403(b) vs 401(k): What’s the Difference?

I know that you were losing sleep because I had not written a post yet that outlines the differences between a 403(b) vs 401(k). Oh wait, you weren’t?

I thought everybody was a retirement tax code freak like me. 😂

Either way, you or someone you know may have the option to fund a 403(b), and understanding how it compares to a 401(k) may prove to be helpful. When people are first hired into a full-time job or some part-time positions, they get handed a variety of paperwork and decisions they have to make right away as a new employee.

Among those items is the establishment of a company retirement account for their potential retirement savings from earnings.

The Difference Between a 403(b) and a 401(k)

Most companies today offer employees a standard 401(k) retirement deferred savings plan. However, if a person works for the government or some organizations, like nonprofits, different options can come up, including the 403(b) plan. This raises the question of which is better, a 401(k) or a 403(b).

A variety of retirement plans exist today, approved by the Internal Revenue Service as legal tax shelters for earnings. In almost all cases, except for a Roth IRA, the plans involve pre-tax income that is deferred to a holding account and allowed to gain profit and interest through compounding and investment.

When the funds are finally withdrawn, usually later in a person’s life, they should, in theory, be part of a larger retirement balance that can be used when a person is no longer working, resulting in a lower tax rate.

 

This maximizes the value of the dollars saved, even with inflation taken into account. Each of these plans has a numerical name, referring to the tax code statute that authorizes the activity and the given plan.

The 401(k) Plan – The Basics

Most people know of or are familiar with the 401(k) retirement plan. But whether you are or you’re not, here are the plan highlights:

Income Tax Treatment: Contributions to a 401(k) plan are deductible from your taxable income in the year they are made. Investment earnings within the account accumulate on a tax-deferred basis.

In this way, you are shifting the tax burden from today until you retire, at which time you’ll presumably be in a lower tax bracket.

Contribution Limits: For 2024, the maximum contribution you can make to a 401(k) plan is $23,000. As the contribution limit rises, so does your investment potential. If you are 50 or older, there is a catch-up provision of $7,500, enabling you to contribute a maximum of up to $30,500 per year.

Employer Matching Contributions: Employers can and often do match an employee’s contributions to a 401(k) plan. A typical match is 50% of the employee’s contribution, up to 6%, which means the employer contributes 3%, bringing the total contribution to 9%.

In theory, an employer match plus the maximum employee contribution can be as high as $61,000 for 2023 (or $67,500 if you’re 50 or older), and $69,000 for 2024 ($76,500 if you’re 50 or older) which is the maximum contribution per employee under IRS regulations.

Withdrawal Requirements: You can begin taking withdrawals from your 401(k) plan once you reach age 59 1/2, and once again, those distributions will be added to your income for tax purposes. If you take withdrawals before turning 59 1/2, you will have to pay an early withdrawal penalty tax of 10% of the distribution, in addition to the regular tax liability that will be owed.

Required Minimum Distributions (RMDs): Like nearly every other type of retirement plan (except Roth IRAs), 401(k) plans require that you begin taking withdrawals from the plan no later than when you reach age 73. If you don’t withdraw an RMD, don’t withdraw the full amount of the RMD, or don’t withdraw the RMD by the applicable deadline, the amount not withdrawn is taxed at 50%.

401(k) Loan Provisions: One of the benefits of a 401(k) is that you can take a loan against your account, as long as it is permitted by your employer (they aren’t legally obligated to do so). You can borrow up to 50% of the plan value, up to a maximum of $50,000, and must repay the loan within five years.

However, if a 401(k) loan is taken for the purpose of purchasing the employee’s principal residence, it can be paid back over a period of more than 5 years.

 

One thing to be aware of, however, is that if you leave your employer and you still have a loan balance outstanding, you must pay it back (within 60 days), otherwise it will be considered a distribution from the plan and subject to regular income tax and, if you’re under age 59 1/2, the 10% early withdrawal penalty.

401(k) Portability and Rollover Provisions: If you leave your employer, you can take your 401(k) with you. You can then do a tax-free rollover either into the 401(k) plan of your new employer, a traditional IRA, a 457 plan, a SEP IRA, or a 403(b) plan.

You may also rollover a 401(k) into a Roth IRA or a designated Roth that’s part of a traditional retirement plan (for example, a Roth 401(k)), but the amount of the rollover will be subject to regular income tax in the year that the conversion is completed. (See the IRS Rollover Chart for rollover summary details.)

401(k) Plan Key Features

FEATURE	DESCRIPTION
Income Tax Treatment	Contributions Are Deductible, Earnings Tax-Deferred
Contribution Limits	Max $23,000 (Or $30,500 if 50+), With Catch-Up Provision
Employer Matching Contributions	Typical 50% Match Up to 6%, Total Contribution 9%
Withdrawal Requirements	Penalty-Free Withdrawals at Age 59 1/2
Required Minimum Distributions	Start at Age 73, Penalties for Missed RMDs
Loan Provisions	Up to 50% Of Account Value, Repay in 5 Years
Portability and Rollover	Transfer to New Employer, IRA, or Other Plans

401(k) Investment Options

Investment options in 401(k) plans run the gamut. In some plans, you may be limited to a half-dozen mutual funds or ETFs and your employer’s company stock. In others, you’ll have as many options as the plan trustee has available.

