401(k) Terms You Should Know
The implications of moving money around in your 401(k) or moving it between plans can be scary enough. Making the wrong decisions can cost you money. Add to that some confusing and inconsistent terminology, and it's enough to give the average investor a case of heartburn. If you mess up and take a "distribution" instead of a "rollover," it can have unwanted tax consequences.
Unfortunately, many 401(k) terms do have dual meanings. It's always best to ask questions to make sure you understand the terms before making a move. Here are some commonly used terms and their correct interpretations.
The word "distribution" is particularly confusing because it can relate to different events. Think of it as something like an umbrella for various methods of taking funds from your 401(k).
For example, funds can be distributed from your plan and moved right into a new 401(k) plan or to an IRA that you have. This is called a "rollover," and a rollover is a distribution. But it doesn't trigger any penalties because the money is not coming to you. It's moving to another investment. Contrast that with a distribution that's categorized as a "withdrawal." In this case, the funds are sent to you and you cash the check and spend the money.
And what about borrowing from your 401(k)? This is not considered a distribution—it's a loan from the plan to you, but if you leave your employment before paying back the loan, the remaining loan balance is then considered a distribution and you would owe taxes and possibly penalties.
Most of the time—but not always—the term "withdrawal" is used when you take money out of a 401(k) plan and spend it rather than roll the funds over into a new tax-deferred account. You can expect to pay taxes on the distribution when you take a withdrawal and possibly an early withdrawal penalty tax, depending on your age at the time. You typically can't take a withdrawal from a 401(k) while you're still working for the company that sponsors your plan, at least not unless the company allows hardship withdrawals.
But if you have an old 401(k) plan and you no longer work for the company or if the company closes, you can take the money out either by cashing in the account and receiving a check or by moving the funds to a new 401(k) plan or an IRA.
This usually means transferring funds between investment options within your plan. You can transfer money between different investment options in your 401(k) plan without incurring any tax liability, although some of the funds inside the plan might charge a fee if you move money too frequently. For example, a fund might require that you own it for at least 30 days and you will be charged a fee if you sell shares before that time.
The word "transfer" can 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" because you're rolling funds over from one company plan to another type of retirement plan.
Many people who have 401(k) plans aren't aware that they can move their funds to an IRA or a 401(k) with a new company when they change employers, and that such a move does not trigger taxes and penalties. This option also applies if you work for a company that goes out of business. This doesn't mean that the invested funds must be distributed to directly to you when it closes its doors.
Moving funds from one plan to another or from a plan to an IRA is a "rollover." You can avoid paying taxes and penalties when you roll the funds to an IRA or a new company plan, and the money can continue to grow for your future retirement. Or you can withdraw it as needed and only pay taxes on the amounts withdrawn as you take them.
Learn the Rules
Learn all the rules before you take action if you're thinking of taking money out of your 401(k) plan. One important rule and one that many people aren't aware of is that your plan is safe from creditors. As long as your money is in the plan, creditors and judgment holders can't reach it. So be sure to check out all your options before you cash out your 401(k). You'll want to do everything you can to keep this money protected and available for your retirement years.