Monthly Financial Jargon: 401(k) vs. 403(b)

The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re diving into the two primary forms of employer-sponsored retirement plans: 401(k) plans and 403(b) plans. Some people mistakenly assume these plans are the same; however, although these two types of retirement savings accounts are very similar, they also have several important differences.

What Are These Plans? 

401(k) and 403(b) plans are qualified tax-advantaged employer-sponsored retirement vehicles. The names for these plans come from sections 401(k) and 403(b) of the U.S. Internal Revenue Code, respectfully. Both 401(k) and 403(b) plans are defined contribution plans, meaning the employee and the employer can make contributions to the account up to the contribution limits set for these accounts by the Internal Revenue Service (IRS). The foremost difference between these two types of retirement plans is based on who the sponsoring employer is. 401(k) plans are offered through private and for-profit companies and corporations, while 403(b) plans are available through non-profit and government organizations, including education systems. For employees with access to these plans, 401(k) and 403(b) plans serve as their primary retirement savings vehicles. Employees make contributions to 401(k) and 403(b) plans via automatic payroll contributions in which a specified percentage of an employee’s pay is automatically deferred from his or her paycheck to his or her 401(k) or 403(b) plan.

401(k) Plans

A 401(k) plan is a tax-advantaged, defined-contribution employer-sponsored retirement account, offered by an employer to its employees. A major benefit of 401(k) plans: an employer can match some or all of an employee’s contributions in a given year, based on the employer’s company match, which is always specified in a percentage. There are two types of 401(k) accounts – a traditional 401(k) and a Roth 401(k) – and these accounts differ based on how they are taxed. Investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws those funds, which typically occurs after retirement (note: you can take a loan from a 401(k) plan, but this carries a hefty fee for taking an early withdrawal). By contrast, in a Roth 401(k) plan, withdrawals are tax-free. In other words, for a traditional 401(k) plan, employees make pre-tax contributions to reduce their taxable income each year, which means that future withdrawals will be taxed. With a Roth 401(k) account, employees make contributions post-tax, meaning the withdrawals from the account will be tax-free in the future. With this in mind, a Roth 401(k) plan, if the Roth option is offered by the employer, is usually the prudent plan for an employee in the earlier years of his or her career, as the employee will most likely be in a higher income tax bracket later in life. If an employer offers both options, an employee can split his or her contributions, putting some into a traditional 401(k) and some into a Roth 401(k); however, keep in mind that the contribution limit is a total across accounts.

As far as investment options go, 401(k) plans tend to offer a wider variety of investment options than 403(b) plans do, including stocks, bonds, mutual funds, and annuities. For 2021, the 401(k) contribution limit is $19,500 for those under age 50, with an additional $6,500 catch-up contribution – for a total contribution limit of $26,000 – for those age 50 and older. All 401(k) plans require participants to hit age 59 ½ to withdraw funds, and most early withdrawals are subject to penalties.

403(b) Plans

A 403(b) plan is an employer-sponsored retirement account offered by non-profits, tax-exempt organizations, and public school systems. Employees that are participants in such plans include government workers, nurses, doctors, school administrators, teachers, and professors, to name a few. In many ways, a 403(b) plan is very similar to a 401(k) plan, as both plans offer employees a tax-advantaged way to save for retirement.

Like a 401(k) plan, there is also a Roth option with 403(b) plans and the same traditional versus Roth rules apply. With a traditional 403(b) plan, an employee makes contributions pre-tax but will have to pay taxes on future withdrawals, and with a Roth 403(b) plan, an employee makes after-tax contributions, meaning future withdrawals will be tax-free. Employees that participate in 403(b) plans may be eligible for employer matching contributions just like participants of a 401(k) plan; however, fewer employers offer matches with their 403(b) plans. This is because an employer who offers a match with its 403(b) plan must comply with regulations created by the Employee Retirement Income Security Act (ERISA), and many employers opt to avoid these regulations because they cost time and money. Consequently, companies with 401(k) plans offer match programs at a much higher rate.

One advantage of 403(b) plans is that these plans tend to include a faster vesting of funds, and some plans even allow the immediate vesting of funds, which is very uncommon in 401(k) plans. This means that an employee typically obtains rights to employer contributions made to the employee’s 403(b) account more quickly than an employee obtains rights over 401(k) employer contributions. In terms of investment options, 403(b) plans offer mutual funds and annuities, and these options tend to be limited compared to the offerings of their 401(k) counterparts.

The 2021 contribution limit for 403(b) plans is the same as it is for 401(k) plans: $19,500 for those under age 50 and an additional $6,500 catch-up limit for those age 50 and older. One difference with 403(b) plans involves the ability for employees to make additional catch-up contributions. Employees with 15 or more years of service with the same employer can contribute an additional $3,000 per year up to a lifetime limit of $15,000, and qualifying employees do not have to be age 50 or older to take advantage of this benefit. As with 401(k) plans, 403(b) plans require participants to reach age 59 ½ before taking withdrawals, and early withdrawal fees apply.

Final Points

Overall, both plans are their respective employees’ primary vehicles for retirement savings. The big differentiator: 401(k) plans serve employees in the private sector and for-profit businesses, while 403(b) plans strictly serve employees in the public sector and of tax-exempt organizations. Because your employer dictates which plan is available to you, be mindful of the characteristics of your plan. Despite the few differences to note, these two plans are overall very similar as far as employer-sponsored retirement plans go: Both have the same basic contribution limits, both offer Roth options, and both require participants to reach age 59 ½ before taking distributions. Most importantly, make sure you are aware of your plan’s benefits to ensure you take full advantage of what you’re eligible for.