403(b) vs. 401(k): A Deep Dive Into Their Similarities & Differences

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Many employees don’t know the differences between 403(b) and 401(k) plans or even that there are differences. The two plans are very similar, both in their basic setup and in the way they work. But there are more subtle differences between the two that can lead to pretty significant changes in outcomes.

Which plan would you rather have? Let’s dive in and see if one is even better than the other.

The Short Version:

  • 403(b) and 401(k) plans are both employer-sponsored defined contribution plans.
  • For the most part, the two plans work the same way, providing very generous contribution amounts that are tax deductible, along with tax-deferred investment earnings.
  • The main differences have to do with the types of employers offering each, investment choices and employer matching contributions.
  • 401(k) plans generally offer more investment options than 403(b) plans.

403(b) vs 401(k) Retirement Accounts: How Are They Similar?

Both 403(b) and 401(k) plans are defined benefit contribution plans that enable participants to put funds aside for retirement. How they operate, who can qualify and what they offer are remarkably similar. Learn more. 

Eligibility

Participants are eligible based on their employment with the employer, and the fact that they have earned income. As is the case with all defined contribution retirement plans, contributions can only be made out of earned income.

In either plan, participation is available to any employee who meets plan criteria for employment status (permanent vs. temporary), employment term (meeting any minimum employment term requirement), and work schedule (full-time vs. part-time).

Are you self-employed or freelancing? What Is a Solo 401(k)?

Tax Benefits

Both 403(b) and 401(k) plans enjoy a twin tax benefit:

  1. Employee contributions to the plan are tax deductible in the year made, thus lowering the employee’s tax liability for that year. For example, if the employee earns $50,000, and makes a $10,000 contribution to either plan, his or her taxable income for federal income tax (and generally state income taxes) will be only $40,000.
    Note: Plan contributions do not reduce your income for the calculation of FICA taxes.
  2. Investment income earned in either plan accumulates on a tax-deferred basis. That means no tax liability is due or payable when investment income is earned, as long as it is not withdrawn from the plan.

This powerful one-two tax punch is one of the reasons 403(b) and 401(k) plans are so popular. The employee not only has the ability to accumulate large amounts of money in the plan from contributions, but income earned on those contributions is not subject to income tax until the funds are withdrawn from the plan (more on that below).

Contribution Limits

Contribution limits to the two plans are identical. Employee elective deferrals can be as high as $20,500 in 2022, and $22,500 for 2023.

However, if you are 50 or older, you can also add a catch-up contribution of $6,500 in 2022, and $7,500 in 2023.

Total contributions for those 50 and older then are $27,000 for 2022, and a whopping $30,000 for 2023.

With either plan, employee deferrals can be up to 100% of the participant’s earned income. In theory at least, a person earning $50,000 in 2022 could make the full employee deferral of $27,000 for the year.

Employer Matching Contributions

This is another area where the 401(k) and the 403(b) plans are identical. Employers can make matching contributions in the employee’s plan for up to $61,000 in 2022 (or $66,000 in 2023), less the contributions made by the employee.

For example, if an employee under the age of 50 were to make the full $27,000 contribution for 2022, the employer could contribute up to $34,000 – for a total of $61,000 – on the employee’s behalf.

If the employee is 50 or older, the catch-up contribution is added to the total contribution limit. For 2022, the total contribution limit for participants 50 and older is $67,500. In 2023, the total contribution limit for the same participants rises to $73,500.

But while the employee can contribute up to 100% of earned income into the plan, employers are subject to a limit.

The employer contribution cannot exceed 25% of the compensation paid to eligible employees during the plan year.

For that reason, the maximum income eligible for the combination of employee contributions and employer matching contributions cannot exceed $305,000 for 2022, or $330,000 for 2023.

The actual total contribution limit is 20% since the amount of the maximum contribution must first be deducted from the maximum income limit before applying to the 25% limit.

For example, if an employee earns $305,000 for 2022, the maximum contribution limit is calculated as follows:

$305,000 – $61,000 (the maximum total contribution limit to all plans) = $244,000 X 25% = $61,000

If you’re confused by that calculation, you’re far from alone. That’s why there are CPAs and tax-preparation software programs!

Withdrawal Rules

Other than RMDs (covered below), plan participants can begin making withdrawals beginning at age 59 ½. At that age, withdrawals taken will be subject only to ordinary income tax rates.

