The retirement savings landscape has changed significantly in the last few decades. Back in the day, employees could stay with an employer for years and retire with a pension. This pension would provide a guaranteed stream of income, but now most employers have eliminated pensions.
Instead, pensions have been replaced by 401(k)s and 403(b)s, which force employees to manage their own retirement funds. 401(k)s are found in most private sector companies while 403(b)s are common among non-profit and government agencies. Both retirement accounts have many similarities and some differences regarding investment options, limits, and tax treatments.
What is a 401(k) retirement plan?
Named after internal revenue section 401(k), the 401(k) was introduced as a retirement option during the late 1970s as a third way to help provide retirement income. Company pensions gave employees guaranteed monthly income all throughout their retirement, however, as people began living longer, employers began eliminating the pension. After realizing that social security wasn’t enough to retire with, employers offered the 401(k) plan.
401(k) plans allow people to increase their retirement savings on either a tax-deferred, Roth, or after-tax basis.
- Tax-deferred 401(k)s allow contributions to be invested without paying taxes on them. However, employees will pay federal and state income taxes on their distributions. It’s wise to avoid taking distributions until age 59.5 to avoid the 10% penalty.
- The Roth option allows employees to contribute funds that have already been taxed, which allows them to not pay taxes on future qualified distributions. This is provided they wait until age 59.5 to take distributions.
- The after-tax option enables employees to contribute money on an after-tax basis with the earnings being subject to taxes. This option might seem like the least advantageous, but it enables high earning employees to contribute more than the annual limit.
Most employers offer Roth and pre-tax options, with some employees choosing to implement hybrid contribution choices. Some employers offer the after-tax bucket, which allows employees to save more towards retirement. The biggest advantage to the after-tax section is the ability to convert it to Roth (i.e Roth conversions). Keep in mind that all after-tax earnings are taxable, which is why it’s generally prudent to convert it to Roth as soon as possible. Roth conversions can be tricky, making it wise to use a Roth conversion calculator and possibly consulting a financial adviser.
401(k) contribution limits
The 401(k) plan has pretty straightforward limits which are:
- $19,000 per year on a combined pre-tax or Roth basis for employees under 50.
- An additional $6,000 per year, or catch up contribution for an employee over age 50.
- The maximum total limit of $56,000. This maximum limit includes employer matches, after tax contributions and profit sharing arrangements.
These limits are updated for the 2019 year and are indexed for inflation. Another factor that impacts contributions is non-discrimination rules for highly compensated employees (HCE).
For example, if low earning employees are making little or no contributions, this limits the amount an HCE can allocate to his or her plan. The two main tests that determine HCEs are if they make more than $120,000 per year and/or own more than 5% of the business. The IRS mandates employers conduct annual nondiscrimination tests and the IRS has detailed rules to help fulfill this requirement.
What is a 403(b) retirement plan?
403(b)s are similar to 401(k)s as they are plans that allow employees to save for retirement on a pre-tax, Roth, or after-tax basis. Like 401(k)s, some 403(b)s have the Roth option and shift retirement planning to the employee. The main difference of a 403(b) is that it’s cheaper and less complex to implement. In fact, 401(k)’s have substantial fees and regulations, which prompts smaller employers to offer alternatives like SIMPLE or SEP IRAs.
403(b)s are only available for employers who qualify like government, hospitals, public schools, and non-profits. Other employers can qualify for this plan, but they must meet tax-exempt status under IRS code 501(c)(3). The main way to qualify under this code is that a business must have charitable intentions with the Salvation Army being an example. The business must always maintain its charitable purpose and can’t use its charitable contributions for political purposes if it wants to maintain its 501(c)(3) status.
Similarities between 401(k) and 403(b) plans
Like 401(k)s, 403(b)s have the same rules regarding distribution timing and the 10% penalty.
Investors will have to wait until age 59.5 to take distributions to avoid paying the penalty. Both 401(k) and 403(b) investors will pay applicable federal and state income taxes on distributions.
403(b)s have the same contribution limits as 401(k)s, which are updated for 2019 and indexed for inflation:
- $19,000 per year on a combined pre-tax or Roth basis for employees under 50.
- An additional $6,000 per year, or catch up contribution for an employee over age 50.
- The maximum total limit of $56,000 with employer matches, after tax and profit sharing being included.
Both 401(k)s and 403(b)s enable the participants to borrow against their account balances. Some occasions like job loss, starting a business, or other expenses demand access to quick cash. Therefore, employees can borrow against their plans to achieve their goals. Employees must pay back the loans within a consistent time period to prevent owing taxes and penalties. Employers have their own specific loan rules, but the IRS limits are 50% of the plan balance or the maximum amount of $50,000.
Each loan must be paid back within 5 years unless the funds are being used for a principal residence, which has a longer term. Employees that leave an employer have 60 days to pay back their loan, or it’s considered a taxable distribution. These loans can be good depending on an employee’s situation, but it’s wise to use these as a last resort. This is due to the money missing out on market gains and strict payback rules.
