The two most common forms of retirement account for employees are the 401(k) and 403(b). The 401(k) retirement plan is offered mostly by for-profit companies, while the 403(b) is a vehicle for non-profit entities.
What's the Difference Between a 401(k) and 403(b)?
A 401(k) is a retirement plan offered mostly by for-profit companies to assist employees in saving for retirement. Decades ago, most companies offered their employees pensions, which are ongoing retirement payments guaranteed by an employer.
Eventually, Congress passed the Revenue Act of 1978, which was when Section 401(k) of the tax code was born. Within two years of the IRS issuing proposed regulations sanctioning using employee salary reductions as retirement plan contributions, nearly half of all large companies offered a 401(k) or were considering it. As of 2020, more than $6.3 trillion was invested into 401(k) plans.
A 401(k) is a qualified plan, which means your company gets a tax benefit for contributing money to the account on your behalf and you can contribute part of your paycheck to the plan before the IRS taxes the funds.
Qualified plans allow employees to contribute up to $19,500 in 2020 and 2021. If you're age 50 or older you can contribute an additional $6,000 in 2020, and $6.500 in 2021, referred to as "catch-up" contributions. You can’t withdraw money out of most 401(k) plans until you reach age 59 1/2 or meet certain IRS conditions, and you have to begin taking withdrawals by age 72, or 70 1/2 if you reached that age before January 1, 2020. Roth 401(k) plans have different rules.
401(k)s and other company-sponsored retirement plans also limit the investment choices you have. Unlike an IRA, where you can choose between most types of traditional investing products, the average 401(k) plan in 2016 had only 27 choices. Fees also eat into your balance. Depending on the quality of the plan, you may be stuck with less-than-ideal options from a fee perspective.
How a 403(b) Works
From the perspective of the average employee, there are few differences between a 401(k) and a 403(b). Generally, nonprofits, including schools, hospitals, and religious groups, offer their employees 403(b) retirement accounts instead of 401(k) accounts. For-profit companies can't offer a 403(b).
Just like a 401(k), the 403(b) allows you to make tax-deferred deposits. It also has the same contribution limits and comes with the same withdrawal rules as the 401(k). There is one difference that applies to a small subset of employees—if you have 15 years of service, and your company is considered a “qualified organization,” you may be eligible to contribute an extra $3,000 to a 403(b). This is not available with a 401(k).
Another difference between a 401(k) and a 403(b) is the investment choices. Although most 401(k) plans offer different types of mutual funds as their investing choices, 401(k) plans have the option to offer other choices. 403(b) plans can only offer mutual funds and annuities. Technically, 403(b)s are more limited on investing options than 401(k)s, but in practice there’s not much difference.
403(b)s have had the reputation of having higher fees than 401(k)s, but recent trends have seen 403(b) plans emerge with lower fees.
403(b) vs. 401(k): Which Is Better?
There are some other benefits to nonprofits that might make a 403(b) more attractive, but to the vast majority of employees, the type of plan doesn’t matter. One isn’t better than the other.
Instead of evaluating a 403(b) versus a 401(k), evaluate the investment options inside the plan. Generally, the larger the company, the lower the plan fees because there are more people participating, which brings costs down. If you work for a small company, consider lower cost index funds as an investment option instead of placing money in higher priced actively managed funds.
Either way, if your company matches your deposits, consider participating in the plan up to the maximum amount they’ll match. After that, open an IRA if the plan’s fees are high or if you want to diversify your investments to options not available in your 401(k) or 403(b). Note, however, that the IRS has specific rules concerning contribution limits and deductibility when contributing to both an employer-sponsored plan and an IRA.
- 401(k)s are offered by for-profit companies.
- 403(b)s are offered by non-profit organizations.
- Both offer tax-advantaged retirement savings.
- You can choose from a limited range of investment options in both types of plans.
- 401(k)s and 403(b)s are similar; one isn't necessarily better than the other.