What’s The Difference Between a 403(b) and a 401(k)

Some employers offer a 403(b) plan and others offer a 401(k), but what’s the difference between the plans?

403B vs 401K
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Many employers offer either a 403(b) plan or a 401(k) plan, but what’s the difference between the two?

Key Takeaways

403(b) and 401(k) both allow for tax-deferred contributions up to $19,500 in 2021

Maximum contributions for both plans will increase to $20,500 in 2022

403(b) plans are for public schools, universities, churches, and other 501(c)(3) exempt organizations

401(k) plans are commonly offered by for-profit companies and are subject to ERISA

403(b) plans tend to have higher fees and less diverse investment options.

What Is A 401(k)

A Brief History of the 401(k)

In 1978 Congress passed the Revenue Act, which included a provision to the internal revenue code – Section 401(k) that made it permissible for employees to defer taxes on investment contributions. However, it wasn’t until 1980 when benefits consultant Ted Hanna discovered the provision and created the first 401(k) plan at his employer Johnson Companies.

Fast forward to 2021, the 401(k) is the most ubiquitous type of employer-sponsored retirement plan with assets totaling over $6 trillion.

401(k) Explained

A 401(k) is a type of qualified plan that allows an employee to elect to have a portion of their wages directed to their 401(k) plan on a tax-deferred basis. Commonly known as elective deferrals, contributions are not reported on an employee’s individual income tax return. They are not subject to federal tax withholding.

There are multiple types of 401(k) plans: a traditional 401(k) plan, SIMPLE 401(k) plan, Safe Harbor 401(k) plan, and Solo 401(k) plans.

Furthermore, many 401(k) plans allow employees to designate a portion of their elective deferrals as “Roth elective deferrals.” This means if you specify a portion of your contribution as a Roth contribution, the contributions are made on an after-tax basis but are not subject to taxation upon withdrawal.

What Is A 403(b)

History of 403(b) Plans

In 1961, 403(b) plans were made available to public education employers. Investment options were limited to annuities, at first, and in 1974 mutual funds became an investment option.

403(b) Plan Explained

A 403(b), also known as a tax-sheltered annuity, is a retirement plan generally administered by public schools, colleges, universities, and qualifying 501(c)(3) plans. 403(b) plans allow its employees to designate a portion of their salary to their plan on a tax-deferred basis, and taxes are only paid upon distribution from the plan.

Similarities Between 401(k) and 403(b) Plans

  • Tax Deferral. Both 401(k) plans and 403(b) plan for contributions on a pre-tax basis and you only pay when you withdraw your funds.

  • Maximum Contribution. In 2021, the maximum contribution amount for both types of plans are $19,500. Over $26,000 if you are 50 or older.

    In 2022, the maximum contribution limit for 403(b) and 401(k) plans will increase to $20,500
  • Roth Contributions. Both 403(b) and 401(k) plans allow plan participants to make contributions on an after-tax basis. Commonly known as Roth elective deferrals, these contributions and earnings are not subject to taxes at distribution because the taxes were paid upfront.

  • Loan Provisions. You may borrow up to 50% of your vested balance, up to a maximum amount of $50,000. The loan is required to be repaid within 5 years, unless the money is used to buy your main home.

  • Tax On Early Distributions. In general, if you take a distribution before age 59 1/2, you may have to pay a 10% additional tax on the distribution.

  • Required Minimum Distributions. Both 401(k) and 403(b) and the majority of retirement accounts will require you to start taking withdraws if you reached age 70 1/2 before July 1st 2019. However, as part of a provision of the SECURE act passed into law in 2019, if your 70th birthday is after July 1st 2019, you do not have start taking withdraws until age 72. You can withdraw more than the minimum amount and that amount will be included as taxable income.

  • Vesting. Employee salary deferrals are always 100% invested. In other words, money the employee contributed to either their 401(k) or 403(b) cannot be forfeited. So, when an employee leaver their place of employment they are entitled to those contribution inclusive of any investments gains or losses.

Although very uncommon, it is possible for an employer to offer both a 401(k) and 403(b).

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Tax-deferred plans are one of the best ways to invest so you can ensure you are able to retire comfortably.

Differences Between 401k and 403(b) Plans

  • Type of Employer. A 401(k) is usually offered by a for profit company think Apple, Google. Whereas 403(b) plans are offered by public schools, colleges, universities, churches, and some 501(c) tax exempt organizations (think American Red Cross).

  • 403(b) Plans Are Not Subject To ERISA. ERISA stands for Employee Retirement Income Security Act. ERISA is a 1974 federal law that sets minimum standards for most voluntarily established retirement and health plans in private industry to protect individuals in these plans. In layman’s terms, if your employer-sponsored retirement plan is subject to ERISA, this means they are subject to more regulations and required to act in the employee’s best interest.

  • Investment Options. 403(b) plans only offer mutual funds and annuities. On the otherhand, 401(k) plans may offer ETFs, Stocks, Bonds, Stock Funds, in addition to mutual funds.

  • Employer Match. Sponsors of 403(b) plans are not prohibited from providing an employer match, although it is much more uncommon for 403(b) sponsors to provide matches as it will require them to be compliant with ERISA.

  • Service Catch-Up Contributions. Suppose your employer includes the provision in their 403(b) plan that permits catch-up contributions. In that case, the limit of elective deferrals may be increased by $3,000 in any taxable year. The employee must have 15 years of service with the same employer, and there is a $ 15,000-lifetime cap. This provision does not exist in 401(k) plans.

  • Higher Fees. In general, because 403(b) plans are not subject to ERISA, they tend to have higher fees. The fees include administrative costs and investment fees. It’s not uncommon for fees in these plans to range between 1% – 2.25%, whereas 401(k) fees usually do not exceed 1%.

New Legislation Related To 403(b) And 401(k) Plans

In 2019 Congress passed the SECURE Act [Setting Every Community Up for Retirement Enhancement]. A few significant changes were as follows:

The minimum age for Required Minimum Distributions increased from 70 1/2 to 72 for those turning 70 after July 1st, 2019.

Individuals are permitted to withdraw up to $10,000 from 529 plans to repay student loans

Making it easier for 401(k) plans to offer annuities in their investment options

Parents are permitted to withdraw $5,000 tax-free within a year of birth or adoption to pay for qualified expenses

Which Plan Is Better?

Unfortunately, most employers either only offer a 403b or 401k, but not both. That said, 401(k) plans tend to have much lower fees in addition to a wider variety of investment options. Therefore, a 401(k) plan is a better choice for most people.

However, since both plans generally have the same contribution limits, it is still advantageous for individuals with only a 403(b) plan available to fully take advantage of the tax-deferred contributions.

Tax-deferred retirement plans are still one of the most sure-fire ways to financial success.

What’s your experience with 403(b) and 401(k) plans? Comment below and let the Real World Personal Finance audience know!

Cheers,

Adam
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