Key Takeaways
403(b) and 401(k) both have the same contribution limits. Tax-deferred contributions up to $20,500 in 2022 ( A $1,000 limit increase from 2021)
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)?
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 2022, 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 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)?
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-Deferred Retirement Investments. Both 401(k) plans and 403(b) plan for contributions on a pre-tax basis and are only subject to income taxes when you start taking withdrawals.
- Maximum Contribution. In 2022, the maximum contribution amount for both types of plans is $20,500. Over $26,000 if you are 50 or older.
In 2022, the maximum contribution limit for 403(b) and 401(k) plans increased 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 must be repaid within 5 years unless the money is used to buy your main home.
- Tax On Early Distributions. 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 reach 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 to start taking withdraws until age 72. You can withdraw more than the minimum amount, which will be included as taxable income.
- Vesting. Employee salary deferrals are always 100% invested.
In other words, the money the employee contributed to either their 401(k) or 403(b) cannot be forfeited. So, when employees leave their place of employment, they are entitled to those contributions inclusive of any investment gains or losses.
Differences Between 401k and 403(B) Plans
- Type of Employer. A 401(k) is usually offered by a for-profit company, like Apple or Google. Whereas 403(b) plans are offered by public schools, colleges, universities, churches, and some 501(c) tax-exempt organizations (think American Red Cross), and government employees.
- 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 other hand, 401(k) plans may offer ETFs, Stocks, Bonds, Stock Funds, and mutual funds.
- Employer Match. Sponsors of 403(b) plans are not prohibited from providing an employer match, although it is uncommon for 403(b) sponsors to provide employer matches.
- 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. 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].
Significant changes are 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 can 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 can 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.
A 401(k) plan is better 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 to fully take advantage of the tax-deferred contributions.
Tax-deferred retirement plans are still one of the most sure-fire ways to succeed financially.
