403(b) vs. 401(k): Two Ways to Save for Retirement

Employer-sponsored plans, such as 403(b)s and 401(k)s, can be important tools to help you save for retirement. Both of these are tax-deferred retirement savings programs that your employer might offer. Whether or not you have a 403(b) or a 401(k) depends on the kind of employer you work for. The IRS rules regarding how much you can invest and in what kinds of securities, also differ between the two accounts. 

If you work in the private sector, you’ll likely have a 401(k), vs. a 403(b), which is more common for government or certain nonprofit workers. In some cases, you might even have both, although that’s rare. Knowing the differences between a 403(b) and a 401(k) can help you prepare for retirement, whether you’re in your 20s, your 60s, or somewhere in between.

How does a 403(b) work?

A 403(b), also known as a tax-sheltered annuity plan, is a defined contribution retirement plan for employees of non-profit organizations, government workers, and public school employees, like professors, teachers, and school administrators. The plan invests the contributions and makes payments to employees, typically after retirement.

• Making contributions: A 403b plan allows you to set aside a portion of your paycheck in a retirement account before taxes are taken out. In addition, employers can contribute to their employees’ plans, often matching a portion of what employees put in.
  
• Investment options: Employees can invest their contributions in mutual funds or annuities and reinvest their returns on a tax-deferred basis, which can help their savings grow faster. Tax-deferred, in this context, means you don’t pay tax until you withdraw the money.
  • Annuities are sold by insurance companies. The purchaser makes a one-time payment or a series of payments to the insurance company. In exchange, the insurance company agrees to make periodic payments right away or at a specific time in the future. Mutual funds are baskets of securities and can include stocks, bonds, and other securities.
    
• Limits on contributions: The IRS determines the maximum amount that you can contribute to a 403(b), and that limit can change from year to year. Annual employee contributions for a 403(b) are capped at $20,500 in 2022, allowing employees to contribute an extra $1,000 compared to previous years. The combined contributions, meaning the sum of what both the employee and the employer put into the account, are limited to $58,000 a year in 2021 and $61,000 a year in 2022, or 100% of the employee’s most recent annual salary, whichever is the lesser amount.
• Catch-up contributions: Employees with 15 years or more of service with a qualified organization may be eligible to make catch-up contributions of an additional $3,000 a year. Employees who are 50 and older are eligible to make catch-up contributions of an additional $6,500 in 2021 and 2022.

• Paying taxes: The money you contribute to your 403(b) is tax deferred, meaning, you don’t pay income tax on the money you contribute or the return on your contributions until you make withdrawals from the account. If you withdraw funds before age 59½, you may owe early withdrawal penalties of 10%, although there are some limited exceptions to the early withdrawal rule.
  
• Required minimum distributions: When you reach age 70½, you must take a certain amount out of your 403(b) every year (or age 72 if your 70th birthday is July 1, 2019 or later); this is called the required minimum distribution (RMD). The government determines how much you are required to withdraw based on your account balance and your life expectancy.

How does a 401(k) work?

Employers in the private sector may offer their employees a 401(k) retirement plan as part of their benefits package. Like 403(b)s, 401(k)s are tax-deferred savings vehicles designed to help employees save for retirement. Contributions are invested, and employees typically begin receiving money after retirement.

• Making contributions: Just like 403(b) plans, 401(k) plans allow employees to make pre-tax contributions. And like 403(b)s, employers may make matching contributions to employee accounts.
  
• Investment options: 401(k) plans typically offer a limited set of investments to choose from, such as a handful of mutual funds, target-date funds, often a special type of mutual fund, and exchange-traded funds (ETFs), which are baskets of investments. Though rare, it’s possible that a 401(k) could include annuities as part of its offerings.
  

• Limits on contributions: 401k plan contribution limits are the same as 403(b)s: $20,500 a year for employees in 2022 ( previously capped at $19,500 in 2020 and 2021);  $58,000 for combined employer/employee contributions in 2021 and $61,000 in 2021. People aged 50 and older are eligible to make catch-up contributions of an additional $6,500 a year in 2021 and 2022.
  
• Paying taxes: Neither employee contributions nor the earnings on investments are taxed until you withdraw funds. Just like with a 403(b) plan, funds withdrawn from a 401(k) before age 59½ are subject to a 10% early withdrawal penalty unless an exception applies.
  
• Required minimum distributions (RMDs): 401(k) plans also have RMDs, beginning at age 70½ or age 72 if your 70th birthday is July 1, 2019 or later.

403(b) vs. 401(k): The difference at a glance

403(b) vs. 401(k): Your options 

As a general rule, employers only offer one kind of plan, so the 403(b) vs. 401(k) decision may be made for you. In the rare case that your employer offers both a 403(b) and a 401(k), you can participate in both, or you may find the differences between 403(b)s and 401(k)s push you in the direction of one or the other. If you do choose both, your combined contributions across both accounts can’t exceed the annual limitations, even though you have two plans.

If a 403(b) or 401(k) is not an option, Stash offers IRAs to help you save

In some cases, the difference between a 403(b) and a 401(k) plan doesn’t matter because your employer doesn’t offer a retirement plan, you aren’t employed, or you are self-employed. But there are still tax-advantaged savings options available to you, and you may want to save for retirement with an individual retirement account (IRA). IRAs for individuals come in two varieties: traditional and Roth. Here is a short overview of how these accounts work:

• Making contributions: Contributions to a traditional IRA are made with pre-tax dollars, while contributions to a Roth IRA are made with after-tax dollars.
• Investment options: IRAs may offer the opportunity to invest in a broader range of securities than 401(k)s and 403(b)s. However, some restrictions apply.
• Limits on contributions: You can contribute up to $6,000 each year in either a Roth or traditional IRA for 2020, 2021, and 2022, although Roth IRAs have some additional limits in 2022. And if you’re 50 or older, you can make an additional catch-up contribution of $1,000, so you can contribute a total of $7,000. You can have both a Roth IRA and a traditional IRA, but the combined contribution limit is still the same; the additional account doesn’t allow you to contribute more.
  
• Paying taxes: For traditional IRAs, neither contributions nor investment returns are taxed until withdrawal. If you withdraw money before age 59½, you’ll owe an additional 10% penalty unless an exception applies. With Roth IRAs, qualified distributions are tax-free. To qualify, a distribution must be made five or more years after the Roth IRA was created, and meet certain other conditions.
  

• RMDs: Traditional IRAs require you to make RMDs at age 70½, or at age 72 if your 70th birthday is on or after July 1, 2019. Roth IRAs, on the other hand, do not have RMDs during the original owner’s lifetime.

Whether you’re looking into a 403(b) vs. a 401(k) or considering an IRA, investing for retirement now, no matter what your age, can help you plan for your financial future.