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403(b) vs. 401(k): What's the Difference?

Employer-sponsored retirement plans such as 403(b)s and 401(k)s are the best way for Americans to pay for their Golden Years. But there exists some confusion about the differences between these two plans. Here's a quick guide to the 403(b) vs. 401(k).

403(b) vs. 401(k): Similarities
Both named after a section number of the IRS tax code, the 403(b) and 401(k) are tax-deferred retirement plans designed to help workers save money for retirement. Both plans allow employees to make pre-tax salary deferrals of up to $17,500 in 2014. If you're 50 or older, you can make an additional catch-up contribution of as much as $5,500, for a total of up to $23,000. Those contribution limits are scheduled to adjust annually in line with inflation.  

Employees elect to have a portion of their pay deducted before taxes are withdrawn. Most for-profit companies match the employees' contribution in some way. The money is deposited with the brokerage firm that manages the retirement plan for its employees, and the deposits are invested in mutual funds, annuities, or other investments offered by the broker. The investments grow tax-free until the owner withdraws the appreciated amount and pays income taxes. A 10% tax penalty is due to the IRS if the owner withdraws money before age 59-1/2. 

403(b) and 401(k) programs offer substantial benefits to participants. First, employees get immediate tax savings in that every dollar contributed reduces their taxable income for the year in which it's contributed. Also, the account grows tax-deferred, which enhances the power of compound interest. For example, a 26-year-old who saves $100 a month in either a 403(b) or 401(k) will have $443,000 by the time he or she retires at age 66. If, instead, the money were not in a tax-advantaged account, the value would be only $240,000. 

403(b) vs. 401(k): Differences
The main difference is the type of employer who can offer these plans. Unlike 401(k) plans that are offered by for-profit companies, 403(b) plans are only available to employees of tax-exempt, nonprofit institutions like schools, hospitals, and charities. Employers offering 403(b) plans rarely match their employers' contributions, which is common among 401(k) plans. And because these types of employers don't generate a profit, 403(b) accounts can't accept profit sharing from the company. Further, the organization has no ownership of the 403(b). Its only legal obligation is to deposit employees' salary deductions into the account.

403(b) programs boast a much simpler review and certification process because they're generally exempt from the Employee Retirement Income Security Act (ERISA). ERISA requires that other tax-deferred accounts like 401(k)s undergo periodic reviews known as "discrimination testing". 403(b)s also don't require special accounting. Altogether, there's less administrative burden on the organization than there is on the employer that offers a 401(k).

403(b) vs. 401(k): Bottom line
Regardless of whether your employer offers a 403(b) vs. 401(k), retirement plans like these are the best way to safeguard your financial future. Knowing the ins and outs of your plan and saving for retirement today will allow you to reap the rewards later.

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Nicole Seghetti
seghetti

Nicole is a contributing writer for The Motley Fool. She's worked as a financial advisor and planner for over a decade. Nicole holds an MBA from the University of the Pacific and a chemical engineering degree from Purdue University. She welcomes you to follow her on Twitter.

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