Investopedia

Contributions to a traditional 401(k), but not a Roth 401(k), reduce your taxable income

Reviewed by Eric Estevez
Fact checked by Suzanne Kvilhaug

Contributions to traditional and Roth 401(k)s are not tax-deductible. Your employer will have already lowered your taxable income by the amount of your contributions to a traditional 401(k), and Roth 401(k) contributions are made after you pay taxes.

Key Takeaways

• Contributions to traditional 401(k)s or other qualified retirement plans are made with pre-tax dollars and aren’t included in your taxable income.
• If you have a Roth 401(k), contributions are made with post-tax dollars and cannot be deducted.
• Your employer will report your taxable income as part of your W-2; there is no need to track or manually deduct your 401(k) contribution from your annual wages.
• In 2025, the 401(k) maximum individual contribution amount allowable is $23,500 (up from $23,000 in 2024). There is also an allowable $7,500 catch-up contribution for individuals 50 years or older.

How 401(k) Contributions Lower Taxes

Because contributions to traditional 401(k) plans shrink your taxable income, your taxes for the year should be reduced by the contributed amount multiplied by your marginal tax rate, as per your tax bracket. 

The higher your income, and thus your tax bracket, the more significant the tax savings from contributing to a plan. For example, take a single earner who makes $208,000 a year and also contributes $5,000 annually to a plan. They were in the 32% tax bracket for 2024. Therefore, their tax saving from the contribution is $5,000 multiplied by 32%, or $1,600.

Note, however, that if you choose the Roth 401(k) option, your contributions won’t reduce your taxable income. Instead, your contributions are made with post-tax income. However, during retirement, as long as you’ve had the account for five years, distributions aren’t taxed.

There are limits to how much you can contribute to such a plan. For 2025, the annual limit is $23,500 (up from $23,000 in 2024). Those age 50 or older can make an additional catch-up contribution of $7,500.

Important

You may find you’ll pay fewer taxes on your retirement funds when it comes time to make withdrawals because working years are often the highest earning years.

Distributions From a 401(k)

Of course, you don’t escape paying taxes forever on your traditional 401(k) contributions—only until you withdraw them from the plan. When you do so, you must pay income tax on the withdrawals at your applicable tax rate at that time. If you withdraw funds when you’re younger than 59½ and don’t qualify for a hardship withdrawal, you’ll likely pay an early withdrawal penalty of 10% of the amount as well.

However, chances are you’ll pay less to withdraw funds from the plan in retirement than you did when you made the contributions. That’s because your income (and tax rate) are likely to have dropped by then, compared to your working years.

Tax Considerations

Any investment income the contributions may have earned in the years between the contribution and its distribution can also be withdrawn. Earnings and contributions are taxed at the same income tax rate.

You might consider maximizing your contributions to a retirement account as a better investment strategy than directing money to a regular brokerage account. Why? Skipping paying tax on your account contributions allows you to have more capital working on your behalf during the years leading up to retirement.

For example, a person in the 22% tax bracket with 20 years until they retire might either contribute a pre-tax $400 a month to a 401(k) plan or divert the same amount of earnings to a brokerage account. The latter option would yield a monthly contribution of $312 after paying a 22% tax.

The extra $88 per month from the 401(k) option not only increases contributions but further expands the nest egg by having a larger balance on which earnings can compound over decades. The difference between the scenarios could be significant over the long run.

Other Ways to Reduce Taxable Income

Although contributing to tax-advantaged retirement accounts is one of the best ways to reduce your taxable income, you also have other options.

Health Savings Account (HSA)

Health savings accounts (HSAs) are tax-advantaged accounts that are allowed for individuals with high-deductible health plans (HDHPs). HSAs are meant to be used for medical expenses, such as dental and prescription drugs. Contributions are made to the account tax-free. Earnings and distributions that are used for qualified medical expenses are also tax-free.

Flexible Spending Account (FSA)

Flexible spending accounts (FSAs) are another tax-advantaged account. Employers establish these accounts for employees. Contributions are made tax-free. Account withdrawals, when used for medical and dental services, are also tax-free.

Other Retirement Accounts

Other retirement vehicles may also be deductible. For example, contributions to traditional individual retirement accounts (IRAs) can also be deducted from your individual federal income tax amount. Similar to a 401(k), Roth IRAs are not deductible but instead have longer-term tax benefits.

Can I Claim 401(k) Contributions on My Taxes?

You can’t claim your contributions because they are deducted from your income by your employer, so you are not taxed on them.

How Much Does Contributing to a 401(k) Reduce Taxes?

It depends on how much you contribute and your tax bracket. The money you contribute is not counted towards your income, so it automatically reduces your tax burden by the amount you contribute.

Do I Get a Tax Credit for 401(k) Contributions?

You might get a tax credit (called a saver’s credit) on your contributions if you meet certain requirements, such as being 18 or older, not being claimed on another’s return as a dependent, and not being a student.

The Bottom Line

Traditional 401(k) contributions are automatically deducted from your taxable income. You’ll have to pay taxes on the rest of your earnings, but you’ll receive immediate, upfront tax benefits. On the other hand, Roth 401(k) contributions are not deductible but instead provide long-term tax benefits.

Reviewed by Robert C. Kelly
Fact checked by David Rubin

Four key economic concepts consumers should understand are scarcity, supply and demand, costs and benefits, and incentives. These economic forces influence our purchasing decisions and impact every moment of our lives.

Key Takeaways

• Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—explain many human decisions.
• Scarcity is a fundamental economic problem in a world with limited resources.
• Scarcity drives supply and demand, which in turn drive prices.
• Economic incentives drive changes in producer and consumer behaviors.

Scarcity

Everyone has an understanding of scarcity, whether they are aware of it or not, because everyone has experienced the effects of scarcity. Scarcity explains a basic economic problem: the world has limited resources and seemingly unlimited needs. This reality forces people to make decisions about allocating resources in the most efficient way possible so that as many of their highest priorities as possible are met.

For example, there is only so much wheat grown every year. Some people want bread, and some would prefer beer. Only so much of a given good can be made because of the scarcity of wheat. How do we decide how much wheat should be made for bread and beer? Generally, decisions are made using measured supply, expected demand, and past consumption data.

Note

Scarcity also drives trade, because a company, country, or person might have resources another doesn’t.

Supply and Demand

Market systems are generally driven by supply and demand. Regarding beer, if reports indicate people want to buy more beer this year than last year, there will likely be more demand than supply. If economic theory holds true and supply remains the same, prices would likely increase. Producers would need to ramp up production to meet the estimated demand.

Once supply meets or exceeds demand, prices would drop (as long as all other economic factors remained the same).

Although this is an overly simplified example, the relationship between supply and demand helps to explain why prices can rise and fall. The toilet paper shortage during the COVID-19 pandemic is an excellent example of supply, demand, and prices—toilet paper prices rose primarily due to consumer panic-buying.

