You’ve certainly seen the term “401(k)” before. And it’s likely that you already have one set up through your employer. But what’s a 403(b)? If you’re wondering what this type of employer-sponsored plan is, who qualifies for it and how it’s different from a 401(k), read on.
401(k) plans are named for the section of the tax code that governs them. They came about in the 1980s as employers started abandoning pension plans, because the cost of running pension plans escalated. (Pension plans are funds that paid out a steady income over the course of the employee’s retirement.)
A 401(k) is a retirement plan offered by an employer — a corporation or privately held company — that allows employees to save and invest with deductions from their paychecks. Most plans have a diverse choice of mutual funds comprised of stocks, bonds and money market investments. Within the plan offerings, you control how the money is invested.
What Is a 403(b)?
A 403(b) plan is a similar to a 401(k). The major difference is a 403(b) plan is used by non-profit companies, religious groups, school districts and some government organizations. Most workplaces that qualify to offer a 403(b) will not also provide a 401(k). And for-profit corporations don’t have the option of offering a 403(b). So you generally don’t get to choose which type of plan you want.
Both 401(k) and 403(b) plans are intended to help employees meet long-term objectives, most typically saving and investing for retirement. The plans are set up to allow you to divert some of your pay into an investment account. These withdrawals are usually in the form of payroll-deducted pre-tax contributions.
In the past, 403(b) plans restricted their participants’ investment options primarily to variable annuities. In fact, these plans get their name from the section of the tax code concerning tax-sheltered annuities. However, this restriction was removed years ago. Now most 403(b) plans let you invest in a wide variety of mutual funds as well as annuities.
Both 401(k) and 403(b) plans are administered by a financial management company chosen by your employer (or one of several they’ll allow you to choose from). Whether your job provides a 401(k) or a 403(b), it’s important to carefully evaluate the available investment options and build a well-diversified portfolio of investments that meets your particular situation and retirement goals.
What Are the Fees?
As part of those decisions, be sure you also understand the plan’s administrative costs and the fees for each investment choice within the plan. The fees associated should be easily ascertained by looking on the website platform or by contacting the plan’s administrative team. From an informed position, you can best decide where and how to invest your money.
How Can I Contribute to a 401(k) or 403(b)?
The difference in overall cost between a 401(k) and a 403(b) can be either small or substantial. Plan costs are most directly determined by:
- what you invest in (for example, fees are typically higher for annuity products than mutual fund investments), and
- the administrative costs, often determined by the level of service the management company provides.
By law, 403(b) organizations are exempt from certain administrative processes that apply to 401(k) plans. This allows organizations with very small budgets to help their employees save for retirement. For this reason, administrative costs are generally lower for 403(b) plans than 401(k) plans.
There are three types of contributions that can be made to your 401(k) or 403(b) account:
- Elective deferrals. These are pre-tax contributions you elect to be taken out of your salary. Your employer withholds money from your paycheck to be contributed directly into the account for your benefit.
- Non-elective contributions. These are untaxed employer contributions to your account and include matching contributions, discretionary contributions and mandatory contributions made by your employer.
- After-tax contributions. These are additional contributions you can make if your plan allows you to make after-tax contributions. You can’t deduct them on your tax return.
A combination of any of these three contribution types can be used if your employer’s plan is set up for it. Although both types of plans will allow employer matching to take place, the reality is that this tends to happen more frequently with 401(k)s. The reason gets back to the nature of 401(k) plans being set up by “for-profit” companies where more money is available for employee benefits. Generally speaking, non-profit companies don’t have as much discretionary income to make matching contributions.
If you choose not to participate in a 403(b) or 401(k) plan, make sure you’re not missing out on an employer match. Your company may match a percentage of what you contribute to the plan. Some companies match the full amount you save, up to a limit. This is essentially “free money” for retirement but available to you only if you participate in the plan.
Are 403(b) Holders Vested?
As your employer makes matching contributions, the amount will show in your retirement funds account, but it may take time for those contributions to be “vested.” When fully vested, you become the owner of the employer contributions you receive. Vesting timetables are usually decided by your plan administrator and can take anywhere from 0 days to several years.
