A 401(k) plan is an employer-sponsored retirement savings plan. 401(k)s are largely self-directed: You decide how much you would like to contribute, and which investments from among those offered by the plan you would like to invest in. Traditional 401(k)s are funded with money deducted from your pre-tax salary. Your earnings are tax deferred until you withdraw your money from your account. Roth 401(k)s are funded with after-tax income, but withdrawals are tax free if you follow the rules.
A 403(b) plan, sometimes known as a tax-sheltered annuity (TSA) or a tax-deferred annuity (TDA), is an employer-sponsored retirement savings plan for employees of not-for-profit organizations, such as colleges, hospitals, foundations and cultural institutions. Some employers offer 403(b) plans as a supplement to—rather than a replacement for—defined benefit pensions.
These tax-deferred retirement savings plans are available to state and municipal employees. Like traditional 401(k) and 403(b) plans, the money you contribute and any earnings that accumulate in your name are not taxed until you withdraw.
Your plan administrator must file an annual report with the IRS using Form 5500. The report, which you may request from your plan administrator, includes information on plan participation, funding and administration.
Asset allocation means dividing your assets on a percentage basis among different broad categories of investments, including stocks, bonds and cash. Asset allocation is a strategy for reducing the risk associated with investing. Since your portfolio is spread among different asset classes, it’s less likely that they will all perform badly at the same time. Finding the right mix of assets depends on your age, your assets, your financial objectives and your risk tolerance.
Different categories of investments that provide returns in different ways are sometimes described as asset classes. Stocks, bonds, cash and cash equivalents, real estate, collectibles and precious metals are among the primary asset classes.
Balanced funds are mutual funds that invest in a combination of common stock, preferred stock and bonds or other fixed-income investments to meet their dual investment goal of seeking a strong return while minimizing risk.
A stock market benchmark is an index or average whose movement is considered a general indicator of the direction of the overall market and against which investors and financial professionals may measure the performance of individual stocks or market sectors. There are also benchmarks for other types of investments, such as bonds, mutual funds and commodities.
Some 401(k) plans allow participants to invest in stocks and funds offered by a brokerage firm selected by your plan administrator. This is often referred to as a brokerage window, or a self-directed account.
Capital gains tax (CGT)
A capital gains tax is due on profits you realize on the sale of a capital asset, such as stock, bonds or real estate. Long-term gains, on assets you own more than a year, are taxed at a lower rate than ordinary income while short-term gains are taxed at your regular rate. Assets held for over five years may be taxed at an even lower capital gains rate.
Cash balance plan
A cash balance retirement plan is a defined benefit plan that has some characteristics of a defined contribution plan, such as portability. The pension benefit accrues over time from contributions, based on a percentage of your current pay, which are credited to a hypothetical account in your name.
The fee paid to a broker for executing a securities trade. If your 401(k) plan has a brokerage window, you should be aware of how high the commissions will be when you trade and what impact those costs may have on your return.
A person or company who provides credit to another person or company functions as a creditor. For example, if you take out a mortgage or car loan at your bank, then the bank is your creditor. But if you buy a bond issued by a corporation or other institution, you are the creditor because the money you pay to buy the bond is actually a loan to the issuer.
A deferred annuity contract allows you to accumulate tax-deferred earnings during the term of the contract and sometimes add assets to your contract over time. Your deferred annuity earnings may be either fixed or variable, depending on the way your money is invested. Deferred annuities are subject to withdrawal rules so you may owe a 10 percent penalty if you withdraw earnings before you reach age 59½. Surrender charges also may apply.
Defined benefit plan
A defined benefit plan provides a specific income for retired employees, either as a lump sum or as a pension, or lifetime annuity. The pension amount usually depends on the employee's age at retirement, final salary and the number of years on the job.
Defined contribution plan
A defined contribution plan is an employer-sponsored retirement plan. The income the plan provides is not predetermined or guaranteed, as it is with a defined benefit pension. Rather, it varies according to how much is contributed to the plan, how the contributions are invested and what the return on that investment is. 401(k), 403(b), 457 and profit-sharing plans are examples of defined contribution plans.
Diversification is an investment strategy for spreading your principal among different markets, sectors, industries and securities. The goal is to protect the value of your overall portfolio in case a single security or market sector takes a serious downturn and drops in price.
Employer-sponsored retirement plan
Employers may offer their employees either defined benefit or defined contribution retirement plans, or they may make both types of plans available. Any employer may offer a defined benefit plan, but certain types of defined contribution plans are available only through specific categories of employers. However, employers are not required to offer plans.
Equity mutual funds invest primarily in stocks. The particular stocks a fund buys depends on the fund's investment objectives and management style.
The Employee Retirement Income Security Act of 1974 (ERISA) sets certain standards for 401(k) plan administrators and requires uniform rights for plan participants.
An expense ratio is the amount you pay annually to a mutual fund for operating expenses and management fees, expressed as a percentage of the net asset value of your investment in the fund.