Costs and Benefits

The concept of costs and benefits is related to the theory of rational choice (and rational expectations) that economics is based on. When economists say that people behave rationally, they mean that people try to maximize the ratio of the benefits to the costs in their purchasing decisions.

If demand for beer is high, breweries will hire more employees to make more beer, but only if the price of beer and the amount of beer they are selling justify the additional costs of their salary and the materials needed to brew more beer. Similarly, the consumer will buy the best beer they can afford to purchase, but not, perhaps, the best-tasting beer in the store.

Although economics assumes that people are generally rational, many of the decisions that humans make are actually very emotional and do not maximize our own benefit. For example, the field of advertising preys on the tendency of humans to act non-rationally. Commercials try to activate the emotional centers of our brain and fool us into overestimating the benefits of a given item.

Everything Is in the Incentives

If you’re a parent, boss, teacher, or anyone with the responsibility of supervision, you’ve probably been in the situation of offering an incentive to increase the likelihood of a particular outcome.

Economic incentives occur when producers are encouraged to supply the goods and services consumers want. When consumer demand for a good increases, the market price of the good rises (ceteris paribus), and producers are incentivized to produce more of the good because they can receive a higher price (until a certain point, where they experience diminishing returns).

On the other hand, when the increasing scarcity of raw materials or inputs for a given good drives costs up, producers might cut back on supply. The price they charge for the good would rise because demand remained the same, and consumers are incentivized to reduce consumption of that good.

Economics Is the Dismal Science

Scarcity underpins all of economics, which is one interpretation of why economics is sometimes called the dismal science. Humans are constantly making choices that are determined by their costs and benefits. On a personal level, scarcity means we must make choices based on the incentives we are given. On a market level, the impact of millions of people making choices manipulates the forces of supply and demand.

What Are the Economic Concepts of Consumers?

Consumer theory attempts to explain how people choose to spend their money based on how much they can spend and the prices of goods and services.

What Are Economic Factors for Consumers?

There are many economic factors that affect consumers, such as employment, wages, prices, and inflation.

What Are the 4 Basic Economic Activities for Consumers?

The four basic economic activities are production, distribution, consumption, and resource management.

The Bottom Line

Four economic concepts that are important to know are the relationship between scarcity, supply and demand, cost and benefit, and economic incentives. Scarcity drives supply and demand, which drive prices, which influence the decisions consumers make based on the costs and benefits of purchasing a good.

Reviewed by Erika Rasure
Fact checked by Betsy Petrick

Target Corporation’s Circle Card program is a leading loyalty program among retailers in the United States. The program is accessible to everyone and is integrated seamlessly into customers’ payment methods.

With lower barriers to entry than other loyalty programs, Target tries to build a relationship with its customers and can personalize the promotions and advertising offered to the consumer with this card.

Target’s Circle Card comes in three forms: a Mastercard credit card, a debit card, and a reloadable card. The debit card is linked to customers’ existing checking accounts. The reloadable card can be spent not only at Target, but anywhere that Visa is accepted. The Mastercard credit card can be used anywhere that accepts Mastercard, and has additional rewards on some purchases outside of Target.

Key Takeaways

• All Target cards can be used at Target stores (brick-and-mortar and online).
• The Target Circle Card comes with 5% off purchases and free two-day shipping.
• The Target debit card is linked to your checking account.
• If you regularly shop at Target, the perks of a Circle Card may be worth the high rates.

Features of the Target Circle Card

All Target cards offer 5% off purchases every day at in-store and online locations and free two-day shipping on most items. Users also have an extended return facility giving them 30 extra days to return products to Target or Target.com. However, RedCard extended returns do not apply to the following:

• Target Optical purchases
• Non-returnable items
• Contract mobile phones
• Online purchases of Supplemental Nutrition Assistance Program (SNAP) eligible
  items using both Electronic Benefits Transfer (EBT) and a RedCard for
  payment.

The Target RedCard has a late payment fee of up to $41 and a return payment fee of up to $30. Customers looking to combine the benefits of the RedCard with a more traditional credit card can sign up for a Mastercard Incorporated RedCard through TD Bank, USA.

What’s in It for Target?

Most companies use loyalty programs to collect customer data in addition to building loyalty among patrons. Target’s data collection system is thorough.

Every purchase, email, or phone call is tracked, and data is applied to algorithms for marketing and planning purposes. By collecting data, the company can personalize deals and discounts for its shoppers.

Important

You should pay off your credit card balance every month to avoid high interest charges.

How Can I Get a Target RedCard?

You can get a Target RedCard by applying online for one. The RedCard credit application is on the Target.com website. You must verify your employment and income and review the terms.

You may be approved to shop online instantly, or you may have to wait for seven to 10 days to get your card, depending on whether Target approves you automatically.

The website isn’t 100% clear on how long it may take to be approved for either RedCard if you are not automatically approved. If you are not approved it may be due to red flags on your credit report or a low credit score.

Like any credit card, you have to meet certain requirements to be approved for a new credit card. If you apply and are not instantly approved, you may get a notice that your file is “in review.”

Is the Target RedCard a Credit Card?

Yes. Target offers a RedCard credit card issued by TD Bank USA. The RedCard brand also has two other options: an in-store credit card and a debit card.

Where Can I Use My Target RedCard?

You can use a Target RedCard Mastercard credit card anywhere that takes Mastercard, and you can use your Target RedCard charge card or Target debit card at Target stores or on Target.com.

How Do I Pay My Target RedCard?

You can pay your Target RedCard charge card online. In the case of the Target RedCard debit card, the money comes immediately out of your checking account when you use it.

How Long Does It Take for the Target RedCard to Post to My Account?

Your Target RedCard may be added immediately to your account at Target if you are automatically approved.

How Do I Close My Target RedCard?

You can call Target’s toll-free number or close it via mail.

The Bottom Line

Target’s RedCard can be used for both in-store and online ordering for user convenience. Once a customer is signed up, Target begins to collect data from that individual’s profile. The program is appealing to shoppers because it provides generous discounts and community donations.

However, users should be aware of the high interest rate and the late payment fees, which could cause debt to mount if the balance is not paid off each month.

Fact checked by Michael Rosenston
Reviewed by Somer Anderson

Standard Deviation vs. Variance: An Overview

Standard deviation and variance are two basic mathematical concepts that have an important place in various parts of the financial sector, from accounting to economics to investing. Both measure the variability of figures within a data set using the mean of a certain group of numbers. They are important to help determine volatility and the distribution of returns.

However, there are inherent differences between the two. While standard deviation measures the square root of the variance, the variance is the average of each point from the mean.

