- 403b and 401k plans are both tax-advantaged defined contribution retirement savings accounts offered through employers.
- 403bs are offered by public sector employers such as public schools, as well as nonprofit and religious organizations, while 401ks are offered by employers in the private sector.
- Although the two retirement plans are similar, the main difference is that 403b plans can allow for higher contribution levels with at least 15 years of service with your employer.
Saving for retirement is an important financial goal for every American, no matter how old. While most are familiar with the concept of a 401k or an IRA, the lesser-known 403b is a similar type of retirement account that is available to workers in the nonprofit, education, and healthcare space.
What Is a 403b Retirement Plan?
Similar to a 401k plan, a 403b plan is a tax-advantaged account intended to help workers save for retirement. As with a 401k, a 403b is an employer-sponsored defined contribution plan. As such, workers can choose to have a percentage of their salaries diverted into their 403b, allowing it to grow tax-free until it is withdrawn at retirement.
Who Can Use a 403b Plan?
While the mechanics of a 403b are similar to those of a 401k, the primary difference lies in who can use a 403b. Most 401k accounts are offered by private companies. However, 403b plans are only offered to workers at specific types of organizations such as:
- Employees at public schools if involved in daily operations
- Employees at tax-exempt organizations (usually 501(c)(3) nonprofit organizations)
- Ministers affiliated with such organizations
Why Use a 403b Plan?
The primary appeal of a 403b plan — as opposed to other investment accounts — is that it is structured to save you money on taxes in two ways. First, in the case of a traditional 403b plan, contributions are made before taxes are taken out of your paycheck. This deduction decreases your adjusted gross income and eventually your taxable income, and can actually lower the amount you pay in income taxes right now.
Second, those contributions — no matter whether they’re made into a traditional or Roth 403b plan — grow tax-free as well. This is where 403b plans shine — as well as 457 and 401k plans.
For a simplified example, say you earn an annual salary that after your standard deduction leaves you with taxable income of $90,000. According to the IRS tax code, this would put you in the marginal tax bracket that pays 24% in income taxes for the amount over $84,200. However, if you were to contribute even just $6,000 each year to a traditional 403b, you won’t have to pay taxes on that amount, and your taxable income would fall to $84,000, dropping you into the lower tax bracket that pays the 22% marginal tax rate. All other things being equal, you would owe approximately $1,440 less in taxes each year ($5,800 * 24% + $200 * 22%) by contributing to a traditional 403b.
As if saving on taxes now weren’t enough, the money you contribute to a 403b also grows tax-deferred, meaning it can grow tax-free until you tap into the funds when you retire. That tax-deferred status allows your money to work harder for you during your working years.
As an example, say that you decided to invest $6K in your 403b early in your career. For the sake of comparison, let’s say you also invested the same amount in a taxable brokerage account. Both accounts boast a 6% annual return on your investment.
Your 403b account will grow tax-free, allowing the money to compound at the full 6.0% rate of return each year. However, because you have to pay a 22% tax on any returns invested in your taxable brokerage account, your after-tax annual return on that fund is in reality 4.6%, rather than the full 6.0%.
While that 1.4% might not seem too significant, as you can see in the chart above, it has a drastic impact on your money’s ability to grow. In fact, after 40 years, your 403b account will accumulate almost twice as much cash as your taxable account.
What Kind of 403b Plans Are Available?
If you find yourself in the select group of workers who have access to a 403b, there are several layers to this type of account that you’ll need to consider. Unlike 401k retirement accounts — which are generally limited in investment types (typically mutual funds, ETFs and even company stock) — 403b retirement accounts can offer investment options that provide guaranteed income for life.
For instance, a 403b could come in the form of an annuity provided by an insurance company, a custodial account from a mutual fund, or a retirement account set up specifically for employees of a church. When 403bs are structured as annuity investments, they are sometimes referred to as Tax-Deferred Annuities (TDAs) or Tax-Sheltered Annuities (TSA).
If your employer allows you the opportunity to choose between an annuity or a mutual fund investment account, it’s best to consult with a financial advisor to determine which investment vehicle would be most advantageous for your personal situation. One key consideration is how inflexible annuity investments can be if you need to withdraw your retirement funds early. (More on 403b withdrawals below.)
In addition to determining whether you’d like to invest your 403b funds into an annuity or mutual funds, you also need to consider whether you’d like to put your money into a traditional 403b or a Roth 403b.
As discussed above, a traditional 403b means that your contributions are invested before you pay tax on that income. Those pre-tax contributions will also lower your current taxable income, and you may end up paying less in federal income taxes now.
