401(k) glossary: Your guide to retirement terminology

Saving for retirement should be simple. But whether you’re an employer sponsoring a 401(k) plan or an employee just trying to save, it can feel like the price of entry is an economics degree.

Put some of the blame on retirement’s complex terminology. Just look at the language used by the experts: fiduciaries, vesting cliffs, summary plan descriptions, distributions — it’s enough to make you want to pour yourself a tall glass of liquidity and rollover.

Guideline believes that saving for retirement should be easy for everyone. Let’s help you clear a few things up. Consider this glossary your secret decoder ring to all things retirement – 401(k) and beyond.

401(k) plan

A 401(k) plan is a retirement savings plan offered by employers as a popular employee benefit, allowing individuals to contribute a portion of their salary to be invested for retirement purposes. Traditionally, money is taken directly from employees’ paychecks pre-tax, deposited in the plan’s trust, growing tax-deferred, and is not taxed until withdrawal. Alternatively, the employee may elect to have the amount taken after tax, deposited in the trust, and invested and withdrawn on a tax-free basis.

Annual rate of return

Your annual rate of return is the percent change in your account due to investment gains or losses over the course of a year. Expressed as a percentage, this number can vary widely based on your investment choices and strategy.

Assets under management (AUM) fee

These are fees that investment advisers and mutual funds charge as a percentage of the money they’re managing on your behalf. These might look like a tiny percentage — 1.60% is the industry average¹ — but their cumulative effect can cost retirement account holders thousands of dollars over the long run. For more on these, read our 401(k) plan fees article.

Auto-IRA

Even if an employee doesn’t have access to a 401(k) plan, their employer may be able to enroll them into a state-run retirement account called an “auto-IRA.” This is actually a requirement in some states (e.g., Illinois Secure Choice.²)

Automatic enrollment

While some companies leave it up to employees to sign up for their retirement plan (opt-in), others automatically enroll them by default. Though employees can back out at any time, they tend not to. Companies with automatic enrollment (sometimes called “auto-enrollment”) historically average a very high 92% plan participation rate.

Automatic rebalancing

You’ve heard the saying, “Buy low, sell high.” While you can micromanage your retirement savings, doing so isn’t practical. Automatic rebalancing is a retirement feature (supported by Guideline’s technology) that rebalances your account automatically. This involves adjusting your portfolio’s percentage of stocks, bonds, cash, and other investments back to your original target. You can learn more about rebalancing here.

Compound earnings

Think of compound earnings as the “earnings on the earnings” that your investments earn. If you invest $100 and get a 10% return each year, you’ll have $110 to invest in the second year, $121 in the third, and so on. In this example, if you continue receiving 10% earnings every year, you would double your money in seven years. Sometimes called “compounding,” this effect makes it possible for even a modest retirement account to grow significantly over a career.³

CalSavers

A California retirement program that requires employers with five or more California-based employees to offer a retirement plan. Learn more here.²

Cliff vesting

While some companies allow 401(k) plan participants to vest in their full employer contributions account gradually, others prefer a more abrupt formula. In cliff vesting, employees remain 0% vested in their employer contributions account until they complete a minimum number of years of service when they become 100% vested. In most 401(k) plans, a cliff vesting schedule cannot require more than three years of service.

Deferrals

Also called employee contributions, deferrals are the portion of an employee’s paycheck that’s set aside for their retirement account. Deferrals might be expressed as either a set dollar amount or a percentage. Sometimes, a company might assign an employee a default deferral rate (see automatic enrollment). Even then, employees can typically update their deferrals at any time.

Defined benefit plan

Commonly referred to as a pension, this arrangement is where retired employees are typically paid a guaranteed monthly income from their employers who choose the plan’s investments.

Defined contribution plan

This is a retirement plan in which contributions are defined and allocated to the individual accounts of each employee. The benefits depend on the investment performance. 401(k) plans are defined contribution plans where participants can contribute a percentage or set amount from their paychecks every pay period. Employer contributions in a 401(k) plan are optional.

Distribution

When you withdraw money from your retirement account for any reason, that’s called a distribution. While this technically includes situations where you might be moving funds from one plan to another (see “rollover”), in most contexts, distributions are taken for the immediate benefit of the account holder. In most cases, you’ll owe federal and state income taxes on the amount. In addition, if you take a distribution before turning 59 ½ (yes, the law’s that specific), you’ll owe the Feds an additional 10% early distribution penalty unless you qualify for a penalty exemption. Some states may also impose an early distribution penalty (e.g. California’s is 2.5%).⁴

Distribution event

While you can take your money out of your IRA at any time, the IRS limits when you can take your money out of an employer-sponsored plan. Individuals can only take money out of their retirement account when specific events (such as death, termination of employment, at age 59 ½ or when a financial hardship) occur. The plan sponsor chooses these events and will be specified in the plan document.

