Understanding 401k terminology
by Gary Foreman
401k Contribution Basics
Choosing Beneficiaries for a 401k Plan
How to Set Up Your First 401k
If you have a 401k plan or are thinking of starting one, you need to know what's going on. To do that, you need to know some 401k basics and to understand the terminology of the 401k. Some terms are familiar, but others will be new to you. Here's a rundown of 401k terms and their meanings.
A 401k Plan is a defined contribution retirement plan. An employee can make 401k contributions from their paycheck either before or after tax (depending on the plan). The contributions are kept in a separate account for the employee. The employee may choose from a selection offered within the plan.
A balanced fund is a mutual fund that invests in a combination of common stock, preferred stock, bonds, and other fix-income investments. Their goal is to achieve a good return while minimizing risk.
A beneficiary is the person or people you want to receive the assets in the account or take ownership should you pass away. Often there will be both a primary and secondary beneficiary. The secondary comes into play if the primary has passed away.
This is the amount contributed to the 401k plan. Contributions can come from both the employee and the employer. Contributions are limited by the IRS, depending on salary.
Defined Contribution Plan
In a defined contribution plan, the contribution level is known now. The benefit level will not be known until it's time to distribute the assets.
The Employee Retirement Income Security Act of 1974 (ERISA) sets certain standards for 401k plan administrators. It also requires uniform rights for plan participants.
The expense ratio is the amount that the fund manager charges the fund for expenses and fees. This is normally stated as a percentage of the net asset value on an annual basis.
Some plans allow for a hardship withdrawal. The employee must qualify for the withdrawal. Income taxes will be owed on the withdrawal, and if the employee is under age 59 1/2, a 10% early withdrawal penalty will be assessed. See your plan administrator to see what circumstances qualify as a hardship.
Highly Compensated Employees
Highly compensated employees have special limits placed on the contributions. The employees are generally owners, executives, or employees who earn more than an IRS set floor.
An index fund is a mutual fund that's designed to duplicate the performance of a specific index (like the S&P 500 or Dow Jones Industrials). The fund will purchase shares of all the companies in the index in the ratio that they're represented in the index.
A lump-sum distribution is a one-time payout of assets in the account (as opposed to a series of scheduled distributions). Often lump-sum distributions are rolled into other investment/savings accounts like an IRA. Some 401k plans will require you to take a lump-sum distribution if you leave your employer.
The plan administrator is typically chosen by your employer. Their job is to make sure that the plan meets government regulations and to provide you information you need to enroll, select, and change investments in the plan.
The plan provider is a mutual fund, insurance or financial services company that creates the plan that your employer has selected.
The plan sponsor is another name for the employer who offers a 401k plan to their employees. The plan sponsor chooses the plan, the plan provider, and the administrator. They may also decide which investments will be available to plan participants.
Required Minimum Distribution (RMD)
At age 70 1/2, 401k plan participants must take a required minimum distribution. This distribution is based on the participant's age and the value of assets in the 401k plan. Failure to take a required minimum distribution will trigger an IRS penalty.
A rollover is a transaction that moves assets from one tax-deferred or tax-free investment to another. Often a rollover occurs when an employee leaves their job and moves 401k plan assets into an individual IRA.
Vesting is the time that must pass before you can withdraw contributions to the 401k plan made by your employer. This is typically based on time with the employer or time that the employer contributions have been in the 401k plan.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.
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