What’s the difference between a 401(k) and a 403(b)?
In addition to health insurance and paid vacation time, the benefits packages offered by many employers often include a tax-advantaged retirement plan. But the specific type of plan available varies based on the company.
Two of the most common options are 401(k) and 403(b) retirement plans. Named after specific sections of the tax code, each plan allows employees to save for retirement. While these plans have many similarities, they also have a few key differences. Here’s a closer look at 401(k) and 403(b) retirement plans and the type of employers that offer each one.
What is a 401(k) plan?
A 401(k) plan is perhaps the most common retirement plan in the United States. According to the Census Bureau, 34.6 percent of retirement savings accounts among working individuals aged 15 to 64 were 401(k) accounts as of 2020.
Established back in 1978, 401(k) accounts allow employees to make pre-tax payroll contributions from their paychecks each pay period. Making these contributions has the effect of lowering the individual’s annual taxable income.
The IRS establishes annual limits on the amount of employee elective contributions can be made to these accounts each year. For 2023, the limit is $22,500. However, employees aged 50 and above at the end of the calendar year are also allowed to make what’s known as catch-up contributions to these accounts. The 2023 limit for catch-up contributions is $7,500.
The money in 401(k) accounts is invested in stocks, bonds, and mutual funds and grows on a tax-deferred basis. In addition, some employers choose to match a portion of their employee’s contributions to 401(k) accounts, helping to accelerate retirement savings.
When a 401(k) account holder reaches retirement age at 59 1/2, they can begin tapping into the money, at which time taxes must be paid. The tax rate that will be applied is the employee’s current tax bracket at the time of retirement. In addition, the IRS requires that account holders begin making withdrawals from these accounts (known as Required Minimum Distributions) at age 73.
Some of the key benefits of a 401(k) plan, according to the IRS include:
- Employer matching contributions to 401(k) accounts are deductible on the employer’s federal income tax return.
- Employee contributions to 401(k) accounts are not taxed until the money is withdrawn during retirement.
- Investment gains in 401(k) accounts also not incurring taxes until the funds are withdrawn during retirement
Roth 401(k) accounts come with additional benefits. For instance, Roth contributions are not taxed when you withdraw them from the plan. In addition, earnings on Roth contributions are not taxed “when they are withdrawn from the plan if your withdrawal is a qualified distribution.” Qualified distributions include those made at least five years after the first contribution to the account and after you are 59 ½. The IRS also makes an exception on taxes if you’re disabled.
Another important point about 401(k) plans is that there are also government regulations that apply to this type of retirement program, which are designed to ensure they comply with non-discrimination requirements. In order to ensure that 401(k) plans adhere to non-discrimination rules, employers must conduct annual tests known as the Actual Deferral Percentage and Actual Contribution Percentage tests. These tests are meant to verify that deferred wages and matching contributions provided by an employer do not discriminate in favor of employees who are more highly compensated, according to the IRS.
What type of companies can offer 401(k) plans
One of the primary distinctions between 401(k) and 403(b) retirement plans is the type of companies that offer them. Contrary to popular belief, a 401(k) retirement plan can be offered by both for-profit and nonprofit organizations. Most large, for-profit businesses offer 401(k) retirement account programs.
What is a 403(b) plan
A 403(b) is also an employer-sponsored retirement plan and it has many features in common with a 401(k).
“Just as with a 401(k) plan, a 403(b) plan lets employees defer some of their salary into individual accounts. The deferred salary is generally not subject to federal or state income tax until it's distributed,” the IRS explains.
However, 403(b) plans are only offered by specific types of employers (more on that in a minute). Additionally, the investments available through these types of retirement accounts are typically more limited than the investment options associated with 401(k) accounts. In the case of 403(b) accounts, participants are generally able to invest in annuities and mutual funds.
Another important distinction, unlike 401(k) funds, there are generally no employer-provided matching contributions with 403(b) plans. This is because not all 403(b) programs are subject to the same annual non-discrimination testing requirements as 401(k) plans. However, if matching contributions are offered through 403(b) plans, they may be required to implement such annual reviews. The need to conduct this testing depends on the type of organization offering the 403(b) plan and on the structure of the plan itself, according to the IRS.
These types of accounts however, come with the same annual contribution limitations as 401(k) accounts—meaning elective salary deferrals can be no more than $22,500 for 2023 and those 50 and older can make similar catch-up contributions..
Also similar to 401(k) accounts, the money in 403(b) funds is not taxed until it is withdrawn during retirement. At that time, the distributions will be taxed at the individual’s current tax rate.
What type of companies can offer 403(b) plans
It is primarily non-profit organizations and some government employers that offer 403(b) plans. According to the IRS, these plans, which are also sometimes still referred to as tax-sheltered annuity or TSA plans, are offered by public schools, colleges, universities, churches, and charitable entities that are tax-exempt and fall within section 501(c)(3) of the U.S. tax code.
The types of employees eligible to participate in a 403(b) retirement plan are typically teachers, government employees, nurses and doctors, for instance.
Key differences between 401(k) and 403 (b) plans
As is probably clear by now, 401(k) and 403(b) plans have many things in common, including both being tax-advantaged retirement accounts offered by employers. Both also reduce an employee's taxable income.
But there are also a few notable differences between these two financial vehicles. Here’s how they compare.
- 403(b) plans are exempt from nondiscrimination testing, while 401(k) plans must comply with the annual requirement that is part of the Employment Retirement Income Security Act.
- In many cases, 403(b) plans do not feature matching employer contributions, though it is possible for employers to offer them.
- 403(b) plans are offered by the non-profit sector and some government organizations.
- 403(b) plans often have more limited investment options focusing on annuities and some mutual funds
The fees associated with 403(b) plans can be highly variable. In some cases they may have lower operating costs because they have less stringent reporting requirements, while 401(k) plans can be more expensive for both the employer offering the plan and the employee as well.
However, 403(b) plans can also have other quite significant expenses that make them more costly than 401(k) accounts. For instance, the expense ratios for the annuities and mutual funds that are part of 403(b) plans are often quite steep. In fact, a 2022 study by the U.S. Government Accountability Office, revealed that the fees for the investment options associated with 403(b) accounts ranged from about 0.01% to 2.37%. That translates to investments that can cost as much as 237 times more than other, lower cost options. There may also be steep surrender fees with 403(b) accounts, in some cases as much as 10%.
The most significant difference between 401(k) and 403(b) plans is the type of employers that offer these retirement programs. While many non-profits opt for 403(b) plans, they may not always be the best choice for your organization or its employees.
The highly variable fees associated with 403(b) plans can often turn out to be a bad deal for employees, as well as the steep surrender costs. Contact Penelope to find out more about how we can build a 401(k) plan that not only meets the needs of non-profit organizations, but also helps your employees save more for retirement.