Dollar-cost averaging

Dollar-cost averaging is a strategy that involves investing the same amount of money on a periodic schedule (e.g. monthly). While the number of shares bought may fluctuate from month to month, the amount invested does not. During periods of price declines, you’re automatically buying more shares than when prices are more expensive. If you set aside money for retirement every paycheck, you’re naturally benefiting from dollar-cost averaging.⁵

Employee contribution limits

The IRS caps how much individuals can set aside in their retirement accounts per year. These contribution limits vary depending on the kind of account. As of 2023, the 401(k) contribution limit for individuals is $22,500. If you turn 50 (or older) during 2023, you can contribute an additional $7,500.⁵ IRA account holders are limited to much smaller contribution limits. In either case, it’s important to note that employer contributions do not count towards this cap.

Employer-sponsored retirement plan

While individuals can open retirement accounts independently (see our explanation of IRAs), employers can also offer their employees access to a plan, usually with the help of a third-party provider. A 401(k) plan is one of the most popular employer-sponsored retirement plans.

Employer matching

If a 401(k) plan has an “employer match,” that means the employer will contribute to an employee’s retirement account based on how much that employee defers. The more the employee contributes, the more the employer does, up to a maximum cap determined by the employer. Employer contributions are tax-deductible for employers up to applicable deduction limits, making them a popular way for companies to reward their employees.³ For more details, read our article on employer matching.

Employee Retirement Income Security Act (ERISA)

Call it the closest thing to a 401(k) rulebook. While the federal government doesn’t require companies to offer retirement plans, it does set minimum standards for those that do. The Employee Retirement Income Security Act (ERISA) outlines the conduct, responsibilities, and obligations 401(k) providers have to their employees. It also requires most retirement plans to pass stringent nondiscrimination testing to ensure that top executives aren’t disproportionately benefiting compared to other employees.

Expense ratio

Most 401(k) plans offer participants control over the investment of their accounts by selecting from among a menu of mutual funds. Each mutual fund in a participant’s portfolio comes with an administrative and operating charge, taken from the participant’s invested funds as a percentage of the assets invested in that fund. This charge is called the fund’s expense ratio. A fund’s expense ratio measures how much of a fund's assets are taken by the fund’s manager for these purposes, and it can vary widely from fund to fund. Some funds charge an expense ratio loaded with high fees.

For example, if your account has $30,000 and that entire amount is invested in a fund with a 1% expense ratio, your account is paying $300 in fees each year for that fund.² If you want to evaluate a plan by how costly it is, consider comparing the expense ratio, as disclosed in the fund’s prospectus, for each fund in the plan’s menu.

Fiduciary

Fiduciaries are individuals or entities entrusted with handling funds or other assets belonging to someone else, or exercising discretion in administrative activities. When it comes to retirement plans, there are a few different kinds of fiduciaries — but generally speaking, they’re the ones managing your company’s 401(k) plan, making benefit determinations, interpreting the plan document, selecting the plan’s fund menu, and/or providing investment advice to those who make those decisions. Fiduciaries are legally obligated to make decisions solely in the interest of plan participants and their beneficiaries.

Form 5500

Each year, 401(k) plan sponsors must file a Form 5500 with the federal government. This annual report outlines basic information about the sponsor’s business, retirement plans, total participants, and other details. The document is typically accompanied by secondary forms or “schedules” with additional detail. Sponsors with at least 100 participants must attach an audited financial statement, while sponsors with fewer than 100 participants may be able to fill out a shorter version of the form.

Graded vesting

Employers may gradually allow 401(k) plan participants to vest in the employer’s contributions over time (e.g., 20% after one year, 40% after two years). This approach is called graded vesting. Federal law mandates that it can’t take longer than six years for employees to vest 100% of their employer contributions.

Hardship withdrawal

Your retirement account wasn’t designed to serve as a personal rainy-day fund. That said, some retirement plans allow participants to take “hardship withdrawals” for certain circumstances, like to pay for medical expenses or purchase a primary residence (sorry, no summer homes). In most cases, hardship withdrawals are subject to federal and state income taxes. Plus, if you’re not yet age 59 ½, there is a federal early distribution tax penalty of 10% unless you qualify for a penalty exemption. Some states may also impose an early distribution penalty (e.g. California’s is 2.5%).⁴

Highly compensated employee (HCE)

For the 2023 plan year, if an employee earned over $135,000 in 2022 and (if the plan administrator chooses to use this criterion) ranks among a company’s top 20% in compensation, the employee is considered a highly compensated employee (HCE) by the IRS. If an employee owns more than a 5% stake in the business or is an employee with a certain family relationship to someone that does, in either 2022 or 2023, they’re also considered an HCE for 2023 regardless of pay. The distinction between HCEs and the rest of a company’s population matters in the context of nondiscrimination testing.

