Your Guide: What Is A 403(b) Retirement Plan?

Understanding the different options to save for retirement is crucial to mapping out a long-term financial planning strategy. A 403(b) retirement plan is similar to a 401(k) – a savings plan that you might be more familiar with – in that it helps with saving for retirement. The difference is that a 403(b) comes with certain eligibility requirements attached.

That said, when deciding what type of retirement plan to go with, it’s not always easy to determine which makes the most sense. Let’s take a closer look at what a 403(b) is, how it works, who qualifies – and why you may want to consider it as part of your prospective investment choices.

What Is A 403(b) Plan?

You may already be familiar with the concept of a 403(b) plan but know it by another name – a tax-sheltered annuity (TSA) plan. It’s a common form of retirement plan for employees of public schools, non-profits, and other tax-exempt organizations. A key upside of a 403(b) plan lies in its ability to help you reduce your taxable income. In addition to making employee contributions, investors can also leverage the power of catch-up contributions to boost their earnings and increase long-term savings as well.

Of course, given these advantages, not everyone qualifies for a 403(b) plan. Given how these plans work, individuals who are eligible to participate in one include:

• Nonprofit employees eligible for tax exemption through IRC Section 501(c)(3)
• Public school employees
• Employees of hospital service organizations
• Government employees

Although certain employees of religious institutions qualify to participate in 403(b) plans, note that religious organizations specifically operate under a plan known as a 403(b)(9).

If you’re a self-employed individual, or someone who works for a for-profit company and wishes to make employee contributions, you likely have the option of participating in a 401(k) plan instead.

That said, in some select situations, certain individuals may be able to participate in and contribute to both a 401(k) and 403(b) plan. If you’re uncertain which you qualify for (or if you qualify for both), be sure to consult with your employer or financial advisor.

How The Two Types Of 403(b) Plans Work

In general, it helps to keep in mind that there are two types of 403(b) plans – each of which is meant to slowly accumulate interest and grow untouched until the later years of your life. Based on the plan that you select, you’ll either be taxed on funds that you contribute or monies that you withdraw as well.

For starters, traditional 403(b) plans are tax-deferred – in other words, money is taken out of your paycheck before taxes are taken out, and you won’t pay taxes on these sums until they’re withdrawn from your account.

However, Roth 403(b) plans operate in different fashion. Because you contribute to them using after-tax dollars, they’re not tax-deferred. Any money put into your retirement savings account is not taxed when it is withdraw using a Roth setup. In other words, you pay the tax before you contribute the funds to a Roth 403(b) plan and are not taxed again later when you withdraw the money.

Both traditional and Roth 403(b) plans typically require you to be at least 59½ years of age in order to withdraw your funds without penalty.

As you might imagine, there are potential tax implications and penalties for engaging in early withdrawal of funds from a 403(b) account. Consult a tax professional and research guidelines on the IRS website to ensure you understand your options.

Similarities And Differences Between 403(b) And 401(k) Plans

At a base level, 403(b) plans and 401(k) plans serve the same general purpose: to help you maximize your retirement savings. However, they are designed for different groups of people. A 403(b) plan is designed for non-profit and public sector workers, while a 401(k) plan is meant for private sector and for-profit plan participants. Each offers a tax advantaged savings opportunities and chances for employers to contribute. Both 401(k) and 403(b) plans come in traditional and Roth flavors and boast similar contribution limits to boot – and require participants to reach age 59½ before withdrawing funds without penalty. Certain versions of 403(b) and 401(k) plans allow for catch up contributions if you’re over a certain age.  

However, a 403(b) plan generally offers more limited investment options (no stock or real estate investment opportunities).

Advantages Of A 403(b) Retirement Plan

Besides offering the possibility for tax-deferred savings and higher distributions, there are several advantages associated with a 403(b) plan. For instance, your funds will tend to vest faster than under a 401(k) plan. Likewise, you’ll also have the ability to make added catch-up contributions if needed. In general, though, one of the biggest advantages to opening a 403(b) is that any contributions you make can help reduce your taxable income – which can, in turn, potentially put you in a lower tax bracket.

In addition, select 403(b) plans don’t have to adhere to the oversight rules of the Employee Retirement Income Security Act (ERISA), which can be relatively strict. As a result, administrative costs on these plans tend to be lower, which can result in you getting to keep more of your hard-earned income.