Key Takeaways

• Standard deviation and variance are two key measures commonly used in the financial sector.
• Standard deviation is the spread of a group of numbers from the mean.
• The variance measures the average degree to which each point differs from the mean.
• While standard deviation is the square root of the variance, variance is the average of the squared difference of each data point from the mean.
• The two concepts are useful and significant for traders, who use them to measure market volatility.

Standard Deviation

Standard deviation is a statistical measurement that looks at how far a group of numbers is from the mean. Put simply, standard deviation measures how far apart numbers are in a data set.

This metric is calculated as the square root of the variance. This means you have to figure out the variation between each data point relative to the mean. Therefore, the calculation of variance uses squares because it weighs outliers more heavily than data that appears closer to the mean. This calculation also prevents differences above the mean from canceling out those below, which would result in a variance of zero.

But how do you interpret standard deviation once you figure it out? If the points are further from the mean, there is a higher deviation within the data. But if they are closer to the mean, there is a lower deviation. So the more spread out the group of numbers are, the higher the standard deviation.

Variance

A variance is the average of the squared differences from the mean. To figure out the variance, calculate the difference between each point within the data set and the mean. Once you figure that out, square and average the results. Using software like Excel can help you in this process.

For example, if a group of numbers ranges from one to 10, you get a mean of 5.5. If you square the differences between each number and the mean and find their sum, the result is 82.5. To figure out the variance:

• Divide the sum, 82.5, by either N (population variance) or N-1 (sample variance).
• In this example, N is 10 and N-1 would be 9.
• The result is a sample variance of 82.5/9 = 9.17 and a population variance of 8.25.

Note that the standard deviation is the square root of the variance, so the standard deviation is about 3.03 for a sample data set. The standard deviation for a population data set would be 2.87.

The sample formula is used when the data set represents a random sample from the entire population in question. The population formula is used when there is data from the entire population being studied or considered.

Important

The mean is the average of a group of numbers and the variance measures the average degree to which each number is different from the mean. The extent of the variance correlates to the size of the overall range of numbers, which means the variance is greater when there is a wider range of numbers in the group, and the variance is less when there is a narrower range of numbers.

Key Differences

Other than how they’re calculated, there are a few other key differences between standard deviation and variance. Here are some of the most basic ones.

• Variance shows how much the values of a data set vary from each other, while standard deviation reflects how much they vary from the mean.
• Standard deviation is the square root of the variance and is expressed in the same units as the data set. Variance can be expressed in squared units or as a percentage (especially in the context of finance).
• Standard deviation can be greater than the variance since the square root of a decimal is larger (and not smaller) than the original number when the variance is less than one (1.0 or 100%).
• The standard deviation is smaller than the variance when the variance is more than one (e.g., 1.2 or 120%).

The table below summarizes some of the key differences between standard deviation and variance.

Key Differences Between Standard Deviation and Variance
	Standard Deviation	Variance
What Is It?	The square root of the variance	The average of the squared differences from the mean
What Does It Indicate?	The spread between numbers in a data set	The average degree to which each point differs from the mean
How Is It Expressed?	The same as the units in the data set	In squared units or as a percentage
What Does It Mean?	A low standard deviation (spread) means low volatility, while a high standard deviation (spread) means higher volatility	The degree to which returns vary or change over time

Standard Deviation and Variance in Investing

These two concepts are of paramount importance for both traders and investors. That’s because they are used to measure security and market volatility, which plays a large role in creating a profitable trading strategy.

Standard deviation is one of the key methods that analysts, portfolio managers, and advisors use to determine risk. When the group of numbers is closer to the mean, the investment is less risky. But when the group of numbers is further from the mean, the investment is of greater risk to a potential purchaser.

Securities that are close to their means are seen as less risky, as they are more likely to continue behaving as such. Securities with large trading ranges that tend to spike or change direction are riskier.

Note

Risk in and of itself isn’t necessarily a bad thing in investing. That’s because riskier investments tend to come with greater rewards and a larger potential for payout.

Standard Deviation vs. Variance Example

To demonstrate how both principles work, let’s look at an example of standard deviation and variance.

Suppose you have a series of numbers and you want to figure out the standard deviation for the group. The numbers are 4, 34, 18, 12, 2, and 26. We need to determine the mean or the average of the numbers. In this case, we determine the mean by adding the numbers up and dividing it by the total count in the group:

(4 + 34 + 18 + 12 + 2 + 26) ÷ 6 = 16

So the mean is 16. Now subtract the mean from each number, then square the result:

• (4 – 16)² = 144
• (34 – 16)² = 324
• (18 – 16)² = 4
• (12 – 16)² = 16
• (2 – 16)² = 196
• (26 – 16)² = 100

Now we have to figure out the average or mean of these squared values to get the variance. This is done by adding up the squared results from above, then dividing it by the total count in the group (population variance) or the total count minus one (sample variance):

Population Variance = (144 + 324 + 4 + 16 + 196 + 100) ÷ 6 = 130.67

Sample Variance = (144 + 324 + 4 + 16 + 196 + 100) ÷ 5 = 156.8

This means we end up with a population variance of 130.67 and sample variance of 156.8. To figure out the standard deviation, we have to take the square root of the variance, which is 11.43 (population variance) or 12.52 (sample variance).

Explain Like I’m Five

Standard deviation and variance are both ways of measuring how closely a set of data points are clustered around their mean, or average. The larger the variance/standard deviation, the more widely those points are spread out. Investors use both metrics to measure the risks of investments: A low variance means that an investment is likely to behave as predicted, while a large variance means less certainty in the possible outcomes.

The main difference is in how they are calculated: standard deviation is the square root of variance.

What Does Variance Mean?

The simple definition of the term “variance” is the spread between numbers in a data set. Variance is a statistical measurement used to determine how far each number is from the mean and from every other number in the set. You can calculate the variance by taking the difference between each point and the mean. Then square and average the results.

What Does Standard Deviation Mean?

Standard deviation measures how data is dispersed relative to its mean and is calculated as the square root of its variance. The further the data points are, the higher the deviation. Closer data points mean a lower deviation. In finance, standard deviation calculates risk so riskier assets have a higher deviation, while safer bets come with a lower standard deviation.

What Is Variance Used for in Finance and Investing?

Investors use variance to assess the risk or volatility associated with assets by comparing their performance within a portfolio to the mean. For instance, you can use the variance in your portfolio to measure the returns of your stocks. This is done by calculating the standard deviation of individual assets within your portfolio as well as the correlation of the securities you hold.

What Are the Shortcomings of Variance?

The variance of an asset may not be a reliable metric. Calculating variance can be fairly lengthy and time-consuming, especially when there are many data points involved. Variance doesn’t account for surprise events that can eat away at returns and it is often hard to use in a practical sense—not only is it a squared value, but so are the individual data points involved.

