Here are some basic financial terms that I often reference in my Money Monday posts. These are just brief descriptions to be used in your understanding of the financial terms used in posts. The concepts can be incredibly complex and different accounts or ideas can be used by people in different ways. If you need additional information for your personal situation, I would recommend doing additional research on the term using Google for these financial terms.
Retirement accounts
Traditional: This is a description of the account and the term can be paired with any of the retirement accounts below. This is the most common type of retirement account. Traditional means that the money you are contributing is “tax-deferred” which reduces your taxable income in the year that it was contributed. In a Traditional account, the distributions (both the amount you contribute and any earnings or gains in the account) will be considered taxable income to you when you withdraw them in retirement. If you withdraw funds before retirement, you may be subject to penalties and will need to factor in the tax effect of the withdrawal. If the title of the account does not explicitly state it is a Roth, usually it is safe to assume it is a traditional account.
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Roth: This is the opposite of the Traditional, and can be paired with most of the retirement plans listed below. A Roth is an after-tax account, meaning you do not get a tax deduction for the money when it is contributed. The distributions (both your contribution and any earnings or gains in the account) are not taxable to you when you withdraw them in retirement. Contributions only (but not investment earnings) can be withdrawn at any time from your account without penalty and are tax-free. Your contribution total is referred to as “basis” in your account and you should be able to look it up if needed.
Match: An amount that your employer contributes to your employer-sponsored retirement account for you. This may be a set dollar amount each year or a % of your salary. Often it requires you to contribute some or the same amount, but some employers will contribute their match regardless of if you contribute. This is often shown as a dollar-for-dollar match of 5% of your salary if you contribute 5% of your salary. So, you are getting 10% of your pay into your retirement account, but you are only contributing 5% of this. All of your match funds will go into your Traditional account as they are taxable upon distribution.
Profit-Sharing Plan: This is a type of company match based on the company profit for the previous year or quarter. It will be based on a published formula set by the company. If the company does not earn a profit in the year, the company usually would not contribute to the retirement account for this period. This type of plan is used to align employee interest to help the company earn a profit so they can receive the contribution. A profit-sharing plan is usually paired with a 401(k) account, but occasionally you will find one operating independently with only profit-sharing contributions.
IRA (Individual Retirement Account): An individually owned investment account that provides tax-advantaged savings options for retirement. They can be either a Roth IRA account to provide tax-free growth or a Traditional IRA account to receive a current-year tax deduction. The account is not connected to an employer and is solely owned by 1 individual. It can be opened at most any financial institution and provides a wide range of types of investments including stocks, bonds, mutual funds, ETFs, and Target date funds. A person can contribute up to $6,000 in 2021, with an additional $1,000 catch-up contribution if you are age 50+.
401(k): This is the most common type of retirement account in the US. Its unique name comes from the section of the IRS code where it was created. It is an employer-sponsored, defined contribution retirement account. Funding comes from the employee contributing a portion of their paycheck to the account and the employer may match funds contributed. These accounts can be both Traditional (pre-tax) and Roth (after-tax) depending on how the employer sets up the 401(k). Typically an employee can choose the investments in the account from a limited range of investment options determined by the employer and investment company. A person can contribute up to $19,500 in 2021, with an additional $6,500 catch-up contribution if you are age 50+.
457 Plans: This is a type of retirement account offered by employers to governmental employees and certain non-governmental employees. It operates very similarly to a 401(k) or 403(b) plan and can be contributed to as both Traditional (pre-tax) or Roth (after-tax) accounts. A unique feature of this plan is that withdrawals before age 55 are not subject to the 10% penalty for early withdrawals (though they are still subject to income tax if taken from a Traditional account).
403(b): This is a type of retirement account offered to Public education organizations and certain nonprofit organizations. It operates very similarly to a 401(k). These plans are usually only offered as Traditional (pre-tax) but some plans are more recently offering a Roth (after-tax) version too. These plans are often offered in conjunction with a defined benefit pension plan and are a great way to save on top of your pension plan.
Thrift Savings Plan: This is a defined contribution plan for US Civil Service employees and military employees. Generally, this is regarded as one of the best retirement plans available in terms of simple and extremely low-cost options to invest in. Currently, the TSP does not offer a Roth (after-tax option). There are several bloggers who are experts in getting the maximum value from these plans like Military Dollar or The Military Wallet.
Employee Stock Ownership Plans (ESOP): This is a unique type of retirement account where the employer gives employees ownership in the company or allows employees to buy (at a reduced cost) into ownership in the company. There are some significant tax benefits to the company to switch to an ESOP plan, (especially in companies where the founder is retiring and there is no one person/organization able to purchase the company). There is often an extended vesting period and a required holding period before you can sell any shares you purchase. These plans can be risky. Essentially you are tying your current paycheck and future retirement plans to the health of the company. If something happens to the company (a great example would be Enron), you are not only out of a job but now your retirement is worth nothing. If you have this program available to you, be cautious in investing in the program and make sure you have retirement savings in an IRA or 401(k) outside of this program to help hedge the risk.
