If you’re new to saving for retirement, all the unfamiliar jargon can be off putting. Here’s a primer on 20 of the most common retirement terms, outlining what they mean and why they’re important. Start here to build your retirement planning confidence.
A 401(k) is the most popular employer-sponsored retirement savings plan. With a traditional 401(k), you contribute a portion of each paycheck to the plan, pick your investments and don’t pay taxes on the contributions or earnings until you start taking withdrawals. As of 2021, 401(k) contribution limits are $19,500 per year, or $26,000 if you’re 50 or older.
Matching contributions are incentives from your employer to encourage you to actively save for retirement. If an employer makes contributions to your 401(k), they generally match a portion of the contributions you’re depositing in the account each month, up to a set percentage of your total salary.
For example, an employer may match 100% of your contributions, up to 3% of your salary. If you earned $50,000 per year, that means your employer would match up to $1,500 of your 401(k) contributions. There is no set formula, so be sure to check with your company.
An annuity is a contract you make with an insurance company or financial services firm. In exchange for one or several contributions in the present, the company agrees to provide future income (usually with some amount of interest) for a set number of years—or the rest of your life. Because of the certainty they offer, annuities are a popular option for people who want to receive reliable income in retirement when they no longer earn a salary.
Annuities come in many forms, including fixed annuities, variable annuities, immediate annuities and index annuities. Their contracts and fees can be very complex, so make sure to get a financial professional’s input on any potential purchases.
Defined benefit plans are employer-sponsored retirement plans that provide workers with guaranteed monthly income in retirement. The most common type of defined benefit plan is a pension.
Due to their high costs and the level of risk assumed by employers when funding and managing investments, defined benefit plans are increasingly rare. Pensions have been widely replaced by 401(k) plans.
Defined contribution plans are employer-sponsored retirement plans that depend on workers to make contributions and manage investments. The most common type of defined contribution plan is the 401(k), but 403(b)s and 457(b)s are also types of defined contribution plans you may encounter, particularly if you work for the government or at a non-profit organization.
With most defined contribution plans, you may only access the money in your account in retirement. If you withdraw the money early—before you reach age 59 ½—you must pay an early withdrawal penalty (there are a handful of exceptions to this rule). The early withdrawal penalty is equal to 10% of the amount you withdraw.
Exchange-traded funds, commonly called ETFs, are an investment that pools your money in a fund with other investors to buy a diversified mix of investments. ETFs aim to duplicate the performance of underlying stock and bond indexes, like the S&P 500. ETFs aren’t generally offered in 401(k)s, but you can invest in ETFs if you have an IRA or taxable investment account.
An IRA is a retirement investment account that is available for anyone. It’s generally not offered by employers, and it’s your best option if you don’t have access to an employer-sponsored retirement plan or if you want to supplement your workplace plan.
With a traditional IRA, your contributions may be tax-deductible, meaning you can decrease your income taxes today. You don’t pay any taxes on the earnings until you start making withdrawals in retirement. As of 2021, the contribution limit for IRAs is $6,000 per year ($7,000 if you’re 50 or older).
Similar to ETFs, mutual funds pool money from many investors to purchase a broad range of stocks, bonds or short-term debt. Mutual funds provide instant diversification, since you’re buying a basket of securities rather than investing in a single company.
Mutual funds are commonly actively managed, meaning a team of experts selects and trades securities to try and provide positive returns. Index funds are mutual funds that aim to duplicate the performance of major market indices are increasingly popular because of the low costs but solid returns they provide.
You can purchase shares of index funds and mutual funds in a 401(k), IRA or taxable investment account.
Required minimum distributions (RMDs) are the minimum amount you must withdraw annually from most tax-advantaged retirement accounts, like traditional IRAs and 401(k)s of all kinds, once you turn 72. Roth IRAs are the only type of retirement account that doesn’t require RMDs.
A rollover IRA is an IRA funded with money you move, or roll over, from a 401(k) or other employer-sponsored retirement account. This most often happens when you leave your job and want to avoid high plan fees or limited investment options. You also might roll over your 401(k) to an IRA simply to reduce the number of retirement accounts you have.
This type of 401(k) offers special tax advantages. Unlike traditional 401(k) accounts, where you make contributions on a pre-tax basis, Roth 401(k) contributions are made with money you’ve already paid taxes on. Because there is no upfront tax deduction, your earnings and withdrawals are tax free once you reach 59 ½.
Contributions to Roth IRAs come from money that’s already been taxed. Because you aren’t taking a tax deduction now, you’re able to withdraw earnings and contributions in retirement without paying federal income tax.
As an added benefit, because the money you put in has already been taxed, you can access your contributions before retirement without paying early withdrawal penalties. (Any gains, however, are subject to taxes and early withdrawal penalty.)
A self-directed IRA (SDIRA) is a retirement plan that allows you to invest in a wider range of investments than the normal IRAs you open at most brokerages allow. Self-directed IRAs can hold precious metals, including gold and silver, real estate, and cryptocurrency, like Bitcoin. They can be traditional or Roth retirement accounts and frequently carry more risk (and higher fees) than normal IRAs.
A Simplified Employee Pension (SEP) IRA is a retirement plan for self-employed individuals, freelancers and small business owners. Employers (or a self-employed person acting as their own employer) are typically the only contributors, and they can contribute up to 25% of the employee’s total compensation or $58,000 for 2021, whichever is less.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement plan generally offered by small employers and new businesses that don’t have the time or resources to administer a 401(k). Employers generally are required to contribute 2% of an employee’s salary, regardless of if they contribute themselves, or to match employee contributions dollar-for-dollar, up to 3% of their salary. Employees can contribute up to $13,500 per year ($16,500 for those 50 or older) in 2021.
Social Security is a pension program primarily for retirees and their families managed by the federal government. It replaces a portion of your wages based on your highest 35 years of earnings and when you decide to start receiving benefit payments.
As the name implies, a Solo 401(k) plan is a 401(k) plan for self-employed individuals and business owners who don’t have employees other than their spouses. Depending on your income, a Solo 401(k) may allow you to contribute more than a SEP IRA. Solo 401(k)s are also available as Roth accounts, which gives them another edge over SEP IRAs for the self-employed.
A target date fund is a professionally managed portfolio held in a mutual fund that adjusts its holdings based on the year you want to retire. When you’re young, a target date fund invests aggressively, primarily in stock-based funds. As you get older, the fund gradually becomes more conservative, introducing more bond- and fixed-income-based funds. Like robo-advisors, target date funds are well suited to those who want hands-off, set-it-and-forget-it retirement investing.
Vesting has nothing to do with outerwear. Instead, vesting generally refers to the amount of ownership you’ve built up over something, like your employer’s contributions to your workplace retirement account.
To encourage you to stay long term, an employer might set up a vesting schedule that grants you increasing ownership over your 401(k) match each year. For example, you might earn 20% of your employer match each year you work at your company until you own all of it outright after five years. If you leave before you’ve reached the end of your vesting period, you forfeit any contributions you haven’t earned.