Taking advantage of workplace retirement plans is a great way to save money on your taxes and build up your retirement nest egg. Employer plans come in different flavors, with strange names like 401(k) and 403(b). Fortunately, in the battle of 403(b) vs. 401(k), everyone can end up a winner by making smart decisions based on their individual circumstances.
403(b) vs. 401(k): The basics
Most people are relatively familiar with a 401(k) plan, because they're much more commonly seen than 403(b) plans. Employers that set up a 401(k) plan give their employees the ability to set aside a portion of their paychecks toward retirement, typically on a pretax basis using traditional 401(k) accounts, but also sometimes on an after-tax basis if the plan has a Roth 401(k) option. Ample annual limits apply to the 401(k), with those under age 50 eligible to contribute up to $17,500 in 2014 and those 50 or older allowed to save $23,000. Assets within 401(k) plans grow tax-deferred, sheltering you from taxes on the investment income those assets generate over the course of your career.
On the other hand, 403(b) plans are less common than 401(k) plans. The reason is simple: Section 403(b) of the Internal Revenue Code, on which 403(b) plans are based, limits eligible participants to employees of tax-exempt organizations such as schools, hospitals, and religious groups. The same contribution limits apply to 403(b) plans as 401(k) plans, and 403(b) plans have the same tax-deferral benefits.
403(b) vs. 401(k): How you can invest
Both 401(k) plans and 403(b) plans allow employers to establish menus of investment choices for their employees. However, the permissible range of investments differs between the two types.
401(k) plans can choose from a wider range of investments, ranging from mutual funds and exchange-traded funds to individual securities. Most employers are more restrictive in their investment selections, typically emphasizing funds but sometimes making a brokerage-account option available to those who want more investment flexibility.
403(b) plans, on the other hand, can only invest in annuities and mutual funds. Originally, 403(b) plans could only offer annuities, leading to their alternative name of tax-sheltered annuity plans. But 40 years ago, lawmakers expanded the rules to allow registered investment company shares -- that is, mutual funds -- as permitted options employers could give their employees.
403(b) vs. 401(k): What to watch out for
403(b) participants need to be careful about the extent to which their employers actually participate in the plan administration. Many 403(b) plans aren't subject to the same regulation as 401(k) plans, allowing employers to step back and put more of the onus on participants to oversee their accounts. Although they're allowed, employer matches and other employer contributions aren't necessarily as common for 403(b) plans as they are for 401(k) plans. That said, private employers with 401(k) plans tend to be stricter about vesting requirements than 403(b) plan providers, which means 403(b) participants who are fortunate enough to get a match often reap the rewards sooner than 401(k) participants do.
Most important, it's essential to know the characteristics of investment options in 403(b) plans. Make sure you know how much in annual expenses you'll pay to invest in a particular fund or annuity. Ask whether any surrender charges or other fees apply if you sell your investment or switch to another type of fund or annuity. These charges can be extremely high, wiping out most or all of the tax benefit of using the 403(b) plan. Also watch out for different classes of mutual funds, which can have big disparities in annual charges. Lastly, make sure the insurer issuing any annuities you decide to buy has a strong insurance rating for financial security.
Most of the time, in comparing 403(b) vs. 401(k), you as the employee won't have a choice. But don't let the unfamiliarity of 403(b) plans keep you from taking advantage of their benefits.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.