401(k) vs. 403(b): What’s the Difference?

Key Takeaways

• The 401(k) and 403(b) plans are the most common employer-administered retirement savings options.

• The 401(k) plan is typically offered by for-profit organizations, while the 403(b) is offered by nonprofits. 

• These types of plans are also available for business owners and self-employed individuals.

Offering workers the occasion to take advantage of tax-deferred investment opportunities, workplace retirement savings plans can be useful post-career income tools. The two most common of these are the 401(k) and the 403(b). For-profit companies usually offer the former, while the latter is provided for employees of non-profit organizations and people who work in government. This article will examine each option to highlight differences between them.

So, what is the difference between a 401(k) and a 403(b)?

What is a 401(k)?

Section 401(k) of The Revenue Act of 1978 was originally intended to provide workers with a tax-free means of deferring the proceeds of bonuses and stock options. The IRS allowed salary deductions to serve as contributions to 401(k) plans in 1981. This led to their adoption as the primary means of funding retirement plans for most American workers. 

Under a 401(k) plan, employees can designate a certain percentage of their salaries to be automatically deposited — before it is taxed — into a retirement account. The funds can then be invested in public equities markets. In some cases, employers match the dollars workers save, up to a certain amount.  These plans have “vesting” periods during which withdrawals are subjected to both income tax and early withdrawal penalties. 

The idea is that these investments will increase in value over the career of the workers. The money grows tax-free, as gains experienced are not subjected to capital gains taxes. However, the resulting funds are taxed as regular income when the retiree begins withdrawals. 

The maximum employee contribution for tax year 2022 is $20,500. People who are 50 years of age or older are allowed an additional $6,500 in “catch up” contributions. The total annual contribution cap for 2022 is the lesser of an annual salary or $61,000. Those who qualify for catch up contributions are capped at $67,500.

Additionally, there is another type of 401(k) that is known as the Roth 401(k), which imposes income tax on dollars deposited. This money can then be withdrawn tax-free when the worker reaches retirement age. Either way, the primary investment choices available to 401(k) participants are publicly traded stocks and bonds, mutual funds, variable annuities, index funds and exchange traded funds.

What is a 403(b)?

Established in 1958, 403(b) plans were introduced to supplement the retirement incomes of teachers. They have since been expanded to encompass employees of churches and non-profit organizations. The basics of their operation are the same as those of a 401(k), in that pre-tax deductions are invested and taxes are paid when the funds are withdrawn as retirement income. There is also a Roth 403(b) plan, which functions under the same guidelines as the Roth 401(k).

While employer contributions are offered with 403(b) plans, they are less common than with 401(k) plans because employers must meet requirements of the Employee Retirement Income Security Act (ERISA). Non-profits tend to opt out of ERISA because its minimum standards for employer retirement plans can be difficult for non-profits to meet. 

Contribution caps are the same as for a 401(k) — up to $20,500 per year, plus $6,500 for those who qualify for catch up contributions. The same is true for employer matches when offered — the lesser of 100% of the contributor’s salary or $61,000 per year ($67,500 for people who qualify for catch up contributions).

There is one key difference with 403(b) plans, however. Workers who have been employed by a qualifying organization for 15 years can make additional annual contributions of up to $3,000 over the maximum amount for five years.

Which is the Better Retirement Option?

Workers seldom have a choice between the two different plans, as the type of employer they have will dictate their option in that regard. However, there are certain instances in which an employee may have access to both plans. 

When this is the case, the 401(k) offers more flexibility in terms of the types of investment opportunities available. The 403(b) contributor is typically limited to mutual funds and annuities. Meanwhile, 401(k) contributions can be invested in a much wider range of assets including publicly traded stocks and bonds, mutual funds, variable annuities, index funds and exchange traded funds.

Moreover, with the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019, 401(k) contributions can be invested in some types of annuities as well. 

Those who have both 410(k) and 403(b) plans from which to choose, and elect to use both, must bear in mind that the annual contribution caps remain the same. In other words, the total maximum amounts must be distributed over both plans. 

Of particular note are plans in which employers offer matching contributions. The wisdom of participating in these plans cannot be overstated. Further, participants should always contribute enough to maximize their employer contribution. After all, this is basically free money. 

Alternative Retirement Plans

While the 401(k) and 403(b) plans can make saving for retirement easier to accomplish, there are several alternatives or plan supplements to consider.

These include Individual Retirement Accounts (IRAs), which also allow workers to save and invest tax-deferred dollars. These also have a Roth variant, in which post-tax dollars can be invested, the gains from which will then be tax-free. However, the contribution caps are much lower than the employer-administered plans. These are $6,000 for those under age 50 in 2022 and $7,000 for workers who are 50 and older.

Self-employed people can take advantage of Simplified Employee Pension IRA (SEP-IRAs), which operate largely within the same guidelines as traditional IRAs, with one important exception. Contribution limits are higher — up to $61,000 in 2022 or 25 percent of eligible compensation, whichever is less.

Business owners can take advantage of a solo 401(k), if they have no employees (other than a spouse). The caps are the same as for a standard 401(k).

Retirement Plans and Alternative Investments

Experts agree that a 401(k) or a 403(b) should be but one aspect of an individual’s retirement plan. Ideally, retirement income should be derived from a combination of three sources —Social Security, pensions, and savings. In turn, the savings component should be bolstered by investment income from a diversified portfolio of assets. 

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. Real estate, private equity, venture capital, digital assets, and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. 

These assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  Yieldstreet opens a number of investment strategies that were formerly available only to institutional investors and the top one percent of earners to all investors. 

The company offers help in capitalizing on the areas mentioned above — as well as a wide range of other unique alternative investments. Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

The Last Word

When it comes to the differences between a 401(k) plan and a 403(b), the main consideration is whether to take advantage of them. After all, in most cases people are limited to a choice of one or the other, based on the for-profit or non-profit status of their employers. While the 401(k) offers more investment opportunities and the advantage of employer-matching contributions, both plans have value and can serve as integral aspects of retirement income.