15 Retirement Terms Every New Investor Needs to Know
Congratulations! By starting your retirement fund, you've taken one of the most important steps toward a comfortable retirement. But as a novice investor, you may feel a bit overwhelmed with all the available information, including contribution limits, early penalty fees, and Roth 401Ks. To help you make sense of it all, let's review 15 key terms you should know:
The 401K is the most popular qualified employer-sponsored retirement plan in the U.S. The two most common types of 401K plans are the traditional 401K, to which you contribute with pretax dollars, and the Roth 401K, which accepts contributions with after-tax dollars. Earnings in a traditional 401K grow on a tax-deferred basis (you'll pay taxes on the funds when you withdraw them during retirement) and those in a Roth 401K grow tax-free forever, since you've paid taxes upfront.
2. After-Tax Contributions
Only certain types of retirement accounts, such as Roth 401Ks and Roth IRAs, accept contributions with after-tax dollars. When you contribute to a retirement account with after-tax dollars, your retirement funds grow tax-free forever, since you've already paid Uncle Sam.
3. Catch-Up Contribution
Retirement investors who are 50 and older at the end of the calendar year can make extra annual "catch-up" contributions to qualifying retirement accounts. Catch-up contributions allow older savers to make up for lower contributions to their retirement accounts in earlier years. In 2016 and 2017, catch-up contributions of up to $6,000 (on top of traditional annual contribution limits) are allowed for 401Ks and up to $1,000 for IRAs.
4. Contribution Limits
Every year, the IRS sets a limit as to how much you can contribute to your retirement accounts. In 2016, you can contribute up to $5,500 ($6,500 if age 50 or over) to traditional and Roth IRAs and up to $18,000 ($24,000 if age 50 or over) to a traditional or Roth 401K. These annual contribution limits to retirement accounts remain unchanged for 2017. If you exceed your contribution limit, you'll receive a penalty fee from the IRS, unless you take out excess moneys by a certain date.
5. Early Distribution Penalty
To discourage retirement savers from withdrawing funds before retirement age, the IRS imposes an additional 10% penalty on distributions before age 59 ½ on certain retirement plans. Keep in mind that you're always liable for applicable income taxes whether you take a distribution from your retirement plan before or after age 59 ½. Under certain circumstances, you're allowed to withdraw money early from a retirement account without the penalty.
You've heard that there is no such thing as a free lunch and no retirement plan is exempt from this rule. There's always a cost for the employer or employee, or both. Always check the prospectus from any fund for its annual expense ratio and any other applicable fee. An annual expense ratio of 0.75% means that for every $1,000 in your retirement account, you're charged $7.50 in fees. And that's assuming that you don't trigger any other fees! (See also: Watch Out for These 5 Sneaky 401K Fees)
7. Index Fund
An index fund is a type of mutual fund that tracks of a basket of securities (generally a market index, such as the Standard & Poor's 500 or the Russell 2000). An index fund is a passively managed mutual fund that provides broad market exposure, low investment cost, and low portfolio turnover. Due to its low annual expense ratios, such as 0.16% for the Vanguard 500 Index Investor Shares [Nasdaq: VFINX], index funds have become a popular way to save for retirement. (See also: 3 Steps to Getting Started in the Stock Market With Index Funds)
Unlike a 401K, an individual retirement account (IRA) is held by custodians, including commercial banks and retail brokers. The financial institutions place the IRA funds in a variety of investments following the instructions of the plan holders. A traditional IRA accepts contributions with pretax dollars, and a Roth IRA accepts contributions with after-tax dollars. An advantage of using a Roth IRA is that it provides several exemptions to the early distribution penalty.
9. 401K Loan
Some retirement plans allow you to take a loan on a portion of your available balance — generally, 50% of your vested account balance, or up to $50,000, whichever is less. While the loan balance is generally due within five years, it becomes fully due within 60 days from separating from your employer. (See also: 5 Questions to Ask Before You Borrow From Your Retirement Account)
10. Mutual Fund
By pooling funds from several investors, money managers are able to invest in a wide variety of securities, ranging from money market instruments to equities. Investing in a mutual fund enables an individual retirement investor to gain access to a wide variety of investments that she wouldn't necessarily have access to on her own. Depending on its investment strategy, mutual funds can have a wide variety of fees. So, make sure to read the fine print. (See also: 4 Sneaky Investment Fees to Watch For)
11. Pretax Contribution
When you contribute to your employer-sponsored retirement account with pretax dollars, you're allowed to reduce your taxable income. For example, if you were to make $50,000 per year and contribute $5,000 to your 401K with pretax dollars, then you would only have to pay applicable income taxes on $45,000! You delay taxation until retirement age when you're more likely to be in a lower tax bracket.
12. Required Minimum Distribution (RMD)
You can't keep moneys in your retirement account forever. At age 70 ½, you generally have to start taking withdrawals from an IRA, SIMPLE IRA, SEP IRA, or 401K. An RMD is the minimum amount required by law that you have take out from your retirement account each year to avoid a penalty from the IRS. You can use of one of these requirement minimum distribution work sheets to calculate your RMD.
When you separate from your employer, you generally have up to 60 days to transfer moneys in your previous retirement account to a new retirement account accepting those moneys. This process is known as a rollover. In a direct rollover, the process is automatic; in an indirect rollover, you receive a cash-out check from your previous employer to rollover the moneys to a new qualifying retirement account. (See also: A Simple Guide to Rolling Over All of Your 401Ks and IRAs)
14. Target-Date Fund
A target-date fund is a retirement investment fund that seeks to provide higher returns to young investors and gradually reduce risk exposure as they get closer to retirement age. Since the Pension Protection Act granted target-date funds the status of qualified default investment alternative in 2006, these type of funds have gained popularity. About half of 401K participants hold a target-date fund.
In any retirement account, only money that is fully vested truly belongs to you. While all of your contributions and the matching contributions from your employer to your retirement account are always fully vested, some employer contributions, such as company stock, may follow a vesting schedule. In cliff vesting, you only become fully vested after a certain period of time. In graded vesting, you gradually gain ownership of those employer contributions.
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