What pops into your head when you hear 403(b) or 401(k)? No, these aren’t droids from the latest Star Wars movie. They’re tools to help you build a solid financial future! And if you’re going to invest your hard-earned money in one of these plans, you need to fully understand how they work.
Last year, our team conducted the largest research study ever done on millionaires. Do you know what their number one wealth-building tool is? Their 401(k) or 403(b). Nearly eight out of 10 millionaires built their wealth primarily through their workplace retirement plan. So, if you’re wondering about the differences between a 403(b) and a 401(k), you’re in good company! You’re thinking like a millionaire.
403(b) and 401(k) plans have a lot in common. You can use either one to chase down your wildest retirement dreams! The main difference between a 403(b) and a 401(k) is the type of employer who offers them. 401(k) plans are offered by private, for-profit companies, but 403(b) plans are offered by nonprofit organizations. We’ll unpack some other differences in a minute.
First, let’s take a look at each plan.
A 401(k) is a retirement savings plan that allows you to contribute a fixed percentage or dollar amount from your paycheck before you pay taxes on it, which lowers your taxable income for the year. Congrats—you get a tax break! But when you start to withdraw money from your 401(k) (at age 59 ½), that income will be taxed. That’s why the 401(k) is called a tax-deferred account.
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The name itself comes from a section of the IRS code—literally, section 401(k)—that was passed into law in 1978. A guy named Ted Benna, a benefits consultant for large companies, studied the tax code and created the concept of a 401(k) program in the fall of 1980.1 Now, almost 40 years later, Americans have invested around $5.8 trillion in 401(k) plans!2
Think of a 401(k) as an egg carton and your investments as the eggs. The 401(k) itself doesn’t make you money—it’s just the container. Your money goes to work and produces a profit through the investments within the 401(k). We recommend you invest in growth stock mutual funds. Make regular contributions and let your money hang out with its two best friends: time and compound interest. You’ll be amazed by how your money grows over the long haul. Try our compound interest calculator that will do the calculations for you!
There are lots of details about 401(k) plans, but we’ll save you some time and summarize the main features:
- Employer Match: Most employers who offer a 401(k) will also offer a match—that’s code for free money! They will match what you contribute up to a certain percentage of your salary—usually 3% or 4%.
- Contribution Limits: In 2020, you can contribute up to $19,500 of your own money in your 401(k) (you can contribute an additional $6,500 if you’re age 50 or older). The combined contribution of your money and your employer’s match cannot exceed $57,000 per year (or $63,500 if you’re age 50 or older).
- Early Withdrawal Penalties: Listen, saving for retirement is a marathon, not a sprint. You need to think long term about your 401(k). Even though there are such things as 401(k) loans and early withdrawals, don’t even think about taking the money out until you’re at least 59 ½. If you do take money out of your 401(k) early, you’ll be hit with big penalties and state and federal income tax.
- Required Minimum Distributions: The IRS requires you to start withdrawing a certain amount from your 401(k) beginning at age 70. These are called RMDs—Required Minimum Distributions.
Now, let’s talk about the 403(b).
If you missed the section about 401(k) plans, go back and read it. Because guess what? 403(b) plans and 401(k) plans are almost identical in nature, but 403(b) plans are only available for employees of tax-exempt organizations. That means if you work for a hospital, school, university, church or nonprofit, chances are you have access to a 403(b) account. For all practical purposes, though, it functions just like a 401(k).
So, why is it called a 403(b)? You guessed it—the plan is outlined in section 403(b) of the tax code. That’s what happens when math nerds are in charge of naming things!
There are a few other differences between the 401(k) and the 403(b). Let us explain.
Differences Between 401(k) and 403(b) Plans
401(k) and 403(b) plans have a lot in common, but here’s what sets them apart:
- Eligibility: 401(k) plans are offered by for-profit companies, and 403(b) plans are offered by tax-exempt organizations, such as hospitals, schools, universities, nonprofits and religious organizations.
- Investment Options: 403(b) plans only offer mutual funds and annuities, but 401(k) plans offer mutual funds, annuities, stocks and bonds. Because 401(k) plans are more expensive for the company, they usually offer a wider range and sometimes better quality of investment options.
- Employer Match: Both plans allow for employer matching, but fewer employers offer matches with their 403(b) plans. If an employer who offers a 403(b) does offer a match, they have to comply with regulations created by ERISA—the Employee Retirement Income Security Act—which was passed in 1974.3 Most employers want to avoid these regulations because they cost time and money.
- Cost: 403(b) plans have lower administrative costs because the government doesn’t want to place extra burdens on nonprofit organizations. 401(k) plans are more expensive for employers. But don’t worry—this doesn’t really affect you as the employee.
Which Plan Should I Choose?
Well, honestly, unless you’re a business owner, you actually don’t have any choice in the matter! Your employer determines which plan they offer you. If you work for a for-profit business, you will most likely have access to a 401(k) as part of your benefits package. But if you work for a school, religious organization, government organization, or hospital, chances are you’ll have access to a 403(b).
You can still invest in retirement accounts outside of work. We encourage everyone to make the most of either your 403(b) or your 401(k) and a Roth IRA.
Start Preparing for Retirement Today
We’ve got some news for you: there’s no magic age when a retirement fairy comes to take care of you. It’s up to you to make a plan for your financial future, no matter which account you use. Use our Investment Calculator to discover how much you can expect to have in retirement.
These are general guidelines. Your situation may be unique. If you have questions, connect with a SmartVestor Pro.