If you work for a public school or nonprofit organization, you might have the option to participate in a 403(b) plan. What is this lesser-known retirement plan, and should you sign up?
Before you make your decision, understand how a 403(b) works and how it can affect your finances and your retirement.
What Is a 403(b) Retirement Plan?
A 403(b) retirement plan, also known as a tax-sheltered annuity (TSA) plan, is an employer-sponsored retirement savings account for employees of public schools and nonprofit organizations.
The account is similar to a 401(k) retirement plan in that employees sign up through an employer with a potential match, and the IRS establishes the account’s contribution limits, tax implications, and withdrawal rules.
Nonprofit employees and educators can contribute to a 403(b) through automatic paycheck deferrals. The money is invested in annuities and mutual funds, so it can grow over time (but, as an investment, returns aren’t guaranteed).
Contributions to a traditional 403(b) are pretax, so they don’t count toward your taxable income. Instead, you’ll pay taxes on the income when you withdraw from the account. You may also be eligible to claim the Saver’s Credit on your taxes for your contributions.
Like any retirement plan, a 403(b) facilitates long-term savings.
It comes with tax advantages to encourage workers to save for retirement, and withdrawal comes with a penalty to discourage savers from using the money early without a pressing need. You have to start contributing early and keep funds in the account long-term to get the greatest benefit, because the investment is meant to grow over time with compound interest.
Who Should Open a 403(b) Retirement Account?
Only these workers are eligible to participate in a 403(b) retirement plan:
- Employees of 501(c)(3) Nonprofit Organizations. These are tax-exempt nonprofits. Employees of other nonprofit organizations (such as advocacy, fundraising, or political organizations) are not eligible.
- Public School Employees. This includes both faculty and staff. The IRS notes employees must be involved in the day-to-day operations of a school.
- Ministers. Eligible ministers must be employed by a 501(c)(3) nonprofit, self-employed, or employed as a minister or chaplain in an organization not designated as 501(c)(3), such as state-run prisons or the U.S. Armed Forces.
- Others. Employees of hospital co-ops, tribal public schools, and civilian employees of the Uniformed Services University of the Health Sciences are also eligible.
You must be employed by a company to open a 403(b), except for self-employed ministers.
401(k) vs. 403(b)
The major differences between a 403(b) and a 401(k) plan are:
- Eligibility. Only public schools and nonprofit organizations can offer a 403(b) plan, while any other employer can offer a 401(k).
- Cost. A 403(b) plan is generally simpler and less expensive to administer than a 401(k), although costs vary depending on investment funds and management firms.
- Investment Options. In the past, 403(b) investments were limited to annuities, but those rules changed years ago to open 403(b) investments to mutual funds as well.
You won’t get to choose which plan you participate in. You only have the option to participate in the plan your employer offers. Most eligible employers opt for a 403(b) plan because it costs less to administer than a 401(k), and it provides an almost identical benefit to employees.
Pension vs. 403(b)
Also a type of retirement savings, a pension is typically a defined-benefit plan, which means you are guaranteed a set amount of income in retirement. Employers assume the long-term risk — they have to pay out the agreed amount regardless of what happens to investments over time.
In contrast, most other retirement accounts, including 401(k)s, 403(b)s, and IRAs, are defined-contribution plans, which means you put in a set amount but aren’t guaranteed a balance upon retirement. Employees assume the risk in this case — your investments could lose money over time, and your savings aren’t guaranteed to be there when you retire.
Some public schools and government organizations still offer employee pensions, but they’re less common and have become almost obsolete among private companies.
Whether you save for retirement through a 403(b) or a pension depends on which plan your employer offers.
What Is a Roth 403(b)?
A Roth 403(b) — like a Roth 401(k) and Roth IRA — lets you contribute to retirement savings with after-tax dollars, which means you won’t deduct contributions from your taxable income. In return, you won’t pay taxes on the income when you withdraw from a Roth account.
The benefit to a Roth account versus a traditional retirement account is that you’ll pay taxes on your contributions now, on an amount that’s likely to be less than what you withdraw in the future because of returns on your investment.
The drawback to a Roth account is missing out on a tax break now, when your tax rate might be higher than it will be in retirement because you’re earning a higher income.
