Special Tax Treatment for 401k and 403b Plans Explained

Saving for retirement is one of the most important financial decisions, and 401(k) and 403(b) plans offer significant tax advantages to help individuals grow their savings. These employer-sponsored retirement accounts reduce taxable income, allow investments to grow tax-deferred, and may include employer contributions.

Contributions and Tax Deferral

Traditional 401(k) and 403(b) plans let employees contribute a portion of their salary on a pre-tax basis, lowering taxable income. In 2024, the IRS allows contributions up to $23,000 for those under 50, with an additional $7,500 in catch-up contributions for those 50 and older. These limits are periodically adjusted for inflation.

Funds grow tax-deferred, meaning investment gains, dividends, and interest accumulate without annual taxation, allowing for compounding growth. For example, contributing $10,000 annually with a 7% return could result in a balance of about $1 million over 30 years.

Withdrawals in retirement are taxed as ordinary income, which can be beneficial if the account holder is in a lower tax bracket. Early withdrawals before age 59½ typically incur a 10% penalty, unless an exception applies, such as disability or medical expenses exceeding 7.5% of adjusted gross income.

Roth Investment Option

A Roth 401(k) or 403(b) allows after-tax contributions, meaning taxes are paid upfront, but withdrawals—including earnings—are tax-free if the account has been held for at least five years and the account holder is at least 59½.

This option benefits those expecting to be in a higher tax bracket in retirement. Since taxes are already paid, retirees avoid future tax increases reducing their income. Younger workers with decades of growth potential and those anticipating significant retirement income may find this option advantageous.

Unlike traditional accounts, Roth contributions don’t lower taxable income in the contribution year. However, Roth accounts are not subject to required minimum distributions (RMDs) during the account holder’s lifetime, allowing funds to grow tax-free indefinitely. This makes them useful for estate planning, as heirs can inherit the account without immediate tax consequences, though distribution rules still apply.

Employer Matches

Many employers enhance retirement savings by offering matching contributions. Matches vary but often follow a formula, such as dollar-for-dollar up to a percentage of salary or 50 cents per dollar up to a set limit. For example, an employer matching 100% of contributions up to 5% of salary means an employee earning $60,000 who contributes $3,000 would receive an additional $3,000.

Employer contributions may be subject to vesting schedules, determining when employees fully own the matched funds. Some companies use graded vesting, where ownership increases over time, while others require employees to stay a set period before full ownership. In 2024, employer contributions must fully vest within three years under cliff vesting or six years under graded schedules. Employees leaving before meeting these requirements may forfeit part of their employer’s contributions.

Distinctive Features for Tax-Exempt Employers

Retirement plans sponsored by tax-exempt organizations, such as public schools, universities, and nonprofit hospitals, have unique features. Many 403(b) plans include investment options like annuities, which were historically the primary choice. While mutual funds are now permitted, some plans still offer annuities, which may affect fees and liquidity.

Certain long-term employees of qualifying 403(b) organizations can make a “15-year catch-up contribution,” allowing an extra $3,000 per year, up to a lifetime maximum of $15,000, if they have at least 15 years of service and prior contributions averaged less than $5,000 annually. This is separate from the standard catch-up contributions for those over 50, providing an opportunity for late-career employees to boost savings.

Rollover Rules

When changing jobs or retiring, individuals must decide what to do with their retirement savings. Rolling funds into another tax-advantaged account helps maintain tax deferral and avoid penalties. The most common option is transferring assets into an IRA, which often offers more investment choices and lower fees. Direct rollovers, where funds move between accounts without the account holder taking possession, prevent tax withholding and penalties. If a distribution is taken and not reinvested within 60 days, it is treated as taxable, with 20% withheld for federal taxes and a potential 10% early withdrawal penalty for those under 59½.

For those with a new employer, rolling funds into the new company’s plan may be possible, allowing continued tax-deferred growth and account consolidation. Some plans restrict incoming rollovers, so reviewing the new employer’s rules is important. Leaving funds in a former employer’s plan is sometimes an option, but investment choices and fees should be considered. Special rules apply to 403(b) rollovers, particularly if annuities are involved, as surrender charges or contractual limitations may affect the transfer.

Mandatory Distributions

Once individuals reach a certain age, they must start withdrawing funds from tax-deferred retirement accounts. Required Minimum Distributions (RMDs) apply to 401(k) and 403(b) plans, with the first withdrawal generally due by April 1 of the year following the account holder’s 73rd birthday, as of 2024. Subsequent RMDs must be taken annually by December 31. Failing to withdraw the required amount results in a penalty—25% of the shortfall, reduced to 10% if corrected within two years.

The required withdrawal amount is determined by dividing the account balance as of December 31 of the prior year by an IRS life expectancy factor. For example, an individual with a $500,000 balance and a factor of 26.5 must withdraw about $18,868.

Roth 401(k) and 403(b) plans were previously subject to RMDs, but as of 2024, this requirement has been eliminated, allowing Roth funds to remain untouched indefinitely. Employees still working past 73 may be able to delay RMDs from their current employer’s plan if they do not own more than 5% of the company, offering flexibility in managing taxable income.