As a physician at a local hospital, my wife has three different retirement account options available to her through her employer. While I think it’s great that they’re providing these avenues for their employees to save for the future, it’s also a little bit confusing.
What’s the difference between a 401(k), 457(b), and 403(b) plan? And, where did they get such creative names?
While they may sound like droids from the Star Wars films, 401(k), 457(b), and 403(b)s are different types of employer-sponsored retirement plans named after the sections in the Internal Revenue Code that allows for their establishment.
Employee contributions are made through payroll deductions as a percentage of salary. The individual contribution limit for each is $18,500 for 2018 with an additional $6,000 available to those over age 50. You can contribute to more than one plan at a time, but which plans you have will affect your contribution limits. If you have both a 401(k) and a 403(b) at the same time, the annual limit applies to both accounts combined. A 457(b) account does not count towards that limit. So, you can contribute $18,500 to both your 401(k) and 403(b) combined (or just one) plus an additional $18,500 to a 457(b) plan.
All plans are permitted to offer loans to participants, though the requirements are decided by each specific plan. They also all require participants to begin taking distributions at age 70 ½.
The 401(k) is the most popular retirement plan because it is what most private-sector employers offer, though some nonprofits also offer them. They are qualified plans, which means they are governed by the Employee Retirement Income Security Act (ERISA). As such, withdrawals made before age 59 ½ are subject to a 10% penalty in addition to regular income tax rates. With some plans, early withdrawals are allowed for “hardships” as laid out by plan documents.
Normally, 401(k) contributions are made pre-tax and growth is tax-deferred. The money is only taxed when distributed. However, some plans offer Roth options as well, where money is contributed after being taxed and distributions are made tax-free. With a Roth, growth is not taxed. Investment options are usually limited to a select few within a 401(k) and independent contractors are not able to participate. Employer matching contributions are common with 401(k) plans, and they do not count towards the annual employee contribution limit.
There are actually two kinds of 457 plans, (b) and (f). The 457(b) is by far the most common, so if your workplace plan is referred to without a letter it is most likely a 457(b). This is the most unique of the three plans we are discussing. It is non-qualified, which means it is not subject to ERISA. Also, if you change employers, you can withdraw your money without penalty.
There is no Roth option available for 457(b) plans, so all contributions are tax-deferred and distributions are taxed at your current income tax rate. One special thing about 457(b) plans is the “3-year catch-up” rule. If you are within 3 years of retirement as specified by your plan, you can contribute either twice the annual limit or the annual limit plus amounts allowed in prior years that you didn’t contribute. However, you may not make use of both the “3-year catch-up” and the age 50+ catch-up of $6,000 at the same time.
Another feature of the 457(b) plan is that you can roll over unused contributions if you are not using one of the catch-up options. So, if you only contribute $10,000 in 2018, you can contribute an additional $8,500 in 2019 on top of the annual limit.
Unlike the other plans, any employer matches count towards the $18,500 annual limit. However, most government employers don’t match, which makes it irrelevant. Independent contractors are also allowed to participate, in contrast to 401(k) plans. Finally, as long as you maintain employment with the plan sponsor, you are not allowed to withdraw any funds until you reach age 70 ½.
Also called a tax-sheltered annuity plan, 403(b)s are very similar to 401(k) plans. Employers can make matching contributions without affecting an individual’s annual limit. As with other qualified plans, participants face a 10% penalty for withdrawing funds before age 59 ½, unless they are separating from their employer after age 55, using the funds for qualified medical expenses or become disabled. Withdrawals not rolled over directly into another retirement account are subject to 20% federal tax withholding.
One unique feature of the 403(b) is the “15-year catch-up” contribution. Employees who have been with the plan sponsor for over 15 years are able to contribute an additional $3,000 each year.
Here is a graph that shows the similarities and differences between the three plans:
All three kinds of retirement plans can be excellent savings vehicles. However, it can be confusing to sort through them and determine which is best for you. If you would like help analyzing your retirement options and coming up with a plan to optimize them, send me an email at firstname.lastname@example.org or call my office at 985-605-7185.
With nearly two decades of experience in the financial services industry, Jeremy Smith serves as a dedicated and knowledgeable financial advisor and the founder of Harbor Wealth Management. He specializes in serving retirees, pre-retirees, small business owners, and widows, providing a comprehensive array of investment management and financial planning services. Jeremy aims to serve his clients as a financial guide who is here for their every need, helping families find lasting solutions so they can focus on what matters most to them. To learn more about Jeremy, visit www.myharborwm.com or connect with him on LinkedIn.
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The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. You should discuss your specific situation with the appropriate professional.