We know: Reading about retirement can sometimes make you feel like you are staring into a bowl of alphabet soup.
So while you know that you need to start building a nest egg, the financial jargon involved can make it seem like a challenging and confusing task—so you keep putting it off until you can “do more research.”
Either that, or you’re hoping there’s a windfall in your future: According to a 2015 study by the Insured Retirement Institute and the Center for Generational Kinetics, more than a quarter of Millennials are banking on either winning the lottery or receiving an inheritance as their retirement strategy. (Spoiler alert: This probably isn’t your best-laid plan.)
So unless you just hit the jackpot, today is as good a time as any to start socking away for retirement. And to make the task less of a mystery, we’ve compiled seven of the most common terms you’re likely to see scattered throughout the paperwork from your HR department or financial services provider.
1. Defined Benefit Plan
An employer-sponsored retirement plan in which your company would pay a regular benefit to you after you retire. This benefit could either be a specified monthly dollar amount or a figure based on a calculation that incorporates factors like your earnings history and years of service. The money typically comes from a pool of funds that is invested by the company on behalf of its employees.
If your company offers this kind of plan, you may or may not be asked to contribute to it, although typically, you won’t. One of the most common types of defined benefit plans is a pension—however, fewer and fewer companies these days offer one, which means pensions are slowly going the way of the dodo. So more likely than not, the retirement plan offered by your new company will be a …
2. Defined Contribution Plan
Consider this the more DIY version of the employer-sponsored retirement plan. In this type you contribute funds into a retirement account set up for you by your employer, who may also make a contribution on your behalf.
However, unlike with a pension, you choose how you’d like to invest your money, based on the options offered by your plan provider. That means how much you end up with in retirement depends on you: how much you choose to contribute as well as what type of return your investments ultimately provide.
A 401(k) is one of the most popular types of defined contribution plans, and there are two different kinds that may be offered to you by your company.
A traditional 401(k) allows you to contribute pretax dollars from your paycheck. This means that what you contribute now helps lower your taxable income, and any earnings in your account are tax-deferred—i.e., you won’t pay taxes on them until you withdraw your funds in the future.
A Roth 401(k) allows you to contribute on an after-tax basis. That means you pay taxes upfront on your contributions—but you don’t pay taxes on that money or any earnings when you make withdrawals in retirement.
Before you go gangbusters on your nest-egg building mission, however, know that there is a maximum amount you can contribute to your 401(k) each year. For 2016, employees under 50 years old can contribute up to $18,000, whether you have a traditional, Roth or a combination of both. Because they are closer to retirement, employees 50-plus can also make additional “catch-up contributions” of up to $6,000, for a maximum contribution of $24,000.
(By the way, if you work for a university, the government or a nonprofit, your version of the 401(k) is likely to be called the 403(b) or 457 plan.)
It’s true that there’s no such thing as free money—but your employer match is about as close as it gets. If your company offers you a 401(k) plan, they may also opt to match any contributions you make to your account, up to a certain point.
For example, your employer may choose to match 50% of your contributions, up to the first 6% of your salary. So in this scenario, if you make $50,000 and contribute $3,000 to your 401(k), your employer will throw in another $1,500—talk about a match made in (financial) heaven.
Short for Individual Retirement Arrangement or Individual Retirement Account, an IRA is an investment account that you use specifically to save and invest for retirement.
Unlike a 401(k), which is provided by your employer, an IRA is something you open and fund on your own. But similar to a 401(k), it has both traditional and Roth versions.
However, the contribution limits for an IRA are also much lower than for a 401(k): In 2016, you can only contribute up to $5,500, whether you have a traditional IRA, a Roth IRA or a combination of both. If you’re 50 and older, you can contribute an extra $1,000, for a total of $6,500. Just note that you have to meet certain income requirements in order to be eligible to contribute to a Roth IRA.
If you really want to be an overachiever when it comes to retirement, by the way, you could always contribute to both a 401(k) and an IRA—although if you have a retirement plan at work, whether you can take a tax deduction for your traditional IRA contributions will, once again, be dependent on your income.
6. Target Date Fund
When you open a retirement account, you’ll notice that you’ll have several types of investments to choose from. One of type of investment you may see that’s geared toward retirement is the target date fund (also known as a “lifecycle” or “age-based” fund).
This is a type of mutual fund whose investing strategy is matched to a specific timeframe. The gist is this: When you’re younger and have a longer time to go until retirement, the fund will likely be weighted more heavily toward riskier investments, such as equities. But as you age, the fund’s allocation may shift to increasingly conservative investments, such as bonds.
Often, a target date fund will have a year in its name that indicates what sort of timeline it is investing for. So, for instance, if you want to retire in 34 years, you may opt to invest in a target date fund with 2050 in its name.
Nope, it’s not a command you give Fido when you want to impress your friends. It’s what you may opt to do if you want to combine disparate retirement accounts into one.
When you leave one job for another, you may get a new 401(k) account with your new employer. But what happens to the old 401(k) account you had at your previous job? That’s where the rollover comes in: You could opt to roll it over (hence the name) into your new company 401(k) or roll it over into an IRA.
One of the biggest advantages of doing a rollover is that you’re consolidating your retirement money and having it all in one place means you may be able to better manage your retirement funds and keep track of how your nest egg is progressing. Rolling over is an especially good idea to consider if your old 401(k) charges higher investment fees—or if you prefer the investment options in your new account over your old one.