Employer Sponsored Plans: 403b vs. 401k

A 401k retirement account is available for employees working for for-profit firms, and a 403b account is available to employees working for non-profit, tax-exempt organizations. This article takes a closer look at the similarities and differences between the two, and which plan could be right for you.

What Is a 401k?

A 401k account is a retirement plan that is offered to eligible employees at for-profit companies. The account takes its name from subsection 401k of the Internal Revenue Code (IRS). Employees can take advantage of a 401k account by making tax-deferred contributions from their salary or wages on either a pre-tax or post-tax basis.

Taxes

A traditional 401k and a Roth 401k differ in how they're taxed. If you utilize a traditional 401k account, you will pay taxes on your savings once you make withdrawals from your account, which in turn decreases your taxable income today. 

A Roth 401k account, on the other hand, is funded through after-tax income. Therefore, when you make withdrawals you do not have to pay income tax. In short, the Roth option allows for withdrawals to be tax-free.

In both plans, your money grows without being taxed, and your investment gains are not taxed by the capital gains tax. To add, if you withdraw funds before retirement age you impose the early withdrawal penalty which is currently a 10% tax that deters premature withdrawals. 

​Required minimum distributions

At age 72, employees must take required minimum distributions (RMDs). RMD rules mandate that employees begin withdrawing money at a certain age or they incur IRS penalties equal to 50% of the amount that should have been withdrawn. Since 2020, this age has been 72, but it is subject to change.

RMDs only exist for traditional retirement accounts and Roth 401k accounts, but not for Roth individual retirement accounts (Roth IRAs). Individual retirement accounts are not sponsored by employers like a 401k plan or 403b plan is.

Contributions

In a 401k account, both employees and employers can make contributions to the retirement savings account, however, there are dollar contribution limits that are set by the IRS. The current elective deferral limit in 2021 is $19,500, and future limits will be outlined in the IRS’s limit website. A 401k plan offers $6,500 catch-up contributions for those age 50 and older in 2020 and 2021 to allow employees to increase their savings. 

Firms that offer a 401k plan can make matching contributions to the plan for eligible employees. Employer matching is an attractive feature for employees looking to maximize their retirement savings.

Investment options

In addition to making contributions, 401(k)s let you invest in mutual funds, exchange-traded funds (ETFs), and index funds.

ERISA requirements

Firms who offer 401k plans must satisfy certain nondiscrimination requirements, and to ensure they do this, they must conduct the Actual Deferral Percentage (ADP) & Actual Contribution Percentage (ACP) Tests which are mandated by the IRS as well as the Employee Retirement Income Security Act (ERISA). These annual tests prevent retirement plan overseers from discriminating in favor of highly compensated employees.

👉 Read Next: The Advantages of a 401(k)

What Is a 403b?

A 403b account, which is also known as a tax-sheltered annuity plan (TSA), is only available to employees who work at non-profit organizations or the government. The account takes its name from subsection 403b of the IRS tax code. Just like the 401(k) plan, a 403(b) plan lets employees defer some of their salaries into individual retirement accounts.

Taxes

A 403b account has a traditional, pre-tax basis option, as well as a Roth option which has the post-tax model. The 403b account also requires employees to reach retirement age, which is currently 59½, to withdraw funds without incurring an early withdrawal penalty.

​Required minimum distributions

403b accounts also have RMDs that mandate that employees must begin taking withdrawals before a certain age. RMDs exist to ensure that employees start taking money from their accounts during retirement and that the government ultimately gains its tax dollars.

Contributions

If you have a 403b account, there is a limit to how much you can contribute to the account, just like a 401k account. This limit is subject to change, but it is the same as the 401k limit. A 403b plan allows for the same catch-up contributions that are seen in a 401k plan in addition to something called the 15-year rule. 

The 15-year rule is unique to those who have at least 15 years of service with a non-profit and it allows for those employees additional catch-up contributions of up to $3,000 per year. 403b plans can include employer-matching contributions, however, it is not as popular as it is in 401k accounts.

Investment options

There are fewer investment choices in a 403b account compared to a 401k. Historically, 403b accounts only provided the opportunity to invest in annuities, which are reliable investments that are overseen by insurance companies. Nowadays, employees are able to invest in more volatile investments such as mutual funds within their 403b accounts. 

No ERISA guidelines

403b accounts are not subject to ERISA guidelines which include the ADP and ACP tests as outlined above. The lack of standardization can be a red flag for those who have 403b accounts and want to ensure that highly compensated employees are not receiving disproportionate benefits from their accounts from creditors. 

Differences

Similarities

Which Plan Is Right for You?

First and foremost, neither a 401k account nor a 403b account is objectively better than the other. Deciding between a 401k and a 403b account ultimately depends on your eligibility, which as mentioned above, is based on your employer.

Those who are not working for a non-profit will most likely utilize a 401k account and base their investment options around their risk appetite. Those working for non-profit organizations can utilize the 403b account which offers fewer options for investing, but can overall be seen as very consistent and reliable.

Once you have determined which plan you are eligible for, it can be helpful to meet with a financial planner who can assist you with determining your risk appetite, or you can research what risks you should be taking based on how far away you are from retiring.

 Retirement planning can be a daunting task, but by understanding the basics, you are on your way to a successful retirement!