401(k) Terms You Should Know - Like Distribution vs. Rollover

401(k) words that can confuse you

Women studying 401(k) terms like distribution and withdrawal.
401(k) language can be confusing. Here's what you need to know. Tetra Images/BrandXPictures/Getty Images

Moving money around in your 401(k), and moving it between plans, can be scary because the terminology used is not consistent. If you do it wrong, and take a 'distribution' instead of a 'rollover', it can have unwanted tax consequences.

Unfortunately, many 401(k) terms have dual meanings, so it's best to ask questions and make sure you understand the terms before making a move. Below are commonly used terms and their interpretations.

401(k) distribution

The word ‘distribution’ is particularly confusing because funds can be distributed from your 401(k) plan and moved right into a new 401(k) plan or IRA that you have. This is called a 'rollover'. A rollover is a distribution from the plan, but it is not a taxable distribution and does not trigger taxes and penalties.

Contrast that with a distribution categorized as a 'withdrawal', where the funds are sent to you and you cash the check and spend the money. When you take a withdrawal expect to pay taxes on the distribution and possibly an early withdrawal penalty tax, depending on your age at the time of the 401(k) withdrawal

And what about the situation where you borrow from your 401(k)? This is not considered a distribution; instead it is a loan from the plan to you. However, if you leave employment before paying back the loan, the remaining loan balance is then considered to be a distribution to you and at that time you would owe taxes and possibly penalties.

Let's take a closer look at the most common types of distributions; withdrawals, transfers and rollovers.

401(k) withdrawal

Most of the time (but not always) the term ‘withdrawal’ is used when you are taking money out of a 401(k) plan and spending it rather than rolling the funds into a new tax-deferred plan like an IRA.

A withdrawal is usually a taxable event. 

You cannot usually take a withdrawal from a 401(k) while you are still working for the company that sponsors your plan unless the company allows hardship withdrawals.

However, if you have an old 401(k) plan and you no longer work for the company you can take the money out of the plan, either by cashing in the account and receiving a check or by moving the funds to a new 401(k) plan or IRA account. 

401(k) transfer

When you hear the term ‘transfer’ applied to 401(k) money it usually means transferring funds between investment options within your 401(k) plan. You can transfer money between different investment options in your 401(k) plan without incurring any tax liability. Some of the funds inside the plan may charge a fee if you move funds too frequently. For example, a fund may require you own the fund for at least 30 days, and if you sell shares before you have owned them for 30 days you may be charged a fee.

The word transfer may also apply to transferring funds from one 401(k) to another. You have the ability to transfer funds from an old 401(k) plan to a new one (if the new plan allows this), but the terminology used is usually ‘rollover’.

You are rolling over funds from one company plan to another type of retirement plan.

401(k) rollover

Many people who have 401(k)plans are not aware that when they leave employment they can move their funds to an IRA or to a 401(k) plan with a new company they may work for – and that such a move does not trigger taxes and penalties.

If you work for a company that goes out of business, this option also applies. You can move your old 401(k) balance to an IRA. Just because the company went out of business does not mean the funds must be distributed to directly to you.

Moving funds from one plan to another, or from a plan to an IRA, is called a rollover. By rolling the funds to an IRA or new company plan you can avoid paying the taxes and penalties, and the money can continue to grow for your future retirement, or you can withdraw it as needed, and then only pay taxes on the amounts withdrawn as you use it.

If you are thinking of taking money out of your 401(k) plan, learn the rules before you take action. One rule many people are not aware of is the creditor protection provided by a 401(k) plan. Be sure to check out all your options before you cash out your 401(k). You want to do everything you can to keep this money protected and available for your retirement years.