401(k) vs. 403(b) vs. 457 Plans: Compare Employer-Sponsored Retirement Plans
401(k) vs. 403(b) vs. 457 – the plan titles are used almost interchangeably when it comes to discussions of retirement.
But apart from the fact that all three are employer-sponsored plans, what do they have in common, and how are they different?
Surprisingly, the three popular employer-sponsored retirement plans have more in common than not.
The main differences are the employers who offer them, and maybe a few small details beyond that.
Whichever plan is offered by your employer, you should take full advantage and participate to the extent your finances will allow.
These are three of the most generous retirement plans available, offering a combination of:
- tax-deductible contributions,
- tax-deferred investment income, and
- often, employer matching contributions.
401(k)s are the most popular of the three plans. They’re offered by many for-profit employers, including the vast majority of large employers.
The main feature that distinguishes them from the other two plans is that they are offered by for-profit employers, like major corporations.
One of the factors that most distinguishes the 401(k) plan – as well as the 403(b) 457 plans, since they all have the same limits – is the very generous contribution amounts.
You can contribute up to $19,500 per year, or $26,000 if you are 50 or over (this includes a $6,500 “catch up” provision for older workers).
You can contribute the full amount up to 100% of your earned income up to the maximum contribution limits.
That means you can contribute $19,500 if you make $100,000 per year, $50,000 per year, or even $25,000.
Since the plans are employer-sponsored, you’ll typically fund them through regular payroll contributions.
Once again, not only are those contributions tax-deductible, but any investment earnings in your account are also tax-deferred.
If you withdraw funds from the plan prior to reaching age 59 ½, you’ll pay ordinary income tax on the amount withdrawn, plus a 10% early withdrawal penalty tax.
However, you can begin taking withdrawals after age 59 ½, subject only to ordinary income tax.
Required minimum distributions (RMDs)
You can allow the funds in your 401(k) plan to continue growing even after you retire. But you will be required to begin taking RMDs beginning in the year when you turn 72.
RMDs will begin at approximately 4% of your plan balance, with the percentage increasing slightly each year throughout the remainder of your life.
The basic idea of the RMD is to force funds out of the plan so that they will become taxable. That’s unfortunate, but that’s the way the plan is set up.
You’ll generally be limited to investment options contained in your employer plan.
That may restrict you to a single mutual fund family, or a large, diversified brokerage firm allowing you to invest in anything you want.
However, you won’t be able to select the broker that will hold your account – that decision is made entirely by your employer.
The 403(b) plan is set up very similar to the 401(k), except it’s designed for a different employer.
In most respects, it works the same way as the 401(k).
The same contribution limits, withdrawal provisions and required minimum distributions.
But there are two important respects in which 403(b) plans depart from 401(k)s.
The first is that the 403(b) plan does not hold the potential to offer a profit-sharing arrangement. Fundamentally, this is because the 403(b) is offered specifically by non-profit organizations and government agencies that do not produce profits.
Under a very generous 401(k) plan, a profit-sharing plan may be offered that will allow employees to receive up to 25% of their income in profit-sharing, up to a maximum of $57,000 per employee. However, this benefit is offered by only some 401(k) plans, and is hardly universal.
The other major difference is that 403(b) are not subject to income discrimination rules. 401(k) plans are subject to income limitations imposed under highly compensated employees, or HCEs.
The short explanation is:
Employees who own at least 5% of the business, earn at least $130,000 per year and are in the top 20% of employees by pay will see their contributions limited.
Employer matching contributions unlikely
However, the absence of the HCE restriction only applies if the employer does not make a matching contribution.
If they do, the HCE restriction applies.
This is why very few employers offering the 403(b) plan make a matching contribution.
More limited investment options
403(b) plans are typically set up like annuities and run by insurance companies.
That will limit your investment options to those offered by the insurance company, if you’ll have any flexibility in that area at all.
If 403(b) plans are offered by nonprofits and governments, 457 plans are provided almost entirely by governments.
That includes state and local governments, though not federal government employers.
Among the three major employer-sponsored plans, 457s are the least common.
457 plans have the same contribution limits and required minimum distribution rules.
However, since like 403(b) plans, 457 plans are sponsored by non-profit generating employers, they similarly don’t offer employer matching contributions.
However, they are not subject to the 10% early withdrawal penalty if funds are withdrawn prior to reaching age 59 ½.
But the 457 plan has a major advantage not offered by either the 401(k) or 403(b). It has a special catch-up deferral, referred to as the “last three-year catch-up”.