Self-directed IRA: This account is an offshoot of a regular IRA. It allows the owner to invest in a broader range of investments outside of a traditional brokerage account. It can be real estate, commodities, or direct company ownership. They can be either Traditional or Roth. These are complex accounts with very specific rules and an investor should be well versed in these rules before opening one.
SEP (Simplified Employee Pension): This retirement account is targeted towards very small businesses. Employers are allowed to contribute to an IRA account (SEP-IRA) set up for each employee. There are unique rules that govern these plans and contribution limits are different from a 401(k). If you are eligible for a SEP, take time to thoroughly review the IRS’s website and plan documents provided by your employer. Usually, these are only available in a traditional (pre-tax) form and include a match or profit-sharing contribution from the employer).
SIMPLE (Savings Incentive Match Plan for Employees): This retirement account is targeted towards very small businesses. Employers are allowed to contribute to an IRA account (SIMPLE IRA) set up for each employee. There are unique rules that govern these plans and contribution limits are different from a 401(k). If you are eligible for a SIMPLE, take time to thoroughly review the IRS’s website and plan documents provided by your employer. Usually, these are only available in a traditional (pre-tax) form and are required to have an employer match or contribution for each employee. The employee is always 100% vested in these plans
Guaranteed Income Annuities: This allows you to convert some of your lump-sum retirement income into a monthly guaranteed income stream (similar to a pension). This type of retirement income shifts the risk of ensuring you have enough money to last until you pass away to the annuity company, rather than on your retirement account. This shift of risk comes at a cost though. Usually, these programs are sold by insurance companies through financial advisors. If you are interested in these, be very very careful in your research and understanding of the programs as often they come with high fees and large commissions paid to the broker or agent who sells them to you.
Vesting: The period of time that you must be an employee at the company before ownership of certain retirement benefits are fully yours. This will apply to the match component of your retirement plan and ESOP plan holding period of shares. This does not apply to your contribution to a retirement plan. Your contribution will always 100% belong to you and you can roll it out of your retirement account at any time. Often you will see this listed as a 3 year vesting period, where you receive access to 33.3% of your employer match with each year you work there. So if you leave the job after 2 years and 2 months, you would be able to roll over all of your employee contributions and 66.6% of the employer match.
Defined Benefit Plan (DB): This is commonly known as a pension plan, and is becoming rarer each year. The employee is guaranteed a “defined benefit” or a preset retirement benefit when they retire, regardless of the amount the employee contributes. This often looks like “if you work for us for at least 20 years, and retire after age 55, you are entitled to 75% of your final year’s salary as a pension for the remainder of your life”. These types of plans were incredibly secure for the employee but very risky for the employer who was locked into providing a required annual payment regardless of how the stock market performed.
Defined Contribution Plan (DC): These are the most common type of retirement account. 401(k), SEP, 403(b) accounts are all examples of this type of account. Essentially, it states that you can contribute what you want (up to the defined maximums), and when you retire you will get what is in the account. There is no guaranteed amount that the account will have or provide for you to live on once you retire. This puts the risk of growth and stock market volatility on the employee rather than the employer. Often the employer puts in a match component of a % of your salary. These can be found as either Traditional or Roth types, and often employers with offer both so employees can choose based on their situation.
DB/DC hybrid model: Some state or governmental entities are going to a hybrid defined benefit/contribution where you get a small amount of your salary as a defined benefit guarantee (maybe 25% of your final salary), but then have the option to defer part of your salary (they may or may not match this) into a defined contribution account to provide additional funds for yourself in retirement. This still provides some of the security of a DB plan, it is shifting risk off of the employer and onto the employee for ensuring retirement funding.
Medical Insurance:
Health Savings Account (HSA): A Health Savings Account (HSA) is a tax-advantaged account created for or by individuals covered under high-deductible health plans (HDHPs) to save for qualified medical expenses. Tax-deferred contributions are made into the account by the individual or their employer and are limited to a maximum amount each year. The contributions can be used to pay for qualified medical expenses, such as medical, dental, and vision care, as well as prescription drugs, but you are not required to use the account up each year (a key difference from an FSA) and can accumulate a balance in the account. For the year 2021, the maximum contributions are $3,600 for individuals and $7,200 for family coverage. If one person who is enrolled in coverage is over 55, then an additional $1,000 contribution can be made. These accounts can be incredibly beneficial from a tax perspective and can be a key part of your retirement savings.
Flexible Spending Account (FSA): The account allows you to contribute a portion of your regular earnings; employers also can contribute to employees’ accounts (usually these contributions are tax-deferred). Distributions from the account must be used to reimburse the employee for qualified expenses related to medical and dental services (some employers offer a child care FSA, but this is rare). Contributions must be spent on qualified medical expenses in the year they are contributed and accumulation of a balance from year to year is not allowed (except for some short-term small amounts).
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Preferred Provider Organization Plan (PPO): A type of health plan that contracts with medical providers, such as hospitals and doctors, to create a network of participating providers. You pay less if you use providers that belong to the plan’s network. You can use doctors, hospitals, and providers outside of the network for an additional cost, but your insurance plan will still be accepted even if you use a non-preferred provider, the cost just may be higher than using a preferred provider. This is the most common plan and provides you the greatest flexibility with using various providers.