Differences between 401(k) and 403(b) plans
The main difference between these plans are the types of employers that use them, costs, and investment options.
A 403(b) plan is also referred to as a tax-sheltered annuity because it was originally designed to invest in solely annuities contracts. This plan was created in 1958 and offers participants the option to invest in either fixed or variable annuities.
Annuities differ from standard investments like ETFs or mutual funds since they are insurance contracts that protect investors against running out of money in retirement. Investors can buy annuities knowing that they will get a guaranteed monthly income in retirement. The main two annuity types are fixed and variable annuities. Fixed annuities guaranteed a fixed yearly payment in exchange for an initial investment. Variable annuities offer monthly income, but this amount can fluctuate based on the underlying funds.
Variable annuities invest in funds that are similar to mutual funds and are managed by the insurance company. Therefore, these funds returns can impact an investor’s monthly annuity payout. Financial experts warn against investing in annuities within 403(b)s due to high fees and surrender charges. Annuities carry much higher fees compared to mutual funds since they guarantee a future monthly income stream. Surrender charges also penalize investors for withdrawing funds from annuities and can be higher than the typical 401(k)/403(b) 10% penalty.
Investment options for both plans
These plans have similar investment options, like mutual funds, ETFs, and target date funds. Most investors choose one of these three options.
The biggest differentiator between the two is that 403(b)s allow investors to choose annuities. Annuities aren’t always the best choice since they’re already in a tax-deferred vehicle, charge high fees, and have steep surrender charges.
The biggest advantage of these plans is that any investment growth is tax-free. Unlike brokerage accounts, investors aren’t taxed on interest, dividends, and capital gains. Brokerage accounts provide more flexibility and don’t have contribution limits, but they report any annual income to the IRS via form 1099. Therefore, brokerage accounts aren’t generally the most tax efficient form of investing.
Mutual funds are investment pools that invest in a large variety of companies. These funds reduce single stock risk, by diversifying among hundreds of companies. Each investor’s mutual fund share represents an interest in hundreds of companies and is more cost effective than buying one hundred individual shares. Mutual funds don’t typically see large gains or losses compared to individual stocks or equities.
ETFs and Target Date Funds
Another popular option for investors is an investment called an ETF, or exchange-traded fund. Mutual funds are good, but ETFs are becoming more popular for 401(k)/403(b) investors for many reasons. Some reasons include that ETFs have cheaper costs (i.e expense ratios), are more flexible and are less complex.
ETFs invest in hundreds of companies per sector and with Vanguard’s VBR fund being a common example. VBR invests in small-cap companies, which have market caps below $5 million. One huge difference between mutual funds and ETFs is that ETFs reprice intraday. Mutual funds change their prices at the market close, which makes them harder to trade.
Target Date funds are available investment options for both 401(k)s and 403(b)s. These help investors “automate” investing with set-and-forget asset allocation. This means that the fund begins with an asset allocation weighted heavier towards riskier investments like stocks. It gradually changes the allocation over time to more conservative investments like bonds.
Generally, younger investors want to select stocks initially since they have more growth potential. Despite stocks’ risk, younger generations have decades to recover from market losses. Conversely, older investors want to start shifting their funds to bonds and other conservative investments because they don’t have the time to recover from volatile markets.
Target date funds usually follow this format “company name, target date fund, year.” The year represents when the investor will retire and helps automate the changes in asset allocation or rebalancing. It’s imperative that investors only choose one target date fund based on the year they will retire.
How to maximize each plan’s earnings
Investing can be tricky, but there are many simple ways to maximize a 401(k) or 403(b) plan. Fortunately, technology has made this goal easier to accomplish. For example, target date funds and robo advisers like Wealthfront automatically adjust your asset allocation (i.e rebalance).
Take advantage of the employer match
An employer match can be seen as “free money” since they contribute part of an employee’s salary in addition to the original contribution. A common example would be matching 50% of the first 6%. So, an employee would have to contribute at least 6% of his or her salary to receive the match of 3% (.50 x 6). Any amount of matching contributions is better than nothing and it can make a huge difference in account balance growth.
Avoid withdrawals and loans
As mentioned above, both plans allow participants to borrow against their balances. While this might be better than a high-interest loan, it’s generally advised not to do this. For instance, any distribution will miss out on market gains, which would significantly impact long term returns. Instead, it’s wise to focus on gradually increasing contributions so they can grow over time. Withdrawals and unpaid loans are subject to penalties and taxes, which can wreak havoc on finances.
Watch out for fees
Fortunately, most employers offer low-cost funds that are passively managed. This means that these funds track a stock market index like the S&P 500 and have an average return of 7%. Conversely, actively managed mutual funds have higher fees and attempt to beat market indexes. However, these funds usually underperform the market and their fees can diminish retirement balances. Even funds that have a seemingly small expense ratio of 1% can do serious damage over the long run. This is why it makes sense to research a fund’s expense ratio, trading costs, and long term returns.
