes attempts to stimulate spending through tax cuts. Such tax cuts can increase consumer spending and boost the overall economy. The effectiveness of this tactic is limited during times of high unemployment since the effects of higher unemployment tend to offset extra consumer spending by those who are employed.

How Much Do Americans Spend on Travel?

In 2024, the average trip cost for Americans in was $5,861. That’s 25% higher than 2023 and 39% higher than 2022, according to a survey by Squaremouth, a travel insurance marketplace.

How Much Do Americans Spend on Dining Out at Restaurants?

In 2023, on average, American families spent $3,933 on food away from home, according to the U.S. Bureau of Labor Statistics. That comes out to $327.75 per month. That’s significantly more than what a 2024 survey by US Foods found: $191 per month. (In 2023, it was $166 per month.) According to the US Foods survey, in 2024, women spent a third (33%) more on average every month than men did. (In 2023, men spent 19% more on average every month than women did.)

The Bottom Line

Consumer goods include durable and non-durable consumer goods. In 2023, Americans spent one-third (33%) of their expenditures on housing. An additional 30% was spent on food and transportation. Changes in consumer spending reflect economic conditions and are monitored by the Bureau of Labor Statistics and the Bureau of Economic Analysis.

Reviewed by David Kindness
Fact checked by Vikki Velasquez

For an auditor, inherent risk is the risk of a material mistatement at the assertion and financial statement levels. Assertions are claims made by business owners or executives that state information provided during an audit is accurate. There is always a risk of financial statement inaccuracy, even when controls are implemented.

Key Takeaways

• Auditors work to ensure that corporate controls exist and that financial statements are free from errors, fraud, and misstatements.
• Inherent risk is inevitable, and occurs even when there are controls in place.
• An auditor’s knowledge and judgment of the industry, corporate transactions, and company assets can help determine inherent risk.
• Companies with complicated business structures and transactions tend to have more inherent risk.
• Lowering inherent risk often involves reevaluating existing internal controls and implementing new practices.

How Inherent Risk Is Assessed

The Public Company Accounting Oversight Board oversees the audits of publicly traded companies, brokers, and dealers and publishes standards for auditors to follow. According to the standards published, “The auditor assesses inherent risk using information obtained from performing risk assessment procedures and considering the characteristics of the accounts and disclosures in the financial statements.”

An auditor’s risk assessment procedures must include:

• Obtaining an understanding of the company and its environment (events, conditions, and activities in the industry, and regulatory concerns)
• Obtaining an understanding of internal control over financial reporting
• Considering information from the client acceptance and retention evaluation, audit planning, activities, past audits, and other engagements performed for the company
• Performing analytical procedures
• Conducting a discussion among engagement team members regarding the risks of material misstatement
• Inquiring of the audit committee, management, and others within the company about the risks of material misstatement

The auditor must also be very familiar with:

• The industry as a whole
• The types of transactions that occur within a particular company
• The assets the company owns
• Generally accepted accounting principles

Note

Material misstatements are errors or fraudulent entries in financial statements that can impact people who use the statements to make decisions.

Based on their assessment, an auditor regards each audit area as either low, medium, or high in inherent risk (some use only high and low, normal and high, or other combinations). Inherent risk is high whenever there is a higher chance of material misstatements. It can also increase for companies with complex and dynamic day-to-day operations.

Why Inherent Risk Matters

There are risks present even if an auditor clears a company’s financial statements of any material misstatements. This is known as audit risk. Despite being given the all-clear, statements may still have some inconsistencies. Audit risk can be divided into three categories: control risk, detection risk, and inherent risk.

The risk that a company’s internal practices and controls don’t prevent any misstatements is called control risk. Detection risk, on the other hand, is the risk of an auditor failing to detect any risks. Inherent risk is any risk of error or fraud that occurs naturally when inadequate risk management is in place to mitigate it. Put simply, there is a risk of material misstatements happening when preparing financial statements.

Important

While companies can’t prevent inherent risk altogether, they can lower its level. Implementing or increasing internal controls is one of the best ways that companies have to reduce the level of inherent risk in their statements.

Examples of Inherent Risk Factors

Assessing inherent risk tends to be a more subjective process than other components of the audit. However, there are often clear and observable factors to consider, such as the economy, the industry, and previously known misstatements that help the auditor arrive at an assessed level of inherent risk for each audit area.

Here are a few examples of inherent risk that exist within the corporate world. The following are types of factors that auditors consider as they assess inherent risk:

• Financial transactions that require complex calculations are inherently more likely to be misstated than simple calculations.
• Cash on hand is, by nature, more susceptible to theft than a large inventory of coal.
• Rapid technological developments may create a higher risk of inventory becoming obsolete more quickly than in other industries.
• A struggling company may inherently have a greater incentive to misstate financial information to meet certain covenants.
• A company that has improperly reported a particular balance in the past may be inherently more likely to misstate it again.

What Best Describes Inherent Risk?

Inherent risk is the chance that a material misstatement exists due to a lack of controls that would prevent the error or fraud.

What Is a Simple Example of Inherent Risk?

A simple example of inherent risk is an internal accountant who makes fraudulent or erroneous entries that create account misstatements on a company’s financial reports.

What Is Meant by Inherent Risk?

Inherent risk is the unavoidable risk of material misstatements on financial statements due to a lack of appropriate controls.

The Bottom Line

Auditors assess inherent risk using their experience and knowledge of accounting procedures to expose material misstatements in a company’s financial statements. The misstatements may be erroneous or fraudulent, but the risks of it occurring are inherently inevitable without implementing controls, and sometimes risks exist even when controls are in place.