As you plan for your retirement years, the menu of savings plan options continues to morph into new plans with new names. And when you compare the older pension-type retirement plan with the newer 403(b) plan, the differences boil down to how each plan structures its contributions, distributions and investment options. But there’s another key difference between the two plans – only a certain sector of the workforce qualifies for a 403(b) plan, including nonprofits, public school employees and ministers.
Pension Vs. 403b Plan Timeline
Before they diverge into their different structures, pension plans and 403(b) plans both work toward the common goal of offering a tax-advantaged retirement plan for workers.
With a long history of providing worker benefits, the earliest U.S. pension plan pre-dates the country’s founding. In 1775, the Continental Congress established pensions for the naval forces defending the American colonies. It wasn’t until 100 years later that the first private-sector pension was offered in 1875 by American Express.
The 403(b) savings plan is much newer than traditional pension plans. It was almost 200 years after the first U.S. pension was offered that the first incarnation of the 403(b) plan made its debut in 1958.
Overview of Pension Plans
In the more traditional “defined benefit” pension plan, an employer calculates an employee’s benefits based on a “defined” formula that considers salary as well as the length of service to the company. Employees who work for participating companies and organizations in the public and private sectors may receive pension plans. Employees do not have to contribute any of their salaries to this plan, instead relying on the employer to fund the plan. Because of this structure, the employer has total authority to manage the fund’s investments.
Overview of 403(b) Plans
The IRS recognizes participants in a 403(b) retirement plan as employees who work for 501(c)(3) tax-exempt organizations, eligible public schools and eligible churches. As a comparison, the primary difference between 401(k) and 403(b) plans is that 401(k) plans are designed for private sector employees, and 403(b) plans are designed for nonprofit and public education employees.
Differences in Contributions
Pension Plans: A pension plan is an employer-funded retirement plan. The employer invests contributions that it sets aside for its employees, and the interest earned on the investments generates additional income for the employees. Some plans also allow employees to contribute part of their income toward the total pension.
403(b) Plans: According to the plan’s regulations, employees contribute to 403(b) plans. Annuity 403(b) contract plans invest funds that are purchased through an insurance company, and custodial 403(b) accounts invest in mutual funds or a church employees’ retirement account. Some plans offer a 403(b) match, which means that employers may contribute matching funds to supplement employees’ contributions, although employers are not obligated to make any contributions.
Differences in Distributions
Distributions are the withdrawals you receive from your retirement plan, and pension plans typically differ in the age at which you can take these distributions without incurring an early withdrawal penalty.
Pension Plans: Pension plans generally have a higher age threshold for distributions than 403(b) plans – age 65 is the standard for pension plans. But different pension plans have different features, and some plans allow employees to begin receiving distributions at age 55. If your plan does allow for early distributions, check the fine print. You may be required to have a certain number of employment years under your belt before you’re vested in the plan to qualify for early distributions.
403(b) Plans: The IRS notes that in addition to receiving 403(b) distributions at age 59 ½, plan participants have other options for receiving their funds without penalty: if employees cease to work for the employer who provided the 403(b), become disabled, have a financial hardship or die, they can withdraw their money from the plan. Unless employees meet one of these exceptions, they may have to pay a 10 percent early withdrawal penalty.
Differences in Investment Structure
Pension Plans: With traditional pension plans, employee contributions are invested at the discretion of the employer. The employees cannot choose the investment vehicle, because it’s the employer who is making the contributions to the plan.
In the event a company goes out of business or its contributions to employee pension plans are underfunded, the Pension Benefit Guaranty Corporation (PBGC) is an insurance company that makes the payments for eligible plans in the private sector. The PBGC does not, however, insure public pension plans. Public pensions typically are covered by taxpayers in the event the plan defaults.
403(b) Plans: Employees who have 403(b) plans choose how they want to invest their money. The IRS lists three types of investments for 403(b) plans: annuity contracts provided through insurance companies, custodial accounts that invest in mutual funds and retirement income accounts established for church employees. An employee may elect to transfer funds from an existing 403(b) plan to a new 403(b) plan, according to the plan’s guidelines and IRS regulations.
Differences in Plan Taxes
Pension plans and 403(b) plans offer tax benefits. Contributions are made on a pre-tax basis, which means that you pay no income tax until you receive your funds at retirement. And, generally, retirees are in a lower tax bracket than when they were members of the workforce, so you’ll likely pay less tax on this deferred income.
Pension Plans. Most pension plans sponsored by employers are considered IRS-qualified, which means that they’re eligible for federal income tax advantages. Since you’ll make no contribution to your employer’s pension plan – it’s fully funded by your employer with no salary deductions form you – you’ll only pay taxes on your pension when you receive your distributions, depending on your tax bracket. The maximum amount an employer can contribute to a defined benefit pension plan for tax year 2019 is $225,000 (up from $200,000 in tax year 2018).
403(b) Plans. Distributions from 403(b) plans likewise carry the same pre-tax contribution benefit as pension plans do. The amount of your elective deferrals (non-taxed income you contribute to the plan), however, is subject to IRS limits. You can contribute the lesser of 100 percent of your includable compensation or $19,000 for the 2019 tax year ($18,500 for tax year 2018). This annual limit represents the total of all your contributions to other retirement plans such as another 403(b) plan, a 401(k) or other IRS-specified retirement plans.
For tax purposes, the IRS defines "includable" compensation in Publication 571, which you can find at IRS.gov/forms by searching for this publication by number. For example, includable compensation is based on your most recent years of service as well as the length of your service and whether your job covers part-time or full-time hours.
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