In the world of obscure IRS tax code references, 401(k) retirement plans get most of the attention, but 403(b) plans are surprisingly common. 403(b)s cover around one in five U.S. employees with around a trillion of savings in 403(b) plans. That’s a lot, so here we’ll run through how these plans work. Plus, we’ll look at how 403(b) plans differ from their more frequently referenced 401(k) cousins. There are more similarities than differences, but the differences can matter. Also, because minimum standards sometimes don’t apply to 403(b) plans, they can be more of a mixed bag than 401(k)s.
What Is a 403(b) Plan?
A 403(b) plan is a tax-sheltered annuity (TSA) plan offered to employees of tax-exempt organizations such as nonprofits, churches, hospitals, and public education institutions. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians. Employers might offer these retirement savings plans as part of an employee’s benefits package, and they can actually benefit both parties.
Employees can have their employers defer portions of their pay to these retirement accounts so that these earnings aren’t subject to income tax until the money is later withdrawn. Employers can match employees’ contributions.
How Does a 403(b) Plan Work?
Just as with a 401(k) plan, you have the option to invest your money in conservative, middle, or high-risk investments when you defer your earnings to a 403(b) plan.
You can balance your 403(b) portfolio between riskier and safer investments by talking to a human resources representative at your company. You might also seek the advice of a financial advisor.
You can take the money with you if you change jobs after you’re vested in the plan, but you might have to roll it over into an IRA account. You’ll lose your employer’s contributions if you’re not vested, but you’ll keep the money that you’ve personally put into your plan.
You own your 403(b) plan when you’re “vested” in it. The percentage that you’re vested increases with each additional year of employment. Your employer can’t take back any contributions they made after you’re 100% vested.
Some employers will require that you roll the account over, while others will allow you to stay with your current plan as long as you have a specific amount in the account. Your human resources representative should be able to answer your questions or connect you with someone who can.
403(b) Plans vs. 401(k) Plans
The 403(b) plan is in many ways similar to its better-known cousin, the 401(k) plan. Each offers employees a tax-advantaged way to save for retirement. Both have the same basic contribution limits: $19,500 in 2020 and 2021. The combination of employee and employer contributions are limited to the lesser of $58,000 in 2021 (up from $57,000 in 2020) or 100% of the employee’s most recent yearly salary. Also, both offer Roth options and require participants to reach age 59½ to withdraw funds without incurring an early withdrawal penalty. Like a 401(k), the 403(b) plan offers $6,500 catch-up contributions for those age 50 and older in 2020 and 2021.
Differences
| 403(b) Plans | 401(k) Plans |
| These plans are offered by tax-exempt organizations. | These plans are offered by for-profit companies. |
| Employers can and usually do match an employee’s contributions. | Employers can only match an employee’s contributions subject to ERISA rules. |
| Investment options are limited to annuities and mutual funds. | Investment options include annuities, mutual funds, stocks, and bonds. |
Pros and Cons of 403(b) Plans
Benefits of a 403(b) plan for an employer include the ability to attract and retain employees by offering matching benefits. A company might offer to match employee contributions to their 403(b) plan dollar-for-dollar on the first 5% of payroll.
Advantages for employees include:
- Pre-tax contributions to a 403(b) plan and earnings on these amounts are not taxed until they’re distributed from the plan.
- Money in a 403(b) can grow tax-deferred for decades, resulting in far more wealth for the owner of the account. They’ll only pay taxes on the funds when they begin to take withdrawals from their 403(b) accounts.
- You might be eligible to take a tax credit for elective deferrals contributed to your 403(b) account.
- Account-holders can take loans against their 403(b) plans if they’re in need of cash in an emergency. But these 403(b) loans must be paid back, just like their 401(k) counterparts, or there will be significant tax consequences.
Disadvantages of a 403(b) Plan?
In most instances, funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty. One may avoid this penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled. Also, 403(b) may offer a narrower choice of investments than the other types of retirement plans. For 403(b)s that don’t have ERISA protection, accounts may lack the same level of protection from creditors as plans that require ERISA compliance. Another disadvantage of non-ERISA 403(b)s includes their exemption from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.
How Much Should You Contribute to a 403(b)?
The average goal for most people is to save around 15% of their incomes for retirement each year. Your employer match also counts toward that total.
Consider investing in your 403(b) plan up to the full amount that your employer matches. You might increase the amount of your contributions each time you get a raise, then max out your IRA contributions. Then you can return to your 403(b) until you’ve reached the 15% goal if you still have funds you’d like to invest in your retirement.
Bottom Line
So 403(b) plans are more of a mixed bag due to lack of minimum ERISA standards, whereas 401(k) plans typically clear a higher bar. Nonetheless, they can be a good way to save for retirement, especially if contribution matching is offered and the investment options are relatively low cost. If your 403(b) plan offers annuities and insurance rather than other investment options, that could be a red flag. 403(b) plans are generally similar in terms of rules to 401(k) plans, but there may be more flexibility around withdrawals and catch-up contributions for longer-term employees.
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