Consider a Roth 401(k)/403(b)
The Roth option allows investors to contribute after-tax money to realize tax-free growth. Earnings which include capital gains, dividends and interest compound over time and are much greater than contributions. This powerful concept can help investors keep more money in retirement. Some investors like to choose a hybrid approach which involves investing some funds pre-tax and others post-tax. Another option includes investing in a pre-tax 401(k) and investing in an outside Roth IRA.
Required minimum distribution (RMDs) for 401(k) and 403(b)
Regardless if a 401(k) or 403(b) is tax-deferred or Roth, employees age 70.5 or older must take out annual required minimum distributions (RMDs). RMDs are the government’s method of obtaining revenue via these distributions.
It’s also interesting to note that Roth 401(k)s/403(b)s are subject to this rule, despite having tax free earnings. IRAs are subject to this rule as well, but Roth IRAs aren’t. It’s extremely important to take sufficient RMDs once an employee turns age 70.5 to avoid the 50% tax on the not withdrawn amount. Thus, it’s smart to use resources like an RMD calculator and applicable worksheets.
Special rules for each plan
401(k)s and 403(b)s have a few interesting rules, with the Rule of 55, SEPP payments and the 15-year catch-up rule standing out above the rest:
Rule of 55
401k/403(b) withdrawals seem simple, right? Let the funds grow for decades and start taking distributions at age 59.5. Any distribution prior to this arbitrary age would trigger taxes and penalties.
However, the Rule of 55 allows investors to take distributions penalty-free once they turn age 55. Keep in mind this loophole only applies to a current employer’s 401k or 403b plan This rule doesn’t apply to IRAs, Roth IRAs, pensions or other retirement plans. The Rule of 55 is very helpful for those that want to retire early. One way to maximize this rule is to roll outside assets into a current employer’s 401k/403b plan.
SEPP, or Substantially equal periodic payments
This unique 401(k)/403(b) trick allows investors to take penalty-free distributions prior to age 59.5. These payments are nicknamed section 72t payments, after IRS code section 72t. It also has more flexibility than the rule of 55 since it can be used with IRAs.
To start SEPP payments, calculate life expectancy, and use that to calculate five substantially equal payments from a retirement plan for five years consecutively prior to the age of 59.5. These distributions can also occur at any age.
One factor to be mindful of is the minimum holding period. If these payments are canceled prior to the minimum holding period’s expiration, the investor will have to pay the IRS all waived penalties and interest. SEPP plans are also permitted with money from employer-sponsored qualified plans, like 401ks, but the investor can’t work for the employer that sponsored the plan.
15-year rule for 403(b)s only
Some employers that qualify for 403(b) plans offer a special kind of catch-up contribution, called the “15-year rule.” Employees that have been working for the same employer for 15 years or more and contributed less than $5,000 per year, can contribute an extra $3,000 extra per year. This rule establishes a $15,000 lifetime maximum and employees don’t need to be 50 years old to implement this. However, those 50 and older have the option to make both types of catch-up contributions in the same year.
Who really benefits from these plans?
Pensions are becoming very rare with even government pensions becoming insolvent. Unfortunately, there is a looming retirement crisis since the median 401(k) balance for 1 in 4 60-year-olds is a mere $26,700. This isn’t close to the million dollar balance experts recommend prior to retiring. On top of that, it’s estimated millennials will need about $2 million to retire due to skyrocketing costs of living. Lastly, social security is underfunded and others believe that it will go bankrupt in 2034.
These factors might paint a grim picture, but both employers and employee can benefit from these plans. Yes, it will be harder than it was generations ago, but it’s possible. Employers benefits because they’re less costly and have fewer regulations compared to pensions. These plans shift retirement planning responsibility to the employees.
Employees can benefit because these plans give them autonomy and the ability to build multiple sources of income. Older generations just had one source of income throughout their lives. This source was their job, which was eventually converted into a pension throughout retirement. 401(k)/403(b) plans along with IRAs give employees the choice to diversify and maximize their investments. Over time, this could give them more security than relying on one single company.
Using these plans will also help employees learn new skills and develop into life long learners. Life long learning will enable them to stay sharp during retirement and learn other skills easier. Life long learners also have a growth mindset, which allows them to overcome obstacles.
The decline of pensions has enabled the standard working class American to manage his or her own retirement funds. This shifts the risk from the employer to the employee and two common retirement plans are 401(k)s and 403(b)s. Private employers offer a standard 401(k), while a 403(b) is used by non-profit or government employers. These plans have some commonalities like investment limits, fund choices and tax treatment.
Disclaimer: This post isn’t investment or tax law advice, but education. Consult a CPA, financial or tax adviser for advice.