The Bottom Line

The standard deviation and variance are two different mathematical concepts that are both closely related. The variance is needed to calculate the standard deviation. These numbers help traders and investors determine the volatility of an investment and allow them to make educated trading decisions.

Correction— Oct. 20, 2024: This article has been corrected to give the correct formulas for calculating standard deviation and variance.

Fact checked by Betsy Petrick
Reviewed by Lea D. Uradu

Earnest money represents a good faith deposit by a homebuyer to sign a purchase agreement letter. An earnest money deposit shows a buyer’s level of seriousness in purchasing the home from the seller.

Earnest money deposits are relatively common in competitive markets, especially when a seller has concerns that a buyer may make multiple offers on other properties.

The real estate agent places the earnest money in an escrow account and cannot release it until both parties provide written permission.

However, the real estate agent or broker may return the earnest money, depending on the circumstances, such as if the home sale falls through because of a failed home inspection or a low appraisal.

Key Takeaways

• Earnest money represents a good faith deposit made by a homebuyer, showing the buyer’s level of seriousness in purchasing the home from the seller.
• Earnest money goes into an escrow account, usually held by the real estate broker or the title company. 
• If the home sale falls through because the house fails to pass a home inspection, the earnest deposit may get returned to the buyer.
• If the home sale goes through, the earnest money often gets applied to the closing costs or purchase price.

Earnest Money Deposits

Earnest money represents a deposit made by a homebuyer indicating the intent to purchase the property from the seller. If the sale goes through, the earnest money gets applied to the purchase price, down payment, or closing costs.

How Much Are Earnest Money Deposits

The rules that govern earnest money deposits in real estate transactions vary from state to state, but an earnest money deposit can range from 1% to 10% of the home’s purchase price.

For example, if you buy a $400,000 home, you may pay $4,000 to $40,000 as an earnest money deposit to show the seller you intend to buy the property.

Paying Earnest Money

Although uncommon, you may buy a home without putting down earnest money, but the seller must waive the earnest money deposit.

Potential homebuyers are discouraged from giving earnest money in cash directly to a seller for multiple reasons, such as it may prove challenging to get your money back if the deal falls through.

Instead, the real estate agent or broker acts as an escrow agent in accepting the earnest money deposit on the seller’s behalf and placing the funds in an escrow account.

Warning

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report, either to the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development (HUD).

The Release of Earnest Money

Although few universal rules exist for handling earnest money, the rules should be outlined in the home’s sales and purchase agreement. The agreement covers how to handle refunds and the parameters that determine whether the money gets returned.

The broker should seek a written release from both parties before releasing the earnest money deposit. If both parties claim the deposit, the broker should not release the funds until the two sides have come to terms or until a court order decides who gets the funds.

When Earnest Money Gets Returned to the Buyer

• The home appraisal value comes in lower than the purchase price agreed by the buyer, and the two parties cannot agree on a new price
• A failed home inspection, whereby significant issues arise, and the seller refuses to lower the price or make repairs
• If the buyer cannot sell their existing home
• If the buyer cannot secure a mortgage loan or financing to buy the property

When Earnest Money Gets Forfeited

• The buyer backs out of the purchase because they found another property
• The buyer agreed that the earnest money deposit was nonrefundable
• The buyer breaks a contractual agreement or deadline without a valid explanation

Important

Another reason to release earnest money is under instruction from a court order, which can occur if the deal turns contentious or unforeseen issues arise.

What Is the Difference Between Earnest Money and a Down Payment?

The down payment represents the amount a buyer puts down at the loan closing. Some mortgage lenders require a borrower to put down 10% to 20% of the purchase price as a down payment.

However, earnest money is optional and represents a deposit showing the seller the buyer plans on going through with the purchase. In return, the seller might take the property off the market.

How Much Do You Need to Pay in Earnest Money?

Although it can vary depending on how competitive the market is for a home, earnest money deposits can range from 1% to 10% of the purchase price.

Do I Get My Earnest Money Back if the Home Purchase Doesn’t Close?

If the transaction doesn’t close because the seller didn’t fulfill their obligations, the buyer can usually get the earnest money deposit returned.

However, if the transaction fails to close due to the buyer’s breach of contract, such as choosing another property and failing to go through with the purchase, the seller may not return the earnest money deposit.

The Bottom Line

Earnest money represents a deposit made by a homebuyer to show the seller they’re serious about buying the home. Earnest money deposits are not mandatory but are fairly common in competitive markets.

The real estate agent or broker who accepts the earnest money deposit on the seller’s behalf places the money in an escrow account. If the purchase goes through, the earnest money typically gets applied to the closing costs or purchase price.

Reviewed by Michael J Boyle
Fact checked by Yarilet Perez

What Is the Balance of Payments (BOP)?

The balance of payments (BOP) is the method countries use to monitor all international monetary transactions in a specific period. The BOP is usually calculated every quarter and every calendar year.

All trades conducted by both the private and public sectors are accounted for in the BOP to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and if a country has paid or given money, the transaction is counted as a debit.

Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice, this is rarely the case. Thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

Key Takeaways

• The balance of payments (BOP) is the record of all international financial transactions made by the residents of a country.
• There are three main categories of the BOP: the current account, the capital account, and the financial account.
• The current account is used to mark the inflow and outflow of goods and services into a country.
• The capital account is where all international capital transfers are recorded.
• In the financial account, international monetary flows related to investment in business, real estate, bonds, and stocks are documented.

How the Balance of Payments (BOP) Is Divided

The BOP is divided into three main categories:

• Current account
• Capital account
• Financial account

Within these three categories are subdivisions that account for a different type of international monetary transaction. As an example, the current account includes a goods and services account, a primary income account, and a secondary income account.

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold, or given away, possibly in the form of aid. Services refer to receipts from tourism, transportation, engineering, business service fees, and royalties from patents and copyrights.

Goods and services together make up a country’s balance of trade (BOT). The BOT is typically the biggest bulk of a country’s balance of payments, as it makes up total imports and exports. If a country has a BOT deficit, it imports more than it exports, and if it has a BOT surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks—in the form of dividends—are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly workers’ remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of nonfinancial assets—for example, a physical asset such as land—and non-produced assets, which are needed for production but have not been produced, such as a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured damage to fixed assets.

The Financial Account

In the financial account, international monetary flows related to investment in business, real estate, bonds, and stocks are documented. Also included are government-owned assets, such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund (IMF), private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

How the BOP Is Balanced

The current account should be balanced against the combined capital and financial accounts; however, as mentioned above, this rarely happens. We should also note that with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies.

If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.

Liberalizing the BOP

The rise of global financial transactions and trade in the late 20th century spurred BOP and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom, developing countries were urged to lift restrictions on capital- and financial-account transactions to take advantage of these capital inflows.

