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How 401(k) and 403(b) Retirement Plans Work

Two of the most common employer-offered retirement plans are 401(k) and 403(b). A 401(k) plan is typically offered by for-profit companies while a 403(b) plan is similar in structure but offered by non-profits or employees of public schools. Plans vary in how they work but their purpose is the same – to help employees build a retirement savings account. Employees contribute a pre-set amount of salary to the offered plan that earns tax-deferred interest until funds are distributed. These plans are designed to build interest over time with money being distributed to the participant any time after age 59½.

Employers can legally offer plans that allow employees (and only employees) to contribute a portion of salary (as much as $19,500 annually) to save for their retirement needs. These plans are only provided by an employer; employees may be automatically enrolled but can opt in or out. The plan allows the employee to keep the account if they leave the employer so it can continue to function as a retirement savings account; it is commonly rolled over to another plan management company.

Both plans allow participants to contribute up to $19,500 in 2020. Participants over age 50 can contribute an additional $6,500 in 2020. Contributions are made through a pre-determined amount -- the participant’s salary is reduced by the amount she or he wants to contribute to the plan. Money in either account will grow on a tax-deferred basis and is not taxed until it is withdrawn.

Plan Distributions

Plan participants can withdraw funds without penalty after they reach age 55 if they have left the employer. In some cases, money in the plan may be accessed prior to the established age limit due to a hardship. Hardship withdrawals require immediate and heavy financial need and have specific rules that must be followed. A participant may borrow up to 50% of the account value or $50,000, whichever is less. Although a plan is not required to provide loans or hardship withdrawals, it may be an option.

Participants may begin withdrawing account balances without penalty based on one of three criteria:

  1. Reaching age 55 and separating from service

  2. Reaching age 59½

  3. Having a disability

Beneficiaries also may withdraw funds without penalty. Specific rules may apply to any distribution plan, the plan administrator should be consulted for specific details.

Required Minimum Distributions (RMDs)

Participants must begin taking funds from the account by age 72 (2020 SECURE Act) unless they continue to work for the employer. The amount of each RMD can be determined using an appropriate chart from the IRS. The first RMD must be taken no later than April 1 of the year following the year in which participants reach age 72. Failure to withdraw the required amount results in a tax penalty of 50% on the amount that was not distributed.

Roth Option in Addition to a 401(k) or 403(b) Plan

A Roth option on either account allows for contributions to be made on an after-tax basis as there are no tax deductions for contributed amounts. When funds are later withdrawn through what is known as a qualified distribution they will not be taxed.

A qualified distribution has two requirements:

  1. Funds must be held in the account for at least five years

  2. Funds cannot be withdrawn prior to reaching age 59 ½, whichever is later otherwise, the same distribution rules apply for a Roth option as for regular 401(k) or 403(b) plans

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Age Well Planner is an educational website created by nonprofit the National Council on Aging (NCOA). We provide information, resources, and referrals on topics such as: Benefits, Income, and Medicare.

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