The Differences Between 401(k) and 403(b) Plans

403(b) plans and 401(k) plans are quite similar, but the differences are very important. While they have the same premise, each has idiosyncrasies that are critical to remember. Probably the most important difference between the two plans is that 401(k) plans apply to most of the population, while 403(b) plans apply to a smaller number, and more specific group, of people.

A 403(b) plan, also known as a tax-sheltered annuity plan, is a retirement savings plan that is used by tax-exempt organizations like public education organizations, some non-profit employers (501(c)(3) only), and cooperative hospital service organizations, among others. Essentially, salary deferrals are put in to a 403(b) plan before income tax is paid and those funds grow tax deferred until the money is taxed as income when withdrawn from the plan, thereby avoiding tax while monies are invested. The Employee Retirement Income Security Act (ERISA) does not require plans to be qualified per US Tax Code 401(a), but they should be similar to qualified plans in most respects. The biggest difference between qualified and unqualified plans are in the ways that money may be withdrawn, before the retirement age (59 1/2), but only if the plan is funded with investments like annuities and mutual funds.

401(k) plans are an employer sponsored retirement plan and act as an employee benefit much like health insurance, and apply to almost everyone who is employed with a normal profit-based company. The employer can choose to match all or part of an employee's cash contributions (withheld salary) in to the plan or alternatively use a profit sharing method that involves company stock and options that may also be matched by the company. In participant-directed plans, employees have a wide range of choices for their investment vehicle, usually including stocks, bonds, money market investments, other options or a combination of several of these. In the other option, trustee-directed 401(k) plans, assets are invested not by individual employees but by a plan appointee, taking the choice away from employees but perhaps entrusting funds to an expert.

Both plans are eligible for Roth contributions, which will allow tax-free withdrawals under certain conditions. Most importantly, Roth contributions must be vested for at least five years, but other exclusions and requirements do apply. This option should be investigated as the tax-free withdrawal option will ultimately save thousands of dollars over the life of an individual and will prevent withdrawn funds at retirement age from being taxed at all or taxed as much.

As with all financial decisions, be sure to consult with a professional to be sure that each decision is the right one for you.