Important

Some economists believe that the liberalization of BOP restrictions eventually lead to financial crises in emerging market nations, such as the Asian financial crisis.

Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and nonfinancial assets. The regulations also limited the transfer of funds abroad.

With capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors but also giving rise to foreign direct investment (FDI).

For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation’s overall gross domestic product (GDP) by allowing for greater volumes of production. Liberalization can also facilitate less risk by allowing greater diversification in various markets.

Explain Like I’m Five

The balance of payments measures how money flows across a country’s borders over a specific period of time. It records the value of a country’s exports and imports, as well as the flows of investments and loans, and remittances by workers. Economists use the balance of payments to assess how a country is interacting with the world market.

What Is the Balance of Payments (BOP) Used for?

The BOP looks at an economy’s transactions with the rest of the globe. It is an important indicator of an economy’s health.

What Are the Main Components of the BOP?

There are three main components of the BOP: the financial account, the capital account, and the current account. The combination of the first two should balance with the third, but that doesn’t always happen.

What Is the Most Important Part of the BOP?

The balance of trade (BOT)—which is the total of imports and exports—is the biggest part of the BOP. It makes it clear whether a country has a trade surplus or deficit.

What Does a Trade Deficit Mean?

A trade deficit happens when the value of a country’s imports is greater than the value of its exports—in other words, it has more money going out than coming in. When the value of exports is greater than the value of imports, it is called a trade surplus.

Is a Trade Deficit Bad?

A trade deficit is not inherently bad, but it comes with tradeoffs that can sometimes have negative consequences for a nation’s economy. Countries with large trade deficits typically rely on overseas markets to provide a large share of consumer goods, which can harm domestic industries and lead to unemployment. Conversely, a trade deficit also allows domestic consumers to have access to a wider variety of in-demand goods. For example, the United States typically imports most of its labor-intensive manufactured goods, because these are more affordable in the overseas market.

The Bottom Line

The balance of payments (BOP) is the method by which countries measure all of the international monetary transactions within a certain period. The BOP consists of three main accounts: the current account, the capital account, and the financial account. The current account is meant to balance against the sum of the financial and capital account but rarely does.

Globalization in the late 20th century led to BOP liberalization in many emerging market economies. These countries lifted restrictions on BOP accounts to take advantage of the cash flows arriving from developed foreign nations, which in turn boosted their economies.

Reviewed by Thomas Brock
Fact checked by Suzanne Kvilhaug

Do You Include Working Capital in Net Present Value (NPV)?

The change in a company’s annual net working capital is used when calculating net present value using the unlevered discounted cash flow (DCF) approach. DCF is the present value of a company’s future cash inflow and is used by analysts when estimating a business’s net present value.

Key Takeaways

• Net present value is the forecasted value of a business’s future cash flows brought back to present value.
• Working capital is the difference between a company’s current assets and its current liabilities.
• Change in net working capital is used when calculating a discounted cash flow model to calculate a business’s net present value (NPV).

Net Present Value

Net present value (NPV) is the forecasted value of a business in the future, brought back to the present (called discounting). It is most often calculated using a discounted cash flow model. NPV is based on the assumption that money today is worth more than money in the future. This is due to assumed inflation and lost opportunity cost—the value of potential gains given up when making a choice.

Important

When determining net present value, it is necessary to forecast using the three main financial statements: the balance sheet, statement of cash flows, and income statement. Generally, analysts will not go too far into the future with their assumptions, usually between five and 10 years. An analyst makes assumptions about the line items on future statements of cash flows and income statements, which are reflected on the future balance sheets under current assets and current liabilities. In turn, changes in net working capital occur.

A positive NPV indicates a profitable investment, while a negative NPV indicates a loss-producing investment. To account for the time value of money, analysts often apply a discount rate when calculating the value of money in the future.

Using NPV to value investments has its advantages, but there are drawbacks as well. NPV calculation relies heavily on assumptions and estimates. Several factors could affect the future value of an investment that is not predicted by the model. For example, the longer the time frame of the investment, the more risk there is.

Net Working Capital

Working capital is the difference between a company’s current assets and its current liabilities. Current assets can include things like cash, accounts receivable, and inventories. Current liabilities can include items like accounts payable or other debts. Working capital is calculated by simply subtracting current liabilities from current assets.

Changes in net working capital (NWC) are used when calculating NPV using the DCF model. There are several formula variations an analyst can use, depending on their preferences:

• NWC = Current Assets – Current Liabilities
• NWC = Current Assets (less cash) – Current Liabilities (less debt)
• NWC = Accounts Receivable + Inventory – Accounts Payable

The analyst then determines the changes in estimated NWC over the periods being forecast.

NWC Effect on NPV

If net working capital increases, the company has more cash outflow. If net working capital decreases, the company has more cash inflow.

Accordingly, cash flow decreases as accounts receivable increase or accounts payable decrease. Therefore, as working capital changes from period to period, it has an effect on a business’s net working capital, which in turn affects NPV.

Is CapEx Included in NPV Calculation?

Capital expenditures are included in a net present value calculation because they are deducted from free cash flow, which is used when using the discounted cash flow model.

What Should Not be Included in the NPV Calculation?

Some items that should not be included in NPV are financing costs, sunk costs, and depreciation expenses.

Does NPV Include Cost of Capital?

NPV can be calculated using a company’s weighted average cost of capital as the discount rate.

The Bottom Line

Net present value is not an easy thing to calculate because there is a laundry list of assumptions that must be made. Analysts must forecast line items for future financial statements and estimate changes in forecasted annual net working capital to calculate a business’s net present value.

Reviewed by Brandon Renfro
Fact checked by Vikki Velasquez

Retirement can evoke images of a relaxing, debt-free life with no monthly mortgage payment, assuming you have already paid it off. However, some financial planners suggest retirees continue to carry a mortgage into and throughout retirement.

Reinvesting the proceeds from your home equity to generate a stream of income might make your golden years more golden.

Carrying a mortgage in retirement has benefits in certain situations but can come with drawbacks since no one-size-fits-all solution exists for increasing retirement income.

Key Takeaways

• Carrying a mortgage into retirement may help you increase your income by reinvesting the equity from a home.
• Carrying a mortgage into retirement also allows you to benefit from the mortgage interest tax deduction.
• On the downside, investment returns can fluctuate while your mortgage payment remains fixed. 
• A diversified portfolio may provide greater returns than your mortgage rate, but you could experience investment losses and still need to repay your loan.

You Can’t Eat Your Home

The basic concept behind taking out a home equity loan is “you can’t eat your home.” Your home equity generates no income unless you borrow against it and invest the funds. Since home equity typically makes up a substantial portion of a retiree’s net worth, it may serve as a drag on income, net worth growth, and overall quality of life in retirement.