Individual retirement account (IRA)

While employers offer 401(k) plans, individual retirement accounts (IRAs) are — you guessed it — only available to individuals. IRAs offer many of the same tax benefits as conventional employer-sponsored plans, though participants can only contribute a much smaller amount. Still, IRAs are an excellent option for those without access to an employer-sponsored plan.

Illinois Secure Choice

This state-mandated retirement program requires Illinois employers who have been in business for two or more years to enroll their employees into a state-managed IRA. Learn more about the program here.²

Liquidity

In short, liquidity refers to the immediate usability of an asset. If you’ve got cash in your wallet, that’s “liquid” — you could easily spend that money if you wanted to. Retirement accounts aren’t considered liquid until you reach distribution age because you can’t take distributions while employed, unless your plan allows for hardship withdrawals, loans or other special circumstances.

Loan

Individuals can sometimes borrow and gradually repay money from their 401(k) account. Rules and eligibility requirements vary from plan to plan, but unlike hardship withdrawals, IRS taxes and penalties don’t apply to 401(k) loans unless you default on them.

Multiple employer plan (MEP)

Retirement plans of unrelated businesses, under the coordination of a third party, can be bundled together under one retirement plan. This arrangement might give them more competitive pricing but typically provides less room for plan customization.

Mutual fund

A mutual fund is a pool of investors’ money that’s subsequently invested in stocks, bonds, and other securities and is managed by someone else, like a fund manager. A mutual fund is structured to achieve certain investment objectives. Mutual funds don’t put investors’ eggs into one basket — meaning if one specific investment does not perform, the damage to the overall investment portfolio of the fund may be limited.

Nondiscrimination testing

By law, a company’s 401(k) plan can’t overly favor owners, executives, or those making the most money. Annual nondiscrimination tests look at employee participation, employer contributions, and other factors to determine if the plan complies with those requirements. Certain retirement plans, like Safe Harbor, automatically satisfy some nondiscrimination testing rules.

OregonSaves

OregonSaves is a retirement program that requires all employers to facilitate a state auto-IRA if they don’t offer a retirement plan for their Oregon-based employees.²

Payroll deduction IRA

As an alternative to a 401(k) plan, companies can help their employees enroll in a payroll deduction IRA. Individuals establish an IRA and the employer’s only responsibility is to facilitate the transfer of the employees' contributions from their paychecks to their IRA account.

Pooled employer plan (PEP)

A PEP is a particular type of open MEP set up for multiple unrelated employers. A PEP requires a pooled plan provider to be a named fiduciary and plan administrator for the PEP and to register with the Department of Labor.

Pre-tax contributions

Depending on the plan, employees can either contribute to their retirement account before or after federal and state taxes are taken out of their paycheck. As the name suggests, pre-tax 401(k) contributions are taken out before, thus they reduce the employee’s gross income in that year, potentially lowering income taxes.

Profit-sharing

In the context of retirement, profit sharing (sometimes referred as nonelective contributions) involves an employer making tax-deductible contributions that are allocated to employees’ 401(k) accounts. Think of it as a bonus deposited directly into employees’ retirement accounts. Profit-sharing comes with a slew of benefits for employers and employees—learn about those here.

Portability

Portability refers to the ease with which you can rollover an employee’s account from one employer’s plan to the plan of a different employer after a job change. In other words, if you contribute to a 401(k) account at your current job, you’ll have the option of rolling over that account to an IRA or future employer’s retirement plan (assuming the future employer’s plan permits such rollovers).

Portfolio

This term simply represents your overall collection of investments. A diverse retirement portfolio features of stocks, bonds, commodities, mutual funds, and other investments. The mix of these reflects how aggressive or conservative an investment strategy is.

Qualified distributions

The amount contributed to a Roth 401(k) or Roth IRA — commonly referred to as the “basis” — is always distributed tax free. However, the earnings on those contributions are subject to taxation unless certain requirements are met. When the requirements are met, you have a qualified distribution and the entire distribution is tax free. Additionally, distributions from from a Roth 401(k) will be subject to a 10% early withdrawal penalty tax unless you qualify for an exemption.⁴

Required minimum distribution (RMD)

While being “hands-off” on your retirement savings is usually a good thing, eventually, you do need to start removing your funds. The IRS requires individuals in their early 70s to begin drawing down their 401(k) accounts and traditional IRAs and pay taxes on these amounts whether or not they are still working. For 401(k) accounts employees who do not own more than 5% of the company and are still working there will not have RMDs due until they actually leave service.