FINRA BrokerCheck is a resource for learning about the professional background, registration/license status and conduct of brokerage firms, individual brokers, investment advisers and firms. If your 401(k) plan has a brokerage window, or if you roll your 401(k) into an IRA at a brokerage firm, you’ll want to use FINRA BrokerCheck to check out the firm and its brokers.
Federally chartered government-sponsored enterprises (GSEs) are shareholder-owned corporations, not federal agencies. Although GSEs, such as Fannie Mae and Freddie Mac, were created to fulfill a public purpose, the mortgage-backed bonds they issue are not insured by the government or backed by its full faith and credit.
Guaranteed investment contract (GIC)
A GIC (pronounced gick) is an insurance company product designed to preserve your principal and to provide a fixed rate of return. You may invest in a GIC through an employer-sponsored salary reduction plan, such as a 401(k) or 403(b), if it is one of the investment options offered.
A hardship withdrawal occurs when you take money out of your 401(k) or other qualified retirement savings plan to cover a pressing financial need. You must qualify to withdraw by meeting the conditions your plan imposes in keeping with Internal Revenue Service (IRS) guidelines. If you're younger than 59½, you may have to pay a 10 percent penalty, plus income tax, on the amount you withdraw, and you may not be permitted to contribute to the plan again for a period of time.
Highly compensated employees
Highly compensated employees are people who earned more from their employer, or own a larger stake in the company, than the floor the government has established for this category of worker. The drawback of being highly compensated is that you may be restricted on what you can contribute to a 401(k).
An index mutual fund is designed to mirror the performance of a stock or bond index, such as Standard & Poor's 500 Index (S&P 500) or the Russell 2000 Index. To do that, the fund purchases all of the securities included in the index, or a representative sample of them, and adds or sells investments only when the securities in the index are changed.
Individual retirement account (IRA)
Individual retirement accounts (IRAs) are self-directed investment accounts that provide the incentive of tax-deferred (in the case of traditional IRAs) or tax-free (in the case of Roth IRAs) earnings on assets in the account. If you earn income, or are married to someone who does, you are limited in how much money you can contribute to your IRA. You can see the current limits in the Annual Contribution Limits table.
A lifecycle fund is a package of individual mutual funds that a fund company puts together to help investors meet their investment objectives without having to select portfolios of funds on their own. The allocation of funds within the fund is altered as the investor moves closer to retirement to help reduce potential volatility and preserve capital.
A liquid investment is one that can be bought or sold quickly in large volume without dramatically affecting its market price. However, the term is sometimes used more generally to describe investments you can buy or sell easily, including mutual funds and most publicly traded stocks and bonds. It may also be used to describe those investments you can sell or cash in easily without loss of principal, such as a money market fund.
A lump-sum distribution is a one-time payout of assets in an account, typically a retirement savings account. When you retire or change jobs, you can take a lump-sum distribution as cash, or you can roll over the distribution into an individual retirement account (IRA). If you take the cash, you owe income tax on the full amount of the distribution, and you may owe an additional 10 percent penalty if you're younger than 59½. If you roll over the lump sum into an IRA, the full amount continues to be tax deferred, and you can postpone paying income tax until you withdraw from the account.
A managed account is a portfolio of stocks or bonds owned by an individual investor. The account has a professional investment manager who makes buy and sell decisions, sometimes in response to the account owner’s instructions. Each managed account has an investment objective, and each manager oversees multiple individual accounts invested to meet the same objective.
Unlike index funds that are designed to track a market index, managed funds rely on the expertise of the mutual fund manager to research and select the stocks or bonds that make up the fund's portfolio.
Market capitalization is a measure of the value of a company, calculated by multiplying the number of existing shares, or shares the company has issued, by the current price per share. For example, a company with 100 million shares of stock with a current market value of $25 a share would have a market capitalization of $2.5 billion. Market capitalization is sometimes used interchangeably with market value. Mutual funds often will note if their focus is on large-, mid- or small-cap stocks.
A market index measures changes in the value of a specific group of stocks, bonds or other investments that it tracks from a specific starting point, which may be as recent as the previous day or some date in the past. An index may be broad, encompassing a large number of stocks or bonds, or quite narrow, including only a limited number.
Net asset value (NAV)
The NAV is the dollar value of one share of a mutual fund at the close of the trading day. It is calculated by totaling the value of all the fund's holdings and dividing by the number of outstanding shares. That means the NAV changes regularly, though day-to-day changes are usually small.
Your 401(k) plan administrator is the person or more typically the company your employer chooses to manage the organization's retirement savings plan. The administrator works with the plan provider to ensure that the plan meets government regulations and that you and other employees have the information you need to enroll, select and change investments in the plan, apply for a loan if the plan allows loans and request distributions.
A 401(k) plan provider is the mutual fund company, insurance company, brokerage firm or other financial services company that creates and sells the plan your employer selects.
A 401(k) plan sponsor is an employer who offers the plan to employees. The sponsor is responsible for choosing the plan, the plan provider and the plan administrator, and for deciding which investments will be offered through the plan.
