1 in 2 people reading this blog post have the option to make retirement investments through your employer through a 401(k) or 403(b). While that’s not all employers, there is an increasing push for companies to offer some retirement savings options. While the two types of plans share a number of similarities, there are also differences worth noting – most of which have to do with the nature of your employment.
What’s a 401(k), anyway?
A 401(k) plan is a tax-advantaged investment vehicle, or account, offered to employees of for-profit companies. It’s also the most common type of employer-sponsored retirement plan. A significant percentage of corporate employers utilize 401(k) plans as a method to enable their employees to save money for retirement, usually on a tax-deferred basis. This means that you’re able to take a portion of your paycheck – before it’s taxed – and invest it for your benefit. You’ll only need to pay taxes when you actively withdraw the money, which for most people, happens in retirement.
Some employers offer Roth 401(k)s, which are similar to traditional 401(k)s but work in the opposite manner. Money contributed to a Roth 401(k) comes from your after-tax wages, but the upside is that you’ll never need to pay tax on Roth money ever again – even when you go to withdraw money in the future. A Roth 401(k) is usually best suited for those who believe their tax rate stands to increase in the future. In other words, they plan to earn more money at the time of retirement than they did when contributing to their Roth 401(k).
For example, say you were to take $1,000 from your current paycheck and deposit it to a Roth 401(k) – assuming an 8% annual rate of return and a time horizon of 30 years, you’d end up with just over $10,000 of tax-free money in retirement. You read that right – in a Roth 401(k), all growth and earnings remain tax-free forever, and you’d only have paid tax on the original $1,000 contribution. So if you’re in a low tax bracket today, it’s certainly not a bad idea to give the Roth 401(k) a look.
One of the main features of employer-sponsored 401(k) plans is that they’re protected by ERISA (“Employee Retirement Income and Safety Act”) standards, which are legal requirements that were written to protect savers. ERISA rules require that employer-sponsored plan managers act as fiduciaries; that is, those who control plan assets are required to act in the best interests of the plan beneficiaries. Essentially, ERISA standards protect the people that actually contribute to retirement plans – a group that includes you – as patterns of mismanagement and discrimination had unfortunately become commonplace before such standards existed.
Another major feature of the typical 401(k) plan is the employer-matching contribution. Employers often offer a cash match for any amount contributed to their 401(k) plan, typically capped at a certain amount of your compensation. Anywhere from 2% to 8% is typical, but the middle of the range tends to be more common. In a simple example, a worker earning $100,000 annually and receiving a 4% employer-match could contribute up to $4,000 by themselves and receive an additional $4,000 from their employer – for a total of $8,000. Higher balances ultimately lead to faster compounding, which can help people build wealth much faster than they would otherwise.
When it comes to annual 401(k) contribution amounts, you’re eligible in 2022 to contribute up to $20,500 ($27,000 if age 50 or older) from your own compensation into the plan, which excludes any amounts contributed by your employer. The limit for total contributions to a 401(k) in 2022 – that’s employer plus employee contributions – is $61,000 ($67,500 if age 40 or older).
What’s a 403(b)?
In short, a 403(b) is a tax-advantaged retirement vehicle that’s available to employees of non-profit organizations, like educational institutions (public schools, state colleges, and universities), churches, and other tax-exempt, 501(c)(3) organizations. With that said, the main difference between a 403(b) and a 401(k) is the type of organization that offers it. If you work for a for-profit business, and you have access to a retirement plan through work, it’s likely to be a 401(k). If you work for a non-profit organization, you’re likely going to see a 403(b).
403(b)s can be exempt from ERISA requirements if the organization offering the plan contributes nothing to it; in other words, if there is no employer matching contribution on the table, the organization can claim an exemption from ERISA standards. This exemption, in theory, would allow the exempt organization to discriminate in its retirement plan. If, on the other hand, the organization does offer a match to its employees, their 403(b) plan will be subject to ERISA regulations, and therefore will make the plan administrator a fiduciary.
With these requirements around matching, many non-profits may not offer a 403(b) match in order to retain their ERISA exemption. As a result, you’re more likely to see matches as part of 401(k) plans, which fall more squarely under ERISA regulations. So it’s entirely possible for you to have a 403(b) plan at work that only accepts employee contributions, so the employer itself (again, a school, church, or other tax-exempt organization) may keep its exemption from ERISA requirements.
403(b)s allow the same contribution limits as 401(k)s, and have very similar mechanics when it comes to contributing money either tax-deferred or tax-exempt. 403(b) plans are quite commonly tax-deferred (you receive a tax deduction in the current year and only pay tax when you withdraw money), though Roth 403(b) plans are becoming more prevalent. Roth 403(b)s work in a similar fashion to Roth 401(k)s, in that you’ll only be able to contribute money that’s already been taxed in the current year. The upside: a $0 tax liability inside the account for the rest of your life, assuming it’s been at least 5 years since your first contribution.
What are the key points to remember about both 401(k)s and 403(b)s?
1. The main difference between 401(k)s and 403(b)s is the type of company that offers each one.
401(k)s are offered by for-profit companies, while 403(b)s are offered by tax-exempt organizations. This is the central difference between the two plans, though there are some legal differences that keep the two plans in separate sections of the IRS code.
2. Your 401(k) or 403(b) plan is connected to your employer.
Unlike IRAs or regular taxable brokerage accounts, your 401(k) or your 403(b) is connected to your employment circumstances. Where you work will ultimately dictate the retirement plans available to you, so it’s a good idea to understand what accounts are used in conjunction with your day-to-day work life. Perhaps the better news is that you can move your 401(k) or 403(b) if you leave your employer – possibly to either an IRA or your new employer.
3. Learn how your employer match works.
If you have a 401(k), there’s a high likelihood that you’ll be offered an employer matching contribution up to some percentage of your total compensation; if you have a 403(b), there is also some likelihood that you’ll have this option. It’s good practice to be clear on what the matching contribution percentage is, and to ensure that you’re taking full advantage of it every year. If you can afford to contribute more than the matching percentage, even better – just remember to be aware of the contribution limits.
4. Your 401(k) or 403(b) plan is likely to be offered as a tax-deferred option.
This is the standard offering across most employer plans. Recall that this means you’ll receive a tax deduction in the current year for contributing, and you won’t have to pay any tax until you withdraw the money in retirement. However, you may have the option of choosing a Roth 401(k) or Roth 403(b), depending on your employer. Those who expect their tax rates to increase over time should consider a Roth option if one exists.
5. You may be able to convert your pre-tax 401(k) to a post-tax Roth 401(k).
It’s entirely possible that your employer allows “in-plan conversions,” which allow you to move money from a pre-tax 401(k) to a Roth 401(k) while still employed at your current company. This is also possible in some 403(b) plans, though it would be presumptive to assume that all 403(b) plans offer this. Remember that you’ll also be liable for taxes due in the year that you complete such a conversion.
The real difference between the two types of retirement plans is the nature of the company that offers them. 401(k)s are most closely associated with standard corporate businesses, while 403(b)s are relevant in the nonprofit world. No matter where or how you work, it’s always a good idea to understand the fine print behind your particular employer’s retirement savings plan, and to take advantage of every opportunity you are afforded.