Typically, participants of 403(b) plans are vested instantly. For 401(k) plans, it takes much longer to become fully vested, because the private companies have more control over the rules and may want to leverage them to discourage employees from job hopping too soon.
Can I Take Out a Loan?
While not recommended by most financial experts, you can borrow money from your 401(k) plan before retirement should you find yourself in a temporary crunch for short-term cash. Some but not all 403(b) plans also offer the option to take a loan against your assets. Essentially, you’re borrowing from your own retirement assets and paying that amount with interest to your own retirement account.
Technically, 401(k) loans are not true loans, because there’s no lender approval process involved. Essentially, you’re simply accessing a portion of your own retirement plan money via a tax-free loan. You then must repay the money under specific rules designed to restore your 401(k) plan to its approximate original state, as if the transaction never occurred. This isn’t money you want to access for the purchase of a new flat-screen TV, but it’s nice to know that the option is there if you find yourself in serious need of a short-term liquidity loan.
For both types of plans, 401(k) and 403(b), you can borrow either 50% of your vested balance or $50,000, whichever is less. If you have less than $10,000 invested, you can borrow up to your account balance.
If you choose to take out a loan against your 401(k) or 403(b), be sure you understand the terms prescribed by your employer’s specific plan. Additionally, there are specific IRS rules that apply, and you need to be careful to follow them exactly. For example, repayment must occur within five years of the date you borrowed the money, and payments must be made quarterly in equal amounts that cover principal and interest.
401(k) vs 403(b) Comparison Chart
Below is a chart that summarizes the features of each plan, and I’ve highlighted where the plans differ. Check out the details on the tax structure and rules set by the federal government. And of course contact the administrator of your employer’s specific plan.
|Who Is Eligible||Employees of corporations or private companies where a plan is offered||Certain employees of public schools;|
employees of certain tax-exempt organizations;
|Invested In||Mutual funds and other investments offered by plan administrator||Tax-sheltered annuities;|
|Contributions Are Made With||Before-tax contributions;|
|Employer Contributions||Employers typically match a certain percentage of the employee’s contribution as an employee benefit and to encourage retirement savings.||Employer matching not common; non-profit companies don’t usually have enough discretionary income to make matching contributions.|
|Vesting||Varies based on employer’s rules||Typically, vesting is immediate|
|Maximum Amount Contribution for 2018||$18,000 per year||$18,000 per year|
|Age 50 Maximum Catch-up Amount (2018)||$6,000 per year, for a total of $24,000||$6,000 per year, for a total of $24,000|
|Tax Rules||Wages are contributed before taxes from each paycheck, like a deferred salary. Taxable income drops by the amount you contribute. You pay income tax on contributions and earnings when you withdraw funds at retirement.||Wages are contributed before taxes from each paycheck, like a deferred salary. Taxable income drops by the amount you contribute. You pay income tax on contributions and earnings when you withdraw funds at retirement.|
|Plan Cost||Varies by employer and includes an administrative fee and costs charged by funds||Tend to be more expensive, because the investment vehicle is most often an annuity, which typically has high frontend fees|
|Withdrawal Rules||No access to funds before age 59½, unless you leave your employer at age 55 or older. If you withdraw early, expect a 10% penalty on top of the usual tax bill.||No access to funds before age 59½, unless you leave your employer at age 55 or older. If you withdraw early, expect a 10% penalty on top of the usual tax bill.|
|Borrowing Rules||The smaller of 50% of your vested balance or $50,000;|
If you have less than $10,000 invested, you can borrow up to your vested account balance.
|The smaller of 50% of your vested balance or $50,000;|
If you have less than $10,000 invested, you can borrow up to your vested account balance.
|Loan Repayment Rules||Subject to employer rules defined by plan.|
IRS deems that repayment must occur within 5 years, and payments must be made quarterly in equal amounts that cover principal and interest.
|Subject to employer rules defined by plan.|
IRS deems that repayment must occour within 5 years and payments must be made quarterly in equal amounts that cover principal and interest.