Planning for retirement is an important aspect of ensuring that you can continue your standard of living when you are no longer working. Two common retirement plan options for employees are a 401(k) and 403(b) plan. A 401(k) plan is a retirement account offered by for-profit companies, while a 403(b) plan is offered by nonprofit organizations. The plans operate in a similar manner, although they have subtle differences. Employees should understand how both accounts work to adequately plan for retirement.
How a 401(k) Works
A 401(k) plan is often labeled as a defined contribution plan because the employee determines the amount of contributions made up to a certain amount. As of publication, the maximum annual contribution limit allowed into a 401(k) plan is $17,000. Employees age 50 and over can contribute an additional $5,500 a year. Employee contributions into a 401(k) plan come directly from the employee’s paycheck. Unlike a 403(b), the contributions are typically invested in a variety of stocks, bonds, mutual funds, exchange-traded funds and possibly alternative assets. In many cases, employers match contributions employees make into their 401(k) plans, up to a certain percentage.
Pros and Cons of a 401(k)
A primary advantage of a 401(k) plan is that contributions are tax-deferred. This means that contributions are made with pretax dollars, allowing you to reduce your taxable income. Another benefit of a 401(k) plan is that matching contributions offered by employers allow you to save more money for retirement in less time. A disadvantage of a 401(k) plan is that you are penalized if you make an unauthorized withdrawal from your account and must pay taxes on the money. The investments you choose for your plan are limited to the investment choices made by the employer, which may not align with your financial plans. The variety of investments in a 401(k), such as annuities, may result in more administrative fees than a 403(b) plan has.
How a 403(b) Works
In contrast to a 401(k) plan, a 403(b) plan is offered by tax-exempt organizations that are under section 501(c)(3) of the Internal Revenue Code. These corporations may include religious organizations, charities, public schools and hospitals. Types of 403(b) plans include annuity contracts, custodial accounts and retirement accounts. The investment options in a 403(b) plan are usually not as plentiful as those in a 401(k). Like 401(k) participants, those with 403(b) plans can make an additional $5,500 contribution if age 50 or over. In addition, employees who have 15 or more years of service with an employer can contribute an additional $3,000 annually to a 403(b). Employers can match employee contributions dollar for dollar up to a certain percentage.
Pros and Cons of a 403(b)
An important benefit of a 403(b) plan is that you are not required to pay income taxes on contributions made into the plan until you begin making scheduled withdrawals, which typically take place after you retire. According to the Internal Revenue Service, another benefit is that eligible employees can possibly take a tax credit for contributions made into their 403(b) plans. A disadvantage is that the IRS can penalize you if contributions are made to your account beyond the maximum amount. Another drawback of a 403(b) plan is that you may encounter restrictions on how you designate beneficiaries. In contrast to a 401(k), the IRS requires that your beneficiaries are established before you die, and beneficiaries may face additional withdrawal requirements from the IRS.
- Fidelity Investments: 403(b) Contribution Limits Calculation Tools
- Internal Revenue Service: 401(k) Plan Resource Guide — Plan Participants — 401(k) Plan Overview
- CNN: How is a 403(b) Different From a 401(k)?
- AXA Equitable: Make the Most of Your 401(k)
- Internal Revenue Service: 403(b) Plan Basics
- Internal Revenue Service: 401(k) Resource Guide — Plan Participants — Limitation on Elective Deferrals
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