Many people choose to automate their retirement savings through employer-sponsored plans that take money directly from their pre-tax income. While the 401(k) remains the most popular plan offered by employers, another common option is the 403(b).
Employees should know which plan they have through their employer and understand the key differences between them. Both plans direct money from your paycheck for retirement investment and allow that amount to grow without taxes. They also both require you to pay taxes upon withdrawal from the account. But while the basic premise of each plan is the same, the details do vary in very important ways.
The Definitions of 401(k) and 403(b) Plans
The terms 401(k) and 403(b) come from the IRS tax code sections that detail each plan. With a 401(k), contributions are deducted from your taxable income. The idea behind the plan is to defer taxes until retirement, at which point you will likely be in a lower tax bracket and therefore save money in the long run.
Similarly, a 403(b) is designed specifically for government workers, as well as employees of hospitals, religious organizations, nonprofits, and public schools. These individuals get a similar tax advantage for investing money directly from their paycheck, which leads to an unspecified amount of money in the plan upon retirement. This general scheme is known as a defined contribution savings model.
On the surface, the two plans look very similar. They have the same contribution limits and both offer a catch-up period of additional savings once individuals turn 50. Also, both plans make it possible for employers to match contributions. Each plan has equivalent withdrawal rules with the same penalties for early withdrawals and the possibility of borrowing against the plan. Individuals can begin making withdrawals at 59 1/2 and must take payments at age 70. Also, the rules about rollover are the same for both plans. While both can be rolled over into a traditional IRA or similar account, it is not generally wise to combine a 401(k) and a 403(b).
The Key Differences between a 401(k) and 403(b)
Once you start diving a bit deeper into these two plans, you will better understand their differences. Failing to recognize and understand these differences can result in poor investment and retirement decisions. The key differences to know include the following:
1. Contribution Limits: While the general contribution limits are the same for both plans, the 403(b) has an added advantage over the 401(k). Once individuals have been with the same organization for 15 years, they can contribute an additional amount of money to the plan each year. This additional amount is currently $3,000 annually, which is on top of the $6,000 catch-up for people 50 and over offered by both plans.
2. Regulations: As a general rule, 403(b) plans have less regulatory oversight than 401(k)s, as each received congressional approval at different times. The result is a slight difference in language for each plan. 401(k) plans are covered by the Employee Retirement Income Security Act (ERISA) of 1974 and are overseen by the US Labor Department. Because of this, the plans are subject to greater scrutiny than 403(b) options. With a 403(b), the expectation is that participants play a greater role in account management. Importantly, if an employer contributes to a 403(b) plan, then it becomes subject to ERISA regulations, but it does not if only the employee makes contributions.
3. Matching Contributions: Employers offering a 403(b) are less likely to make matching contributions to avoid the headache of ERISA regulations. Even when organizations do match contributions, what they offer is typically lower than 401(k) plan matches. Most companies offering a 401(k) will offer matched contributions up to a certain percentage of annual income, although schemes vary and it has become more common not to match at all. The maximum contributions, in either case, apply to combined contributions, not just those made by the employee.
4. Investment Options: One of the most important differences between the two types of plans has to do with investment options. Typically, 401(k) plans offer many more investment options than do 403(b)s. Most 401(k) investment options include stocks, exchange-traded funds, money market funds, bond funds, stock funds, and annuities, while 403(b) plans tend to offer only mutual funds and annuities due to congressional limits on investments through these accounts. While these limitations were placed to protect you from excess investment risk, it can hurt your overall diversification.
5. Fees: An unfortunate consequence of the difference in investment options is that 403(b) plans tend to have higher fees. Actively managed mutual funds, in addition to both variable and fixed annuities, tend to come with higher fees. As a result, 403(b) plans are often more expensive than 401(k)s, which offer lower-cost investment options. However, fee structures for both types of plans can vary a great deal between providers.