For example, if the plan is held with Fidelity, chances are you’ll be picking from a selection of Fidelity funds. That will likely generate a selection of target date funds. Blah! In case you didn’t know, I’m not a big fan of target date funds, but that’s a story for a different post.

The 403(b) Plan – The Basics

403(b) plans are very similar to 401(k) plans, except that where 401(k) plans are sponsored by for-profit businesses, 403(b) plans are for not-for-profit organizations that are tax-exempt under IRS Code 501(c)3. That includes educational institutions, school districts, governmental organizations, religious organizations, and hospitals.

• Income Tax Treatment: Same as for the 401(k) plan.
• Contribution Limits: Same as for the 401(k) plan, except for the maximum allowable contribution (MAC) provision below.
• Employer Matching Contributions: Same as for the 401(k) plan.
• Withdrawal Requirements: Same as for the 401(k) plan.
• Required Minimum Distributions (RMDs): Same as for the 401(k) plan, except that 403(b) plans have a special allowance for plans that received pre-1987 amounts. If so, then distributions are not required until December 31 of the year in which the plan participant turns 75 or, if later, April 1 of the calendar year immediately following the calendar year in which the participant retires.
• 403(b) Loan Provisions: Same as for the 401(k) plan.
• 403(b) Portability and Rollover Provisions: Same as for the 401(k) plan, except that a 403(b) plan can also be rolled over into a 401(k) plan of a new employer.

Special MAC Rule With 403(b) Plans

Those with 15 years of service to an employer can then add another $3,000 to their annual contribution limit, depositing a potential $23,000 per year (or $30,500 if you’re 50 or older for 2020). This is called the maximum allowable contribution, or simply MAC.

Unfortunately, just because MAC is allowed under the IRS code does not mean the employer has to honor it. They have to include it in their plan document for it to go into effect.

I had a client that met the 15-year requirement, but since she was one of the only ones that did, her employer wasn’t aware of the MAC rule and didn’t feel the need to include it in their plan.

Double check with your 403(b) provider to see if they recognize the MAC rule.

	403(b) MAC RULES
Eligibility	Employees Who Are Eligible for the Employer’s Contribution Must Be at Least 21 Years Old and Have Completed at Least Three Years of Service With the Employer
Contribution Percentage	Employers Are Required to Make an Annual Contribution to Eligible Employees’ 403(b) Plans That Is at Least Equal to 1% Of the Employee’s Salary, This Percentage Increases to 3% After 15 Years of Service
Timing	Employers Must Make Contributions to Eligible Employees’ 403(b) Plans No Later Than the End of the Plan Year
Employer Contributions	Employers May Make Additional Contributions at Their Discretion, but They Are Not Required to Do So
Notice	Employers May Make Additional Contributions at Their Discretion, but They Are Not Required to Do So

403(b) Investment Options

Most 403(b) plans provide a choice of mutual funds or annuities for the investment of saved funds. Ever since there was a shakeup in the 403(b) market a few years ago, I’ve seen quite a few mutual fund companies pull out. That means you’re seeing a lot more insurance companies offer some sort of annuity product in their plans. Personally, I’m not a big fan of this.

 

403(b) accounts typically appear in non-profit organizations, churches, school organizations, and the government. There is a significant administrative difference between a 403(b), as eligible organizations have less paperwork to file with the IRS versus compared to a 401(k) plan.

Because the 403(b) plan is cheaper to administer as well, it’s favored by small entities with tight budgets but still wanting to offer workers a retirement perk.

Manage Your Investments on Autopilot

Both 401(k) and 403(b) retirement plans can be easily managed through a company called Blooom. 

Blooom will explore all the investment options available through your employer’s chosen platform and make recommendations based on how you answer some simple questions.

The questionnaire is there to determine how much risk you can tolerate in your portfolio. So people who want to go lower risk will get low risk recommendations, while high risk people will get higher risk, higher reward recommendations.

The cost for the full service is $10 a month, but you can get the free service and get just recommendations. You can read more in our Blooom review.

Summary: 403(b) vs 401(k)

Is one plan better than the other? In some respects, yes. But in most regards, they’re the same plan, with the 403(b) plan serving the same purpose for government and nonprofit employers that the 401(k) plan does for profit-generating employers.

The two areas where the differences are the most significant are with investments and the MAC. Investment options are generally more numerous with 401(k) plans, particularly if the plan trustee is one of the major investment brokerage firms that offer something close to unlimited investment choices.

But the MAC provision is a definite plus in favor of the 403(b) plan. It enables long-term employees to make higher contributions, even in addition to the catch-up provisions that are normally offered to participants who are 50 or older.

Both plans offer employees a significant ability to shelter income from taxes and save for their retirement, regardless of the differences between the two.

In some cases, employers even provide a match to employees, depending on how much they deposit from their own money. This match is essentially free dollars, which everyone should take advantage of as much as possible when available.

That said, depending on the employer, a different plan type will be available. Few employers offer both types of accounts.