Disadvantages Of A 403(b) Plan

Of course, there are also some potential downsides to 403(b) plans too. For example, you can’t invest your money in every type of investment that you might wish, given certain plan limitations – like when real estate and stock investments are prohibited. (Noting that you may earn more money exploring the use of mutual funds, annuity contracts, or variable annuities.) Some 403(b) retirement plans also aren’t protected under the provisions of the Employee Retirement Income Security Act, as we mentioned in the advantages section above. While the flexibility can be a good thing, this also means that some 403(b) accounts don’t enjoy the same amount of protection from creditors as those that are covered under the Act.

Contribution Limits Of A 403(b) Retirement Plan

Contribution limits effectively put a cap on the total contributions that you can make to this savings plan. These maximum contribution levels will differ depending on the type of retirement plan that you hold and your age. Like a 401(k) plan, contribution limits are $22,500 in 2023.

How Employer Matching Works With A 403(b) Plan

If you’re looking to maximize your retirement savings, it helps to capitalize on your employer’s contributions, if they offer them. In effect, as with a 401(k), when you contribute to your retirement account, your employer can opt to match your contributions. It may help to note that they can contribute in two different ways.

On the one hand, a nonelective contribution occurs when your employer contributes a certain amount of money to your retirement savings plan, regardless of whether or not you actively contribute yourself. Note that your employer will not take money out of your salary or paycheck to provide this contribution – rather, it comes out of their own pocket instead.

On the flip side, a matching contribution occurs when your employer chooses to match your contribution up to a certain preset maximum amount. For example, your employer might choose to contribute $0.50 for every dollar that you put into your retirement savings, up to 3% - 6% of your pay.

While employer contributions may function in similar fashion to a 401(k) plan though, keep in mind that under the terms of a 403(b) plan, there is often a shorter vesting period. In essence, you won’t generally have to wait to be able to permanently keep your employer’s contributions within your retirement savings account if you decide to leave your job, unlike someone who owns a 401(k) account.

Early Withdrawal From Your 403(b) Retirement Plan

Should you wish to withdraw funds from your account before 59½ years of age, you will incur a penalty fee on your money, which amounts to an additional 10% in early withdrawal tax. There are some exceptions to this tax listed on the IRS website that you’ll want to review if you’re considering making an early withdrawal.

Pros And Cons Of A 403(b) Plan

There are upsides and downsides to consider when contemplating opening a 403(b) plan, such as:

Pros

·       Retirement contributions may reduce your taxable income for the year – and, potentially, help you bring your overall earnings down into a lower tax bracket.

·       Shorter vesting term means that you may have the opportunity to leave your job earlier and still keep 100% of your employer’s contributions.

·       Catch-up contributions can help you maximize your retirement savings and make up for any prospective shortfalls you might expect to encounter.

Cons

·       Certain types of investments are ineligible – like stocks and real estate, which are often among the more lucrative types of investment options.

·       Not all 403(b)s are protected by ERISA, which may leave your accounts and savings open to additional exposure from creditors.

·       Withdrawals from retirement accounts made prior to age 59½ will subject you to a 10% tax penalty.

403(b) Retirement Plan FAQs

You may have certain questions in mind concerning 403(b) plans. We have answers.

What is a 403(b) and how does it work?

It’s a form of tax-sheltered annuity plan (retirement plan) designed for use by employees of public schools, non-profits, and other tax-exempt organizations. For example: A 403(b) is designed to help employees of certain schools, charities, or religious institutions reduce their taxable income and save for retirement.

What is the difference between a 403(b) and a 401(k)?

As described earlier, though it generally functions in similar fashion to a 401(k), a 403(b) is designed to serve employees of tax-exempt organizations, public schools, and religious institutions. They may offer faster vesting of funds than a 401(k).

What are the disadvantages of a 403(b)?

You can’t always invest your money wherever you like. You’ll get hit with an early withdrawal penalty if you remove funds from your account before age 59½. Some accounts don’t come with as many robust legal and financial protections as others.

What is the purpose of a 403(b)?

By using a 403(b), you can set more money aside and give it more opportunities to grow, all while keeping an eye towards retirement savings and long-term investment.

The Bottom Line: 403(b) Offers Tax-Deferred Retirement Funding For Certain Industries

A 403(b) plan, which is similar in general nature to a 401(k) plan, empowers employees of public schools (teachers, nurses, government employees, etc.) and non-profits to save more money for retirement. Both employees and employers (who can make optional matching contributions in line with sums contributed by their workers) that qualify can contribute to these retirement savings accounts.

However, a 403(b) plan – which is again not available to everyone – tends to vest faster than a 401(k). At the same time, it doesn’t necessarily offer as much flexibility in potential investment options as a 401(k) – and early withdrawals from your account can come with sizable tax penalties. Long story short, a 403(b) makes a handy way to help you boost your retirement savings if you qualify.

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