403b vs. 401k: What’s the Difference?

Joseph Meyer
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Table of Contents

{1}. 403b or 401k: What’s the Difference?
{2}. Pros and Cons of a 403b Annuity
{3}. Pros and Cons of a 401k Annuity
{4}. The Difference in Interest Rates
{5}. Additional Features of a 401k Annuity
{6}. Summary

The Difference between a 403b and a 401k

Do you know what a 403b is and how it differs from a 401k?

These are two very similar plans – 403b and 401k — that people can use for tax-deferrable savings for retirement and that are relatively new additions to the world of defined contribution plans. So, it’s no surprise that you’ve probably heard people talk about them interchangeably.

In fact, you might even be participating in one or the other without really understanding what either one of them is and whether or not they’re going to serve your needs.

You won’t be alone if you’re confused about these two plans. In fact, in many ways, 403b and 401k plans are so similar, and it’s easy to see at a glance why people lump them together.

They both came about around the same time, during the 1970s, and they both allow you to save money tax-deferred for your retirement years. And maybe the most important thing, they both let you put some money aside for retirement while letting you keep all the money you don’t use during that year for other things, like to buy a car, pay for college, pay off some debt, or simply pocket some extra cash.

The 401(k) Plan – The Basics

401(k) Investment Options

A 401k is a workplace savings plan that is offered to employees by employers. The primary purpose of the 401k is to encourage employees to set aside part of their income in a tax-advantaged account.

Employers claim they gain two main advantages by setting up a 401(k) plan. First, they can reduce federal and state taxes on their employees by offering tax-deductible and pre-tax contributions. Secondly, they can attract and retain top-level employees. By offering a tax-advantaged retirement savings program, employers can differentiate themselves from competitors and attract top talent.

The 401k plan itself is fairly complicated – offering a wide range of investment options and mutual funds with multiple classes for each fund. Within the 401k investment menu, however, you’ll find a variety of options, including stock funds, bond funds, and multiple international options. In general, the 401k investment menu is wider than the typical mutual fund package offered by an individual retirement account (IRA).

The 403b Plan – The Basics

Think of the 403(b) plan as the budget-friendly alternative to the 401(k). Both types of plans are funded by an employee and are tax-advantaged, meaning that the money goes into your retirement fund and is invested without being taxed in the year in which you make the deposit, as would happen if you were to take that money out of your paychecks. In some cases, you might get a match on your contributions.

The 403(b) is very similar to a 401(k) plan. They both let you contribute pre-tax dollars, they’re both portable from job to job, they’re both overseen by the same regulatory bodies, and they’re both a simple and effective way to save for your retirement. The difference lies in the rules around who can contribute to a 403(b) plan and where it can be used.

Special MAC Rule with 403(b) Plans

In 2005, the IRS made a change to the 403(b) plan that allowed participants to roll over an IRA distribution into an 403(b) without having to pay a 10% early distribution penalty. This change had a major impact on the 403(b) plan industry. You see, prior to the IRS new ruling, many 403(b) plans did not allow you to rollover your IRAs into them.

In fact, according to a recent study from the Employee Benefit Research Institute, only 25% of 403(b) plans allowed for this rollover option when the new ruling came into effect.

The new ruling is not without its limitations. By law, the IRS can only affect 401(k) rollovers of traditional IRAs and IRAs. The IRS can’t (yet) supersede the trustee-to-trustee transfer of 403(b) plans directly to IRAs, which is a big part of the 403(b) industry. In addition, when you rollover your IRA to a 403(b) plan, your employer must still be the custodian of your funds, just as it would be if you did a 401k to IRA rollover.

403(b) Investment Options

A 403(b) is a retirement savings plan that is available to employees of tax-exempt organizations, such as non-profit hospitals, schools and churches. This type of retirement plan is also known as a tax-sheltered annuity or TSA, and it’s offered by government agencies, unions, and private organizations.

The investment options offered under a 403(b) are more limited than those offered under a 401(k), but the administrative costs tend to be less than what you’d find with a 401(k). A 403(b) also allows for catch-up contributions for workers over age 50.

To participate in a 403(b) plan, you must be part of the non-profit organization that will make contributions to the plan on your behalf. Like a 401(k), your contributions are made with pretax pay meaning that your pay will be lower as your contributions will be matched by your employer.

In addition to its tax-deferred contributions and tax-deferred growth, the 403(b) also has some investment options that make it similar to a 401(k). These include fixed and variable annuities and mutual funds. You can also add some of your own investments to make up for some of the lack of investment options offered in a 403(b).

Manage Your Investments on Autopilot

Investing in the stock market is a great way to guarantee a secure retirement. But especially when you’re first starting out, it can be difficult to know what to invest in, where to invest, how to decide on those investments, and how to monitor your progress. If you feel overwhelmed by investing, a retirement fund can help you get on track and make investments with a bit less stress.

So, what is a retirement fund? The IRS categorizes retirement accounts so that they are easy to identify. The two main types of retirement accounts are individual retirement accounts and custodial accounts. There are two main types of custodial accounts “ UGMA and UTMA custodial accounts. UTMA accounts are really for minor children ages 18 and under.

The two types of account we’re discussing in this post are Individual Retirement Accounts and Custodial Accounts. Specifically, the two accounts we’ll dive into are Individual Retirement Accounts (IRAs) and Custodial Retirement Funds (also sometimes called Educational Savings Accounts or Coverdell Education Savings Accounts).

There are a lot of similarities between IRAs and custodial accounts. In this post, we’ll take a look at some of those similarities and discuss some of the key differences.

Summary: 403(b) vs. 401(k)

The 403(b) plan was created as a retirement savings option for public-sector employees. This 401(k) alternative has several advantages over traditional retirement plans, two of which are the ability to contribute more money on a pre-tax basis and to borrow against the accumulated funds without having to pay taxes or interest. Despite the advantages, many public employees still opt for the 401(k) or self-directed 403(b) plan when the employer offers it.

A 401(k) is a defined-contribution plan that’s offered through an employer or through an outside financial management firm. In the former case, the employer is generally required to match a certain percentage of your pre-tax wages. The contributions are deposited directly into a 401(k) account sponsored by the employer. This is why it’s often called the 401(k) plan. Some employers don’t offer a match and these companies typically offer a self-directed 401(k) called a 401(k) plan. Many other plans exist too.

The key advantage of a 401(k) plan is the ability to defer taxes on your contributions and investment earnings during your employment. As an employee, you also get to include your pre-tax contributions in the calculation of your income for that year.

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Each year, millions of Americans participate in the retirement savings process by contributing to a 401k. These plans offer exceptional benefits: enormous tax breaks, employer matching funds, and the option to invest in your own portfolio.

But beyond contributing to a 401k, what are other options? The 401k isn’t the only plan out there, and if your company doesn’t sponsor one, finding a matching alternative is critical for your retirement savings success.

In this article, we’re going to compare the most popular retirement plans – 401k and 403b – to help you decide which plan is the best for you.

401k vs. 403b: History

This is the easiest way to think of the difference between 401k and 403b: the former was created for business owners while the latter was created for non-profit organizations.

401k was first created by an act of Congress in 1978. This Act allowed companies to set up tax-deferred individual retirement accounts to encourage Americans to save for retirement.

In 1986, Congress passed a new bill creating 403b plans specifically for non-profit organizations.