What’s the difference between a 401(k) and a 403(b)? How about variable and fixed annuities? Heck, what is an annuity anyway?
Financial planning is full of complex language that may be second nature to insiders but is often gobbly-gook to those who need to understand it most -- people trying to plan for retirement. Shelly-Ann Eweka, director of Individual Advisory Services at TIAA, provided The Huffington Post with a mini-dictionary of "must know" terms for retirees. Our suggestion is to memorize two a day and by Monday, you'll pass this vocabulary test with flying colors.
The most common type of workplace retirement plan, a 401(k) allows employees to defer up to $18,000 of their annual salary on a pre-tax basis. Many employers will match your contributions up to a certain percentage point. This is a good thing and everyone (younger people included) should be enrolled at least to the point of taking advantage of the company match. Anything less and you are walking away from free money.
401(k) savings are generally pooled into mutual funds, where, thanks to compound interest (defined below), they can grow considerably. Distributions are made during retirement and taxed as ordinary income. There are also 403(b)s, which are like a 401(k) but for employees of tax-exempt, nonprofit institutions -- think schools and hospitals. The contribution limit and other rules are the same as with a 401(k), but there is rarely an employer match, which is a bummer.
2. Asset allocation
This is the strategy of dividing your investments among different assets, such as stocks and bonds. The aim is to find the sweet spot for your money so that risk and reward are balanced. A typical portfolio for a younger saver would likely put 90 percent in stocks and 10 percent in bonds. When you are younger, you can tolerate greater risk because you have time to recover if things go south. In many popular funds, the asset allocation adjusts itself automatically based on the risk tolerance and age of the participant. But since no two people are the same or have identical goals, it's always good to initiate an annual review with a live person.
The investments in your retirement account earn interest -- and that interest itself earns interest. The longer your money compounds, the faster it grows. Let’s say you own stocks growing at 6 percent per year; the value of that investment will double in about 12 years but will be worth four times as much in 24 years. The earlier you start saving, the more you benefit from compounding. If saving is delayed, the power of compounding is lost and savers need to defer a greater percentage of their salary to catch up.
4. Defined contribution plan
Defined contribution plans, such as the 401(k), have largely replaced old-fashioned defined benefit plans (otherwise known as a company pension where employees were promised a specific benefit in retirement). DC plans shifted responsibility from employer to employee with the spin that this gave the control to the worker over how much he wanted to save and how that money was being invested. While a lovely idea, things didn't quite go the way they were supposed to. By 2011, almost half of working Americans were not offered a retirement account by their employer. And a staggering 68 percent of working-age people did not participate in an employer-sponsored retirement plan, according to a study by the Economic Policy Research group.
“Fiduciary” is a legal term that comes from the Latin word for “trust.” As a fiduciary, your financial advisor is legally required to put your interests above all others (for instance, the commission they may receive for selling you a product) and act with “care, skill, prudence and diligence.” Fiduciaries have a duty to continually monitor your investments and financial situation.
6. Fixed annuities
In exchange for a lump-sum cash payment, an insurance company can provide you with a steady stream of income for life (or whichever period of time you choose). The money invested in your annuity is guaranteed to earn a fixed rate of return. Typically you need to wait for a set period of time before your payments kick in.
7. Fixed-income funds
These funds are less risky than equity funds but generally provide less growth. As you near retirement, your portfolio will typically become more weighted toward fixed-income funds, such as bonds.
An Individual Retirement Account is often used to supplement workplace plans. It has the same tax advantages (contributions are deductible from your gross income) for most people, but the annual contribution limit is much lower ($5,500). If you leave your job, you can transfer (or “roll over”) the balance from your workplace retirement plan into an IRA; that way you get to continue enjoying tax-deferred growth on your assets. If you prefer a more hands-on approach to investing, there are self-directed IRAs, which enable you to call the shots and have complete control over your investment choices. Most retirement plans offer varying degrees of self-directed investing. There are also Roth IRAs, which allow you to make contributions on an after-tax basis, but there are income limits for contributing to a Roth IRA, so they aren’t an option for higher earners.
9. Mutual fund
Professionally managed funds that pool money from many investors to invest in stocks, bonds and other securities. Typically, the cash you put into your retirement plan will be invested in mutual funds.
10. Variable annuities
Like a fixed annuity, you are handing over a lump sum in exchange for a steady income in retirement. The difference is you get to choose from a mix of investments. The size of your payments will vary according to how those investments are performing.
Remember: Two words a day, test on Monday.