Passive Profit Guide

Making the Right Choice

Understanding the Basics: 401k and 403b Plans

Retirement planning can feel like navigating a complex maze, especially when faced with different savings options. Two popular retirement savings vehicles that often come up in discussions are 401k and 403b plans.

While they share many similarities, there are crucial differences that can significantly impact your retirement savings strategy.

At their core, both 401k and 403b plans are tax-advantaged retirement savings accounts sponsored by employers. They allow employees to save and invest a portion of their paycheck before taxes are taken out, effectively reducing their current taxable income.

This tax-deferred growth can lead to substantial savings over time, as your investments grow without being taxed until withdrawal.

The primary distinction between these two plans comes from the types of employers that can offer them. 401k plans are typically offered by for-profit companies, ranging from small businesses to large corporations.

On the other hand, 403b plans are available to employees of tax-exempt organizations, such as public schools, religious organizations, and certain nonprofits.

Contribution Limits: Maximizing Your Savings Potential

One of the first aspects to consider when comparing 401k and 403b plans is the contribution limits. In 2023, the basic contribution limit for both plans is identical: $20,500 per year for those under 50.

If you’re 50 or older, you can make extra catch-up contributions of $6,500 per year.

These limits are set by the IRS and are subject to change annually, so it’s crucial to stay informed about any updates.

However, 403b plans have a unique feature called the “15-year rule” that can give participants a slight edge in terms of savings potential. If you’ve worked for your current employer for at least 15 years and your average annual contribution has been less than $5,000, you may be eligible to contribute an extra $3,000 per year, up to a lifetime maximum of $15,000.

This rule can be particularly useful for long-term employees of eligible organizations who are looking to boost their retirement savings in their later working years.

Be aware that these contribution limits apply to employee contributions only. Employer contributions, if offered, are in addition to these limits.

The total combined contribution limit (employee + employer) for both 401k and 403b plans in 2023 is $66,000, or $73,500 if you’re 50 or older and eligible for catch-up contributions.

Investment Options: Diversifying Your Portfolio

When it comes to investment options, 401k plans often have the upper hand. These plans typically offer a wider range of investment choices, including mutual funds, exchange-traded funds (ETFs), and sometimes even person stocks.

This variety allows participants to create a more diversified portfolio tailored to their risk tolerance and investment goals.

401k plans often include a mix of domestic and international stock funds, bond funds, and target-date funds that automatically adjust their asset allocation as you approach retirement. Some plans may also offer more specialized options like real estate investment trusts (REITs) or commodity funds.

403b plans have traditionally been more limited in their investment options. Many 403b plans only offer annuity contracts and mutual funds.

Annuities, which are insurance products that provide a guaranteed income stream in retirement, have been a staple of 403b plans for years.

While they can provide stability and guaranteed income, they often come with higher fees and less flexibility compared to mutual funds.

However, the landscape of 403b plans is changing. Many plans now offer a broader range of investment choices similar to 401k plans, including low-cost index funds and ETFs.

This shift has been driven by increased awareness of the importance of low-cost investing and the demand for more diverse investment options from plan participants.

When evaluating your plan’s investment options, consider factors such as:

1. Diversity of asset classes
2. Expense ratios of available funds
3. Historical performance (while keeping in mind that past performance doesn’t guarantee future results)
4. Availability of target-date or lifecycle funds
5. Options for socially responsible or ESG (Environmental, Social, and Governance) investing

Remember, the specific investment options available to you will depend on your employer’s chosen plan provider. It’s crucial to review the options carefully and consider seeking advice from a financial professional if you’re unsure about which investments are best suited to your goals and risk tolerance.

Employer Matching: Boosting Your Retirement Savings

Both 401k and 403b plans may offer employer matching contributions, but this feature is more common in 401k plans. Employer matching is essentially extra funds your employer contributes to your retirement account based on your contributions.

This can significantly boost your retirement savings over time.

