403b vs. 401k: What’s the Difference?

403b vs. 401kI know that you were losing sleep because I had not written a post yet that outlines the differences between a 403b vs. 401k.

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 403b and understanding how it compares to a 401k may prove to be helpful.

When people are first hired into a full-time job and 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.

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

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When the funds are finally withdrawn, usually later in a person’s life, they should in theory be part of a larger retirement balance which can be used when a person is no longer working, ergo at a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 given plan.

The 401k Plan

401k vs. 403b

Most people know or are familiar with the 401k retirement plan.

This approach allows funds to be deferred from gross earnings into a savings account that can be invested on the public market, depending how the employer set up the retirement plan.

Some only use mutual funds, others offer open market choices to their employees.

Employees are allowed to save up to $ 17,000 per year in their 401k account (401k limits have just increased to $17,500 for 2013). Employees over age 50 can use a catch-up provision to deposit up to $22,500 per year ($23,000 for 2013).

There is no extra deposit bonus for years worked with an employer under a 401k plan. Workers can borrow from their 401k, but have to pay it back with interest, or it triggers an early withdrawal penalty. A departing employee can take his 401k with him, either transferring it to another employer as a cash balance or withdrawing the funds into a personal, pre-tax IRA account at a bank.

401k Investment Options

Most 401k’s allow you to invest into a mutual funds which are provided by the company based on who your company has chosen to handle their 401k plan.  For example, if your company has a 401k through Fidelity chances are you’ll be picking from a selection of Fidelity funds.   You’ll probably see a selection of target date funds.  Blah!  In case you didn’t know, I’m not a big fan of target date funds.

The 403b Plan

The 403b plan works similar to a 401k, but it allows a higher amount of funds to be taken from gross earnings and saved in the deferred savings account. Most can save up to $17,000, while a few can save more annually. Again, employees over age 50 can use a catch-up provision to deposit up to $22,500 per year ($23,000 in 2013 – same as 401k).

Special MAC Rule with 403bs

Those with 15 years of service to an employer can then add another $3,000 to their annual limit, depositing a potential $26,000 per year in 2013 if over the age of 50.  This is called the MAC or maximum allowable contribution. Unfortunately, just because MAC is allowed under the IRS code does not mean the employer has to honor it.   They have to include in their plan document for it to go in 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.

403b Investment Options

Most 403b plans provide a choice of mutual funds or annuities for investment of saved funds. Ever since their was a shakeup in the 403b 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 the plans.  Personally, I’m not a big fan of this.

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

Summary 403b vs. 401k

Both plans offer employees a significant ability to shelter income from taxes and save for their retirement, regardless of the differences in a 401k vs. 403b. In some cases, employers even provide a match to employees, depending how much they deposit from their own money. This match is essentially free dollars 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.

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