A financial planner or investment adviser can help you determine whether traditional or Roth contributions make the most sense throughout your career. You can split your contributions among both accounts, but the total limit is the same.
Pros & Cons of a 403(b) Plan
Are 403(b) plans good for educators and nonprofit employees?
Consider the advantages and disadvantages to determine whether you should contribute to an employer-sponsored 403(b) plan, or whether your organization should offer the plan as a benefit to employees.
- Cheaper to Administer Than a 401(k). 403(b) plans often cost less to administer than a 401(k), which reduces the burden for public and nonprofit organizations.
- Potential for an Employer Match. Employers might offer to match what you contribute to a 403(b) account up to a percentage limit. Opting not to contribute at least that percentage of your paycheck means you forfeit that benefit.
- Employee-Controlled Investments. Many employees opt to leave their retirement accounts on autopilot, letting the management firm choose the best balance. But you can adjust your 403(b) investments if you want, unlike with a pension.
- Higher Contribution Limit Than an IRA. If you don’t want to contribute to an employer-sponsored 403(b), your other main retirement savings option is an individual retirement account, which limits contributions to $6,000 per year in 2020, compared to the 403(b) limit of $19,500.
- Special Catch-Up Provision. Each tax-advantaged retirement plan includes a catch-up provision that increases your annual contribution limit after you turn 50. A 403(b) plan includes that increase, plus a years-of-service catch-up that boosts your limit if you’ve been with your employer for at least 15 years.
- Limited Eligibility. Only public schools, nonprofits, and select religious and government organizations can offer a 403(b) plan to employees.
- Employer Chooses Investment Management Firm. Although you have control over your funds, your employer chooses who manages its 403(b) plan investments. A firm might come with fees, policies, or customer service you don’t like. By contrast, you control where to open an IRA and can move your account anytime.
- No Guaranteed Benefit. Unlike a pension or savings account, a 403(b) plan leaves your retirement savings at risk of stock market volatility.
Contributions to a 403(b) account come directly out of your paycheck, so you’ll designate the amount with your employer.
403(b) Contribution Limits in 2020
How much you can contribute to a 403(b) each year depends on your age and how you’re adding the money to the account.
For workers under age 50, 403(b) limits include:
- Elective Deferrals (Your Payroll Deductions). The annual limit on your 403(b) contributions via payroll in 2020 is $19,500.
- Annual Additions. The total annual limit on contributions to your 403(b) — including your contributions, your employer’s match, and additional after-tax contributions — is $57,000 for 2020.
Once you turn 50, you’re allowed to contribute more each year, what’s called “catch-up” contributions. Workers age 50 or older can contribute an additional $6,500 to a 403(b) for 2020.
Uniquely, 403(b) accounts also include a years-of-service catch-up provision. If you’ve worked with your employer for at least 15 years and you’re 50 or older, you can add another $3,000 in catch-up contributions per year, up to $15,000 over several years.
So, total 403(b) 2020 contribution limits are:
- Workers 49 and Younger: $19,500
- Workers 50 and Older: $26,000
- Workers 50 and Older with at Least 15 Years of Service: $29,000
Want to save more for retirement each year? You can open to an IRA in addition to your 403(b). You can contribute up to $6,000 in 2020 to an IRA or $7,000 if you’re 50 or older.
Where Are 403(b) Contributions Invested?
Employers typically contract with a financial services firm, such as TIAA-CREF or Fidelity, to administer the company’s 403(b) plan and manage investments.
Your investment options vary depending on what’s available through that firm, but generally you can choose from a variety of mutual funds and annuity products.
When you sign up, you’ll probably have the option to go with a default portfolio that lets the investment firm invest your money as it determines is best for your situation. If you want to be involved, you can choose which funds or annuities you invest in. However, you can’t invest directly in individual stocks through a 403(b) the way you can with an IRA.
If you leave your job, you can take your retirement account with you.
You can roll over your 403(b) into:
- A new 403(b) if your new employer offers one
- A 401(k) if your new employer offers one
- An IRA if your new employer doesn’t offer a retirement account, you prefer to invest independently, or you don’t start a new job
You cannot roll a Roth account into a traditional account. You can roll a traditional account into a Roth account, but you’ll have to include the rollover amount in your taxable income for that year.
