401(k) Terms You Should Know

Investing terminology and concepts can be confusing since some investments share terms but assign different meanings to them. If you're saving for retirement, an employer-sponsored 401(k) is a popular choice since it allows employees to save a portion of their wages for the future.

Whether you're signing up for the first time or need to update an existing 401(k), the terms can be confusing. 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.

Sponsors

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.

Distributions

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 your income tax bracket.

In retirement, the IRS requires you to withdraw a minimum amount of money each year from your 401(k)—called required minimum distributions (RMDs). RMDs don't begin immediately but within a few years of retiring, depending on when you were born.

• If you turned 70 1/2 before Jan. 1, 2020, RMDs would have been required at age 70 1/2.
• If you turned 70 1/2 on or after Jan. 1, 2020, you must begin RMDs at age 72.

Withdrawals

If you take money from your account before 59 1/2 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.

Withdrawals made from a 401(k) before the age of 59 1/2 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 its delivery to you.

You've earned that money, and it is still yours. However, you can't claim it until you retire or withdraw it. Deferrals are elective because employees choose to have the money deferred into their 401(k) accounts.

Matching

Some employers make 401(k) contributions to their employees' plans, up to a certain percentage of their salary or pay—called contribution matching. Matching is an employer option and generally comes with minimum employee contribution guidelines and a maximum employer contribution amount.

For example, if your employer provides a 50% match up to 6% of your salary, your 6% deferral would get you an additional 3% from your employer. So, if you earned $40,000 and contributed 6% of your salary or $2,400, your employer would match $1,200 (50% * $2,400).

The employer matching is essentially free money added to your retirement account every year. However, you need to participate and contribute the minimum amount required by your plan in order to receive the employer match.

Vesting

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.

Although you can usually take out your contributions, 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.

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 if you leave to work elsewhere, you can roll over your 401(k) funds to your new retirement account without triggering taxes or penalties.

Pre-Tax

Some 401(k) retirement accounts allow you to contribute pre-tax money. In other words, employers deduct your contribution from your pay before income taxes are deducted. As a result, your taxable income is lower in the year you made the contribution.

For example, let's say you earn $40,000 annually and you made $5,000 in 401(k) contributions; you would only be taxed on $35,000 since the contribution reduced your taxable income by $5,000.

Tax-Deferred

Typically, 401(k)s are tax-deferred investment accounts, meaning you don't need to claim the investment income earned in the account each year on your tax return.

For example, if you invested your 401(k) funds and it earned $2,000 in investment income, you would not have to pay any capital gains tax on those funds. As long as the funds remain in the account, the money will grow tax-free. Any distributions or withdrawals in retirement would be taxed according to your marginal tax bracket at that time.

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 less tax when your money is tax-deferred.

ERISA

One 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. If you or your employer declare bankruptcy, your retirement plans are safe in most cases—as long as they are ERISA-qualified plans.

Frequently Asked Questions (FAQs)