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How are 403(b) and 401(k) plans similar?
How are 403(b) and 401(k) plans different?
Pros and cons of 403(b) and 401(k) plans
The bottom line
Aug 31, 2022
6 min read
Having a 403(b) or 401(k) plan can be beneficial when saving for retirement. Both are tax-advantaged accounts that provide high contributions to accomplish that goal.
Both 403(b) and 401(k) plans are employer-sponsored retirement plans that help employees save for retirement. They are also both tax-deferred accounts, meaning an investor can save on taxes now because income taxes are deferred until later when the money is withdrawn, typically in retirement. One major distinction between the two is the type of employer that can offer each plan.
A 403(b) is for non-profit organizations, or employers defined as 501(c)(3) tax-exempt organizations, public schools, hospitals, and some government agencies.
A 401(k), on the other hand, is for for-profit companies. However, tax-exempt organizations can also offer a 401(k) rather than a 403(b).
403(b) and 401(k) plans work like other retirement accounts, in that both have contribution limits and specific withdrawal rules. For each, employees can elect to defer some of their salary by contributing to their retirement plan. The employee determines how much they want to contribute and the amount is automatically deducted from their paycheck before taxes are calculated each pay period. The contribution is then deposited into their account and invested in the options the employee has chosen for their plan. Since the contributions are deducted from their income before taxes, it reduces the employee’s taxable income for that year.
Despite distinct differences, 403(b)s and 401(k)s have some similarities.
Both plans are employer-sponsored, meaning they are plans that employers offer and not plans individuals can contribute to on their own unless they are a business owner, like in a solo 401(k). An individual looking to contribute to a plan outside of an employer could open and contribute to an IRA.
Both a 403(b) and a 401(k) are funded with pre-tax dollars. Contributions are deducted from an employee’s income before taxes are calculated. Income taxes are due when the money is withdrawn from the account, typically in retirement. Making contributions can reduce taxable income in the year the contributions are made.
Both plans have the same contribution limits for employees and employers. The maximum contribution limit for an employee is $20,500 in 2022. Employers are also allowed to contribute to employee plans. The total limit for employee and employer contributions is $61,000 in 2022. However, this number excludes catch up contributions.
Both plans allow withdrawals at age 59 ½ with no penalty. An employee who is retiring at age 55 or older from the employer sponsoring the plan can also make withdrawals from both types of accounts without penalty. An employee who becomes permanently disabled can withdraw funds from either type of account without penalty. Early withdrawals not meeting one of those exceptions will incur a 10% penalty tax on the withdrawn amount.
Although a 403(b) and 401(k) are both employer-sponsored retirement plans, there are distinct differences.
One benefit of having a retirement account through an employer is the chance of an employer matching contributions. Not all employers provide a match, but if they do, it can be dollar-for-dollar or a percentage match of the employee’s contributions.
While both a 403(b) and 401(k) plans allow for employer contributions, it is less likely to find a 403(b) with an employer match. That is because 403(b)s can apply for an exemption from the Employee Retirement Income Security Act (ERISA). This federal law sets protections and standards for private industry retirement accounts. To qualify for an exemption, employers offering a 403(b) cannot provide an employer match. Because of this, it is more common to see matching contributions at employers offering a 401(k).
Both 403(b) and 401(k) plans allow catch up contributions for employees age 50 or older: They can contribute an additional $6,500 per year. However, some 403(b) plans also allow an additional catch-up contribution of up to $3,000 for at least 15 years of service with the employer. This is a unique catch-up contribution for 403(b) plans.
A 403(b) has fewer investment options to choose from than a 401(k). The Internal Revenue Code (IRS) limits the types of investments a 403(b) can have to mutual funds and annuities.
The investment options typically found in a 401(k) are stock mutual funds, bond mutual funds, target-date funds, and money market funds. The employer can choose which types of funds to offer, so the availability of funds varies between 401(k) plans.
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The type of employer determines the eligibility to have a 403(b) or a 401(k). Some people may never work in a job that offers a 403(b) since it is for employees at tax-exempt organizations such as public schools, certain government entities, non-profit organizations, churches, and public hospitals.
A 401(k) is typically offered at for-profit companies but can be offered at tax-exempt organizations as well.
Because of the limited investment options in a 403(b), there are typically higher investment fees and costs associated with them.
The fees associated with a 401(k), however, may be lower than a 403(b) because of more options.
There are notable differences between the two employer-sponsored retirement plans. With 401(k)s, employers are required to comply with the regulations set out by ERISA.
Employers offering 403(b)s can apply for exemption. To maintain an exemption from ERISA, employers cannot contribute to an employee’s 403(b) plan. This leads to the practical difference that 401(k)s are more likely to offer matching contributions than 403(b)s.
Having any type of retirement account may benefit an investor’s financial future. Since there are a variety of retirement plans, however, certain plans may be a better fit for some people over others. There are benefits and drawbacks to both types of plans.
When considering saving for retirement, there are a number of benefits to participating in these types of employer-sponsored plans.
Both plans have higher contribution limits than other retirement accounts, such as an IRA.
There is a possibility of matching contributions since both are employer-sponsored plans.
It is possible to take an early distribution at age 55 or older without penalty if the employee retires from the employer sponsoring the plan.
If an employee faces hard financial circumstances and needs funds, both types of plans allow for hardship withdrawals and loans, depending on the specific employer’s plan terms.
There can also be several disadvantages to consider.
Since the employer gets to choose the types of investment options, the investor has less control over investment options.
Since there are limited options in both accounts, there is a potential for higher investment and expense fees compared to other types of retirement accounts.
Both types of plans are tied to a person’s employer, so there is a decision to be made when leaving that job.
The accounts are set up to deter withdrawing funds before retirement. So if a person wants to withdraw funds early, it could be difficult and potentially incur a penalty.
Having a 403(b) plan or a 401(k) plan can be beneficial when saving for retirement. Although not as common as a 401(k), the 403(b) has similar contribution and withdrawal rules. Both are tax-advantaged accounts that incentivize saving for retirement and provide high contribution limits to accomplish that goal. The major difference with a 403(b) is the type of employer that can offer the plan, which is typically public schools, non-profit organizations, hospitals, and churches. Still, both plans offer a powerful way to save for the golden years.
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