We’ve all heard that saving for retirement is one of the smartest decisions we can make with our money.
But with so many options available, it can get pretty overwhelming to know which retirement plan(s) to participate in and which ones are available to you.
One of the best places to start is to see if your employer offers a retirement plan. According to the Bureau of Labor Statistics, 67% of private industry companies provided an employer sponsored retirement plan to their employees in 20210. With so many employers participating, there’s a fairly good chance you have one at work.
Today we will cover two of the most common plans: 403(b)s and 401(k)s.
These retirement plans have some distinct similarities, but they also differ in some categories. Read on to find out what they are.
What is a 403(b)?
A 403(b) is a retirement savings plan that is available to employees of public schools and 501(c)(3) organizations. These institutions do not have to pay taxes and are referred to as "tax-exempt organizations."
Sometimes referred to as “tax-sheltered annuities” (TSAs), 403(b) plans are common retirement accounts for employees of school systems, religious organizations, hospitals, and other nonprofit organizations.
What is a 401(k)?
A 401(k) is a retirement plan sponsored by an employer in the private sector (non-government, for-profit companies). The money in the account belongs to the employee earmarked for retirement.
With a 401(k), employees can choose from a selection of investments, typically exchange-traded funds (ETFs) and mutual funds.
401(k)s are a type of defined contribution plan. This means that the balance of the account depends on how much the employee contributes and how well the investments perform.
How are 403(b)s and 401(k)s similar?
Contributions
Employee contributions to 403(b)s and 401(k)s are made on a pre-tax basis, meaning there are no federal or state taxes deducted from the amounts you invest.
Some 403(b) and 401(k) accounts also allow employer matching contributions. These typically come in the form of a lump sum or a dollar-for-dollar match up to a certain percentage of an employee’s salary (e.g., 5%).
As an added incentive for older generations that are behind on their retirement goals, the IRS allows workers aged 50 and older to contribute an extra $6,500 to their 403(b)s and 401(k)s in 2022 (catch-up contributions).
Tax treatment
Both plans offer tax benefits to participants, allowing employees to contribute a portion of their salary to the plan, and those contributions are generally not subject to taxes.
In addition, the earnings on those contributions are also tax-deferred. Tax-deferred investment accounts allow the account owner to delay paying taxes until they start taking funds out (typically during retirement), at which time they will pay ordinary income taxes. This means that participants can accumulate more money in their accounts than they would if their earnings were subject to taxes.
Some plans also offer a Roth option for 403(b) and 401(k) plans. In these plans, contributions are taxed as ordinary income before they are invested in the plan. However, on the back end, withdrawals at retirement age come out tax-free.
Contribution limits
The IRS designates your annual contribution limit for your 403(b)s and 401(k)s.
- For 2022, that amount is $20,500 ($1,000 more than the limit in 2021
- Catch-up contribution: You can contribute an additional ($19,500) if you’re under 50; $27,000 if you’re over 50 ($20,500 + $6,500).
- In 2023, these limits will increase even higher: $22,500 for those under 50 and $30,000 for those over 50.
- There are also potential "extra' catch-up contributions for 403(b) participants that have been with their employer for 15 years or more.
If allowed by the 403(b) plan, an employee with a minimum of 15 years of service with the same 403(b) employer has a 403(b) elective deferral limit that is increased by the lesser of:
- $3,000,
- $15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule, or
- $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.
Your employer has limits as well. They depend on how much you contribute. In 2022, your combined contributions, along with employer contributions, cannot exceed the lesser of $61,000 or 100% of your compensation. In 2023, these will increase to $66,000 and $73,500, respectively.
Here’s a simple hypothetical to illustrate:
If you bring in $60,000 a year, the most you and your employer can contribute is $60,000. If you make $500,000 a year, the most you can contribute is $61,000.
Distributions
A distribution is a fancy word for a withdrawal from a qualified plan. When you take money out of your 403(b) or 401(k), you generally have to be at least 59½ to avoid a 10% penalty.
However, exceptions exist where the IRS allows for penalty-free distributions, such as child support, disability, and active military duty, among others.
Investment options
403(b)s and 401(k)s typically offer a wide range of investment options, including company stock ETFs, and mutual funds.
While each option carries its own risks, they all offer the potential for growth over time.
Employees can typically choose how their contributions will be invested by either manually selecting investments or choosing a portfolio pegged to their estimated retirement date.
Fees
Every 403(b) and 401(k) plan charges fees that vary depending on the size of the plan, the number of enrollees, and the employer’s history. Companies with more employees tend to pay less in fees, while smaller companies pay considerably more.
Fees can get pretty confusing and hard to find—typically buried in novel-sized plan-summaries. Employer-sponsored plans come with various fees. Some of the more common ones include:
- Plan administration fees
- Investment fees
- Individual service fees
- Sales charges (loads)
- Management fees
According to a report from Morningstar, the smallest 401(k) plans by aggregate savings (< $25M) charge total fees of 0.88% annually. On the other end of the spectrum, the biggest plans (> $500 million) charge an annual fee of 0.41%.
How are 403(b)s and 401(k)s different?
While there are a lot of similarities between these two retirement plans, there are still some distinct differences you should know.
Investment options
The standard investment vehicles in a typical 401(k) plan are mutual funds, stocks, and bonds. 403(b) plans are more limited, generally offering only mutual funds and annuities.
Regulations
401(k) plans must comply with many of the regulations outlined in the Employee Retirement Income Security Act (ERISA). ERISA is a set of rules designed to protect employer-sponsored plan participants and their retirement assets.
Employers offering 403(b) plans that do not fund contributions are not subject to many ERISA laws. One of the more important regulations that a non-contributing organization does not have to comply with is “nondiscrimination testing.” This annual test prevents highly-compensated employees from getting more than their fair share of plan benefits.
If an employer offering a 403(b) does make contributions to its employee accounts, they are not exempt from ERISA requirements and must comply with the same rules as a 401(k) plan.
Income limits
No matter their income, anyone can contribute to a 401(k). The only limit placed on high-income earners is how much of their salary their employer can contribute to their account. In 2022, this annual compensation limit is $305,000; in 2023, $330,000.
Final Word
As you can see, 403(b) and 401(k) plans have a number of commonalities, sharing similar contribution limits, distribution restrictions, tax treatment, and much more.
However, it’s important to remember that these plans aren’t 100% the same, and they often confuse even the savviest of plan participants.
That’s why it is always wise to get an unbiased, third-party review of your plan to see if it is set up to meet your objectives.
Whether you’ve just started contributing to your retirement plan or nearing retirement, Facet’s CFP® professionals are here to help when you’re ready with more than just your retirement accounts - we're here for everything your money touches.
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