The Basics: 401(k), 403(b), 457, Roth IRA, and Traditional IRA

There tends to be a quite a bit of confusion between all of the different letters, like Roth IRA, and numbers associated with the various retirement accounts. Many people believe that 401(k)s are “better” than 403(b)s. Many also believe that a Roth IRA performs better than a 401(k).

The confusion stems from the simple misunderstanding about what exactly all of these numbers and letters mean – something I’ve commonly heard referred to as the alphabet soup.

Umbrella

They’re All RETIREMENT Accounts

The first thing to understand about the 401(k), 403(b), 457, Roth IRA, and Traditional IRA is that they’re all retirement accounts.

The best way to explain this is to simply look at all of these numbers/letters as a big umbrella.

An umbrella typically protects us from rain, but in this instance they’re protecting your assets from taxes.

Without getting into extreme details and the caveats to everything, retirement plans all have similar features:

They Grow Tax-Deferred (an Umbrella)

Tax-deferred growth simply means that you do not get a tax bill for all of the money (interest) that you earn each and every year.

This is different than a normal brokerage or bank accounts that you earn interest in, in which you will get a 1099-INT form at the end of each year and pay taxes on your earnings.

The major benefit of the tax-deferred growth is that you’re allowed to keep more money in your account that’s earning interest every year. So the effect of compound interest is greater in a Tax-Deferred account (401(k), 403(b), Roth IRA, etc) than in a Taxable account (brokerage, CD, money market, savings account, etc).

You Get Penalized if You Withdrawal the Money Before Age 59 1/2

While there is the benefit of Tax-Deferred growth, the government certainly wouldn’t allow you to have too much of a good thing, so there is a stipulation on when you can begin withdrawing your money.

While there are scenarios where you can get to this money prior to age 59 1/2, it’s wise for most people to assume they can’t touch it. It is in-fact a RETIREMENT account; that’s why you’ve been putting money in there…so keep your hands off!

The Amount You Withdrawal is 100% Taxable

If you withdrawal the money before or after age 59 1/2, every penny that you withdrawal is 100% taxable. The only account where this rule doesn’t apply is the Roth IRA (assuming you take it out after age 59 1/2).

The 401(k), 403(b), 457, and Traditional IRA are all funded with PRE-TAX dollars – which simply means you’ve yet to be taxed on all of the money you’ve put into those accounts.

With that understanding, it’s important for you to realize that you WILL pay taxes on your contributions and earnings upon withdrawal (you will only pay taxes on the amount you withdrawal in that given year, not the entire account balance).

A Roth IRA does not PERFORM Better Than a 401(k)

Hopefully with my explanation above you now understand that a 401(k), 403(b), 457, Roth IRA, and Traditional IRA are simply retirement accounts.

So the notion that your Roth IRA PERFORMS better than my 401(k) is plain false.

The performance of your retirement account is based on what you own inside of your UMBRELLA.

So, if my 401(k) and your Roth IRA were invested in exactly the same mutual fund, then their performance would be precisely the same.

Sure, you have more investment options in a Roth IRA, but that doesn’t guarantee it will perform better.

Let’s look at some quick facts about each of these umbrellas in hopes that you can learn more about each of the primary retirement accounts:

What is a 401(k)?

  • Most private and public companies (depending on size) offer the 401(k).
  • It’s a defined contribution plan which companies started to offer in the 80′s to take the place of pensions.
  • Account is funded with pre-tax dollars.
  • Grows tax-deferred and whatever you withdrawal is 100% taxable in the year you withdrawal it.
  • Penalized 10% (on top of paying taxes) on any withdrawals prior to age 59 1/2 (there are some exceptions).
  • Annual contribution limit of $17,000 for 2012 (or no more than 50% of your income – whichever is lower).
  • If over age 50, you can contribute an additional $5,500/year (catch-up provision).
  • Common for employers to match a portion (usually in percentage) of your contribution.
  • Required Minimum Distributions (RMDs) – at age 70 1/2 you will be required to start withdrawing a portion of money in this account (usually 3-4%).

What is a 403(b)?

  • Used by Public Education and non-profit organizations (i.e. churches, hospitals, etc).
  • Sometimes referred to as a ‘Tax-Sheltered Annuity’ although there are often other investment options inside of them.
  • Account is funded with pre-tax dollars.
  • Grows tax-deferred and whatever you withdrawal is 100% taxable in the year you withdrawal it.
  • Penalized 10% (on top of paying taxes) on any withdrawals prior to age 59 1/2 (there are some exceptions).
  • Annual contribution limit of $17,000 for 2012 (or no more than 50% of your income – whichever is lower).
  • If over age 50, you can contribute an additional $5,500/year (catch-up provision).
  • If you have at least 15 years of service with that organization you can contribute an additional $3,000/year.
  • Common for employers to match a portion (usually in percentage) of your contribution.
  • Required Minimum Distributions (RMDs) – at age 70 1/2 you will be required to start withdrawing a portion of money in this account (usually 3-4%).

