Is a 401(k) or 403(b) Better for a Teacher? What is the Difference?

Investing

In general, 401(k) plans and 403(b) plans are very similar—both are defined-contribution retirement plans offered by employers to employees. The primary difference between the two is the type of employer that typcially sponsors them and the investment options. The 403(b) plan is offered to employees of tax-exempt organizations, such as charitable organizations and public schools. And 401(k) plans can be adopted by both tax-exempt and for-profit organizations.

Key Takeaways

  • 403(b) plans can be adopted only by non-profit organizations.
  • 401(k) plans can be adopted by any employer—tax-exempt and for-profit.
  • Their similarities include tax -deferred growth, contribution limits, and when you may withdraw funds.
  • A major difference is that 401(k) plans may offer investment options that include stocks, bonds, and mutual funds; whereas investment options for 403(b)s depend on the type of account.

If your employer offers both a 401(k) and a 403(b), but if your employer does offer both, you may choose to participate in either or both—if allowed. If you are among those with a choice, you’ll need to understand the particulars of how each plan works and their key differences, such as investment options, to decide what works best for you. The same applies if you work for different employers and you have access to both options.

401(k) and 403(b) Plans: The Similarities

Both are tax-advantaged retirement plans. Earnings and returns grow tax-deferred until withdrawn. For Roth accounts—which can be an added feature of both types of plans—qualified distributions are tax-free.

The elective deferral contribution limits are the same for each. In 2020, the maximum tax-deferred elective deferral contribution allowed is 100% of compensation up to $19,500, up from $19,000 in 2019. Participants who are least 50 by the end of the year may contribute an additional $6,500 (up from $6,000 in 2019), which is known as a catch-up contribution. The contribution limit is the same whether you contribute to one of the two or to both.

Employers also may choose to make matching contributions and/or nonelective contributions, although this is less common for 403(b)s than 401(k)s.

Employees must meet certain requirements to be eligible to make withdrawals, such as no longer working for the plan sponsor or reaching age 59½. Withdrawals before age 59½ are subject to a 10% early distribution penalty, unless an exception applies—there’s no penalty when they reach age 59½.

Both plans can offer loans to employees, but it’s up to the employer whether or not they choose to make loans available.

401(k) and 403(b) Plans: The Differences

A key difference between 401(k) and 403(b) plans is the available investment options. While an employer may limit the investment options under a 401(k), it may permit a wide range of investments, including stocks, bonds, and mutual funds.

For 403(b)s, the investment options depend on the type of 403(b) account under the 403(b) plan. For 403(b)(1) it’s annuities, for 403(b)(7) it’s mutual funds, and 403(b)(9) church plans allow for broader investment options.

A little history: 403(b)s used to be restricted to annuities, also known as taxed-sheltered annuities, but this restriction was lifted in 1974, allowing 403(b)(7) accounts as an option.These 403(b)(7) accounts are usually available at brokerage firms..

Another difference is that some 403(b) plans allow additional elective deferral contributions for employees with 15 or more years of service, an option that is not available under 401(k) plans. Under this provision, if allowed under the 403(b) plan, you can contribute an additional amount of up to $3,000 a year, subject to a lifetime limit of $15,000. And unlike other retirement-plan catch-up provisions, you don’t do not need to be 50 or older to take advantage of this benefit.

What If You Are Offered Both Plan Types?

If you have access to both a 401(k) and 403(b), you should weigh the pros and cons of each. Consider the investment options available, whether your employer makes matching contributions, and if you can make additional catch-up contributions that are not available under a 401(k). Depending on the particulars of the plans available to you, it may make sense to choose one over the other or to contribute to both.

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