403(b) vs. 401(k): What's the difference?

• 403(b) and 401(k) plans are similar retirement savings tools offered by employers.
• The main differences between 403(b)s and 401(k)s are the type an employer can offer and investment options participants have.
• Both plans give employees options to add after-tax funds, take loans against existing balances, and have special circumstances to withdraw funds without penalty.

Whether we want to think about it or not, retirement will come for us all at some point in our lives. When it's your turn, will you have enough money to sustain you for the rest of your life? That's the question every adult has to answer for themselves and the reason so many of us choose to participate in some kind of retirement savings program.

The two most common are the 403(b) and 401(k) plans. These are savings programs offered by employers that enable you to allocate some of the money you earn into a special account where it will be invested and possibly matched by contributions from your employer. Here is a closer look at how both of these plans work and in which situations you might want to consider enrolling in one.

403(b) vs. 401(k): At a glance

Both 403(b) and 401(k) are employer-sponsored retirement plans aimed at helping workers invest their earnings and see them grow into a pot of money they can live on once they retire. There are some differences between the two that make each appropriate for different kinds of investors.

• 403(b) plans are tax-sheltered annuity plans offered by nonprofits and other tax-exempt employers.
• 401(k) plans are qualified profit-sharing plans offered by for-profit companies to enable employees to save for retirement.

What is a 403(b) plan?

A 403(b) plan is a type of retirement plan that can only be offered by qualifying tax-exempt employers. It's also known as a tax-sheltered annuity, though money can be invested into both annuities and mutual funds. These plans enable employees to contribute pre-tax money from their earnings directly to their plan. That money is then invested in annuities or mutual funds that are likely to gain in value over time.

Earnings grow tax-deferred until you start taking dispersals. You need to be at least 59 ½ to begin to withdraw funds from a 403(b) without paying a penalty, unless you qualify for a special circumstance, such as financial hardship or disability.

403(b) plans are only offered by tax-exempt employers, such as 501(c)(3) nonprofits, public schools, cooperative hospitals, and some religious organizations. The employer is the 403(b) plan sponsor and usually hires a provider to develop the options it will offer employees and to administer the plan itself.

Every plan is different and tailored to what the employer chooses to provide, such as the ability to take out loans or contribute after-tax dollars. You are generally eligible to participate in a 403(b) when your employment begins, though some employers set their own rules for eligibility and may opt to automatically enroll you in a plan.

Quick tip: If your 403(b) plan allows you to contribute after-tax dollars to a designated Roth account, you won't have to pay taxes when you withdraw those funds.

Employees usually get to choose how much to contribute to the plan and employers may or may not provide additional contributions. Depending on what options your employer offers with its 403(b) plan, you may also be able to add post-tax dollars to your account. Because you've already paid taxes on this money, you won't have to do so again when you collect dispersals of these funds once eligible.

In 2021, you can contribute up to $19,500 in salary to a 403(b) if you are under age 50 and up to $26,000 if you are older than age 50. The most both an employee and employer can contribute this year is the lesser of $58,000 or an employee's total includible compensation for their most recent year of service.

403(b) plans can also offer special provisions for employees to catch up on their retirement savings. This is one of the main advantages they have over 401(k) plans. If you've worked for a qualified organization for at least 15 years and meet specific requirements, you could add up to a maximum of $15,000 in contributions to your 403(b) over the course of five years. Otherwise, the 403(b) is very similar to the 401(k).

Example of a 403(b)

You begin working as a full-time employee of the local school system and are automatically enrolled in the district's 403(b) plan. Each paycheck, money is deducted before taxes and sent into the plan for investment. The district also makes a deposit into your 403(b) account each time you are paid. You don't pay taxes on either contribution, which lowers the immediate tax liability on your income and the money you send into the plan is invested.

"For instance, if your annual salary in 2021 is $50,000 and you contribute $5,000 to your 403(b), you would pay income tax on [only] $45,000," says Alexandra Demosthenes, a CFP and certified public accountant with Investment Advisory Professionals, LLC. "Any investment income generated in the 403(b) would not be taxed either. Once you are retired and withdrawing money from your retirement account, you will pay ordinary income tax on all withdrawals."

The funds in your 403(b) continue to grow through contributions and investment earnings until you reach an age to be eligible to withdraw funds. Those monies are counted as income for the tax year in which they're withdrawn and you will owe taxes based on your income bracket at that time. If your annual income is less than it was when the funds first were moved into the 403(b) plan, you will likely have saved some money in taxes.

What is a 401(k)?