Important

Carrying a mortgage during retirement may prove troublesome if investment returns fluctuate, leading to an inability to repay the mortgage or uneasiness related to carrying so much debt during a market downturn. 

As a homeowner, you could shift your assets from your home by taking out a mortgage loan and investing the money in securities. The theory is that the investment return should outperform the after-tax cost of the mortgage, enhancing your net worth and cash flow. Additionally, you can readily liquidate investments like some mutual funds and exchange-traded funds (ETFs) to meet your spending needs. 

This strategy sounds attractive, but it’s not simple since you’re introducing more leverage into your finances. Before considering taking out a mortgage or equity loan on your house to invest or spend the funds, consider the pros and cons of carrying a mortgage in retirement.

Pros of Carrying a Mortgage into Retirement

A properly diversified investment portfolio may outperform residential real estate returns over the long term. For example, if residential real estate generates single-digit annual rates of return while your diversified portfolio performs much better, some homeowners might prefer to carry a mortgage in retirement.

Having a mortgage loan in retirement also has tax benefits since the interest is tax-deductible, which can serve to minimize the cost of borrowing. A tax break can also increase the overall return on investment for your securities.

Finally, from an investment point of view, you could consider a single property as undiversified, which is bad news if it comprises a substantial portion of your net worth. Diversification can help you maintain financial stability and peace of mind.

Cons of Carrying a Mortgage into Retirement

Despite the potential benefits, having a mortgage in retirement strategy can cause some unpleasant side effects. Using this strategy can increase your total asset exposure to include your house and investments.

However, taking out a mortgage is another form of leverage, which can increase your total risk exposure and complicate your financial life. Also, the income earned from your investments will fluctuate, and you could lose all or a portion of your invested funds. Prolonged market downturns can negatively impact your retirement portfolio and be challenging to manage. 

Furthermore, the Tax Cuts and Jobs Act of 2017 mitigated the deductibility advantage. Taxpayers can deduct interest on $750,000 of qualified residence mortgage (down from $1 million). The act also suspended the deduction for interest paid on home equity loans and lines of credit unless they are used to buy, build or substantially improve the home, securing the financing.

Pros

• Investment returns can exceed the mortgage rate

• Mortgage interest tax deduction

• More diversified with both a home and investments

Cons

• Increases your leverage or debt

• Risk of investment loss

• Fewer tax deductions on home equity loans

Investment Returns vs. Mortgages

Keep in mind that investment returns can fluctuate significantly in the short term, while mortgages tend to remain fixed. It is reasonable to expect periods of time when your portfolio substantially underperforms the mortgage cost.

The Psychology of Leverage

Periods of market underperformance can erode your financial base and potentially jeopardize your ability to keep up with payments. This volatility could also compromise your peace of mind, make you nervous during a market downturn and lead you to sell your portfolio to pay off your mortgage.

As a result, you would miss out on the benefits of a recovery in your investments, potentially decreasing your net worth instead of increasing it. It’s important not to underestimate the unsettling psychological influence of leverage.

Hurdle Rate

There are many objective financial factors you need to take into consideration to determine the merit of this strategy in your given financial situation. While some financial planners may issue the same advice across the board, this strategy is not appropriate for everyone.

An important consideration includes determining your total mortgage interest cost since this represents the hurdle rate your investment portfolio must overcome to achieve a net positive gain. The factors that affect your mortgage rate include your creditworthiness and prevailing mortgage interest rates.

Of course, the better your credit, the lower your total interest cost. Furthermore, the higher your tax bracket, the more tax benefit you receive from the interest write-off. 

Tapping Your Home Equity During Retirement 

First, speak with your loan officer and accountant to determine your mortgage interest cost—net of the tax benefit—which will tell you how much your investment portfolio needs to earn to pay the mortgage interest rate charges. Next, consult an investment advisor to discuss outperforming this investment hurdle.

Risk Tolerance and Rate of Return

Knowing your desired rate of return is simple enough, but whether you can reasonably achieve that rate of return or tolerate the necessary risk is another story. Generally speaking, beating your mortgage cost may require a larger allocation to equities, which can lead to portfolio volatility.

Most retirees are unlikely to accept such levels of volatility, especially since they have less time to ride out the market’s ups and downs. Another factor to consider is that most financial advisors rely on historical averages to estimate a portfolio’s future return. In other words, do not totally rely on return expectations. 

Determine Your Net Worth

Finally, the last major consideration is determining the percentage of your total net worth your home represents. The larger the percentage of your net worth your home represents, the more important this decision becomes.

For example, if you have a $2 million net worth and your home only represents $200,000 of it, the net marginal gain from this strategy will probably have a minimal effect on your net worth.

However, if you have a $400,000 net worth with $200,000 from your home, investing your home equity may have a profound meaning in your financial planning.

Warning

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report, either to the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development (HUD).

Should I Include My House in My Retirement Plan?

Your home equity can help you in retirement since it often represents a large portion of your net worth. By using your home equity, you can pay for medical bills and generate income.

Does It Make Sense to Have a Mortgage in Retirement?

It can help you to have a mortgage in retirement since you can invest the funds and perhaps earn a rate of return that exceeds the interest rate on the mortgage. However, be aware that investing comes with the risk of loss.

Does Net Worth Include My Home?

Yes. Your net worth includes the value of your home minus any outstanding mortgage or home equity loans.

The Bottom Line

It’s never a good idea to blindly accept a piece of advice, even if it comes from a financial planner. The safety of carrying a mortgage into retirement depends on several factors. This strategy is not guaranteed to succeed and can substantially complicate your financial life. Most importantly, leverage is a double-edged sword, meaning you could experience investment losses, leading to dire financial consequences for a retiree.

Martha Stewart is a businesswoman and media personality

Reviewed by David Kindness
Fact checked by Michael Rosenston

Known to millions for her cooking and decorating products, books, shows, and more Martha Stewart is a successful entrepreneur who built a media empire from scratch out of the old adage “there is no place like home.” During her pinnacle as a prominent media mogul, she found her name among the world’s wealthiest and most powerful business leaders on the Forbes billionaires list.

Martha Stewart first became a self-made billionaire when her company, Martha Stewart Living Omnimedia, went public in 1999. The initial public offering raised $1.9 billion and the stock climbed to an all-time high of $39.75 per share the following day. Her net worth did significantly drop in the early 2000s but has since slightly recuperated. Her fortune in 2025 is estimated to be somewhere around $400 million.

Key Takeaways:

• Down from over a billion, Martha Stewart’s net worth is estimated to be in the vicinity of $400 million as of 2025.
• Martha Stewart first became a billionaire when her company, Martha Stewart Living Omnimedia, went public in 1999.
• Due to obstruction of justice, making false statements to federal investigators, and conspiracy to lie, Stewart served five months in jail in 2004.
• In 2015, Martha Stewart Living Omnimedia was sold to Sequential Brands Group for $350 million.
• Sequential Brands Group sold Martha Stewart Living Omnimedia in 2019 to Marquee Brands for $175 million.

