Choosing a retirement plan is overwhelming when you’re looking to save for the future — especially when some plans are only available to specific professional sectors or companies, such as the 401k and 403b.
Since employers offer both of these plans to their employees, they can seem similar. However, they each have their own tax advantages.
Read on to learn more about each type of retirement plan, including their advantages and disadvantages, and which is better for you.
What is a 401k plan?
A 401k is a plan extended to employees by for-profit companies to help them save for retirement. Both employers and employees pay into the plan.
Two types of 401k retirement accounts exist: a traditional 401k and a Roth 401k.
With a traditional 401k, employee contributions come from your regular paycheck, reducing your taxable income. You’ll need to pay taxes on those funds when you leave the workforce and withdraw your savings. In a Roth 401k, you pay more taxes on your contributions to the account so that you don’t owe any additional tax when it comes time to withdraw your savings.
Your savings grow tax-free with each plan while you work toward retirement. You can do whatever you choose with this money once you retire, whether that’s spending it on an extended vacation or investing it in stocks and bonds.
If you decide to withdraw your money before the standard retirement age of 59 ½, you’ll be subject to both early withdrawal penalties and income tax.
An employer matches the contributions from your paychecks in two different ways. They can pay a predetermined percentage based on your current salary, or they can opt to deposit a lump sum instead, known as a non-matching contribution.
According to government regulations, you can only contribute a limited amount of money each year. As of 2021, that number is $19,500. If you are 50 years of age or older, you can contribute an extra $6,500.
What is a 403b plan?
A 403b retirement plan is exclusive to employees of non-profit organizations or tax-exempt organizations, like schools and churches.
Like the 401k, there are two versions of this plan: a traditional 403b and a Roth 403b. Holders of a traditional plan receive a tax break on their contributions while they’re part of the workforce, and then must pay them upon withdrawal. For the Roth 403b, you aren’t taxed once you retire and withdraw your funds.
Your money also grows tax-free in a 403b, and you must be 59 ½ years old to withdraw without any penalties.
Employer contributions do happen, but they’re less frequent. Annual contribution limits for a 403b are identical to that of the 401k.
Despite the many similarities, 403b plans do offer an advantage to users. If you work for an organization for 15 years or longer, you can contribute an extra $3,000 per year for five years.
Main differences between the 401k and the 403b
Many state laws mandate that employers provide some form of a retirement plan to their workers. Not every state offers a 401k option.
The size of the company itself also determines your available plan. If you’re self-employed or a lone business owner, you can apply for a one-participant 401k for you and your spouse.
403b plans only apply to individuals working for public schools, colleges and universities, churches, and charities.
401k plans allow you to invest your money in various entities, though mutual funds are the most common. A mutual fund is an economic entity formed by amalgamating money from investors, which are then collectively reinvested into other assets. 403b plans are more restrictive but also permit mutual fund investments.
As a general rule of thumb, though, the bigger the company, the lower the fees associated with additional investment options.
Even though the option of additional contributions doesn’t apply to the 401k, 403b plans may come with slightly higher fees.
Summarized below are the key differences between each plan.
The bottom line
Typically, you don’t choose which plan you receive. The plan depends on your type of employer and, ultimately, the sector in which you work. There’s no best retirement plan — the trick is taking advantage of any opportunities available to you.
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