It allows you to defer in three years before you reach the plan’s normal retirement age, up to twice the normal annual contribution of $19,500.
That means it will be possible to contribute up to $39,000 in each of the last three years you participate in the plan.
How Do You Go About Choosing Between the Three Plans?
In most cases, you won’t have a choice as to which plan you’ll participate in.
That's to say:
Your choice is determined by the type of employer you work for.
If it’s a private, for-profit corporation or business, you’ll most likely be offered the 401(k) plan. But if it’s a non-profit or government agency, you may be offered either the 403(b) or 457 plan.
However, a very limited number of government agencies offer a 401(k) in addition to either a 403(b) or 457 plan.
And in some cases you may have different plans with different employers.
For example, you may begin the year with a government agency that offers a 457 plan and end the year with a private corporation offering a 401(k) plan.
If you have an opportunity to participate in both plans, the maximum annual combination of contributions will be $57,000, or $63,500 if you are 50 or older. That includes your own regular contributions, catch-up contributions, and any employer matching contributions.
How to Best Manage Your 401(k), 403(b) or 457 Plan
If your employer offers any of the above three plans, you should participate.
Even if you’re covered by a defined benefit pension plan – which few workers are these days – a tax-deferred retirement savings plan can be an excellent supplement to a regular pension and monthly Social Security check.
By contributing as much as you can, you’ll not only get the benefit of a lower annual tax bill, but you’ll build a large retirement nest egg more quickly.
If that’s done early in your life and consistently thereafter, it may eventually open the opportunity to early retirement.
Employer matching contributions
This applies primarily to 401(k) plan participants. But even then, employers are not required to offer a matching contribution, though many do.
At a minimum, you should make the smallest contribution you can to get the largest employer match.
For example, if your employer will match 50% of your contribution, up to 3% of your salary, you should contribute at least 6% of your pay to the plan. That will not only maximize the employer matching contribution, but also get you an effective 9% annual contribution rate.
Explore Roth options
Many employers offering any of the three plans also provide a Roth option.
If offered, your contributions to the Roth portion will not be tax-deductible.
However, investment income will accumulate in the plan on the tax-deferred basis.
Upon reaching age 59 ½ – and if you’ve participated in the plan for a minimum of five years – you’ll be able to begin taking distributions from the Roth portion of your plan on a tax-free basis.
It’s an excellent strategy to create tax diversified retirement income.
If an employer does offer a Roth option, you’ll generally be given the ability to determine how much of your plan contribution will go to the regular plan and how much to the Roth portion.
But if you choose, you’ll be able to direct up to 100% of your total contributions into the Roth portion.
One factor to be aware of however is the employer match.
If the employer does match your contribution to the Roth portion, it will not go into your Roth account. Instead, it will be placed into a regular plan, even if you don’t have one in place. That’s because while your own contributions to a Roth account can potentially be withdrawn tax-free, employer matching contributions cannot.
Be Careful of Loan Provisions
An employer can offer a loan provision on any of the three plans, but it’s not required to do so by the IRS.
If a loan provision is offered, it’s limited to not more than 50% of your vested plan balance, up to a maximum of $50,000. It must generally be repaid in not more than five years.
But as convenient as retirement plan loans are, use them sparingly. Even if they are technically “paying interest to yourself”, that “return” is generally lower than what you’ll earn on other investments.
Since part of your retirement contributions will be going toward loan repayment, this will reduce the future value of your plan.
Also be aware that if you terminate your employment before the loan is repaid, you’ll be required to repay the loan proceeds within 60 days of departure.
If not, the employer is required to consider the unpaid portion of the loan to be a distribution.
Not only will it be subject to ordinary income tax, but also the 10% early withdrawal penalty tax if you are under age 59 ½.
What Happens to Your Plan When You Terminate Your Employment?
Whether you have a 401(k), 403(b) or 457 plan, you’ll be given one of four options when you terminate your employment:
- Keep the plan where it is.
- Roll the plan over to a comparable plan with a new employer.
- Roll the plan over to a traditional IRA account.
- Take distribution of the plan funds personally.
If you choose one of the first three options, there’ll be no tax consequences.
But if you choose the fourth option, the total amount of the distributed funds will be subject to ordinary income tax, as well as the 10% early withdrawal penalty if you’re under age 59 ½.
401(k), 403(b) and 457 plans are among the most generous defined contribution plans available.
If offered by your employer, you should take full advantage.
Invest as much as you can, as early as you can, since that will create the greatest growth in your plan.
If you heavily fund your plan early in life, you may have sufficient funds that you can either reduce future contributions or eliminate them entirely.