Rollover

When you move your retirement savings from one plan to another (as might be the case when switching employers), that’s called a rollover. If the old and new employers share the same third-party 401(k) plan provider, the transfer is a simple one. In all other cases, the old provider will likely directly transfer the value of the account in cash to the new plan.

Roth 401(k) deferrals

Roth 401(k) deferrals allow employees to contribute to their retirement accounts on an “after-tax” basis, meaning they won’t owe taxes on that money, or the investment income on that money, when they retire. Roth accounts tend to be a popular option for younger employees since they have more time for their earnings to compound.

Roth IRA

Roth IRAs allow individuals to contribute to their retirement accounts on an “after-tax” basis, meaning they won’t owe taxes on qualified distributions (including any earnings) that are withdrawn from the IRA when they retire. Unlike 401(k) plans, IRAs are not necessarily employer-sponsored.

Safe Harbor 401(k) plans

Companies that offer retirement plans are subject to many compliance requirements, including nondiscrimination testing. Safe Harbor plans are a special kind of 401(k) plan that automatically satisfies some nondiscrimination tests. As a trade-off, these plans require companies to contribute a minimum amount to their employees’ retirement accounts. Learn about these minimums here.

Simplified employee pension (SEP) plan

SEP Plan stands for simplified employee pension plan, which is a type of IRA where contributions are made by the employer only. SEPs are tax-deferred retirement plans that may be established by businesses of any size. They are generally popular with entrepreneurs and small business owners due to larger contribution limits, greater flexibility, and fewer administration requirements compared to other retirement plans. If you own a company without many employees and want a low-stress, flexible way to contribute to retirement, a SEP IRA may be a good fit. Learn more about SEP IRAs here, as well as how SEP differs from a 401(k).

Summary plan description (SPD)

By law, companies with retirement plans are required to provide employees with an overview of the program that is written in language designed to be understood by the average participant. How the plan works, eligibility requirements, vesting details, and other important details need to be included.

Target-date fund

Mutual funds designed to invest funds in a manner to help achieve the investor’s investment objectives at a specific point in time are called target-date funds. In the context of retirement, a target date fund’s strategy typically gets more conservative the closer an individual gets to retirement age. Learn more about target-date funds here.

Tax-deferred

If you have a 401(k) account, your investment earnings are growing on a “tax-deferred” basis. This means that, unlike in a normal taxable investment account, you won’t pay taxes on earnings in your account every year. When it comes time to take a distribution, you’ll just owe income taxes on what you take out.

Tax penalty

If you take out retirement funds before turning 59½ years old, you’ll do so at a cost. The IRS will assess a 10% fee — a tax penalty — in addition to federal and state income taxes unless you meet one of the penalty exemptions.

Traditional 401(k) deferrals

Traditional 401(k) deferrals allow participants to set aside a share of their paycheck on a pre-tax basis. This means that generally the IRS will only tax these funds when the individual receives a distribution from the plan.

Traditional IRA

Traditional IRAs are tax-advantaged accounts at a bank, insurance company or other regulated financial institution that allow individuals to contribute money on a pre-tax basis. This means that the IRS will only tax these funds when the individual receives a distribution from the account. Unlike 401(k) plans, IRAs are not necessarily employer-sponsored.

Workplace retirement plan

Companies often offer their employees access to a retirement account as a benefit. A traditional 401(k) plan is the most popular example of a workplace retirement plan.

Need help keeping your terminology straight? If you’re thinking about offering or upgrading your retirement plan, we can help simplify things. To learn more about Guideline, schedule a plan consultation today.

Disclosures:

The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal, financial, personal investment advice, and/or a guarantee of performance that considers all relevant facts and circumstances. investing involves risk and investments may lose value. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.

¹  The average investment expense of plan assets for 401(k) plans with 25 participants and $250,000 in assets is 1.60% of assets, according to the 23rd Edition of the 401k Averages Book. Data is updated through September 30, 2022, and is inclusive of investment management fees, fund expense ratios, 12b-1 fees, sub-transfer agent fees, contract charges, wrap and advisor fees or any other asset based charges.

² This information is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. Deadlines, fees, and other program details are subject to change by the state without notice and should be checked prior to making any decisions.

³ This information is for illustrative purposes only and does not represent the actual account value you would accrue as a Guideline client. Information shown here does not account for common factors that affect the value of your account balance over time such as gains, losses, distributions, additional contributions, etc., and is not intended to constitute investment advice nor an assurance or guarantee of future performance.

⁴ This content is for informational purposes only and is not intended to be construed as tax advice. You should consult a tax professional to learn more about tax implications that considers all relevant facts and circumstances.

⁵ Dollar-cost averaging does not assure a profit or protect against loss in declining markets. It also involves continuous investment in securities, so you should consider your financial ability to continue your purchases through periods of low price levels

⁶ Subject to IRS cost‑of‑living adjustments.