However, while the money in the account will grow tax-free — because you didn’t pay taxes on the funds when you made your contribution — you will have to pay income taxes on the withdrawals you make in retirement. Retirees, once they forego earned income, often earn less in retirement income, and therefore fall into a lower tax bracket when they take their distributions. As a result, many retirees often pay less in taxes overall by choosing a traditional 403b.
No matter whether you choose an annuity or mutual funds as your investment vehicle — as with a Roth 401k or Roth IRA — if you choose to put your money away in a Roth 403b, your contributions will be after-tax. As a result, if you choose this type of 403b account, your contributions will not lower your taxable income. That’s the downside. However, the upside of this type of account is that Roth contributions will still grow tax-deferred, and when you decide to withdraw your funds you will not have to pay taxes on those distributions so long as IRS rules are followed (generally upon reaching age 59 1/2 and the account is at least five years old).
How Does a 403b Plan Work?
Just as with other 401k plans and IRAs, 403b plans have specific regulations that govern how they work. If you have access to one of these plans — whether you choose an annuity or mutual fund in a traditional or Roth version — you need to know three main things:
- How much you can contribute
- How to rollover funds when you change jobs
- When and how you can withdraw
1. 403b Contribution Limits
In 2019, the IRS limited elective deferrals, or contributions deducted directly from an employee’s paycheck, to 403b accounts to $19,000 per year — the same limit in place for 401k accounts. And as with 401k accounts, if you are aged 50 or older, you can elect to contribute an additional $6,000 per year to your 403b as a “catch-up” contribution, which raises the annual contribution limit to a total amount of $25,000.
However, unlike 401k plans, the IRS also allows for additional catch-up contribution of a maximum of $3,000 if you have 15 years of service with the same public school system, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches — even if you are younger than 50 years of age.
Now, employer match contributions to your 403b account do not count toward the $19,000 annual limit. However, those matching contributions are still subject to some restrictions. In fact, the combination of employee and employer contributions is limited to the lesser of $56,000 per year or 100% of the employee’s yearly salary.
All these provisions are detailed in the employer’s 403b plan documents, including any modifications or restrictions that the employer opted for when designing the plan. Be sure to check with your HR department regarding the specifics of your 403b as they may vary.
2. 403b Withdrawal Rules
While 403b plans differ slightly from a 401k when it comes to rules surrounding their contribution limits, 403b and 401k plans have very similar withdrawal rules. In short, early withdrawals from a 403b plan — that is, any withdrawal before the age of 59 1/2 — is subject to a 10% tax penalty. One caveat to the age 59 1/2 rule with a retirement plan like the 403b is that if you are at least 55 years old and you “separate from service” (leave the company), you may be allowed to withdraw funds from your 403b without penalty.
However, because many 403b plans invest in annuities, there is an additional complication. If you choose to invest your 403b funds into an annuity over a mutual fund, but want to dissolve that annuity contract to access the money, you would also have to pay a surrender charge in the range of 7-10% of the account value — easily wiping off any hard-earned returns.
While there are very specific instances where you can withdraw money from your 403b early — for instance hardship distributions or loans — it’s difficult to meet the requirements necessary to avoid any penalty. In the end, it’s easier — and much more lucrative — to wait until you reach age 59 1/2 to withdraw money from your 403b. You’ll avoid paying additional taxes and penalties, and your money will have more time to grow tax-deferred.
The IRS attaches many rules to withdrawals, as you can see. Before making any moves on your account, be sure to consult with your HR department, review your employer’s 403b plan documents, and perhaps consult an experienced financial planner to steer clear of headwinds and pitfalls.
3. 403b Rollovers
You might one day decide to leave the employer that provides you access to your current 403b. There are a few options available when it comes to managing your 403b account when you leave your employer:
- You can leave it in your old employer’s account.
- You can roll over your 403b into your new employer’s 403b or 401k plan.
- You can roll over your 403b into an Individual Retirement Account (IRA).
You’ll need to check if the options 1 and 2 are allowed by your old and new employer’s plans. If you choose to rollover your 403b in either the second or third option, as with a 401k rollover, the best way to move money from account to account is via a direct transfer from your old 403b provider to the new retirement plan. In this way, your new provider can help you navigate the bureaucracy involved in the transfer, and help you avoid all possible tax withholding or penalties.
Take Every Advantage for a Winning Retirement
Having access to a 403b retirement savings plan — its tax benefits, the extra savings allowed — gives you a leg up when it comes to planning for your future. No matter how old you are, taking full advantage of your 403b is one of the best ways to ensure you’ll have enough in retirement income when you finally hang up your hat. If you save early and often, chances are it’ll be smooth sailing when your retirement finally rolls around.
Check out other helpful retirement topics on our Novi blog.