By Anne-Lyse Wealth, WCI Contributor
There are many different ways to save for retirement in tax-advantaged accounts. Two of the best known (and most commonly available) are the 403(b) and the 401(k). With both accounts, the employer takes a percentage of your salary before it's taxed and deposits it into one of those accounts (and perhaps the employee even matches the contribution). Then, the money grows in the account, and you don't pay taxes on it until you withdraw it many years later. The idea, of course, is that when you take the money out in retirement, you'll be in a lower tax bracket than you were when the contribution was made, meaning you'll have saved yourself from paying higher taxes.
But the 403(b) and the 401(k), while similar in many ways, have some key differences. Here's what you need to know about both kinds of retirement savings accounts.
What Is a 401(k)?
A 401(k) is a qualified savings plan in which employees can contribute a portion of their income before taxes toward an individual retirement account. It allows employees to set money aside for retirement while also reducing their tax liability compared to investing in a taxable brokerage account.
An employee who participates in their company's 401(k) plan agrees to have a percentage of each paycheck directly sent to the 401(k) plan. The employee can then decide how to invest the money based on the options available in the plan—usually mutual funds, stocks, bonds, and exchange-traded funds. Each employee can select their investment options based on their risk tolerance.
Traditional vs. Roth 401(k) Plans
With a traditional 401(k) plan, employees can use a portion of their salary to fund their 401(k) plan, up to the maximum contribution amount that year, $20,500 in 2022 if you are under 50 and an additional catch-up contribution of $6,500 if you are 50 or older. An employee's contributions are automatically deducted from the employee's paycheck, which lowers the employee's gross income that year. As a result, the employee's taxable income for that year is reduced by the amount of the 401(k) contributions. In addition, taxes will be deferred until the employee starts withdrawing money out of the 401(k), which usually happens at retirement (after the age of 59 1/2) to avoid a 10% penalty unless an exception applies.
A Roth 401(k) allows employees to make annual contributions up to the maximum amount that year—$20,500 in 2022 if under 50 and an additional $6,500 if you are 50 or older.
Similar to a traditional 401(k), contributions in a Roth 401(k) are made from earned income. However, Roth 401(k) contributions are deducted from the individual's taxable income and will not provide tax benefits upfront. Contributions in a Roth 401(k) are taxed before being added to the account as they come from an employee's after-tax pay; but the earnings grow tax-free. An individual can also withdraw their Roth 401(k) contributions at any time without penalties as long as they have had the account for at least five years. In addition, there are no taxes to pay on the investment earnings when withdrawn at retirement age.
With a Roth 401(k), an individual pays taxes upfront on the contributions, which do not have to be subject to taxes at retirement. When earnings are withdrawn mostly at retirement age to avoid penalties, unlike with a traditional 401(k), there won't be any taxes to pay.
A solo 401(k) plan is designed for self-employed individuals or business owners who do not have other full-time employees, aside from a spouse. With a solo 401(k), an individual can contribute both as an employee and as an employer up to the contribution limit that year. In 2022, the total solo 401(k) contribution limit is $61,000, plus an additional catch-up contribution of $6,500 for anyone 50 or older.
Solo 401(k) contributions reduce business income as they come directly from the business.
A business owner can decide between a traditional solo 401(k) or a Roth solo 401(k). Again, the difference would be whether contributions are in pre-tax dollars or after-tax dollars, which will either defer taxes on contributions (traditional) or involve taxes upfront (Roth).
The Roth account reduces your spending power in the year of contribution, which impacts your current budget and reduces your tax liability at retirement. Whether a traditional or a Roth account is more appropriate for you depends on how much room you have in your budget and your future income tax bracket.
Most companies with 401(k) plans offer a contribution match to their employees up to a certain amount. On average, companies match up to 4.3% of an employee’s pay, with the most common match being 50 cents for every dollar contributed by the employee up to the limit designated by the company. While 71% of companies offer a 50% match, about 20% of companies provide a dollar-for-dollar match up to the contribution limit—up to 3% of the employee's salary on average.
Should You Do a Traditional 401(k) or a Roth 401 (k)?
