401(k) vs. 403(b): An Overview
Named after sections 401(k) and 403(b) of the tax code, respectively, both 401(k) plans and 403(b) plans are qualified tax-advantaged retirement vehicles offered by employers. The primary difference between the two is the type of employer sponsoring the plans—401(k) plans are offered by private, for-profit companies, whereas 403(b) plans are only available to nonprofit organizations and government employers. Another key difference between 403(b) and 401(k) plans lies in the investment options each offer, although that distinction lessens over time.
Once also known as tax-sheltered annuities, 403(b) plans used to be restricted to an annuity format. This restriction was removed in 1974.
- 401(k) and 403(b) plans are qualified tax-advantaged retirement plans offered by employers to their employees.
- 401(k) plans are offered by for-profit companies to eligible employees who contribute pre or post-tax money through payroll deduction.
- 403(b) plans are offered to employees of non-profit organizations and government.
- 403(b) plans are exempt from nondiscrimination testing, whereas 401(k) plans are not.
A 401(k) plan is a qualified employer-sponsored retirement plan that eligible employees may make tax-deferred contributions from their salary or wages to on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis. 401(k) plans are offered through private employers.
When you withdraw funds from your 401(k)—or “take distributions,” as the lingo goes—you begin to both enjoy the income from this retirement mainstay and face its tax consequences. For most people and with most 401(k)s, distributions are taxed as ordinary income, much like a paycheck. However, the tax burden you’ll incur varies by the type of 401(k) and on how and when you withdraw funds from it.
A 403(b) plan is a retirement plan for specific employees of public schools, tax-exempt organizations, and certain ministers. These plans can invest in either annuities or mutual funds. A 403(b) plan is also another name for a tax-sheltered annuity plan, and the features of a 403(b) plan are comparable to those found in a 401(k) plan.
Employees of tax-exempt organizations are eligible to participate in the plan. Participants include teachers, school administrators, professors, government employees, nurses, doctors, and librarians. Many plans vest funds over a shorter period than 401(k) plans or may allow immediate vesting of funds.
Legal Differences Between 401(k) and 403(b) Plans
403(b) plans are unable to accept profit sharing from their sponsor employer. This makes sense because the entities that are allowed to offer 403(b) plans—nonprofits and the government—are not working to make a profit. Also, 403(b) plans do not have to comply with many of the regulations in the Employee Retirement Income Security Act (ERISA), which governs qualified, tax-deferred retirement investments, including 401(k)s and 403(b)s. For example, 403(b)s are exempt from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or "highly compensated" employees from receiving a disproportionate amount of benefits from a given plan.
The reason for this and other exemptions is a long-standing Department of Labor regulation, under which 403(b) plans are not technically labeled as employer-sponsored as long as the employer does not fund contributions. However, if an employer does make contributions to employee 403(b) accounts, they are subject to the same ERISA guidelines and reporting requirements as those who offer 401(k) plans.
Additionally, investment funds are required to qualify as a registered investment company under the 1940 Securities and Exchange Act to be included in a 403(b) plan. This is not the case for 401(k) investment options.
Practical Differences Between 401(k) and 403(b) Plans
Even though 403(b) plans are legally able to provide employer-matches to their participants' contributions, most employers are unwilling to offer matches so they do not lose ERISA exemption. Consequently, 401(k) plans offer match programs at a far higher rate. However, if an employee has over 15 years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to their 403(b) plans that those with 401(k) plans can't.
Another difference between 401(k) and 403(b) plans is that for non-ERISA 403(b) plans, expense ratios can be much lower since they are subject to less stringent reporting requirements.
Typically, the plan providers and administrators are different for each type of plan. 401(k) plans tend to be administered by mutual fund companies, while 403(b) plans are more often administered by insurance companies. This is one reason why many 403(b) plans limit investment options and prominently feature annuities, while 401(k) plans tend to offer a lot of mutual funds.
The SECURE Act and Annuities in 401(k) Plans
However, with the Setting Every Community Up for Retirement Enhancement (SECURE) Act, employees may see more annuity options offered in their 401(k) plans. This is because the SECURE Act eliminates many of the barriers that previously discouraged employers from offering annuities as part of their retirement plan options.
By implementing certain guidelines and procedures, ERISA fiduciaries are now protected from being held liable should an annuity carrier have financial problems that prevent it from meeting its obligations to its 401(k) participants. Additionally, under Section 109 of the SECURE Act, annuity plans offered in a 401(k) are now portable. This means if the annuity plan is discontinued as an investment option, participants can transfer their annuity to another employer-sponsored retirement plan or IRA, thereby eliminating the need to liquidate the annuity and pay surrender charges and fees.
The Bottom Line
Nevertheless, 401(k) plans and 403(b) plans are very similar as far as retirement vehicles go. Both have the same basic contribution limits, both offer Roth options and both require participants to reach age 59.5 before taking distributions.
Though it is not very common, it is possible to have an employer offer both a 401(k) and a 403(b). In these cases, employees may contribute to both accounts.