For many people, retirement accounts are one of the most intimidating hurdles to managing their finances. It doesn’t help when they have names like “401k” and “403b” that make you feel like you're doing taxes or signing up for a marathon. (Although saving for retirement is a kind of marathon in itself—so it works!)
Today, let’s demystify these two retirement savings vehicles. We’ll look at 403b vs. 401k accounts, who’s eligible for each account type, the difference between the 401k and 403b, and how to invest in them. I’ll also share some alternatives if you’re not eligible for either account type.
403b vs. 401k: How do these retirement accounts work?
You can’t have both, so how do these numerically named accounts stack up against one another? We’ll start at the beginning: what are they?
What is a 403b?
A 403b is a tax-advantaged retirement account available to employees of organizations like hospitals, schools, nonprofits, and churches. It's up to each organization whether they offer one and what their specific terms are. You can use a 403b to invest in mutual funds and annuities.
$19,500 per year is the standard contribution limit for a 403b, but older employees may qualify to contribute more as catch-up contributions. You can start making withdrawals at 55 years old (or younger with a 10% penalty).
Employers who offer 403b plans often sweeten the deal with a match benefit for contributions. That means they'll match a certain amount of however much you're putting in, based on your salary. For instance, a company might offer a 50-cent-per-dollar match up to 6% of your salary, so if you make $50,000 a year and contribute at least $3,000, they'll contribute another $1,500.
Often, you’ll have a choice to contribute to a traditional 403b or a Roth 403b. Traditional means that your contributions are pre-tax (thus lowering your taxable income), and instead will be taxed when you withdraw the money in retirement. A Roth option means you pay taxes on the money now and won't be taxed on withdrawals later. Check out this article for a more in-depth comparison of traditional vs. Roth accounts. (Either one is better than a non-tax-advantaged account, where you contribute pre-taxed income and get taxed on growth!)
What is a 401k?
A 401k is a type of employer-sponsored retirement account available at for-profit companies. You'll use your 401k as a tax-advantaged vehicle to invest in the stock market. It's more common than the 403b, but it's still up to each company whether to offer a 401k plan. Large companies usually have plans, while smaller companies may not.
The 401k has several similarities to the 403b:
- They have a $19,500 per year contribution limit in 2020, and potentially more as catch-up contributions for qualified older employees
- Employers often offer 401k matches as a company perk
- You often have a choice between a traditional and Roth 401k, so you can choose between pre-tax and post-tax contributions
We'll go over some of their differences below.
Investing in a 401k or 403b
401k and 403b accounts are both just vehicles for investments, not investments themselves. When you start either account, you’ll need to make selections for how to invest your money inside the account (aka asset allocation). The exact investment options available to you will depend on your company's plan.
Review your company plan
403b accounts can only offer mutual funds and annuities, while 401ks can offer these plus other types of investments like individual stocks. This isn't that big a deal, since it's usually best to choose from a mix of mutual funds with either account. The 3-fund portfolio is a very simple and well-diversified way to invest in different asset types.
If you're interested in annuities (or if that's all your plan offers), know that they have pros and cons. They can help you minimize risk in bad markets by guaranteeing you a certain amount of income. However, they also tend to limit your upside in a good market, they come with high fees, and they can have complex rules. Annuities used to be popular, but they aren't considered one of the best investment options today.
Speak to an advisor if needed
You can ask the advice of a financial advisor if you’re unsure about which investments to choose. However, be careful about hiring someone to fully manage your account, since their fees are often steep. Plus, managing your own portfolio is pretty simple if you just pick index funds and leave it alone.
Take any match offered
We briefly went over company matches above. If your company offers a 401k or 403b with a match, you should definitely contribute enough to get the full amount if you can. It's free money!
With matches, just be aware of the fine print: a company will usually require that you stay at the company a certain amount of time to keep the full match. This is called "vesting," and it's a way for the company to make sure they're investing the most in their employees who stay the longest. If you're 50% vested by the time you leave the company, you'll get to keep 50% of the company match amount you've earned over your tenure. Vesting only affects their contributions, not yours. Learn more about how vesting works exactly.
The difference between 401k and 403b accounts
Honestly, when it comes to the 403b vs. 401k, there are more similarities than differences! The main difference boils down to who can contribute (what type of organization you work for). If you don't work for a nonprofit, school, or other tax-exempt organization, you won't be eligible for a 403b.
403b accounts have more limited investment options, and can also have higher plan fees since they’re typically offered by smaller companies with fewer employees participating. (Learn about what kinds of fees you may be charged here.) One perk of 403b plans is that they tend to offer faster vesting.
Other than that, they’re really just different ways to fulfill the same purpose: investing for your retirement with tax advantages and a little help from your employer.
What if you’re not eligible for a 401k or 403b?
If you’re self-employed, like a business owner or freelancer, you won’t be eligible for the traditional version of either account, since they’re provided through employers. Or, even if you are a regular employee, your employer might not offer a retirement savings plan.
Self-employed people can open an alternative account called a solo 401k. Since you count as both employee and employer, you can make contributions on both ends as well. 2020 solo 401k limits are $19,500 as an employee, plus an extra 25% of your wages as a contribution from the business end. Read more about saving for retirement as an entrepreneur here!
For those who work at a company without a plan, you can try proposing that they start one. If you're comfortable approaching someone in management or HR, it can't hurt to do some research and make your case.
Consider an IRA
IRAs are another great retirement account option since anyone with earned income (from any source) can open one. However, when you compare an IRA vs. 403b vs. 401k, the IRA contribution limits come in at the lowest. In 2020, you can contribute a maximum of $6,000 to a traditional or Roth IRA, as long as you've earned at least that much in taxable income.
Head to this article to read everything you need to know about these retirement accounts and others.
In the end, the best way to go about saving for retirement is just to get started! Use whatever vehicles are available to you, invest as much as you can, and sit back to watch your money grow.