Differences in 401k and 403b Plans
QUESTION: I was interested in your recent column on 401k salary reduction plans because I am enrolled in a plan that is very similar but has a different name: 403b. How are they different?--D. A. P.
ANSWER: There are two key differences, one critical to employees and the other of importance to employers.
The 403b is a so-called non-qualified plan, meaning that it doesn’t qualify for the special tax treatment to which many retirement plans are entitled. That is an important distinction for you and other employees enrolled in the 403b plans because it means that your tax bill will be bigger when you withdraw your money.
Money withdrawn from a 401k salary reduction plan--which is a qualified plan--is taxed, too. But the tax owed on these funds is figured using 10-year income averaging, a special tax treatment that was designed to ease the tax burden on taxpayers whose income rises dramatically in a single year because of a distribution from a retirement plan.
The 403b plan doesn’t qualify for this special tax treatment.
These plans are more accurately known as tax shelter annuity contracts but are sometimes called salary reduction plans because they are entitled to adopt that feature.
The terms salary reduction plan and 401k plan often are used interchangeably. But a 401k savings plan can be designed without a salary reduction feature. Incidentally, salaries of employees enrolled in salary reduction plans are “reduced” by the amount of the contributions for tax and accounting purposes only. The participants don’t actually take a pay cut.
The 403b plans are most often used by nonprofit organizations and colleges and universities, many of which were offering 403b plans to their employees long before the advent of 401k plans.
Despite the tax disadvantage for their employees, some employers still prefer 403b plans over their 401k cousins because they don’t have to meet stringent and complicated non-discrimination rules as they do with the 401k. These rules are designed to ensure that the plan is available to all of the company’s employees--not just the top executives and best-paid salaried employees.
Employers also have a freer rein in determining when employees may withdraw money from a 403b plan. The IRS frowns on early withdrawals from a 401k except in emergencies--the most notable of which are disability, college expenses and the purchase of a first home--or upon the employee’s death.
But the government gives employers much more leeway in setting the rules for withdrawal of money from a 403b plan.
Thus, some 403b participants can easily get their hands on their money when they need it. But others find it even harder to withdraw funds from a 403b than from a 401k. Ask your employer if you’re unsure of your plan’s withdrawal rules.
Q: Your recent column on 10-year averaging was very helpful, but did the rules you cited apply to retirement funds distributed by a tax-exempt institution? One of the tax advice books that I own warns employees of tax-exempt institutions that such averaging isn’t available to them for lump-sum distributions.--J. W. O.
A: That is good advice--but only for certain types of retirement plans available to tax-exempt institutions.
Employees of tax-exempt institutions who are enrolled in so-called 403b retirement plans should heed that warning. Distributions from that type of plan are not classified as lump-sum distributions by the IRS and therefore don’t qualify for the more favorable 10-year income averaging tax treatment.
So it is the type of plan and not the type of institution offering the plan that is important here.
As 401k salary reduction plans have become popular, some tax-exempt institutions have traded in their 403b plans for 401k plans. The latter do qualify for 10-year averaging treatment--regardless of whether they are offered by a for-profit or nonprofit business. So be sure to find out which type of plan you have.
If you are enrolled in a 401k plan from a tax-exempt institution, you should know that they are controversial and that the Treasury Department would like to ban them as part of its drive for tax reform.
Why shouldn’t employees of tax-exempt institutions be entitled to the same type of retirement plan as employees of for-profit businesses? The arguement is that 401k plans are a type of profit-sharing or stock bonus plan and that, since nonprofit businesses don’t distribute stock and theoretically have no profits to share, they have no right to offer a 401k plan.
Nonprofit employers counter that nonprofit businesses are entitled to make a profit; they just cannot distribute that profit to the public. They argue that sharing these profits with employees is quite a different matter and that there is no law prohibiting that. The IRS, in an internal legal memo, has argued that this interpretation is valid as long as certain rules are met.
Q: I am 50 years old and have never owned stock in a company. Now that my children are through college and living on their own, my husband and I are a little braver than before and are thinking about buying some stock. We have a very basic question for starters. What is the difference between an income fund and a growth fund? That is the first question we have been asked by three different brokers and we were too embarrassed to admit that we don’t know what they mean.--T. M.
A: Income funds are a more conservative investment, and growth funds are for the more aggressive investor. But many investors divide their investments between the two.
Say you have $10,000 to invest. Depending on your temperament, you may feel comfortable putting the bulk of it in the stocks of a big, established (blue-chip) company with a tradition of profitability and steady dividend payments (this is the income from which the income fund takes its name) and $2,000 or $3,000 in a riskier growth fund, where your chances of winning big or losing big are much greater.
Growth funds take their name from the fact that they invest primarily in the stocks of established but still growing companies, or of aggressively managed companies that are growing significantly faster than the economy.
Income funds, because they generally pay quarterly dividends and invest their money in blue-chip stocks and high-grade government and corporate bonds, are popular among retired individuals.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.
