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What's the difference between 401(k) & 403(b) plans?

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The 401(k) is nearly synonymous with retirement saving in the U.S., although it's certainly not the only workplace plan that offers powerful tax advantages. Millions of workers invest through other retirement accounts, including the widely used 403(b).

So what, exactly, is the difference between 401(k) and 403(b) plans? While they may look nearly identical at first glance, there are a few important distinctions. Here's a look at who's eligible for each one and how they diverge.

Brief overview of 401(k)s and 403(b)s

Whether your employer offers a 401(k) or a 403(b) depends on the type of organization you work for. If it's a for-profit business, you may have the option to contribute to a 401(k) plan. Meanwhile, 403(b)s are geared toward tax-exempt employers such as public schools and universities, nonprofit hospitals, churches and charitable organizations.

That means 401(k)s are much more common. As of 2019, about 87 million participants were contributing to 401(k) plans. In contrast, just 9.9 million workers were actively participating in a 403(b) plan.

The basic concept of both is similar. Employees are allowed to select from a menu of investment choices within the plan. They can contribute pre-tax dollars through payroll deductions, and their money grows, tax-deferred, until they withdraw it after age 59½. At that point, any distributions are subject to ordinary income taxes.

Both 401(k)s and 403(b)s may offer Roth versions, which changes the tax advantage. Instead of investing pre-tax money, employees contribute after-tax dollars that grow on a tax-deferred basis. The employee can withdraw their funds (contributions and earnings) tax-free after reaching age 59½ and owning the account for at least five years.

Comparing 401(k) and 403(b) plans

While for-profit and nonprofit employer plans have similar rules, some distinctions between them are important. Put simply, both 401(ks) and 403(bs) can include a variety of investments, have set contribution limits and are typically eligible for employer matches. But they differ because each plan typically has its own options, rules and fees. Here are the details:

Investment options

Employers have the ability to select the investment options that are available to their employees whether they offer a 401(k) or 403(b). In both cases, these choices can include index funds, actively managed mutual funds and target-date funds that automatically shift toward lower-risk assets over time. In the case of a publicly traded company, the 401(k) also may allow the purchase of the organization's own shares.

Among 403(b) plans, annuities are another common choice, and there's a reason for that. When the federal government created these plans in the 1970s annuities were the only option they could offer. What's more, public school plans aren't protected by the federal Employee Retirement Income Security Act (ERISA), which governs most employer plans. That means school districts have more leeway to select higher-cost financial products than other sponsors.

That's not to say annuities are necessarily a bad choice. The fact that they provide a guaranteed stream of income for life is certainly an appealing feature for many public educators and other nonprofit employees. There's a death benefit and potential income stream, but whether it's beneficial or not is going to depend on the contract and mortality tables used. And annuity fees can be higher than those of mutual funds, which can dampen the returns they pay out to the owner.

Contribution limits

The amount you can put into your account is virtually the same regardless of which plan your employer offers. Both 401(k)s and 403(b)s have an annual contribution limit of $20,500 in 2022. If you're age 50 or older, both plans provide a catch-up provision that allows you to contribute an additional $6,500 per year.

However, 403(b)s have a separate catch-up rule for employees with at least 15 years of service at the same organization. The IRS has a formula for this additional amount, which can go as high as $3,000 a year for certain workers.

Matching funds

A perk of both plans is that employers often will match some or all of your contributions. Your organization might contribute dollar-for-dollar of what you kick in up to a certain percentage of your salary. Or they might match a percentage of your total allocation — say, 50% of your invested dollars — up to a limit. So whether you work for a private-sector employer or a public or nonprofit one, if you're not putting enough money into your account to maximize the employer contribution, you're leaving money on the table.

Both types of employers also have the option to offer safe harbor plans, which essentially create fewer administrative hurdles for the sponsor. For safe harbor plans, organizations can provide a match equal to 4% of employee deferrals. Or they can make a standard 3% contribution of all plan participants regardless of whether they make contributions of their own.

Hardship withdrawals

Another similarity between 401(k)s and 403(b)s: The employer is allowed—though not required—to allow hardship withdrawals for workers contributing to the retirement plan. If employers want to offer them, they need to have clear, written guidelines for what's allowed and what's not.

They have to abide by IRS rules, which state that hardships have to be the result of an "immediate and heavy financial need." That may include situations like these:

  • Medical expenses
  • Higher education costs
  • The purchase of a primary residence
  • Funeral costs

Those withdrawals also have to represent a last resort for the employee. According to the IRS website, "a distribution is not considered necessary to satisfy an immediate and heavy financial need of an employee if the employee has other resources available to meet the need, including assets of the employee's spouse and minor children."

Even if you meet your employer's criteria, the money you pull out because of a hardship withdrawal still may be subject to income taxes and a 10% early withdrawal penalty. It also sets back your retirement savings. Therefore, you'll want to exhaust all other options before moving forward.

Loans and repayment

Workplace retirement plans also are allowed to offer loans, which represent another option for employees in dire straights financially. Per IRS rules, plans can provide loans of up to 50% of the employee's vested balance or $50,000, whichever is less.

Typically, employees have to pay back the loan within five years, although that may be extended if you're using the funds to purchase a primary residence. Organizations can charge interest—generally a percentage point or two over the prime rate—but unlike traditional loans, this "fee" goes into your account.

One of the benefits of a loan versus a hardship withdrawal is that you don't have to worry about incurring income taxes or an early withdrawal penalty if you pay yourself back in a timely manner. But there's a caveat: If you fall behind on your repayment, the overdue amount is treated as an early distribution. And if you leave the employer for any reason, the plan typically will accelerate your repayment schedule, making it harder to avoid negative consequences.

While loans have several appealing features, it's important to weigh the pros and cons carefully. For instance, while you're paying yourself back at a modest rate of interest, the money you've borrowed may not be keeping up with the return of the market. And you have to use after-tax dollars to repay the loan, negating the benefit if it was originally a pre-tax contribution.

Required minimum distributions

Whether you participate in a 401(k) or 403(b), the IRS doesn't let you hold off on withdrawing from your account for as long as you'd like. Once you reach age 72, you have to start taking required minimum distributions (RMDs). Should you work beyond age 72, however, that start date is postponed until you retire, as long as the plan document allows for the delay. (Business owners with more than 5% ownership are excluded from this provision.)

The amount of your annual RMD is determined by taking the prior year's ending account balance and dividing it by the life expectancy factor outlined in IRS Publication 590-B. There's a big incentive to comply: Any amount that you don't withdraw by the required date is subject to a stiff 50% penalty.

The takeaway

If 401(k) plans and their public-sector cousin, the 403(b), seem remarkably similar, that's because they are. Both offer tax benefits that can significantly increase your net return. If your employer offers matching funds, these accounts become an even more powerful way to build long-term assets.

The key difference between 401(k) and 403(b) plans tends to be the investment options. Government and nonprofit workers are more likely to see annuities that provide lifetime income but typically charge more in fees. If you're unsure how these plans may fit into your overall financial plan or which investments are right for your needs, a local Thrivent advisor can lend you a hand.

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Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.