A 401(k) is a defined contribution retirement plan offered by for-profit employers. The name comes from the section of the Internal Revenue Code that authorized it. Employees elect to defer a portion of each paycheck into the plan on a pre-tax basis, reducing current taxable income. The money grows tax-deferred until withdrawn in retirement, at which point withdrawals are taxed as ordinary income.
Real-world example: Sarah earns $80,000/year and contributes 10% ($8,000) to her 401(k). She pays income tax only on $72,000 this year — the $8,000 is not taxed until she withdraws it decades later. Her employer also matches 50% of contributions up to 6% of salary ($2,400 employer contribution), effectively delivering a 3% raise she would otherwise forfeit by not participating.
Roth 401(k) option: Many modern plans now offer a Roth 401(k) — same contribution limits as the traditional 401(k), but contributions are made after-tax. Qualified withdrawals are completely tax-free. Under SECURE Act 2.0, Roth 401(k) accounts are no longer subject to RMDs beginning in 2024.
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A 403(b) plan — also called a Tax-Sheltered Annuity (TSA) — is the retirement plan equivalent of a 401(k) for employees of:
Functionally, 403(b)s operate nearly identically to 401(k)s: pre-tax contributions, potential employer matching, same contribution limits, and the same withdrawal rules. Historically 403(b)s were restricted to annuity contracts (hence "tax-sheltered annuity"), but modern plans typically also offer mutual fund options.
Key exam distinction: 403(b) = nonprofits/schools; 401(k) = for-profit companies. This distinction is tested frequently.
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| Plan | Under Age 50 | Age 50+ (with catch-up) | |---|---|---| | 401(k) | $23,000 | $30,500 | | 403(b) | $23,000 | $30,500 | | 457(b) (government) | $23,000 | $30,500 |
These limits apply to employee elective deferrals only. The total combined contributions (employee + employer) are capped at $69,000 (2024) or 100% of compensation, whichever is less.
SECURE Act 2.0 enhanced catch-up (ages 60–63): Beginning in 2025, employees aged 60–63 can contribute an additional $10,000 (or 150% of the regular catch-up amount, whichever is greater) to their 401(k) or 403(b).
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Employer matching is the most valuable benefit associated with 401(k)/403(b) plans. Common matching structures:
50% match up to 6% of salary: The employer contributes $0.50 for every $1.00 the employee puts in, up to 6% of salary. To capture the maximum match, the employee must contribute at least 6% of salary.
100% match up to 3% of salary: The employer matches dollar-for-dollar up to 3% of salary.
Employee's own contributions (elective deferrals) are always 100% immediately vested — they are the employee's money from day one. Employer matching contributions vest on a schedule.
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Vesting determines when employer contributions become permanently and irrevocably the employee's property. If an employee leaves before full vesting, unvested employer contributions are forfeited back to the plan.
Cliff vesting: The employee receives nothing from employer contributions until the cliff date, then becomes 100% vested all at once.
Graded vesting: Ownership of employer contributions increases incrementally over time.
Real-world scenario: An employee has been at her company for 2.5 years under a 3-year cliff vesting schedule. The employer has contributed $6,000 to her 401(k). If she resigns today, she keeps all of her own contributions — but forfeits the entire $6,000 in employer contributions (0% vested before the 3-year cliff).
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A hardship withdrawal permits access to 401(k) funds before age 59½ without a loan structure. Unlike IRA hardship exceptions, 401(k) hardship withdrawals are subject to both ordinary income tax AND the 10% early withdrawal penalty.
The IRS requires an "immediate and heavy financial need":
After a hardship withdrawal, the plan may suspend the employee's new contributions for up to 6 months.
Critical exam trap: The education exception waives the 10% penalty for Traditional IRA withdrawals — but NOT for 401(k) hardship withdrawals. The penalty applies to 401(k) hardship distributions regardless of purpose.
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Unlike hardship withdrawals, 401(k) loans can be repaid — preserving the tax-deferred status of the borrowed funds if handled correctly.