Exclusive Provider Organization Plan (EPO): A managed care plan where services are covered only if you go to doctors, specialists, or hospitals in the plan’s network (except in an emergency). Any non-emergency out-of-network care will not be paid or count towards your deductible. These plans are usually lower cost, but be cautious of the restrictions of the network.
Health Maintenance Organization Plan (HMO): A type of health insurance plan that usually limits coverage to care from doctors who work for or contract with the HMO. It generally won’t cover out-of-network care except in an emergency. An HMO may require you to live or work in its service area to be eligible for coverage. HMOs often provide integrated care and focus on prevention and wellness. These plans are usually lower cost, but be cautious of the restrictions of the network.
Co-pay: A copay is a fixed out-of-pocket amount paid by an insured for covered services. It is a standard part of many health insurance plans. Insurance providers often charge co-pays for services such as doctor visits or prescription drugs. Copays are a specified dollar amount rather than a percentage of the bill, and they are usually paid at the time of service directly to the provider. Copay’s do not count towards your deductible. As an example, copays are usually listed on the insurance information page as $20 for an in-office doctor visit or $15 for a generic prescription. This amount is separate from the plan deductible and will still need to be paid even if you hit your plan deductible.
Deductible: The amount you pay out of pocket for covered health care services before your insurance plan starts to pay. There is usually still some benefit provided in this period because you receive the insurance company’s negotiated preferred discounted rate rather than the higher non-insured price. The amount and remaining balance of your deductible are usually found on the Explanation of Benefits that the insurance company provides whenever they process a claim for you. Generally, the lower the deductible is, the higher the cost of coverage is. Plans may have multiple deductibles (medical care deductible and separate prescription deductible) or will have a per person deductible and a family aggregate deductible.
Co-insurance: The percentage of costs of a covered health care service you pay after you’ve met your deductible. Coinsurance is a way of saying that you and your insurance carrier each pay a share of eligible costs that add up to 100 percent. Often this will show on the insurance information as an 80/20 plan meaning after the deductible has been met, you are responsible for 20% of the cost of care and the insurance company is responsible for 80% of the cost. This co-insurance cost is in place until you have met the out-of-pocket max for the year.
Out-of-pocket maximum: The maximum you could pay for covered medical expenses in a year. This amount includes money you spend on deductibles, copays, and coinsurance. It does not include the cost of insurance premiums or non-covered medical care. Once you reach your annual out-of-pocket maximum, your health plan will pay 100% of covered medical and prescription costs for the rest of the year. You will still be responsible for any co-pays required.
Investment Terms
Brokerage Account/Taxable Account: Type of investment account held at an investment firm (Vanguard, Fidelity, Edward Jones, Merrill Lynch, etc) where there are no tax benefits, you can invest in a wide range of individual stocks, bonds, mutual funds, ETF’s and alternative investments. The accounts are taxable for any dividends, interest, or capital gains earned during the year and will send a 1099 form to report taxable activity.
Stocks: A fractional ownership in a publicly-traded company. You own a share of their assets and are entitled to a share of their profit or loss each year. Most often traded on a public exchange that allows anyone to purchase an amount from 1 share up to the maximum amount that is available for sale. Stocks are the foundation of most retirement and investment accounts and there are thousands of US and foreign stocks that you can purchase through your brokerage account. Ownership in private companies is also called stock, but this is rare and is arranged privately between the seller and buyer. Stocks are considered more volatile or risky than bonds.
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Bonds: Are corporate or governmental debt issued by an entity, purchased by an investor with a guaranteed interest rate and a certain date where the principal is returned. They are used to finance buildings or large operation deficits. The value of the bond does not change as drastically as stocks can, and the interest income earned is more reliable. Therefore these are seen as safer than stock investments and are usually used by people who are in retirement or close to retirement.
Mutual Funds: Are a type of investment that allows multiple investors to pool their money to invest in securities like stock or bonds. These are most commonly offered by financial brokerage companies like Vanguard and Fidelity where they combine investment amounts of many customers who sign up into the mutual fund into one large investment into many specific investments. Often there is a professional manager in charge of buying new investments and selling underperforming assets. A mutual fund is a marketable security that allows it to be purchased and sold on a trading platform just like stocks.
ETF (Exchange Traded Funds): Is a type of security that tracks a specific index, sector, commodity, or other assets. These funds are automated. There is no manager making changes between positive and negative performing assets, which reduces the cost of these funds. A common example of an ETF is the SPDR S&P 500 ETF which tracks exactly the S&P 500 Index used to measure the stock market performance. An ETF is a marketable security that allows it to be purchased and sold on a trading platform like stocks.
Target date funds: This is a type of mutual fund or ETF that periodically rebalances to become more conservative (fewer stocks and more bonds) as it gets closer to its “target date”. These are very popular for retirement accounts. If you are going to retire around 2050, you can select a Target 2050 fund which is 90% stocks and 10% bonds today but will slowly shift to be 50% stocks and 50% bonds in 2050 at retirement. These are also can be useful for shorter-term savings like college saving when starting the savings account as a baby.