A 401(k) is a retirement plan offered by many private employers that allow participants to divert pre-tax money from their pay into an investment account. Employers often provide additional funds to 401(k) plans in addition to what employees contribute. There are three kinds of 401(k) plans:

1. Traditional 401(k): This plan enables employees to designate how much of their pay is added to the fund per pay period and employers to provide matching funds as well as set up a vesting schedule. These plans must pass nondiscrimination testing that proves company contributions don't favor highly compensated employees. Companies of any size can offer this kind of plan and they can be offered in addition to other retirement plans.

2. Safe harbor 401(k): This plan is similar to the Traditional 401(k), but requires employer contributions to be 100% vested. Safe harbor 401(k)s are not subject to nondiscrimination testing. However, they do have rules about notifying employees about their rights and obligations regarding the plans. Companies of any size can offer this kind of plan and they can be offered in addition to other retirement plans.

3. SIMPLE 401(k): This type of plan is aimed at enabling small businesses with fewer than 100 employees to offer retirement benefits and maintain cost efficiency. Employer contributions have to be fully vested, but the plans don't have to meet annual nondiscrimination testing.

Quick tip: Vesting refers to the amount of ownership in a retirement plan. The money an employee adds to their 401(k) is 100% vested, meaning they own all of that money. The money an employer provides is not necessarily vested immediately. A period of time may have to pass before those funds belong 100% to the employee.

You may be automatically enrolled into a 401(k) or have to contact the appropriate person in your company to participate. It all depends on what your employer's policies are regarding eligibility and participation.

Employers can also decide what kinds of benefits they choose to offer with their 401(k) plans, companies to administer the plan, and types of products you can invest in. Options may include shares of company stock, individual stocks, bonds, or securities, variable annuities, or mutual funds.

Note: An employer can't require having more than one year of service as a condition of participating in their 401(k) plan.

401(k) plans have an income limit. In 2021, no more than $290,000 of an employee's income can be considered when calculating contributions based on a percentage of compensation.

The same individual contribution limits for 403(b) plans apply to traditional and safe harbor 401(k) plans in 2021: $19,500 if you are under age 50 and up to $26,000 if you are older than age 50. For SIMPLE 401(k) plans, the limit is $13,500 if you are younger than 50 and $16,500 if you are older than 50.

401(k) contributions are pre-tax, thereby lowering your taxable income in the years contributions are made. Taxes are paid upon withdrawal of funds once you reach an eligible age, have a special circumstance that allows penalty-free withdrawals, or opt to withdraw funds early and pay a 10% penalty. A plan may also have provisions that allow after-tax contributions, which will not be subject to taxation upon withdrawal. All taxes on 401(k) withdrawals are calculated as regular income tax.

"Sometimes, employers will permit loans on 401(k) plan balances," says Cassandra Kirby, a Certified Financial Planner and wealth advisor with Braun-Bostich & Associates. "This allows up to 50% of the vested balance to be loaned up to a maximum of $50,000. You must repay the loan within five years. There are some exceptions to this rule if the loan is for a first-time homebuyer. "

Though most people don't have a choice between a 401(k) and 403(b), the former generally offers participants more flexibility for choosing how your money is invested than you get with 403(b) plans. Many employers offer 401(k)s as a way of providing profit sharing to employees, which isn't possible with a nonprofit that offers a 403(b). Fees may also be less with a 401(k) than with a 403(b), but fees are common in general.

"Unfortunately, historically the 401(k) and the 403(b) plan markets have been dominated by higher fee providers," says Katharine Earhart, partner and co-founder of Fairlight Advisors. "It's important to understand and know the fees for your plan, including the fees associated with the investments inside your plan. Plan sponsors (typically the employer) should be sending an annual participant fee disclosure document which clearly and transparently displays the fees for the funds."

Example of a 401(k)

You become eligible to participate in your company's 401(k) program and complete your enrollment paperwork. You choose to allocate 2% of your gross pay of $100,000 to your 401(k) account: 100,000 x .02 = $2,000. Your employer offers to match that amount, adding another $2,000.

This means at the end of your first year participating in your company's 401(k), your account will have $4,000 in it to be invested and grow. As a result, your taxable income drops from $100,000 to $98,000: 100,000 - 2,000 = $98,000. The amount your employer contributes doesn't impact your taxable income.

The financial takeaway

Both 403(b) and 401(k) plans are vehicles offered by employers to help employees save for retirement. Because one is only for nonprofit organizations, you will likely not have the option to choose one over the other. However, they are very similar in how they work, each offering some advantages over the other.

It's always a good idea to consult with a financial advisor if you're considering participating in a retirement plan such as these. And any opportunity to save for the future will be beneficial, especially if your employer offers matching contributions. That's free money that will grow in a plan like a 401(k) or 403(b). Either way, they're both worth considering if they're available options to you.

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