Loan rules:
Termination risk: If you leave your job (voluntarily or are terminated), the outstanding loan balance typically becomes due within 60–90 days. If you cannot repay, the balance is treated as a distribution — taxable as ordinary income plus a 10% early withdrawal penalty if you are under 59½.
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The Employee Retirement Income Security Act (ERISA) is the federal law governing private-sector employer-sponsored retirement plans. ERISA establishes:
Fiduciary duty: Plan administrators, trustees, and investment managers are fiduciaries. They must act solely in the interest of plan participants and beneficiaries — not in the interest of the employer (plan sponsor). ERISA imposes the "prudent expert" standard: act as a knowledgeable investment professional would, not merely as a reasonable layperson.
Core fiduciary obligations:
Disclosure requirements: Plans must provide participants with a Summary Plan Description (SPD), annual fee disclosures, and quarterly account statements.
Prohibited transactions: Plan fiduciaries cannot engage in self-dealing — for example, lending plan assets to the plan sponsor is a prohibited transaction subject to excise taxes.
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Quiz Questions:
Q1. A teacher at a public high school wants to contribute to an employer-sponsored retirement plan. Which plan would she MOST likely be offered?
A) 401(k) B) 403(b) C) SEP-IRA D) SIMPLE IRA
Answer: B — 403(b) plans serve employees of public schools, nonprofit organizations, hospitals, and certain other tax-exempt entities. 401(k) plans are for for-profit companies. SEP-IRAs and SIMPLE IRAs are for self-employed individuals and small businesses, not institutional employees.
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Q2. An employee has $90,000 in a fully vested 401(k) and wants to take a plan loan. What is the MAXIMUM she may borrow?
A) $90,000 B) $50,000 C) $45,000 D) $25,000
Answer: C — The loan limit is the lesser of 50% of the vested balance or $50,000. 50% × $90,000 = $45,000. Since $45,000 < $50,000, the maximum loan is $45,000. If the vested balance were $120,000, then 50% = $60,000, which exceeds the $50,000 cap, so the maximum would be $50,000.
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Q3. An employee participates in a 401(k) with a 6-year graded vesting schedule (20% per year starting year 1). She leaves after exactly 4 years of service. Her own contributions total $18,000 and her employer's total contributions are $9,000. How much does she take with her?
A) $18,000 B) $23,400 C) $25,200 D) $27,000
Answer: C — Employee contributions are always 100% immediately vested → she keeps all $18,000. Under 6-year graded at 20%/year: after 4 years she is 80% vested in employer contributions → 80% × $9,000 = $7,200. Total: $18,000 + $7,200 = $25,200.
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Q4. Under ERISA, which of the following BEST describes the fiduciary standard imposed on a 401(k) plan administrator?
A) Act in the best interest of the plan sponsor (employer) when investment decisions affect company finances B) Act with the care, skill, and diligence of a prudent expert, solely in the interest of plan participants and beneficiaries C) Recommend only SEC-registered investment options within the plan D) Follow the investment elections made by the majority of plan participants
Answer: B — ERISA imposes a "prudent expert" fiduciary standard: the administrator must act as a knowledgeable investment professional would, solely for the benefit of participants and beneficiaries. Acting in the employer's interest (A) is a fiduciary breach. ERISA does not require only SEC-registered options (C). Participant preferences do not govern fiduciary investment decisions (D).
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Q5. A 401(k) participant, age 46, takes a $25,000 hardship withdrawal to pay for her son's first year of college tuition. She is in the 22% tax bracket. What is her total federal tax cost on this withdrawal?
A) $5,500 (income tax only — education expenses are a penalty exception for retirement plans) B) $8,000 ($5,500 income tax + $2,500 penalty) C) $2,500 (10% penalty only; education withdrawals are tax-free) D) $0 — hardship withdrawals are never subject to tax
Answer: B — This is the classic 401(k) vs. IRA trap. The education exception to the 10% penalty applies to Traditional IRA withdrawals — but NOT to 401(k) hardship withdrawals. All 401(k) hardship withdrawals are subject to both ordinary income tax and the 10% early withdrawal penalty. Income tax: $25,000 × 22% = $5,500. Penalty: $25,000 × 10% = $2,500. Total cost: $8,000.