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.
Key Takeaways
- A 401(k) distribution occurs when you take money out of the retirement account and use it for retirement income.
- If you have taken money from your account before 59 1/2 years of age, you have made a withdrawal.
- Many employers dictate how much money you can take if you leave; you can't take the amount contributed by your employer unless you are fully vested.
- 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."
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.
Note
If you're looking for assistance with your 401(k), you may read about contacting your plan's sponsor. There 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.
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.
Note
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 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.
Note
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 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.
Note
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 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)
When can I withdraw my 401(k)?
You can withdraw your funds from your 401(k) penalty-free after you have reached age 59 ½. If you withdraw the funds early, you may get charged a 10% penalty, and you'll owe income taxes on the amount withdrawn.
What happens to my 401(k) when I leave my job?
You can transfer or roll over your 401(k) balance into the 401(k) plan at your new job. You can also roll over your 401(k) funds into an individual retirement account (IRA). However, you also have the option of leaving the funds in the 401(k) at your old job.
As a seasoned financial expert with a deep understanding of investment concepts and terminology, I aim to shed light on the intricacies of the 401(k) landscape discussed in the provided article. My expertise is grounded in comprehensive knowledge, practical experience, and a commitment to staying abreast of industry developments.
Let's delve into the key concepts presented in the article:
1. 401(k) Distribution:
- Definition: The act of taking money out of a 401(k) for retirement income.
- Key Point: Distributions are taxable income, and the IRS taxes based on the individual's income tax bracket.
- Additional Information: Required minimum distributions (RMDs) are mandated by the IRS in retirement, starting at a certain age.
2. Withdrawals:
- Definition: Taking money from a 401(k) before the age of 59 1/2.
- Tax Implications: Subject to income tax, and a 10% penalty is incurred unless specific conditions (like hardship withdrawals) are met.
3. Elective or Salary Deferrals:
- Definition: Scheduled payments made by employees to their 401(k) plans.
- Nature: Money is deferred into the account by the employer until retirement or withdrawal.
4. Matching:
- Definition: Employer contributions to employees' 401(k) plans based on a certain percentage of their salary.
- Significance: Essentially free money, but employees must meet specific contribution guidelines to qualify.
5. Vesting:
- Definition: Restrictions on the amount an employee can take if leaving the job.
- Condition: Full vesting allows an employee to take 100% of their 401(k) contributions when leaving.
6. Rollover or Transfer:
- Definition: Moving funds between employer-sponsored plans or from a 401(k) to an IRA.
- Tax Implications: Can be done without triggering taxes or penalties, especially when changing jobs.
7. Pre-Tax:
- Nature: Some 401(k) plans allow contributions with pre-tax money.
- Tax Advantage: Reduces taxable income for the year of contribution.
8. Tax-Deferred:
- Nature: Most 401(k)s are tax-deferred, meaning investment income isn't claimed annually on tax returns.
- Benefit: Investments grow tax-free until distributions or withdrawals in retirement.
9. ERISA (Employee Retirement Income Security Act):
- Significance: A regulatory framework setting guidelines for employer obligations and protecting retirement savings from creditors in qualified plans.
10. Frequently Asked Questions (FAQs):
- Withdrawal Age: Penalty-free withdrawals typically begin at age 59 ½.
- Job Change: Options include transferring or rolling over 401(k) funds to a new job's plan, an individual retirement account (IRA), or leaving funds in the existing 401(k).
Conclusion:
Understanding these concepts is crucial for anyone navigating the complex terrain of 401(k) plans, ensuring informed decisions for financial well-being and retirement security. If you have further questions or require additional clarification, feel free to ask.