If withdrawals begin before age 59 ½, the participant will be subject to the payment of ordinary income tax, plus a 10% early withdrawal penalty tax.

However, there is a fairly long list of exceptions to the 10% early withdrawal penalty. One of those exceptions is when the employee separates from employment during or after the year in which the employee reaches age 55. (The age is 50 for public safety employees of the state, or political subdivision of a state, in a governmental defined benefit plan.)

Required Minimum Distributions (RMDs)

Both 403(b) and 401(k) plans can accumulate tax-deferred income well into retirement. And naturally, the longer the plan goes without withdrawals, the greater the potential is for continued plan growth.

But the IRS does put a limit on that accumulation, and it’s known as required minimum distributions — commonly referred to as RMDs.

Under the provision, all tax-deferred retirement accounts – with the lone exception of the Roth IRA – must begin making distributions to the plan owner. The distributions must begin in the year in which the owner turns 72 and be made annually thereafter.

Distributions are based on the participant’s age in each year a distribution is made. Since the participant’s life expectancy decreases with age, the percentage distributed will rise slightly in each year.

This isn’t a percentage you need to calculate, since it will be performed by your plan administrator or trustee.

The purpose of the RMD from the IRS standpoint is to require distributions – and the tax liability they generate – after many years of tax deferral.

Learn more >>> Required Minimum Distributions: What You Need to Know

Roth Provisions

Both a 401(k) plan and a 403(b) plan can establish a separate Roth provision. If offered, you’ll be permitted to make after-tax contributions to the Roth portion of the plan.

In doing so, you would not get the benefit of the tax deductibility of your contribution. Those contributions will accumulate investment earnings on a tax-deferred basis. And once you reach age 59 ½, and have been participating in a Roth plan for at least five years, you can begin taking withdrawals that won't be subject to either ordinary income tax or the 10% early withdrawal penalty.

In that way, the Roth provision will create a tax-free income stream for you in retirement.

However, employer matching contributions – if made – will be put into the ordinary portion of either plan, and not into the Roth portion.

Loan Provisions

Both 403(b) and 401(k) plans can offer loan provisions. However, contrary to popular belief, employers are not required by the IRS to make these provisions available. The establishment of a plan loan provision is completely within the discretion of the employer. Fortunately, many employers do add this feature.

If loans are permitted, the employer can set the limits. However, the IRS sets maximum limits at either (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less. The employer may permit multiple plan loans, but the total outstanding balance of all loans at any time cannot exceed the IRS limit.

What’s more, the maximum loan amount is calculated based on the vested amount of the participant’s plan balance. If the plan has employer contributions that are not vested, they are not used in calculating the maximum loan amount.

The maximum term of a plan loan is five years, but that can be extended if the loan is taken for the purpose of purchasing the employee’s primary residence.

Loan repayments are not to be confused with plan contributions. They are strictly a repayment of the loan principal taken from the plan. However, interest paid with the loan is credited to the participant’s plan balance.

If a loan is not repaid within the required term, or if the participant terminates employment with the employer, the loan must be fully repaid, generally within 60 days. If not, the employer is required to report the unpaid balance of the loan as a taxable distribution to the participant.

403(b) vs 401(k) Retirement Accounts: How Are They Different?

While most people generally consider 403(b) and 401(k) accounts to be the same — and, as you've read above, they certainly seem that way — there are very subtle differences between them. Namely: Who offers them and what you can invest in.

Eligibility

The general parameters of eligibility between the two plans are identical. But the differences involve the type of organizations sponsoring each plan.

  • A 401(k) plan is typically sponsored by a for-profit company.
  • A 403(b) plan is offered by governments and government agencies, and nonprofit organizations. This can include churches and charities.

Vesting Periods

Whether you are enrolled in a 403(b) or 401(k) plan, plan contributions made by the employee are 100% vested immediately. That means the funds contributed are fully the property of the employee, subject to the terms of the plan.

But where vesting periods become a factor is with employer matching contributions. Since those contributions are made by the employer, and not the employee, the employer can determine when those contributions become fully vested in the employee.

The IRS provides employers with two types of vesting schedules, which are known as cliff vesting and graded vesting.

  • Cliff vesting refers to an arrangement in which the employer matching contribution becomes fully vested all at once. For example, the employer may determine no vesting is available within the first two years of employee service, after which the employer matching contributions become 100% vested.
  • Graded vesting is a method in which vesting occurs gradually, over several years. For example, an employer may permit no vesting in the first year of employment, 20% in the second year, 40% in the third year, and so on.