After a rollover, you’re subject to the tax implications, withdrawal rules, and contribution limits of your new account.
How to Start a 403(b) Rollover
You initiate a retirement account rollover with the investment firm that manages your old company’s plan. Your old employer should give you that information before you leave, but ask for it if you don’t know it.
In most cases, you can start a rollover online by logging into your account with the investment firm. Call the firm if that’s not an option. Some firms charge a fee of about $50 to initiate a rollover.
After you request the rollover, the firm will tell you how you’ll receive the funds, either as a paper check in the mail or deposited directly into your new retirement account. If you receive a check, you have a limited amount of time to send it to the new investment firm before you have to claim it as income and pay taxes on it, so read all instructions carefully.
403(b) Withdrawal Rules
As a retirement savings plan, a 403(b) account restricts your ability to pull funds throughout your life. The money is yours, so you always have access to it, but to incentivize long-term savings and justify the tax breaks, early withdrawals come with financial penalties.
When Can You Withdraw from a 403(b)?
In general, you can’t receive distributions from your 403(b) account until:
- You’re 59 1/2 years old
- You’re 55 years old and retired
- You die (survivors or beneficiaries receive distributions)
If you take early distributions, you’ll have to pay a 10% penalty on top of normal taxes for the income. That fee is included with your tax return for the year.
A hardship withdrawal is any early distribution you receive from your 403(b) while you’re still working. Most financial firms allow hardship withdrawals in emergency circumstances, including:
- Medical Expenses. These are large, unreimbursed expenses for you, your spouse, or dependents.
- Home Down Payment. This is permitted for a primary residence, not investment properties.
- Tuition and Fees. You must use the funds for higher education due in the next 12 months.
- Eviction or Foreclosure. This can cover rent or mortgage payments if you have no other income or assets to cover costs.
Hardship withdrawals are subject to regular taxes and the 10% early distribution penalty.
As long as the firm that holds your account allows it, you can borrow from your 403(b) up to $50,000 or half of the account’s value, whichever is less.
The firm sets an interest rate based on market rates. It also treats a loan as an early distribution, so you have to pay the 10% penalty in taxes for the year you receive the loan.
You have to repay a 403(b) loan within five years, and you face serious tax consequences if you default.
Taxes on 403(b) Distributions
You’ll pay taxes on 403(b) distributions like ordinary income, except for those from a Roth account. Your tax rate depends on how much you receive, including any other income you earned for the year.
You’ll pay those same taxes on an early withdrawal, plus an extra 10% penalty.
If you expect to withdraw quite a bit, either in retirement or early as a hardship withdrawal or loan, consider paying estimated taxes each quarter to avoid a huge tax bill and an underpayment penalty in April.
Once you’re eligible, you can withdraw as much or as little as you want from your 403(b) account until you’re 70 1/2 ears old. After that, you have to withdraw at least a minimum amount each year or face a tax penalty.
The minimum required distribution amount depends on the total account balance and your age. The IRS provides worksheets to help you determine your required minimum distributions (RMDs). Based on life expectancy, the calculated RMD is intended to draw down all of your retirement savings within your lifetime.
A 403(b) retirement savings plan is a tax-advantaged way for public school and nonprofit employees to save for retirement. If your employer offers one, especially with a contribution match, it can be a financially sound long-term savings option.
To maximize savings in your 403(b), invest in mutual funds that match your risk tolerance and personal situation. For example, young investors tend to have tolerance for more aggressive (and risky) portfolios, and investors become more conservative as they near retirement.
However you invest, a tax-advantaged, employer-sponsored account is one of the simplest and smartest ways to save for retirement. The earlier you start saving, the more benefit you can get out of investment returns because of compound interest.
Don’t be intimidated by the details. Someone in your company’s human resources department should be able to guide you through setting up a 403(b) account. Contributions come directly out of your paycheck, setting your savings on autopilot. And you can always roll over the balance into an IRA or another retirement account if you leave your job, so you can always keep your savings with you.
Are you considering opening a 403(b) account? What’s stopping you?