403b vs 401k: What’s the Difference?
So, for some reason or other, you’re beginning to tune in a little more intently to your retirement planning, and you know that some people contribute to a 403b and others to a 401k, or even other retirement investment plans. As a teacher or other school district employee, you probably have the option to participate in a 403b plan offered by your district. If you happen to be married to a non-teacher, you are probably aware that your private sector spouse may, on the other hand, have the opportunity to contribute to a different kind of plan, known as a 401k. Knowing what the key differences between them can help you make the right choices for building a nest egg that can provide you with a little peace of mind and security in your retirement years. While you may be passionate about teaching, you don’t want to work forever, so it’s important that you are equipped with the facts about how to compare potential choices you may be considering. As a financial professional, I advise clients who have participated in each of these plans. Here is a rundown of some of the basic differences and similarities.
Comparing the Similarities and Key Structure Differences
To begin with, the 403b and 40k investment plans are not that different. For example, both allow for contributions and growth of your portfolio to be tax-deferred. Also, both plans generally have the same restrictions on annual contribution amount capped currently at $19,000. Both plans are considered “qualified plans” and are governed by the IRS, requiring fiduciary responsibilities from the plan administrator.
Similarities between the 403b and the 401k
- Tax-Deferred Contributions
- Potential Employer Matching
- Allow Higher Contributions than IRA’s
- Provide Asset Allocation Choices
- Allow Dollar Cost Averaging
Differences between the 403b and the 401k
- 401k plans are offered by for-profit companies, whereas non-profit organizations such as public and private schools offer 403b plans to employees.
- 403b plans for teachers are exempt from non-discrimination testing requirements for deferral of salary, while 401k plans are subject to this testing. This means that salary contributions may be required to be returned to higher paid 401k plan participants.
- 403b plans for teachers are subject to the “universal availability” law, which states that if an organization offers a 403b investment plan to one employee, that same opportunity must be available to all employees. 401k plans are subject to an eligibility requirement.
- Both the 403b and the 401k plans have an annual limit on employee contributions, however some 403b plans allow for additional flexibility with a “catch-contribution” of up to an additional $3,000 annually for contributors that have served for 15 years or more.
- Schools that offer 403b plans allow participants to contribute immediately upon being hired, whereas corporations that offer the 401k plan typically enforce a waiting period for employees before they can begin pre-tax contributions.
- 401k plans provide a larger platform of investment choices for employees. The 403b plan for teachers is restricted to custodial accounts that offer conservative mutual funds or annuity contracts provided by an insurance company.
Understanding Eligibility vs Availability
There are also some distinct differences between the 401k and 403b plans regarding employee participation.
401k Eligibility – In order to maintain tax-exempt status, companies with 401k plans are required to offer participation for employees that are at least 21 years of age and have fulfilled a service requirement that is clearly defined in the written plan as hours of service or a specific period of time as an employee. The working requirement is usually 1,000 hours of service before the employee is eligible to contribute, whereas the time requirement for employment can range from 30 to 90 days and is at the discretion of the employer.
403b Availability – Schools offering a 403b retirement plan for teachers are required to follow the “Universal Availability Rule” in order to qualify for and maintain its tax-exempt status. The availability rule requires school districts to offer the opportunity for all employees to defer salary into the 403b plan. Exceptions to the availability rule include employees working less than 20 hours per week, employees who are actively participating in another qualified plan (such as a 401k or 457 plan), or employees that gross less than $200 per year with the school district.
Comparing the Benefits
Both the 403b and the 401k offer you great benefits as an investor, not the least of which is an opportunity to allocate pre-tax dollars from your paycheck that can grow tax-deferred. In addition to tax deferred growth, your employer may provide a contribution match for every dollar that you invest in the plan. The employer match may vary, but it’s a win-win for both your employer and for you the employee: your employer earns a significant tax deduction for the organization, while you collect extra money toward your retirement. As qualified investment plans, both the 403b and the 401k allow participants to access retirement funds (without IRS tax penalty) at age 59 ½ and require investors to begin drawing a required minimum distribution by age 70 ½.
Consider the Investment Options
While both the 401k and 403b plans are qualified plans governed by the Employee Retirement Income Safety Act of 1974 (ERISA), you will typically have a larger investment platform to work with within a 401k plan, which means you will have more choices, and can take more risk. The 403b plan for teachers is commonly referred to as a tax-sheltered annuity and is somewhat restrictive because the funds are associated with a public interest. Employers offering either plan MUST follow a written program, which acts as a guide for investment options.
Knowing the Plan Cost
Retirement investment plans are not cheap. Based the industry standard, if you’re paying more than 1% of your portfolio balance in management fees, you’re probably paying too much. With 403b plans for teachers, the fee structure is slightly lower because sometimes there is a public bidding process for financial professionals to manage the accounts. Generally speaking, the larger the company offering a 401k plan, the lower the fees will be because the higher number of participants tends to drive down costs. You should either receive a monthly statement by mail or have the option to login to the plan administrator’s website to check your balance. If you’re not sure what you’re paying in fees, contact your human resources department for assistance.
Final Thoughts on 403b Vs 401k
While you may be contributing to a 403b as a teacher, and your spouse may be a participant in a 401k program, some important things to consider when saving for your retirement include investment options, employer contributions, taxes, and of course, risk. If you’ve ever read the prospectus of almost any investment opportunity registered with the securities exchange commission, you’re probably familiar with the often-used phrase, “Past performance does not guarantee future results.” While you may have previously glazed over this verbiage, it’s an important statement to consider when you’re investing your hard-earned money. As an intelligent investor, you’ll want to generate the largest return on your investment, while simultaneously managing risk to prevent loss. Although there are some differences, both the 403b and the 401k are great investment platforms to help you accomplish your goals.
Michael Garvin is a Financial Advisor with 10 years of experience in retirement planning and investment management. Michael holds insurance Licenses for all personal & commercial insurance lines including life, disability and health.