A portable retirement plan is one where you can take your contributions plus any earnings with you when you change jobs. 401(k) plans are portable and you can usually leave the money with your former employer, roll over the money into your new employer's plan, roll over the money into an IRA or take the cash value of your contributions and any earnings.
Principal can refer to an amount of money you invest, the face amount of a bond or the balance you owe on a debt, aside from the interest.
A profit-sharing plan is a type of defined contribution retirement plan that employers may establish for their workers. The employer may add up to the annual limit set by Congress to each employee's profit-sharing account in any year the company has a profit to share, though there is no obligation to make a contribution in any year.
Real rate of return
The real rate of return on an investment is the rate of return minus the rate of inflation. For example, if you are earning 6 percent interest on a bond in a period when inflation is running at 2 percent, your real rate of return is 4 percent. But if inflation were at 4 percent, your real rate of return would be only 2 percent.
Required minimum distribution (RMD)
A required minimum distribution is the smallest amount you can take each year from your 401(k), 403(b), traditional IRA or other retirement savings plan once you've reached the mandatory age for making withdrawals, usually 70½. If you take less than the required minimum, you owe a 50 percent penalty on the amount you should have taken. You calculate your RMD by dividing your account balance at the end of your plan's fiscal year—usually, but not always, December 31—using a divisor determined by your age.
If you move your assets from one tax-deferred or tax-free investment to another, it's called a rollover. For example, if you move money from one individual retirement account (IRA) to another IRA, or from a qualified retirement plan into an IRA, the transaction is a rollover.
A Roth IRA is an individual retirement account from which you can withdraw your earnings completely tax free any time after you reach age 59½, provided your account has been open at least five years. To qualify to contribute to a Roth IRA, your income must be less than the level set by Congress. However, even if you are not eligible to contribute to a Roth IRA, you may convert a traditional IRA to a Roth IRA and pay the tax that’s due on contributions and accumulated earnings.
Salary reduction plan
A salary reduction plan, such as a traditional 401(k) or 403(b), is a type of employer-sponsored retirement savings plan that allows you to contribute pretax income to a retirement account in your name and to accumulate tax-deferred earnings. In contrast, with a Roth 401(k) and 403(b) you contribute after-tax income to a retirement account in your name and may make tax-free withdrawals after you retire if you’re at least 59½ and your account has been open at least five years. All of these plans, which may be described as salary deferral plans because part of your current salary goes into your retirement account rather than being included in your take-home pay, have the same annual contribution cap, which is set by Congress, and allow annual catch-up contributions for participants 50 and older.
Sector mutual funds, also called specialty or specialized funds, concentrate their investments in a single segment of an industry, such as biotechnology, natural resources, utilities or regional banks, for example. Sector funds tend to be more volatile than more broadly diversified funds, and often dominate both the top and bottom of annual mutual fund performance charts.
Self-directed retirement plan
A self-directed retirement plan is one in which you select the investments. When the plan is employer sponsored, such as a 401(k), you usually select from a menu of choices your plan offers. When it’s an individual retirement account (IRA), you typically may choose from the full range of investments other than collectibles and non-US coins. In contrast, if you’re part of a defined benefit pension plan, your employer is responsible for making the investment decisions.
Summary plan description (SPD)
A summary plan description is a document describing the features of an employer-sponsored plan. The Employee Retirement Income Security Act (ERISA) requires that SPDs address several different aspects of the plan, such as participant rights.
Tax deferral means that income taxes that would otherwise be due on employment or investment earnings are postponed until some point the future, often when you retire. Then tax is due on the amounts you withdraw, at the same rate you pay on your regular income. For example, if you contribute pretax income to a retirement savings plan, such as a 401(k) or 403(b), you owe no tax on the contributions or any earnings in the plan until you withdraw those funds. In other plans, such as individual retirement accounts (IRA), the contribution may be taxable but the earnings are tax deferred.
Total return is your annual gain or loss on an equity or debt investment. It includes reinvested dividends or interest, plus any change in the market value of the investment. When total return is expressed as a percentage, it's figured by dividing the increase in value, plus dividends or interest, by the original purchase price. On bonds you hold to maturity, however, your total return is the same as your yield to maturity (YTM).
A variable annuity is a contract offered by an insurance company that can be used to accumulate savings tax deferred. You allocate your premium among a number of subaccounts or investment portfolios offered through the contract. Your contract value, which fluctuates over time, reflects the performance of the underlying investments held by the funds you have selected, minus the contract expenses. Withdrawals are taxed as ordinary income, rather than at the lower capital gains rate. If you make withdrawals before you reach age 59½, you may also be subject to a 10 percent early withdrawal penalty. Unlike fixed annuities, variable annuities are securities registered with the Securities and Exchange Commission (SEC).
If you are part of an employer pension plan or participate in an employer-sponsored retirement plan, such as a 401(k), you become fully vested—or entitled to the contributions your employer has made to the plan, including matching and discretionary contributions—after a certain period of service with the employer. Qualified plans must determine the period using standards set by the federal government. If you leave your job before becoming fully vested, you forfeit all or part of those benefits.