A typical employer match might be 50% of your contributions up to 6% of your salary. For example, if you earn $50,000 per year and contribute 6% ($3,000) to your 401k, your employer would add an extra $1,500 to your account.

That’s an immediate 50% return on your investment!

While some 403b plans do offer matching contributions, it’s less common. Public schools and non-profit organizations often have tighter budgets, which can make it challenging to offer matching contributions.

However, if your employer offers a match in either type of plan, it’s generally advisable to contribute at least enough to take full advantage of this benefit.

Employer matching contributions are subject to vesting schedules, which we’ll discuss in the next section. It’s important to understand that even if you leave your job before you’re fully vested, you always get to keep 100% of your own contributions.

When comparing plans, consider:

1. Whether a match is offered
2. The matching formula (e.g., 50% up to 6% of salary)
3. Any limits on the total match amount
4. The vesting schedule for matched funds

Remember, employer matching is essentially free money for your retirement. If you’re not taking full advantage of it, you’re leaving valuable benefits on the table.

Vesting Schedules: When the Money Becomes Yours

Vesting refers to the process by which you gain ownership of the employer contributions to your retirement account. Your own contributions are always 100% vested, meaning they’re yours to keep even if you leave your job.

However, employer contributions often come with a vesting schedule.

401k plans typically have more complex vesting schedules, which can be either:

1. Cliff vesting: You become 100% vested after a specific period, usually three to five years.

For example, you might be 0% vested for the first three years, then suddenly become 100% vested on your third work anniversary.

2. Graded vesting: You become vested gradually over time.

A common schedule might be 20% vested after two years, 40% after three years, 60% after four years, 80% after five years, and 100% after six years.

403b plans, on the other hand, often have immediate vesting or shorter vesting periods. This can be useful if you’re not planning to stay with your employer for an extended period.

Some 403b plans offer immediate 100% vesting of employer contributions, while others might have a short cliff vesting period of one or two years.

The vesting schedule can have a significant impact on your retirement savings, especially if you’re considering changing jobs. If you leave your job before you’re fully vested, you’ll forfeit some or all of the unvested employer contributions.

When evaluating vesting schedules, consider:

1. The length of the vesting period
2. Whether it’s a cliff or graded schedule
3. How the schedule aligns with your career plans
4. The potential financial impact of leaving before full vesting

Remember, vesting only applies to employer contributions. Your own contributions and their earnings are always 100% vested and yours to keep.

Fees and Expenses: The Hidden Costs of Saving

Both 401k and 403b plans come with various fees and expenses that can eat into your investment returns over time. These may include administrative fees, investment management fees, and person service fees.

Understanding these costs is crucial, as even small differences in fees can have a significant impact on your retirement savings over the long term.

Historically, 403b plans have been known to have higher fees, particularly those invested in annuity products. Annuities often come with higher administrative costs and surrender charges, which can make them more expensive than mutual funds.

However, this gap has narrowed in recent years as more 403b plans have moved away from annuities and towards mutual funds and other lower-cost investment options.

401k plans, especially those offered by larger employers, often benefit from economies of scale, which can result in lower overall fees. However, this isn’t always the case, and it’s important to review the fee structure of any plan you’re considering.

When evaluating fees, look for:

1. Expense ratios of person funds: This is the annual fee charged by the fund, expressed as a percentage of assets.

Lower is generally better.

2. Administrative fees: These cover the cost of running the plan and may be charged as a flat fee or a percentage of assets.
3. Individual service fees: These might include fees for loans, hardship withdrawals, or other special services.
4. Investment advice fees: Some plans offer professional investment advice for an extra fee.

To get a clear picture of the fees you’re paying, review your plan’s fee disclosure statement. This document, which your plan administrator is required to provide, outlines all the fees associated with your plan.

Remember, while fees are important, they shouldn’t be the only factor in your decision. A plan with slightly higher fees might be worth it if it offers better investment options, stronger employer matching, or other valuable features.

