Investment terms and concepts can be confusing because some investments share terminology but give it different meanings. If you are saving for retirement, the 401(k) plan offered by your employer is a popular option because it allows employees to save a portion of their wages for the future.
Plan Sponsors
When an employer decides – or is required by law – to create retirement plans for employees, they become the plan sponsor. Many employers contract with retirement plan administrators to run their plans to reduce the internal costs of managing them.
Distributions
401(k) distributions occur when funds are withdrawn from a retirement account and used as retirement income. The tax authority considers distributed funds as taxable income and taxes you based on your income tax bracket.
Withdrawals
If you withdraw funds from your account before reaching age 59 and a half, you have made a withdrawal. The tax authority taxes withdrawals as income, and adds the withdrawal to your annual income. Generally, the tax bracket you are in at that time determines how much tax you pay.
Salary Deferral
Deferral is the scheduled payment you make to your 401(k) plan. It is called “deferral” because your employer puts the money into the account on your behalf, deferring its delivery to you.
Matching
Some employers make contributions to their employees’ 401(k) plans, up to a certain percentage of their salary or wages – called matching. Matching is at the employer’s discretion and usually comes with guidelines for a minimum employee contribution and a maximum employer contribution.
Vesting
Many employers have restrictions on how much you can take with you if you leave your job. Typically, there is a necessary period that an employee must work for the employer.
Transfer or Roll Over
Transferring funds from one employer’s plan to another or from a 401(k) plan to an Individual Retirement Account (IRA) is called a “rollover.” Some may also refer to it as a “transfer.” If your employer closes the 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 dollars. In other words, employers deduct your contribution from your pay before income taxes are taken out. As a result, your taxable income is lower in the year you contributed.
Tax-Deferred
401(k) accounts are typically tax-deferred, meaning you do not have to claim any investment income earned in the account each year on your tax return.
ERISA
The Employee Retirement Income Security Act of 1974 (ERISA) is an important regulation you should be aware of. This law not only defines the obligations employers have towards their employees’ retirement but also protects your retirement savings from creditors. If you declare bankruptcy or your employer does, your retirement plans are safe in most cases – as long as they are ERISA-qualified plans.
FAQs
When can I withdraw my money from my 401(k)? You can withdraw your money from your 401(k) without penalties after you reach age 59 and a half. If you withdraw funds early, you may incur a 10% penalty, and you will owe income tax on the withdrawn amount.
What happens to my 401(k) when I leave my job? You can transfer or roll over your 401(k) balance to a new job’s 401(k) plan. You can also roll over your 401(k) funds into an Individual Retirement Account (IRA). However, you also have the option to leave the funds in your 401(k) from your old job.
What happens if…
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Sources: IRS. “Frequently Asked Questions about Minimum Required Distributions from Retirement Plans and IRAs.” IRS. “Retirement Topics – Penalty Exceptions for Early Withdrawals.” IRS. “Retirement Topics – Hardship Distributions.” IRS. “Rollovers from Retirement Plans and IRA Distributions.” IRS. “Retirement Topics – Contributions.” U.S. Department of Labor. “Employer Bankruptcy – How Will It Affect Your Employee Benefits?”
Source: https://www.thebalancemoney.com/like-distribution-vs-rollover-2388226
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