Retirement doesn't have to be confusing.
Retirement savings plans can be inherently confusing. You know you should have a 401(k), but you may not be quite sure what it is, what it does, or even if you should put money into it.
It gets even murkier when you consider the other options, like 403(b) plans. Start talking about Roth IRAs and traditional IRAs, and your head may be spinning. And why do certain employers offer one plan and not the other? Which do you have to take on yourself? Should you invest your own money, or will you have enough for retirement with just your employer’s contributions?
Don’t panic. We’re going to start with two of the major retirement plans: 401(k)s and 403(b)s. The major difference between the two is that 403(b) retirement plans are offered to those working at certain tax-exempt or not-for-profit organizations (like schools, certain educational institutions, or hospitals) while 401(k) plans are offered to employees at for-profit firms.
But don’t worry: Both great retirement savings options. Here’s the rundown of each.
Named for the federal tax code it falls under, a 401(k) is an employer-sponsored, tax-advantaged retirement plan that is funded by deductions from your payroll.
Many employers will match at least part of your contributions.
You can choose the amount you contribute each pay period, though most experts suggest contributing the maximum matched by your employer, since it’s essentially free money.
The important thing to remember when considering your 401(k) is that it’s the account you put money into, not your actual investments.
You are responsible for choosing your investments and actually investing that money. Your investment options can include company stock, ETFs, cash alternatives, and other investment vehicles, though investment options vary depending on your company and plan administrator.
A 403(b) account is similar to the 401(k) plan, though it usually takes the form of annuity contracts or mutual fund custodial accounts. Similarly, its name refers to the tax code that established it, but 403(b)s are also known as “tax sheltered annuity” (TSA) plans.
As with 401(k) plans, contributions to 403(b) plans are tax deductible, employers can also offer matching contributions, and you can even take a loan out against either account, (though some experts advise against this).
How They’re Similar
There are many similarities between the two account types. First, they have the same contribution limits. If you are under 50 years old, the maximum you can contribute is $18,000 annually. If you’re over 50, you are also eligible for a “catch-up” contribution of $6,000, making the limit $24,000 annually.
Additionally, both types of plans require you to reach age 59 ½ before you can withdraw from them. And they both can offer Roth options if your employer adds that feature to your plan.
“I think the benefits of both plans are very similar in that employees have the opportunity to invest in their futures via tax-deductible and tax-deferred investment vehicles… with the ultimate goal of creating an additional and very important source of retirement income,” explains Lynn Ballou, CFP® and regional director of EP Wealth Advisors in Lafayette, Calif.
The drawbacks of each plan are also similar, she notes.
“For both plans, the government provides a lot of tax incentives for investing and future growth,” she says. “But hand in hand with that benefit comes a big penalty for pulling money out before the age of 59-1/2. While there are some exemptions from those penalties, a 10 percent hand slap is a big ouch, and your state may penalize you as well. And of course, money you pull out is taxed at ordinary income rates.”
Which One is Better?
So which is better? Both are solid retirement savings options, Ballou says.
“I think they are both great! Because matching contributions are frequently provided by more profitable companies in 401(k) plans, that’s a phenomenal benefit that fewer non-profit firms can afford. And more and more ‘for-profit’ employers are offering a Roth 401(k) option, which adds more planning opportunities to choose from, although 403(b) Roth plans are also allowable. Last but not least, there is the ability within both plans to borrow up to 50 percent of the value of the plan to certain limits (with strict pay back rules), which can be very helpful when funding a home purchase or college education, for example,” she explains.
However, Ballou stresses that you should check with your plan administrator to determine which feature(s) you can take advantage of through your particular plan.
Just Get Started
When it comes to saving for retirement, the emphasis should be placed on getting started, Ballou notes.
“Most of us find that if the money comes home, it gets spent! So the power of employer-sponsored plans that are funded through payroll deductions cannot be over-promoted,” she says.
Of course, there are many other vehicles through which you can save for retirement.
“Other choices are typically ones we need to create for ourselves, such as funding IRAs and Roth IRAs where we are able,” she explains. “Because these are self-created and funded, you need to really pay attention and create fiscal discipline to find ways to invest… And last but absolutely not least, don’t fear the idea of simply setting up a tax-efficient portfolio outside of any qualified plan.”
“Although sales within these accounts might create taxable capital gain income and the assets themselves might generate some taxable income, you have a lot more freedom to tap into these resources as needed throughout your lives, and this additional nest egg can often make the difference between a comfortable or more limited retirement lifestyle.