The 5 Most Important 401(k) Terms You Should Know

The Basics of 401(k) Investing for Retirement

401k Terms
There are five major 401(k) terms you should know to better understand how your retirement savings can work for you. Alex Cao, Photodisc, Getty Images

If you are new to investing in your 401(k) plan, there are a few important concepts you should understand. By learning the basics of your 401(k) account, how it works, and how you have an opportunity to make money from investing in it, you stand a better chance of making decisions that can help you retire financially secure.

The 401(k) Matching Rate

The 401(k) matching rate is the rate at which your employer will match your contributions.

An employer that matches dollar-for-dollar, or 100%, would contribute $1.00 to your 401(k) for every $1.00 you saved, instantly doubling the money you have to invest. If your employer matched $0.50 on the dollar, or 50%, you would see an extra $0.50 deposited into your 401(k) for every $1.00 you saved through the account.

The 401(k) Matching Limitation

Companies know that 401(k) matching is a great deal. They do it to help their employees invest for retirement and to help attract talented managers and executives. But virtually all companies place a limit on the percentage of your salary you can contribute to a 401(k) plan and receive matching funds.

A common matching fund limitation for 401(k) accounts seems to be 3% of salary. Some companies go 8% of salary. It really depends upon the firm's retirement policies. To illustrate: If you earned $50,000 a year and your company matched 401(k) contributions on a 100% basis up to 3% of salary, you would receive $1 for every $1 you saved for the first $1,500 you put into your 401(k) account ($50,000 x 3% = $1,500 match limitation).

Additional money contributed above that matching threshold and below the 401(k) contribution limit wouldn't receive any matching from your employer.

401(k) Contribution Limit

Congress wants you to save for retirement, but they do put limits on the amount of money you can shelter in a 401(k) account by establishing so-called 401(k) contribution limits.

These often change from year-to-year based upon the inflation rate.

401(k) Tax Deduction

When you contribute money to your 401(k), the IRS treats the contribution as a tax deduction so you don't owe payroll or income taxes on it. That is, if you invest $5,000 through your 401(k) account, and you had $50,000 in income, you are going to see a $5,000 tax deduction, lowering your adjusted gross income to $45,000. It isn't always that simple, but for the most part, this is how it works if you are an average employee.

This means that 401(k) contributions have a bigger advantage as you make your way into higher income tax brackets. If you and your spouse are in the combined 25% tax bracket and you file jointly, a $5,000 401(k) contribution will lower your Federal tax bill by $1,250 ($5,000 contribution x 25% tax bracket = $1,250 tax deduction).

401(k) Hardship Withdrawal

In some cases, it is possible to take an emergency loan from your 401(k) plan. This is known as a 401(k) hardship loan and you must pay it back or face significant taxes and tax penalties.