What Is a 403b and How Does it Work?
When saving for retirement, it’s easy to focus on the two biggest contenders: IRAs and 401(k) plans. That’s because these two plans are extremely popular and available to most workers in America.
However, employees of some tax-exempt organizations are eligible for an additional retirement option: the 403(b) plan.
While not as widely available, understanding how 403(b) plans work can help those workers eligible to enroll in one. They also come with many advantages with only a few downsides.
So, today, we’re helping those of you eligible for a 403(b) plan learn more about what they are, how they work, and the advantages they can have for your retirement planning.
What is a 403(b) plan?
A 403(b) plan is an employer-sponsored retirement plan designed for employees of certain tax-exempt organizations. It helps eligible employees save for retirement by making regular contributions to the plan, which get invested into relatively safe investment options. While these investments might grow relatively slowly, they generally outpace inflation, allowing you to earn much more money than a traditional savings account.
Those eligible for 403(b) savings plans include:
- Public school system employees (including those organized by Indian tribal governments)
- Church employees
- Ministers (including those employed by 501(c)(3) tax-exempt organizations and self-employed ministers)
How does a 403b work?
A 403(b) works much the same way as a 401(k) plan.
Eligible employees can enroll when hired, or the employer can enroll them automatically. For automatic enrollment, the employer’s sponsored plan must offer that feature.
Employee contributions are made from elective deferrals (payroll deductions). The employee elects to defer a portion of their salary directly to their 403(b) account each pay cycle. Like a 401(k) plan, the contributions get invested so they can slowly grow wealth over time.
Contributions are made with pre-tax dollars, meaning the money is deducted from their paycheck before taxes are taken out. This reduces the employee’s taxable income and allows the contributions to grow tax-free until withdrawn.
Advantages of a 403(b)
A 403(b) plan has several advantages that make it an attractive retirement savings option for eligible employees of certain tax-exempt organizations. These advantages include:
One of the primary advantages of a 403(b) plan is that pre-tax contributions can lower an employee’s taxable income. This can reduce their yearly tax burden, providing potential savings for decades before retiring.
As an employer-sponsored retirement plan, employers can contribute to a 403(b) on their employees’ behalf. These employer contributions are made in addition to the employee’s contributions.
Typically, an employer offers to match a certain amount of the employee’s contributions. For instance, if an employee chooses to defer 4% of their salary for contributions, their employer might offer to match contributions up to 2% of that employee’s salary.
Like other retirement plans, 403(b) plans allow catch-up contributions. This lets employees contribute additional funds beyond the annual contribution limit to grow their retirement savings further.
However, there’s a significant difference. Unlike other retirement plans, 403(b) participants don’t need to reach age 50 before they can make additional contributions. Instead, employees can make catch-up contributions after 15 years of service at an eligible tax-exempt organization.
Participants can make $3,000 in catch-up contributions each year, up to the lifetime limit of $15,000.
However, those savers age 50 and older can still make traditional catch-up contributions. For 2023, the limit for these traditional catch-up contributions is $7,500.
Rollovers are a feature of retirement plans that let participants move their money from one plan to another. This is helpful when the employee changes employers. Often, employer-sponsored retirement plans (such as a 403b or 401k) get inadvertently abandoned during the transition from one employer to the next.
With a rollover, employees can move the money from their former employer’s 403(b) to a 401(k) or another qualified retirement plan with their new employer.
This allows the employee to continue to grow their retirement savings without losing track of their plans.
Shorter vesting periods
Many retirement plans come with vesting periods—an amount of time participants must wait before they own 100% of their account balance. With most plans, vesting periods can take years as employees own an increasingly higher percentage of their balance.
With 403(b) plans, vesting periods are often much shorter. In fact, many 403(b)s offer no vesting period at all. In that case, employees enter the plan fully vested, owning 100% of their balance.
Low management fees
Any retirement plan composed of an investment portfolio comes with management fees. However, many 403(b) accounts aren’t required to comply with the Employee Retirement Income Security Act (ERISA). Because of this, 403(b) plans can often have much lower management fees than other retirement plans.
Disavantages of a 403(b)
While a 403(b) plan has many advantages, there are also some potential disadvantages that employees should be aware of before enrolling.
Some of the most important disadvantages of 403(b) plans include:
Limited investment options
While 403(b) plans offer a few investment options, they’re pretty limited. Generally, 403(b) contributions get invested in either mutual funds or annuities. For eligible employees of religious organizations, the church can set up retirement accounts employees can contribute to. These church-sponsored retirement accounts are referred to as 403(b)(9) plans.
These limited options can make it difficult for employees to tailor their investment strategy to their specific needs and preferences. Additionally, some investment options may have high fees or limited growth potential, negatively impacting the employee’s retirement savings.
403(b) plans come with restrictions on when money can be withdrawn from the plan. Generally, the funds cannot be withdrawn until the employee reaches age 59 1/2. However, there are some exceptions for certain circumstances, such as disability or financial hardship.
If the employee withdraws the money before age 59 1/2, they may be subject to a 10% penalty in addition to regular income taxes.
403b contribution limits are more of a gray area. The IRS does limit how much employees can contribute to their accounts each year. However, the contribution limits are relatively high. Still, some savers might prefer to contribute more to their accounts.
Like 401(k) contribution limits, the limit for 403(b) plans go up every year. For 2023, the 403(b) contribution limit is $22,500. Keep in mind that eligible employees can make catch-up contributions beyond this amount.
Additionally, employer contributions don’t count toward the limit. In 2023, employers can contribute up to $43,500 to a 403(b), making for a combined contribution limit of $66,000.
Types of 403(b) plans
Much like a 401(k), there are two primary types of 403(b) plans: traditional and Roth.
With a traditional 403(b), contributions are made with pre-tax dollars. While this lets investments grow tax-free, withdrawals made during retirement (“distributions”) are considered taxable income. So, retirees will have to pay taxes on any distributions they take.
With a Roth 403(b), contributions are made with after-tax dollars. While this somewhat limits the plan’s potential growth, it allows for tax-free distributions during retirement.
Essentially, the choice between a traditional and Roth 403(b) is the same as a 401(k): Would you rather pay more income tax while working or during retirement?