401(k) Terms You Should Know
Investing terminology and concepts can be confusing. Many investment types share terms but assign different meanings to them. If you're beginning to invest, signing up for a 401(k) for the first time, or need to update the one you have, you might find yourself asking what a term means.
You're not alone in this. It's easy to forget 401(k)-specific terms after you've signed up and gone back to the grind, or you may become confused if you're choosing your first retirement investment. It helps to learn the terms or refresh your memory before making a decision about your retirement plans. Here are the most common 401(k) terms.
When an employer decides—or by law is required—to set up retirement plans for employees, they become the plan's sponsor. Many employers contract retirement plan administrators to run their plans to reduce the internal costs of administering them.
If you're looking for assistance with your 401(k), you may read about contacting your plan's sponsor. This is usually a point of contact at your employer who knows more about the programs or can put you in touch with the administrators or fund managers.
A 401(k) distribution occurs when you take money out of the retirement account and use it for retirement income. The IRS counts distributions as taxable income and taxes you based on the tax bracket.
If you take money from your account before 59.5 years of age, you have made a withdrawal. The IRS taxes withdrawals as income, adding the withdrawal to your annual income. Generally, the income tax bracket you're in at that time determines the amount of taxes you pay.
The losses when withdrawing early from a 401(k) are significant. You could lose close to half of the money you withdraw due to taxes and penalties.
Withdrawals made from a 401(k) before the age of 59.5 incur a penalty of 10%. Generally, you can't make a withdrawal from a 401(k) while you're still working for the company that sponsors your plan unless the company allows hardship withdrawals.
Elective or Salary Deferrals
A deferral is the scheduled payment you make to your 401(k) plan. It is called a deferral because your employer places the money in the account for you, essentially deferring it's delivery to you. You've earned that money, and it is still yours; you can't claim it until you retire or withdraw it, however.
Deferrals are elective because employees choose to have the money deferred into their 401(k) accounts.
Some employers make 401(k) contributions to their employees' plans, up to a certain percentage of their salary or pay. This is called contribution matching. Matching is an employer option and generally comes with minimum employee contribution guidelines and a maximum employer contribution amount, i.e., your employer may provide a 50% match up to 6% of your salary, meaning your 6% deferral would get you an additional 3% of your pay from your employer.
Many employers have restrictions regarding how much money you can take with you if you leave. Commonly, there is a necessary period an employee needs to work for one employer.
You may not be able to take the amount contributed by your employer if you leave unless you are fully vested. A fully vested employee is one who has met the requirements to take 100% of their 401(k) with them if they leave.
The time needed to be vested depends on the employer and can range from a few years to more than a decade.
Rollover or Transfer
Moving funds from one employer-sponsored plan to another or from a 401(k) plan to an IRA is called a rollover—some might also call it a transfer. If your employer goes out of business or you leave to work elsewhere, you can roll your 401(k) to your new retirement account without triggering taxes or penalties.
Some retirement accounts allow you to place money that has not been taxed into them. This is known as a tax-deferred contribution. Employers deduct your contribution from your pay before they factor in taxes. The money you contribute is then taxed according to the tax bracket you're in when you retire and begin receiving distributions.
Not all 401(k) plans are tax-deferred. Check with your plan sponsor to find out.
Deferring taxes from contributions works under the assumption that you will be in a lower tax bracket when you retire. Since distributions are counted as income by the IRS, you pay fewer taxes when your money is tax-deferred.
An important regulation to become familiar with is the Employee Retirement Income Security Act (ERISA) of 1974. This act not only sets the guidelines for employers' obligations to their employees' retirements, but it also protects your retirement savings from creditors and collectors. If you or your employer declare bankruptcy, your retirement plans are safe in most cases—as long as they are ERISA-qualified plans.