Salary/Financial Definitions

What is a 401(k) Plan?

A 401(k) is a voluntary retirement plan that companies may offer to their workers. Employees set aside a percentage of their wages before taxes, up to a certain maximum, and invest those funds within the retirement plan. The percentage you can contribute varies from company to company, and the federally mandated yearly maximum may increase over the years. (Starting in 2002, the yearly federal maximum contribution is $11,000 and rises in increments until 2006.) An employer often contributes to its employees’ 401(k) by matching the employee’s contributions up to a certain percentage. The contributions and the interest and gains that accrue are not taxed until the funds are withdrawn. There are restrictions on when and how 401(k) funds can be withdrawn.

How does a 401(k) plan work?

You decide how much of your paycheck (up to the maximum allowed) you will contribute to your 401(k) plan. That amount is deducted from your paycheck before taxes are taken out and is deposited automatically into the plan. Normally, you have a choice of several possible mutual funds and other investment vehicles with a variety of levels of potential risk and return. You will be given information about the investment opportunities when you sign up for the 401(k). Many corporations do not allow you to participate in their 401(k) plans until you have worked there for at least one year.

What is a 403(b)?

Employees of nonprofit organizations, for example, some hospitals, universities, and charitable organizations, generally have 403(b) plans available to them.

What’s the difference between a 401(k) and a 403(b)?

From the perspective as an investor, they work almost identically. (Please see above.) The main difference is that in some 403(b)s, you cannot change the amount of money that you put in every month. You must decide once, at the beginning of the year.

What is a profit sharing retirement plan?

This is a retirement plan where a company uses its profits to fund a qualified retirement plan for its employees. Unfortunately, in this kind of plan an employer does not have to contribute to the plan, even when there are profits to share. On the other hand, a company may well decide to contribute to your plan even if it has not made a profit that year. Yes, you heard it right - in a profit-sharing plan, the employer has the discretion to contribute or not, regardless of profitability. An employer can contribute absolutely nothing; and an employer feeling generous is limited in how much he or she can contribute. The contribution formula is based on compensation and as of the year 2001 cannot be more than 15 percent of your pay, up to a maximum of $170,000 of income. So even if you make $200,000 a year, the maximum your employer could contribute to your profit-sharing plan (for the year 2001) would be $25,000 - 15 percent of $170,000. Please note that in the year 2002 the maximum contribution rises to $40,00.

What is a defined-benefit pension plan?

A defined-benefit pension plan is a qualified retirement plan that promises to pay a specific amount to an employee who retires after a certain number of years. The benefit might be an exact dollar amount, for example $4,000 per month. More common, the benefit might be determined by a formula that takes into account factors such as salary and length of employment with the company. For example, you might receive a monthly payment of 1 percent of your average salary during the last five years of employment for every year of service with your employer.

A defined-benefit pension plan is funded by the employer that creates it, not by the employees. The money that is held within a defined-benefit plan is not allocated to individual accounts; it is kept in one big account with all the money for all the employees. Money from this plan is usually not available for withdrawal until you reach retirement age, at which time you can receive it as a lump-sum payment, if your plans allow it, or as a lifetime annuity. Also, though you have been promised a defined benefit when you retire, if you leave that job or retire before the set retirement date, benefits will be redefined. The bottom line is that the company is responsible for funding the plan, and it is responsible for giving the full benefit that has been defined. By law, it cannot fall short of that goal.

What is a stock bonus plan?

This qualified retirement plan works very much like a profit-sharing plan. The only difference is that the employer makes its contributions in the form of company stock instead of cash.

Stock-option Plans

Give employees of a particular company the opportunity (or option) to purchase a particular amount of the company’s stock for a fixed price within a specified period. Acting on this opportunity is known as exercising the option, and the fixed price is known as the exercise price.

Stock Purchase Plan

Typically, with a stock purchase plan, employees can designate an amount of money to be withheld from their regular paychecks and used to buy stock in the company, sometimes at rates discounted from the market price. The money then grows (or shrinks!) tax-deferred until the employee sells the stock, usually after an extended period.

Vested versus Nonvested

Your stock is considered vested if, according to the agreement you made with your employer, you retain the full value of the stock no matter what happens. “No matter what” include your quitting your job or getting fired. It also means that you have the right, if you wish, to transfer this stock to anyone you want. Any agreement other than this means that you have been given nonvested stock. Your stock may become vested over time.

The above excerpts are from Suze Orman’s book,
The Road to Wealth: A Comprehensive Guide to Your Money

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