An example of the two vesting schedules is presented side-by-side in the screenshot below:

Once the employee's years of service reaches the point of 100% vesting, all matching contributions made by the employer are automatically the property of the employee.

All the above notwithstanding, 403(b) plans typically offer shorter vesting periods than 401(k) plans.

Employer Matching Contributions

While both 403(b) and 401(k) plans can offer employer matching contributions, and most 401(k) plans do, most 403(b) plans don’t.

This has to do with a combination of factors. First, since 403(b) plans are primarily offered by nonprofit organizations and government agencies, employers often lack funds to provide matching contributions.

Second, 403(b) plans often fail to offer an employer match so they will not lose their ERISA exemption. The loss of that exemption would require the employer to be subject to nondiscrimination testing.

This is an annual test designed to limit highly compensated employees from receiving a large share of a plan’s benefits. By not offering an employer matching contribution, the 403(b) avoids ERISA and the nondiscrimination testing requirement.

However, if a 403(b) does not offer an employer match, they may enable an employee with over 15 years of service to make additional catch-up contributions to the plan (this option is not available to 401(k) plan participants).

For an employee with more than 15 years of service, additional catch-up contributions can be made as the lesser of:

  • $3,000;
  • $15,000 reduced by the sum of prior years’ 15-year catch-up deferrals; or
  • $5,000 x years of service with the employer, minus the total of all elective deferrals made to a 403(b), 401(k), SARSEP or SIMPLE IRA plan maintained by the employer, including the 15-year catch-up, but excluding the age 50 catch-up.

The additional catch-up contribution is over and above the normal catch-up contribution of $6,500 for 2022, and $7,500 for 2023. The maximum additional catch-up contribution is $15,000, no matter how many years the employee has been employed by the agency.

Investment Choices

This is one of the more significant differences between the 403(b) and 401(k) plans. As a general rule, a 401(k) plan will offer more investment options than a 403(b).

This owes to the fact that a 401(k) plan can be set up with a mutual fund family, or even a diversified investment broker. That would allow participants to choose investments from among the fund options offered by the fund family, or from a nearly unlimited choice if the plan is held with an investment broker. Many companies also offer their employees an opportunity to invest in company stock through the plan.

403(b) plans can be held with mutual funds, similar to 401(k) plans, but are more often held instead in annuities sponsored by insurance companies. If that’s the case, there may be few if any investment choices available to employees. The insurance company may determine what type of annuities the plan will be held in.

Read more >>> 7 Safest 401(k) Investments During a Recession

Can I Have Both a 401(k) and a 403(b)?

It is possible to have and participate in both a 401(k) and a 403(b) plan at the same time.

For example, if you have two jobs, one with a for-profit company and another for a nonprofit, you may participate in both plans.

The only limitation if you have both plans is that your total contributions to both plans cannot exceed $20,500 for 2022 (or $27,000 if you are 50 or older) to both plans.

For example, if you are under 50 and you contribute $10,000 to your 401(k) plan, the maximum you can contribute to the 403(b) is $10,500.

How Are 403(b) and 401(k)s Different From IRAs?

403(b) and 401(k) plans are generally employer-sponsored plans. The employer sponsors and administers each and sets the parameters for the plan. They’re typically group plans, and larger ones may have thousands of participants.

IRAs are private plans that will only cover one individual.

Contribution limits for IRAs are much lower than they are for the employer plans. For 2022, the maximum IRA contribution is $6,000, or $7,000 if you are 50 or older. (For 2023, the maximum contributions are $6,500 and $7,500.)

Because they're individual plans, IRAs are usually self-directed, though you can choose a managed option, like a robo-advisor. That means the funds can be invested in any assets permitted by the IRS. As a result, IRAs usually offer more investment options than either 401(k) or 403(b) plans.

The Takeaway: The Objects In the Mirror Appear Closer Than They Are

As you can see, 403(b) and 401(k) plans have more similarities than differences. They’re virtually identical in regard to eligibility, contribution amounts, taxability, withdrawal provisions, Roth provisions, and RMDs.

But the main differences are the employers who sponsor the plans, the presence or absence of employer matching contributions, vesting schedules, and investment options.

Either plan is a good one, and you should sign up without delay if your employer makes one available.

More Retirement Account Guides >>> 

Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids.

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