Early Life and Education

Martha Stewart was born on August 3, 1941, in Jersey City, New Jersey. Even when she was just a child, Martha was making money. When she was 10 years old she often found herself babysitting for extra change.

At 13, she modeled on the side and regularly appeared in television commercials. One of her clients was the luxury fashion company, Chanel.

Following her graduation from Barnard College, she made an impressive income and learned about business as a stockbroker in New York.

Stewart’s billion-dollar empire actually started out as a small home-based catering business that she founded with a friend as her partner. The business began to see success. However, the pair split due to disagreements.

Notable Accomplishments

Publishing Powerhouse

In 1980, Martha had been hired to cater for a book release event. At the party, she met Alan Mirken, who was the head of Crown Publishing Group.

Following that night, the two began having discussions regarding the possibility of publishing a cookbook based on the recipes that Martha used for her catering events. That idea bore fruit when Martha’s first book, “Entertaining,” was published in 1982 by Crown imprint Clarkson Potter. The book went on to sell more than 625,000 copies.

From 1983 to 1989, Martha published a number of other cookbooks for Clarkson Potter. During that time she was slowly becoming a household name throughout the United States.

In addition to contributing columns on home-keeping to newspapers and magazines, Martha began to regularly appear on a handful of well-watched television programs such as “Larry King Tonight” and “The Oprah Winfrey Show.”

Martha Stewart Living Magazine

By the early 90s, Martha Stewart had achieved a great deal of fame and success. However, she was not completely satisfied. In an attempt to further extend her reach and expand her brand, she signed a magazine deal with Time Publishing Ventures, Inc.

With a quarter of a million subscribers signed up for the initial issue, Martha released Martha Stewart Living magazine in late 1990. Subscriptions for the magazine quickly grew to over two million.

Note

Martha Stewart’s career history includes being a stockbroker, starting her empire through a catering business, publishing successful cookbooks, and founding her own magazine.

Originally started as a quarterly magazine, it soon grew into a monthly publication. Each issue featured a variety of cooking recipes, decoration instructions, craft ideas, and homemaking guides.

Billionaire Status

Martha may have been the face behind her magazine and other merchandise, but she did not completely own all the rights to them. Time Warner, for example, owned and published the Martha Stewart Living magazine.

This all changed in 1997 when Stewart raised the money to purchase the rights to all of her related brands. Martha borrowed $85 million to finance the acquisition of the magazine alone.

She formed Martha Stewart Living Omnimedia in 1996, which became the holding company that housed all of her projects, publishing, and merchandise.

Three years following the formation of Martha Stewart Living Omnimedia, Stewart listed the company on the New York Stock Exchange. This allowed her many fans and followers across the country to actually own a piece of Martha’s media powerhouse.

On the day the company went public in 1999, Martha Stewart Living Omnimedia’s stock opened at $18 per share. The price soared from day one, and that growth made Martha’s 96% stake in the company worth more than a billion dollars.

Important

Martha Stewart Living Omnimedia, once valued at $2 billion, was sold for $350 million in 2015 and then again for $175 million in 2019.

Criminal Conviction

Stewart’s life and her media empire were both interrupted when Stewart was convicted of obstruction of justice, making false statements, and conspiracy for lying to investigators about her sale of shares of ImClone Systems in 2001.

She sold shares a day before the company announced a negative Food and Drug Administration ruling about one of its cancer drugs that prompted a massive sell-off in the stock. She served five months in a federal correctional facility following her conviction in 2004.

On May 31, 2018, former President Trump indicated that he might grant Stewart a presidential pardon. However, he left office without doing so. While Stewart never faced insider trading charges for the sale, she paid $195,000 to settle civil charges with the Securities and Exchange Commission.

Post-Prision Successes

Since her release from prison in March 2005, Martha Stewart has embarked on a remarkable journey of rebuilding and expanding her brand. She quickly returned to television with The Martha Stewart Show, which aired from 2005 to 2012, and also appeared in The Apprentice: Martha Stewart, although the latter was not renewed for a second season.

In addition to her television ventures, Stewart has been prolific in publishing. She released several books, including The Martha Rules in 2005, Martha Stewart Baking Handbook later that year, and Martha Stewart’s Homekeeping Handbook in 2006. Her books have been generally well-received, contributing to her enduring popularity and influence in the lifestyle industry post-scandal.

Stewart’s post-prison career has also been marked by innovative partnerships and ventures. She has collaborated with numerous brands, launching collections ranging from home decor and kitchenware to frozen foods and beauty products. Notably, she has partnered with rapper Snoop Dogg on various projects, including a line of handbags called “Best Buds Bags” and several television shows, such as Martha & Snoop’s Dinner Party and Martha & Snoop’s Potluck Party Challenge.

How Did Martha Stewart Get Famous?

Martha Stewart was a model as a child, then became a stockbroker after college, then a caterer, a cookbook author, a publisher, and a media icon.

What’s Martha Stewart’s Net Worth?

As of 2025, Martha Stewart’s net worth is estimated to be around $400 million.

How Long Was Martha Stewart in Prison?

In 2004, Martha Stewart was convicted of obstruction of justice, making false statements, and conspiracy. She served five months in a federal correctional facility.

What’s the Relationship Between Martha Stewart and Snoop Dogg?

Martha Stewart and Snoop Dogg met on Martha’s television show in 2008. Since then, they have appeared together many times on talk shows, game shows, and other events.

The Bottom Line

Stewart has made an indelible mark in the media industry as well as the lives of countless Americans looking to brighten their lives in the household.

She continues to be an entrepreneur, having launched her own podcast, becoming involved in the cannabis business, having her own TV shows, selling new products on her website, and more. A successful entrepreneur, Martha Stewart shows no signs of slowing down.

Reviewed by Andy Smith
Fact checked by Michael Rosenston

Accrual Accounting vs. Cash Basis Accounting: An Overview

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method provides an immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.

Key Takeaways

• Accrual accounting records revenue and expenses when transactions occur but before money is received or dispensed.
• Cash basis accounting records revenue and expenses when cash related to those transactions is actually received or dispensed.
• Accrual accounting provides a more accurate view of a company’s health by including accounts payable and accounts receivable.
• The accrual method is the more commonly used method by large companies, especially by publicly traded companies, as it smooths out earnings over time.
• The cash basis method is generally used by sole proprietors and smaller businesses.

Accrual Accounting

Accrual accounting is a method that records revenue when it is earned, meaning when a product or service has been delivered to a customer and there is a reasonable expectation of payment. This approach follows the principle that financial events should be recognized in the period in which they occur, regardless of when payment is received.

