403(b) VS. 401(k): What is the Difference?

With Social Security on unstable footing, Americans are looking toward employer-sponsored retirement plans to pay for their golden years. Tax advantaged accounts are set to play a central role in most of Generation X's and Generation Y's retirement plans.

Named for the section number of the IRS code, 403(b) plans are identical in most ways to 401(k) plans. Both 403(b) and 401(k) plans work like this: A company contracts with a brokerage to manage the retirement plan for its employees. Employees elect to have a portion of their payroll deducted before taxes are taken out, and this amount is deposited with the brokerage. Most companies match the employees contribution in some way. The deposits to the account are invested in mutual funds, annuities, Real Estate Investment Trusts, or any other investment vehicle offered by the broker. The investments grow tax free until the owner reaches age 59 1/2. After that age, the owner can withdraw the appreciated amount and pay regular income tax rates on the amount.

403(b) and 401(k) programs offer a substantial benefit to participants by deferring taxes until retirement. Employees get immediate tax advantages, and the employer match is essentially free money. The account grows tax-free, which vastly accelerates the power of compound interest. For example, a 25 year old who saves $90 a month in a 401(k)/403(b) and receives a one-for-one employer match will have $683,000 by the time he or she retires. If the money was not in a tax-advantaged account, the value would be only $217,000. So clearly, the smart money participates in 401(k) and 401(b).

The major difference is that 403(b) plans can only be offered by non-profit institutions like schools, hospitals, charities, and research institutes. Because these types of employers don't generate a profit, 403(b) accounts are unable to accept profit sharing or dividends from the company. Further, the organization has no ownership of the plan, and its only legal responsibility is to deposit employees' payroll deductions into the account.

In practice, there are two advantages for employers. 403(b) programs have far simpler review and certification process because they are exempt from the Employee Retirement Income Security Act (ERISA). ERISA requires that other tax-deferred accounts undergo periodic reviews called discrimination testing. 403(b)'s do not require special accounting and due process for being fully funded by the organization. Since the employer sidesteps these requirements, there is little administrative drain on the organization.

There are two major differences for employees with 403(b) accounts. First, the employer's contribution to the account can be withdrawn without penalty if it invested in an annuity. Since the organization who contributed it does not owe taxes, the government considers this money to be clear from tax liability. The second advantage is the ability to leave the account with a former employer. Since there are no administrative costs for the account, employers will generally let an employee leave the account in place after termination.

403(b) accounts can be handled by any investment broker or advisor. These accounts are building a solid future for those who work in nonprofit fields for common good.