Loan Provisions: Borrowing from Your Future Self

Both 401k and 403b plans may allow you to borrow from your account balance, but the terms can vary. Generally, you can borrow up to 50% of your vested account balance or $50,000, whichever is less.

The loan must typically be repaid within five years, with payments made at least quarterly.

While the ability to borrow from your retirement account can be a useful safety net, it’s important to approach this option with caution. Borrowing reduces the amount of money growing tax-deferred in your account and can significantly impact your long-term retirement savings if not repaid promptly.

Key considerations for retirement plan loans include:

1. Interest rates: You’ll pay interest on the loan, typically at a rate close to the prime rate.

This interest goes back into your account.

2. Repayment terms: Loans must usually be repaid within five years, unless used to purchase a primary residence.
3. Tax implications: If you leave your job with an outstanding loan balance, you may need to repay the full amount immediately or face taxes and penalties.
4. Opportunity cost: The money you borrow isn’t invested, potentially missing out on market gains.
5. Double taxation: You repay the loan with after-tax dollars, but you’ll pay taxes again when you withdraw the money in retirement.

While 401k and 403b loans can be a source of emergency funds, they should generally be considered a last resort. Exhausting other options like emergency savings or a home equity line of credit before tapping into your retirement savings is often advisable.

Early Withdrawal Penalties: Protecting Your Nest Egg

Both 401k and 403b plans are designed for long-term retirement savings, and as such, there are penalties for early withdrawals. In general, if you withdraw money from either type of plan before age 59½, you’ll face a 10% early withdrawal penalty in addition to regular income taxes on the amount withdrawn.

However, both plans offer exceptions to this rule for certain hardship situations, such as:

1. Significant medical expenses
2. Costs related to purchasing a primary residence
3. Tuition and educational fees
4. Payments necessary to prevent eviction or foreclosure
5. Burial or funeral expenses
6. Expenses for repairs of damage to your principal residence

The specific rules for hardship withdrawals can differ between 401k and 403b plans, so be sure to check your plan’s provisions. Some plans may need you to exhaust other options, like taking a loan, before allowing a hardship withdrawal.

Be aware that while hardship withdrawals can provide much-needed funds in emergencies, they come with significant drawbacks:

1. You’ll owe income taxes on the withdrawal
2. You may still be subject to the 10% early withdrawal penalty
3. The money withdrawn can’t be repaid to the plan
4. You lose out on potential future growth of those funds

Given these drawbacks, hardship withdrawals should be considered a last resort. If possible, explore other options like loans or emergency savings before tapping into your retirement funds.

Required Minimum Distributions: Planning for the Long Haul

Both 401k and 403b plans are subject to Required Minimum Distributions (RMDs). These are mandatory withdrawals that you must start taking from your account once you reach a certain age (currently 72, but this may change with pending legislation).

The amount of the RMD is calculated based on your account balance and life expectancy.

The purpose of RMDs is to confirm that retirement accounts, which have enjoyed tax-deferred growth, don’t continue to grow tax-free indefinitely. The IRS wants to start collecting taxes on these funds eventually.

Key points about RMDs:

1. They begin at age 72 (or 70½ if you reached 70½ before January 1, 2020)
2. The first RMD can be delayed until April 1 of the year following the year you turn 72
3. Subsequent RMDs must be taken by December 31 each year
4. The amount is calculated based on your account balance and life expectancy
5. Failure to take RMDs results in a hefty 50% penalty on the amount not withdrawn

One key difference between 401k and 403b plans regarding RMDs is that 403b plans may allow you to delay RMDs on money you’ve contributed if you’re still working for the employer sponsoring the plan, regardless of your age. This provision is not typically available in 401k plans unless you own less than 5% of the company.

This “still working” exception can be useful if you plan to work past age 72 and want to continue growing your retirement savings tax-deferred. However, this exception only applies to the 403b plan of your current employer. You’ll still need to take RMDs from any 403b plans from previous employers or other retirement accounts like Traditional IRAs.

