403(b) vs. 401(k): Key Differences You Need to Know

When planning for retirement, choosing the right savings vehicle is crucial. Two popular options are 403(b) and 401(k) plans, each offering unique benefits tailored to different employees. Understanding their differences can significantly impact your financial future. This article explores aspects such as contribution limits, vesting schedules, and distribution requirements to help you make an informed decision.

Sponsorship Requirements

The sponsorship requirements for 403(b) and 401(k) plans reflect the types of organizations that typically offer them. A 403(b) plan is available to employees of public schools, certain non-profits, and some religious institutions. These plans are governed by Section 403(b) of the Internal Revenue Code, which specifies eligibility criteria for employers. Non-profits must be tax-exempt under IRC Section 501(c)(3) to qualify.

401(k) plans, on the other hand, are offered by private sector employers, including corporations and businesses of various sizes. These plans fall under the Employee Retirement Income Security Act (ERISA), which requires employers to act in the best interest of participants and manage plans with reasonable fees.

Investment options also vary. 403(b) plans often focus on annuities and mutual funds, reflecting their association with educational and non-profit sectors. In contrast, 401(k) plans typically provide a broader selection, including stocks, bonds, and ETFs.

Contribution Limits and Catch-Up

For 2024, the IRS has set the elective deferral limit for both 403(b) and 401(k) plans at $23,000, which represents the maximum amount an employee can defer from their salary into these accounts.

Employees aged 50 and above can make catch-up contributions to boost savings. The catch-up contribution limit for 2024 is $7,500 for both plans, offering an additional opportunity to increase retirement funds, especially for those who started saving later in their careers.

Vesting and Employer Matching

Vesting schedules and employer matching contributions play a significant role in retirement planning. Vesting determines when employees gain ownership of employer contributions to their accounts. In 401(k) plans, schedules vary and may include immediate vesting, graded vesting, or cliff vesting.

403(b) plans often feature shorter vesting periods or immediate vesting, reflecting the practices of educational and non-profit employers. Employer matching contributions in 401(k) plans can vary widely, with some offering dollar-for-dollar matches up to a certain percentage of salary. Matching contributions in 403(b) plans are less common due to the financial constraints of non-profit organizations.

Distribution Requirements

Distribution rules for 403(b) and 401(k) plans affect tax liabilities and retirement income. Both plans require minimum distributions (RMDs) to begin by April 1 of the year after the account holder turns 73, as stipulated by the SECURE Act 2.0.

Withdrawals from both plans are taxed as ordinary income. Early withdrawals before age 59½ generally incur a 10% penalty in addition to income tax.

Fee Structures

The fees associated with retirement plans can significantly affect long-term savings. Both 403(b) and 401(k) plans involve administrative, investment, and custodial fees, but their structures differ.

403(b) plans, historically tied to annuities, often have higher fees due to annuity contracts. While mutual fund options are now more common, provider competition remains limited in many cases.

401(k) plans often benefit from economies of scale, especially in larger organizations. They typically offer a broader range of low-cost investment options, such as index funds and ETFs, which help reduce expense ratios. Administrative fees are often shared between employers and employees.

Rollover Processes

Rolling over retirement funds is an important consideration when changing jobs or consolidating accounts. Both 403(b) and 401(k) plans allow rollovers into other qualified accounts, such as IRAs or new employer-sponsored plans.

For 403(b) plans, rollovers are generally allowed when an employee leaves their job, retires, or reaches age 59½. However, the process can be more complicated due to the involvement of multiple providers within a single plan.

401(k) rollovers are often simpler, especially for plans managed by a single provider. Direct rollovers, where funds are transferred directly to the new account, are common and help avoid tax withholding.