What is a 457?

  • Used primarily for government employees.
  • Account is funded with pre-tax dollars.
  • Grows tax-deferred and whatever you withdrawal is 100% taxable in the year you withdrawal it.
  • Is not penalized 10% for early withdrawals as this is technically a “deferred compensation” plan.
  • Annual contribution limit of $17,000 for 2012 (or no more than 50% of your income – whichever is lower).
  • If over age 50, you can contribute an additional $5,500/year (catch-up provision).
  • Common for employers to match a portion (usually in percentage) of your contribution.
  • Required Minimum Distributions (RMDs) – at age 70 1/2 you will be required to start withdrawing a portion of money in this account (usually 3-4%).

What is a Traditional IRA?

  • IRA = Individual Retirement Account.
  • Opened by you (outside of work) and funded by you (outside of work).
  • Account is funded with pre-tax dollars (you write off contributions as a deduction when you file taxes).
  • Grows tax-deferred and whatever you withdrawal is 100% taxable in the year you withdrawal it.
  • Penalized 10% (on top of paying taxes) on any withdrawals prior to age 59 1/2 (there are some exceptions).
  • Annual contribution limit of $5,000/person/year for 2012 ($1,000 catch-up provision if over age 50).
  • Required Minimum Distributions (RMDs) – at age 70 1/2 you will be required to start withdrawing a portion of money in this account (usually 3-4%).

What is a Roth IRA?

  • Individual Retirement Account.
  • Opened by you (outside of work) and funded by you (outside of work).
  • Account is funded with AFTER-tax dollars.
  • Grows tax-deferred and everything you withdrawal (after age 59 1/2) is TAX-FREE.
  • Penalized 10% (on top of paying taxes on gains) on any withdrawals prior to age 59 1/2 (there are some exceptions).
  • Annual contribution limit of $5,000/person/year for 2012 ($1,000 catch-up provision if over age 50).
  • No Required Minimum Distributions

Picture by digitalart.

About the Author

By , on Apr 9, 2012
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the publisher of WorkSaveLive.com.

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{36 Comments}

  1. Zhubin says:

    Hi Andy!

    Thank you so much for all the postings here about different plans. They are very helpful. I have a question here: I am a public school teacher and thus have both 403 (B) and 457 with my employer. Can I also establish a traditional IRA at the same time?

    Zhubin

    • Andy says:

      You are welcome Zhubin!

      Before you make any decisions on where (which accounts) to make contributions, I’d encourage you to check out my post this coming money as I talk about the Retirement Investing Order of Priority.

      To answer your question though: you can absolutely open and contribute to a Traditional IRA while also contributing to your employers 403(b) and/or 457 plan.

  2. Shilpan says:

    I enjoyed details on all the tax deferred instruments, Andy. You can also include SEP for the business owners. I really like your to the point and precise info on the retirement account. It’s amazing that many think that one is better than the other.

    • Andy says:

      SEP and SIMPLE are both that I considered adding but I didn’t want to bring any more confusion to the already confusing topic that people face. :)

  3. Karunesh says:

    It’s a common myth that IRA would perform better than 401k in all the scenario’s. I would like to appreciate the effort you have made to compile this article. It is well researched and presented in very simplified form. With so many plans taxing is made deliberately complex.

    • Andy says:

      I agree with that! I don’t understand why the 403(b) and 401(k) can’t just be made into one plan! Why do we need two?

  4. Thanks Andy, very straightforward and I’m not even American! Looking forward to seeing your views on order of investment. If it was me I would always top up to the max the tax efficient wrapper of the 401k before investing elsewhere, but I’ll leave you to explain the order.

    • Andy says:

      They’re all tax-efficient wrappers…the 401k, 403b, 457, and Traditional IRA all perform precisely the same as far as taxes are concerned. The only one that’s treated different is the Roth IRA.

  5. Andy says:

    They’re all basically the same as the 401(k) – well, other than the 457. That’s deferred compensation, so it’s not even really a retirement account (hence the no early withdrawal penalty). It’s still tax-deferred though so it really is utilized the same as a retirement vehicle.

  6. Michelle says:

    Thanks for such an easy-to-understand explanation of the different types of retirement plans, Andy. Yes, you do get penalized….we found that out the hard way!

  7. Very nice primer on the topic of retirement accounts. I think some people find all the terminology and strange nomenclature alone so daunting they’re scared off from using these fantastic vehicles to save for retirement. So this sort of explanation is really valuable!

    • Andy says:

      I agree Kurt! Some people just get so intimidated and overwhelmed. My hope was this helped a few people out there with all the mumbo-jumbo.

