For this week's edition of Macro Mondays, I thought I would touch on a question I'm asked frequently: what is the difference between a 401(k) and a 403(b)? The answer is actually quite simple: there isn't much difference except in the organization that offers them to its employees. What does that mean? Well, keep reading!
For more information on the 403(b) plan and other plans, check out Investopedia.
What is a 403(b) Plan and How is it Different from a 401(k) Plan?
A 403(b) plan is a retirement plan for specific employees of public schools, tax-exempt organizations and certain ministers. These plans can invest in either annuities or mutual funds. A 403(b) plan is another name for a tax-sheltered annuity (TSA) plan.
The features of a 403(b) plan are comparable to those found in a 401(k) plan, the names come from the different codes that the IRS uses to differentiate one from the other for tax purposes. Basically, if you work for a public school, a church or religious organization, or certain non-profits, you will be offered a 403(b) plan in lieu of a 401(k) plan.
What are the benefits of a 403(b)?
Earnings and returns on amounts in a 403(b) plan are tax-deferred until withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions. Employees age 50 or over can make catch-up contributions to both plan types. Employees may be eligible for matching contributions, which varies by employer.
For example, an employer matches funds at 50% of any contributions an employee gives, up to 6% of an employee's salary. If an employee earns $75,000 and contributes 6%, or $4,500, the employer contributes $2,250, which is essentially free money towards the employee's retirement. This helps employees exceed the annual maximum contribution limits, receive tax deductions and accelerate their retirement goals.
So how can i contribute to this plan?
Different types of contributions fund TSAs, such as after-tax contributions, nonelective contributions and elective deferrals. After-tax contributions are voluntary contributions up to 25% of a participant's salary that a participant must include in income when filing taxes. Nonelective contributions are mandatory employer contributions, such as discretionary contributions that include end-of-plan-year contributions or profit-sharing contributions.
Elective deferrals are voluntary contributions set up by the employee that allows an employer to withhold money from the employee's paycheck to be paid directly into his TSA. These contributions are a percentage of the employee's salary. Another funding option is using a combination of elective, nonelective and after-tax contributions.
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