403(b) Plan vs 401(k)
401(k) plans and 403(b) plans are both retirement plans designed to help employees save in a tax-deferred manner.
The main difference is that 401(k) plans are offered strictly to employees in the private sector, while 403(b) plans are offered to non-profit organizations that are governed by Section 501(c)3 of the Internal Revenue Code.
These include schools, hospitals, religious organizations and even some governmental organizations.
If you’re wondering which type of plan is better, your question is likely a moot point, because you’ll automatically be offered (assuming the employer offers this) either one type of plan or the other.
You will never be offered a choice between these two types of plans from the same employer.
If you work two jobs and have one employer in the private sector and the other in the non-profit sector, then you may have this choice.
In that case, the better option will depend upon the investment choices offered in each type of plan.
Difference Between 403(b) and 401(k) Plan
Here is a breakdown of the differences and similarities between the two types of plans:
Similarities:
- Both plans have the following characteristics in common:
- Identical annual contribution limits, including catch-up contributions
- Tax-deferral
- Pretax contributions
- A preset selection of investment choices
- Loan provisions (which can vary to some extent by plan)
- Required minimum distributions starting at age 72
- 10% early withdrawal penalty for distributions taken before plan participant reaches age 59 ½, unless a qualified exception applies
- Regular distributions are taxed as ordinary income (at the participant’s top marginal tax bracket)
- Contributions are deducted from from employee’s paycheck and deposited directly into the plan
- Roth feature is permitted
- Matching employer contributions
- Vesting schedules
- Identical portability and rollover provisions in most cases
Differences:
- Although these two types of plans are similar in many ways, they also have a few differing characteristics, listed as follows:
- 403(b) plans have a Maximum Allowable Contribution (MAC) rule that allows plan participants with at least 15 years of service to their employer to contribute an additional $3,000 per year to the plan. However, employers are not required to add this feature. Apart from this rule, all contribution limits are identical.
- 401(k) plans usually have a wider selection of investments to choose from. They often offer mutual funds, annuities, stocks (especially company stock), ETFs and money market funds. 403(b) plans usually only offer annuities and mutual funds, because there is stricter oversight with these plans concerning the amount of investment risk that employees can take.
- 403(b) plans tend to have less regulatory oversight than 401(k) plans. The former type of plan was introduced in 1958, while 401(k) plans didn’t come along until 1978 with the passage of the Revenue Act of 1978. 401(k) plans are governed by strict fiduciary standards, while 403(b) plans are not governed by ERISA regulations except in certain circumstances (see below).
- Although 403(b) plans are allowed to make matching contributions, they usually don’t do so because this will cause the plan to fall under ERISA oversight. And plans that do offer matching contributions usually offer a smaller match than most participants in 401(k) plans get.
- Because 403(b) plans are usually limited to offering mutual funds and annuities as investment choices, their participants usually end up paying higher fees on average than 401(k) plan participants, who often have access to very low-cost alternatives such as ETFs and index funds.
- 403(b) plans usually have lower administration costs than 401(k) plans because they are usually not required to adhere to ERISA guidelines.
Although both plans can contain vesting schedules, this schedule usually lasts for 5-7 years in a 401(k) plan, while vesting in 403(b) plans is usually immediate.
403(b) Plan vs 401(k) FAQs
401(k) Plan | A Complete Beginner's Guide
401(k) Meaning
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.