  8. Am I right that, should you change jobs, you can roll these from one tax deferred account to another one?

    • Andy says:

      Thad,

      You are correct that the law allows for that, but if you’re rolling a 401(k) to another 401(k), or a 403(b) to a 403(b), or 401(k) to 403(b), etc., then it is really up to the receiving employer on whether or not they will accept the funds.

      So, really it’s up to whichever company you’re moving to and what their new plan stipulates.

      To make it a little less confusing, I simply recommend that people rollover their old employer-sponsored retirement accounts into a Traditional IRA. That way you have it out of company control and you’re fully responsible for it. It gives you a lot more investment options and gives you more flexibility.

  9. AverageJoe says:

    I think the reason many people think a 401k is better than a 403b is because many still think as a 403b as being synonymous with annuities and don’t realize that a 403b7 can include mutual funds or other investments.

    That said, I think sometimes when you compare the safety features of an expensive annuity and the free-for-all of an ugly 401k, the annuity might give someone more “bang for the buck” between two lousy choices!

  10. Katie says:

    Very interesting to hear that a Roth IRA will not outperform a 401k. Most of the articles I have read seem to be very partial to Roth’s. I love all the break downs on the retirement accounts. I am still a newbie and I need to learn the in’s and out’s before I go open an account and make a huge mistake.

    • Andy says:

      Katie,

      The tax advantages are very different between the accounts, but the actual performance (investment within the accounts) can be exactly the same. So the actual performance (return on investment) isn’t determined by the type of retirement account it is.

      Hope that makes sense. :)

  11. CultOfMoney says:

    Well done explaining the ins and outs of the various different revnue code sections for the US retirement plans! There really are a bunch of different terms that all essentially mean the same thing, with the exception of the Roth. Thanks for laying these all out for all to see, it’s really helpful.

  12. ShortRoadTo says:

    Awesome post. You have done a great job of talking about the differences and similarities. There is only one thing I would like to add. You can avoid the penalty on distributions from retirement accounts if you set up what is known as a substantial equal periodic payment (SEPP). Investopedia has a good explanation of it. http://www.investopedia.com/articles/retirement/02/112602.asp#axzz1rZQBZcxg

    • Andy says:

      Thanks SR2R! You’re absolutely correct and I appreciate you adding that.

      I wanted to avoid all of the caveats on the withdrawals for this post, but it is definitely an option that’s available if you’d like to retire before age 59 1/2.

  13. Andy says:

    That’s really all what this series is about, TB! Too many people want to talk about investing and the sophisticated elements when most of us don’t even know where or how to properly begin!

  14. Thanks for this overall summary. I had no idea what some of the contents of the “alphabet soup” were or meant.

  15. Andy – This is going to be a very helpful series! I find a lot of people get very confused by all these different plans. Thanks for also teaching me something new: “■If you have at least 15 years of service with that organization you can contribute an additional $3,000/year.”

    • Andy says:

      Yeah, I didn’t realize that fact either until I did some more research! Most people these days don’t stay at one place that long so I don’t think it’s very common.

  16. Edward Antrobus says:

    I think the idea that IRA’s perform better than 401(k)’s comes from the fact that most companies seem to provide the worst performing options on the planet. Earlier this year. my wife’s 401(k) actually started GAINING money for the first time since we got married two and a half years ago.

    • Andy says:

      LOL. The 401(k) investment options are a joke sometimes. I’ve seen some people with brutal choices, but there are certainly some plans that have great mutual funds in them.

      If they’re all bad investment options, then I’d use the Roth IRA to invest in unless your wife’s company match is good.

      • Edward Antrobus says:

        Their match is phenomonal. I’ve never been able to figure out the exact math, but a match on up to 5%, plus a bonus at the end of the year. We are only at the point of being able to contribute 1% of her income to the 401(k), but with the year end bonus, that amount is basically getting tripled.

        • Andy says:

          That is a really great match! Hopefully when you’re able to you can start taking full advantage of that thing!

  17. Nick says:

    Really great summary of the different accounts. I’m a 401(k) and Roth guy currently…. I just wish they’d increase the limits…

    • Andy says:

      I am as well, Nick! They were nice to bump the 401(k) to $17k this year. I hope they do it with the Roth but I’m just not sure they will (if they do, it won’t be much).

  18. Thanks, Andy! This is about a complete an explanation on the different types of retirement accounts that I’ve come across so far in the blogosphere. In fact, I’ve printed it out for future reference. Very nice work!

  19. Andy, Great article on the nuts and bolts of the alphabet soup! I have seen some people at my job receive 457 but never took the time to actually figure out what it was. I learn something every day!

    • Andy says:

      That is precisely true and if you didn’t learn something today then you would have wasted it! :)

      Glad I could help!

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