A 403(b) plan is a type of defined contribution retirement plan that is similar to a 401(k) plan. It is named after the section of the U.S. tax code that governs it. A 403(b) plan is typically offered to employees of certain non-profit organizations, such as public schools, hospitals, and certain religious organizations.
Under a 403(b) plan, employees can choose to have a portion of their salary withheld and contributed to the plan on a pre-tax basis. The money in the plan can then be invested in a variety of options, such as mutual funds, annuities, and certain types of bonds.
Employers may also choose to make contributions to their employees’ 403(b) plans, either through matching contributions or profit-sharing contributions. These contributions can help employees save for retirement more quickly.
One of the benefits of a 403(b) plan is that the contributions are made on a pre-tax basis, which can lower an individual’s current tax bill. Additionally, the money in the plan can grow tax-free until it is withdrawn in retirement.
Employees are typically allowed to begin withdrawing money from their 403(b) plan at age 59 1/2 without incurring a penalty. However, if they withdraw money earlier, they may be subject to a 10% early withdrawal penalty and taxes.
It’s important to note that 403(b) plans are typically offered by non-profit organizations and are restricted to eligible employees.
How 403(b) Plans Work and its Participants
Individuals working for tax-exempt organizations, such as schools and non-profits, can save for retirement through a 403(b) plan, which functions similarly to a 401(k) plan for private-sector employees. Eligible participants include employees of public schools, state colleges, and universities, public school employees of Indian tribal governments, church employees, employees of tax-exempt 501(c)(3) organizations, and ministers and clergy members. The plan has the same annual contribution limits as the 401(k) plan, with a maximum of $20,500 for 2022 and $22,500 for 2023. Additionally, there is a catch-up contribution of $6,500 for those over 50 in 2022 and $7,500 in 2023. The combined employee and employer contributions are limited to either $61,000 in 2022 and $66,000 in 2023 or 100% of the employee’s most recent yearly salary. Funds can only be withdrawn without penalty once the participant reaches 59½ years of age.
Advantages of 403(b) Plans
The earnings and returns on a regular 403(b) plan are not subject to taxes until they are withdrawn, while the earnings and returns on a Roth 403(b) plan are tax-free if the withdrawals are considered qualified distributions. Some 403(b) plans are not subject to the strict regulations set forth by the Employee Retirement Income Security Act (ERISA), which results in lower administrative costs for the employee. Additionally, many 403(b) plans have quicker vesting periods than 401(k)s and some even allow for immediate vesting, which is rare in 401(k)s. Furthermore, employees with 15 or more years of service at certain non-profits or government agencies may be eligible to make additional catch-up contributions to a 403(b) plan, with a limit of $3,000 per year and a lifetime limit of $15,000. This is an advantage that does not require the employee to be 50 years or older as long as they have worked for the same eligible employer for the full 15 years.
Disadvantages of 403(b) Plans
Withdrawing funds from a 403(b) plan before the age of 59½ will result in a 10% tax penalty, except under certain exceptions such as separating from an employer at 55 or older, incurring qualified medical expenses, or becoming disabled. A 403(b) plan may offer a limited selection of investments compared to other plans, typically offering only the choice between fixed and variable contracts and mutual funds within these contracts. Other securities such as stocks and REITs are not allowed. The emphasis on annuities in 403(b) plans is viewed as a disadvantage by many financial advisors, as these plans may lack the same level of protection from creditors as those that comply with ERISA. If you are at risk of creditors pursuing you, it is important to consult with a local attorney familiar with the laws in your state. Additionally, non-ERISA 403(b) plans are exempt from nondiscrimination testing, which is conducted annually to ensure that management-level or highly compensated employees do not receive an excessive portion of benefits from the plan.
Similarities Between 401(k) and 403(b)
Both 401(k) and 403(b) plans are types of defined contribution plans that allow employees to save and invest for retirement. Some similarities between the two include:
- Both plans allow employees to make contributions to the plan through payroll deductions.
- Both plans have limits on how much an employee can contribute each year, which are set by the IRS. For the 2022 tax year, the contribution limit for both plans is $19,500, and for 2023 tax year is $19,500 for 401(k) and $22,500 for 403(b)
- Both plans have catch-up contributions for employees who are age 50 or older, which allow them to contribute more to the plan.
- Both plans offer tax-deferred growth on the contributions and investment earnings within the plan.
- Both plans have penalties for withdrawals before reaching 59 1/2 years of age, unless the withdrawal qualifies for an exception.
However, there are also differences between the two, such as the types of employers that are eligible to offer the plans and the specific rules and regulations that govern each plan.