In this system, revenue is not dependent on the timing of cash transactions. Instead, it is recorded once the earning process is complete and the business has fulfilled its obligations to the customer. This method is especially important for companies that provide goods or services on credit or have long-term contracts, as it ensures that income is matched with the time period in which it was actually earned.

Likewise, expenses are recorded when they are incurred, not when they are paid. If a business receives goods or services in a given period, the associated expense is recognized during that same period, even if the company doesn’t make the payment right away. This matching of expenses with the revenues is at the heart of accrual accounting.

Cash Basis Accounting

In cash basis accounting, revenue is recorded only when cash is actually received. A business recognizes income at the moment payment is collected, regardless of when the product or service was delivered. This approach is an easier way to track money coming into the business and provides no discrepancies between the amount of revenue earned and the amount of cash received.

Expenses are recorded only when they are paid, not when they are incurred. This means a bill does not show in financial records until payment has been made. For example, if a company receives an invoice for services in January but doesn’t pay the bill until February, the expense would show up in February.

This method is often favored for its simplicity and ease of use, especially by small businesses and individuals managing personal finances. It requires minimal tracking of accounts receivable or payable and focuses solely on transactions that affect the actual cash balance. It also follows the logic that revenue isn’t truly “earned” until you’ve received the actual cash from the sale, regardless of what a customer actually owes you.

Note

Advanced accounting software platforms can reconcile between the two methods. As you enter transactions, you can then pull cash-basis or accrual-basis financial reports depending on your needs.

Key Differences

Timing of Revenue/Expense Recognition

In cash basis accounting, revenue is recognized only when cash is physically received. Accrual accounting recognizes revenue at the point it is earned—typically when a product is delivered or a service is performed—regardless of when payment is made. Similarly, expenses under the cash method are recorded only when the payment is actually made whereas accrual accounting records them when they’ve been incurred.

Complexity

Cash basis accounting is simpler and easier to implement. It does not require complex accounting systems or extensive record-keeping. Accrual accounting is more intricate, requiring more robust systems to track items owed to others or owed to you.

Adherance to the Matching Principle

Accrual accounting adheres to the matching principle, which requires that expenses be matched with the revenues they help generate in the same reporting period. This produces a more accurate depiction of financial performance. Cash accounting does not follow this principle.

Use of Accounts Payable and Accounts Receivable

Accounts receivable and accounts payable are integral to accrual accounting. These accounts help track money owed by customers and money owed to suppliers. These are not used in cash accounting, as transactions are recorded only when cash is exchanged so there’s never any outstanding payments or receivables.

Implications for Long-Term Contracts

For businesses that engage in long-term projects, such as construction or software development, accrual accounting offers superior financial insight. It allows them to recognize portions of revenue and associated expenses as the project progresses. Instead of potentially having to wait years until revenue is collected under cash basis accounting, incremental revenue can be recognized over the life of the long-term contract.

Regulatory Compliance

Regulatory bodies, such as the IRS in the U.S. or the SEC for public companies, often mandate the use of accrual accounting for companies above a certain size or revenue threshold. This requirement stems from the method’s ability to provide a more consistent and transparent financial picture. Cash accounting may be permissible for smaller entities but is typically not accepted for audited financial statements or filings under GAAP or IFRS.

Tax Implications

The method of accounting can significantly affect tax liabilities. Under cash accounting, income is not taxable until it is received, and expenses are not deductible until they are paid. This allows for some flexibility in managing taxable income, as businessowners could theoretically delay when they deposit a check to defer that revenue into the following period.

Recognition of Unearned Revenue

When customers pay in advance for goods or services, accrual accounting records this payment as unearned revenue—a liability—until the service is performed or the product delivered. Under cash accounting, such payments are recorded as revenue immediately. In this case, cash accounting fails to consider that the company still has an obligation to satisfy (i.e. provide the good or service that customer has prepaid for).

Use of Accruals and Deferrals

Accrual accounting incorporates both accruals and deferrals to ensure that revenues and expenses are recorded in the appropriate periods. Accruals include items like unpaid wages or earned interest, while deferrals refer to prepaid expenses and unearned income. Both types of entries are used to record revenues and expenses before the cash transaction has occurred.

Use of Depreciation and Amortization

In accrual accounting, the cost of long-term assets is allocated over their useful lives through depreciation or amortization. This aligns expenses with the periods that benefit from the asset, as the cost of a capital asset is spread over its life as it gets used. Cash accounting typically expenses the entire asset cost at the time of purchase. This can severely distort earnings, as a company may have a gigantic expense one year followed by little to no expense the next.

Note

The Tax Cuts and Jobs Act increased the number of small business taxpayers entitled to use the cash basis accounting method. As of 2024, small business taxpayers with average annual gross receipts of $30 million or less in the prior three-year period can use it.

Special Considerations

The accrual method is the more commonly used method, particularly by publicly traded companies. One reason for the accrual method’s popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they’re generated.

The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.

For example, under the cash basis method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season. However, they would look unprofitable in the next year’s Q1 as consumer spending declines following the holiday rush.

Both methods have their advantages and disadvantages. Each provides different views of the financial health of a company. For investors, it’s important to understand the impact of both methods when making investment decisions.

The vast majority of companies that people would potentially invest in will be using accrual-based accounting. However, should you come across a small company using cash-based accounting, it’s definitely something to watch out for.

Accrual Accounting vs. Cash Basis Accounting: Example

Let’s say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check.

Under the accrual method, the $5,000 is recorded as revenue as of the day the sale was made, though you may receive the money a few days, weeks, or even months later.

The same principle applies to expenses. If the company receives an electric bill for $1,700, under the cash method, the amount is not recorded until the company actually pays the bill. However, under the accrual method, the $1,700 is recorded as an expense the day the company receives the bill.

What Is Accrual Accounting?

Accrual accounting is an accounting method that records revenues and expenses before payments are received or issued. In other words, it records revenue when a sales transaction occurs. It records expenses when a transaction for the purchase of goods or services occurs.

What Is the Difference Between Cash Basis and Accrual Accounting?

Cash basis accounting records revenue and expenses when actual payments are received or disbursed. It doesn’t account for either when the transactions that create them occur. On the other hand, accrual accounting records revenue and expenses when those transactions occur and before any money is received or paid out.

Companies might also use modified accrual accounting and modified cash basis accounting.

When Does a Company Account for Revenue If It Uses Cash Basis Accounting?

Under the cash basis accounting method, a company accounts for revenue only when it receives payment for the products or services it provides a customer.

The Bottom Line

Accrual accounting and cash basis accounting are two ways to record financial transactions. They differ in when a transaction is recorded: accrual accounting when money is earned or an expense is incurred, and cash basis accounting when money is received or an expense is paid. Accrual accounting is required by law; however, there are exceptions where cash basis accounting can be used.