If your budget is tight, taking advantage of the tax deduction upfront via a traditional account might be the best option for you. At retirement, if you anticipate that your income tax bracket will be higher than it is right now, then a Roth account is something to consider. On the opposite side, if you expect to be in a lower income tax bracket at retirement, like most doctors and other high earners, then avoiding taxes on earnings later by contributing into a traditional account might be best for you.
But if you are decades away from retirement, you cannot necessarily predict which income bracket you'll be in at retirement.
So, here are some guidelines about whether it's better to do a traditional or a Roth 401(k):
- If you’re a resident or military member, maximize Roth contributions.
- If you’re in a low-income year for any reason, such as a sabbatical, use Roth contributions.
- Use a personal and spousal Backdoor Roth IRA each year. That way, even if you choose to make all traditional 401(k) contributions, you’re still getting some money into Roth accounts.
- If you can pay the tax with money in a taxable account and expect to work part-time or retire in your 50s, then consider making Roth conversions during those years before receiving Social Security or a pension to “fill up the lower brackets.”
- If you save and invest more than 20% of your gross income, lean a little more toward Roth investments. If you save and invest less, use tax-deferred accounts preferentially.
Remember, the most important consideration in the Roth vs traditional 401(k) debate is your current tax rate and how it will change when you retire (most doctors currently in their peak earning years are going to be better off deferring taxes whenever possible).
What Is a 403(b)?
A 403(b) is a retirement account that allows public employees—such as teachers, doctors, nurses, librarians, and other employees in tax-exempt organizations—to set some money aside to invest for retirement.
403(b) plans also offer a traditional and a Roth option. Contributions in a traditional 403(b) are made through payroll deductions, which offer a tax benefit upfront. Employees will pay taxes on contributions upon withdrawals at 59 1/2 in most cases to avoid a withdrawal penalty or in a Roth 403(b) in after-tax dollars, which will defer the tax benefits until retirement.
In a 403(b) plan, the employee can usually invest contributions into mutual funds and annuities.
403(b) Contribution Limits
Annual contribution limits for 403(b) plans are the same as 401(k) contribution limits: $20,500 in 2022 if you are under 50 and an additional catch-up contribution of $6,500 if you are 50 or older. Also, employees with 15 years or more of service with specific government agencies or nonprofit organizations can contribute up to an additional lifetime limit of $15,000.
Difference Between 401(k) and 403(b)
The 401(k) and the 403(b) offer similar options to employees; however, the 403(b) generally has fewer investment options compared to a 401(k). As noted by Investopedia, 401(k)s are usually run by mutual fund companies, while 403(b)s are run by insurance companies. That's one reason why 401(k)s tend to have more investment options than a 403(b).
Both 401(k)s and 403(b)s allow for a maximum contribution of $20,500 in 2022. If you're older than 50, you can also put another $6,500 into a 401(k) and a 403(b) because it falls into the category of catch-up contributions. If you have a 401(k) or a 403(b), the total annual limit in 2022 that includes your contributions and the contributions of your employer is $61,000 (or $67,500 with catch-up contributions).
But for employees with 15 years or more of service for the same organization, the 403(b) actually offers slightly higher contribution limits (there's the $20,500 per year you can contribute in 2022 plus an additional contribution of $3,000 per year up to a lifetime maximum of $15,000).
You also should be aware that using a 403(b) prevents many doctors from maxing out their individual 401(k) if they own 50% or more of the company that is providing that individual 401(k) (hint: they probably do). Basically, your 403(b) at work, unlike a 401(k), is considered to be controlled by you. So, you are stuck with the same limit of $61,000. That means if you put $20,500 into your 403(b) at work, you are only allowed to put $61,000-$20,500=$40,500 into an individual 401(k).
Which Is Better – 401(k) vs. 403(b)?
401(k) plans are offered by for-profit organizations, while tax-exempt organizations offer 403(b)s. The choice between a 401(k) and a 403(b) plan is usually not up to you but up to your employer. Whether your employer offers a 401(k) or a 403(b), the most important thing to do is participate and invest money toward your retirement while taking advantage of tax breaks. For a physician, it's one of the best (and easiest) ways to build wealth on the way to financial independence.
If you need extra help with planning for retirement or have
questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
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