Making the Right Choice: Factors to Consider

When deciding between a 401k and 403b plan, consider the following factors:

1. Employer type: Your choice may be limited by the type of organization you work for.

For-profit companies typically offer 401k plans, while non-profit and public sector employers usually offer 403b plans.

2. Investment options: Review the available investment choices in each plan.

401k plans often offer a wider range of options, but many 403b plans are catching up in this regard.

3. Employer matching: If offered, this can significantly boost your retirement savings.

Check the matching formula and vesting schedule.

4. Fees: Compare the fee structures of the plans available to you.

Look at both administrative fees and the expense ratios of the investment options.

5. Vesting schedule: Consider how long you plan to stay with your current employer and how this aligns with the vesting schedule for employer contributions.
6. Additional features: Look at loan provisions, hardship withdrawal rules, and any unique benefits offered by each plan.
7. Contribution limits: While the basic limits are the same for both plans, 403b plans may offer extra catch-up contributions under the “15-year rule.”
8. RMD rules: If you plan to work past age 72, the 403b “still working” exception for RMDs might be useful.

Remember, the most important factor is not necessarily which plan you choose, but that you’re actively saving for retirement. Both 401k and 403b plans offer valuable tax advantages and can be powerful tools for building your retirement nest egg.

Frequently Asked Questions

What’s the difference between a 401k and a 403b?

The main difference is the type of employer that offers them. 401k plans are typically offered by for-profit companies, while 403b plans are available to employees of tax-exempt organizations like schools and non-profits.

Can I contribute to both a 401k and a 403b?

If you work for two different employers, one offering a 401k and the other a 403b, you can contribute to both. However, your total contributions to both plans combined cannot exceed the annual limit set by the IRS.

Are 403b plans better than 401k plans?

Neither is inherently better. Each has it’s own advantages depending on your specific situation.

403b plans may offer extra catch-up contributions, while 401k plans often have more investment options.

Do 403b plans offer employer matching?

Some 403b plans do offer employer matching, but it’s less common than in 401k plans. If your 403b plan offers a match, it’s generally advisable to contribute enough to take full advantage of it.

What happens to my 401k or 403b if I change jobs?

You have several options: you can leave the money in your old employer’s plan, roll it over to your new employer’s plan (if allowed), roll it over to an IRA, or cash it out (though this often incurs penalties and taxes).

Can I lose money in a 401k or 403b?

Yes, it’s possible to lose money in these plans as they are investment accounts. The value of your investments can go up or down based on market performance.

Are there any advantages to 403b plans for long-term employees?

Yes, 403b plans offer an extra catch-up contribution option called the “15-year rule” for long-term employees of qualifying organizations.

How do I choose the right investments in my 401k or 403b?

Consider factors like your risk tolerance, time until retirement, and overall financial goals. Many plans offer target-date funds that automatically adjust their asset allocation as you approach retirement.

Can I withdraw money from my 401k or 403b before retirement?

While it’s possible to withdraw money early, it often comes with penalties and taxes. Both plans offer hardship withdrawals for specific circumstances, and many allow loans against your balance.

How much should I contribute to my 401k or 403b?

Financial advisors often recommend contributing at least enough to get the full employer match, if offered. Beyond that, aim to save 10-15% of your income for retirement, including any employer contributions.

Key Takeaways

1. 401k plans are typically offered by for-profit companies, while 403b plans are available to employees of tax-exempt organizations.
2. Both plans have similar contribution limits, but 403b plans may offer extra catch-up contributions under the “15-year rule.”
3. 401k plans often offer a wider range of investment options compared to 403b plans, though this gap is narrowing.
4. Employer matching is more common in 401k plans, but some 403b plans also offer this benefit.
5. 403b plans often have more favorable vesting schedules compared to 401k plans.
6. Both plans have loan provisions and early withdrawal penalties, but the specific rules may vary.
7. The best choice depends on your personal circumstances, including your employer type, investment preferences, and long-term career plans.