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There are lots of acronyms to keep track of in investing. Between exchange-traded funds (ETFs), individual retirement accounts (IRAs), and initial public offerings (IPOs), the acronyms are endless. Add numbers into the mix, and there are even more combos to keep straight!
Amid the many letters and digits, two retirement plan combinations are worth understanding, the 401(k) and the 403(b).
401(k) vs. 403(b) Overview
Named after the tax code from which they hail, these two employer-sponsored retirement plans have more in common than they don’t.
401(k)s are offered by for-profit companies in the private sector, and 403(b)s are offered by nonprofits and government organizations.
Both plans have the same yearly contribution limits and withdrawal conditions, and earnings and returns grow tax-deferred in each type of account. We’ll dive into the legal and applied differences later, but first, we’ll look into account specifics.
Understanding 401(k) Plans
The 401(k) was introduced in 1978 almost by accident when Congress passed the Revenue Act of 1978 that included a provision allowing private employees to avoid taxation on salary deferrals.
Within just a few years, the idea of a 401(k) seriously kicked off, and it is now the most popular retirement plan available.
There are two types of 401(k)s—traditional and Roth. Employers generally don’t offer both types, but it may be wise to use both to give yourself withdrawal options in retirement if they do.
In traditional 401(k)s, employees defer a percentage or dollar amount of their salary to their retirement account before taxes are removed.
In Roth 401(k)s, contributions are after-tax dollars, just like in any Roth-specific account. These differences mean you must pay taxes on your traditional 401(k) withdrawals but not on the Roth 401(k) withdrawals. Got to pay Uncle Sam sometime!
401(k) plans typically allow investment in a large selection of mutual funds, including stock funds, bond funds, and real estate funds.
The target date fund is utilized often in retirement accounts. It’s a popular type of fund designed to inherently shift from an aggressive to a conservative investment strategy as one approaches their target retirement date, hence the name.
>> More: Differences Between Roth IRAs and Traditional IRAs
Contribution Limits and Withdrawal Guidelines
The IRS sets contribution limits each year for retirement accounts. For 2021, the max is $19,500, but if employees are 50 years or older, they can contribute an additional $6,500 a year. The same rules applied to 2020.
There are certain conditions to withdraw money from a 401(k) without penalty: reach age 59 ½, become permanently disabled, or encounter a financial hardship. Individuals can also avoid the 10% penalty fee if they separate from their employer at age 55 or older.
The key perk about 401(k)s is the contribution match made by employers. Typically, a company will offer a maximum percentage they are willing to match, and sometimes these can be very generous.
If you have a 401(k), try to max out your contribution to meet your employer’s. In rare cases, an employer may even match dollar for dollar.
When contributions are non-matching, bosses simply deposit a lump sum into the retirement account.
Created before the 401(k), the 403(b) plan’sroots can be found in 1958 when Congress made available a tax-deferred savings vehicle for employees of certain 501(c)(3) organizations.
By the mid-’80s, various legislation had imposed rules that shaped the account more closely into what we see today.
Like the 401(k), there are traditional and Roth options for a 403(b) plan. Traditional accounts are funded through pre-tax salary deferrals, and Roth accounts are funded with after-tax dollars. Therefore, taxes are due upon withdrawal from the traditional account, but not the Roth.
Contribution Limits and Withdrawal Guidelines
The restrictions on contributions to a 403(b) are the exact same as those for a 401(k).
Participants younger than 50 are allowed to deposit up to $19,500 this year, and those 50 or older can allocate an additional $6,500 in the form of catch-up contributions, totaling $26,000 for 2021. Additionally, the 403(b) also shares the same withdrawal guidelines as the 401(k).
>> More: Beginners Guide to Retirement Investments
What Are the Differences Between a 401(k) and a 403(b)?
You’ve probably gathered these two retirement plans have a lot in common. Now let’s cover their dissimilarities, which is important to know if you happen to be offered access to both.
Mutual funds are becoming more widely available for use in 403(b)s, but since plans are offered by insurance companies, the annuity contract is still king in these accounts.
Annuity contracts, especially variable ones, can be complex and challenging to comprehend. They are appropriate for some people, but not all.
By comparison, 401(k) plans are primarily offered by investment companies, resulting in a wider selection of fund availability.
The Employee Retirement Income Security Act (ERISA) sets rules surrounding plan participation, vesting, and benefit accrual, but its main objective is to prevent plan fiduciaries from mismanaging plan assets.
If employers contribute to their worker’s accounts, they are subjected to ERISA guidelines. So, the 401(k) and the rare 403(b) that does include an employer match are subjected to stringent guidelines.
NOTE: If your plan isn’t covered by ERISA, it could warrant a quality check.
Account contribution limits are the same, right? Well, in some 403(b) plans, employees with 15 or more years of service with the same organization may be allowed additional contributions.
They can contribute up to $3,000 a year with a $15,000 lifetime limit, and there is no age restriction to take advantage of.
When an employer deposits money into an individual’s retirement account, there can be restrictions on it.
For example, workers may only gain ownership of 20% of employer contributions each year until year five, when they finally own 100%.
Therefore, if employees leave their job before the vesting is complete, they will only walk away with a portion of their employer’s contributions.
This vesting period refers only to the availability of employer-sponsored funds, so 403(b)s either have a short wait or none at all, but 401(k)s almost always do.
Can You Have a 401k and a 403b?
You can have a 401(k) and a 403(b), but an employer rarely offers both. If they do, the yearly contribution limit is an aggregate of all accounts. In other words, you can’t contribute $19,500 twice.
403(b) vs. 401(k): Which Is Better?
The type of retirement plan offered to you is up to your employer, so comparing them can be a moot point.
But with their wider selection of funds and the promise of employer contributions, 401(k)s edge out their counterpart as the better account.
Remember how long-standing public service workers can gradually deposit an extra $15,000 into their 403(b)? This perk may stand out more if it were not afforded by only certain organizations.
Bottom Line: 401(k) Plan vs. 403(b) Plan
Whether you have a 401(k) or a 403(b), the crucial thing is to take advantage of it. It is designed to help you be better prepared for retirement.
We recommend increasing your retirement account contribution if you’re not already maxed out every time you get a raise.
Remember, all investing carries some risk, but the gamble of not investing for retirement is worse.