What Is a 403(b) Retirement Plan?
The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, and librarians.
The 403(b) plan, which is closely related to the better-known 401(k) plan, allows participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There’s also an option for the employer to match part of the employee’s contribution.
KEY TAKEAWAYS
- 403(b)s are retirement savings plans that serve employees of public schools and tax-exempt organizations.
- Contributions to 403(b) plans are made through payroll deductions.
- The IRS limits the amount that employees can contribute to their 403(b) plans.
- The advantages of a 403(b) include faster vesting of funds and the ability to make additional catch-up contributions.
- Investment choices may be more limited with a 403(b) and some accounts offer less protection from creditors than 401(k)s.
How 403(b) Plans Work
As noted above, individuals employed by schools and other tax-exempt organizations can save for retirement by contributing to a 403(b) plan through payroll deductions. The plan is akin to the 401(k) plan used by private-sector employees. Participants can 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
- Ministers and clergy members2
Advantages and Disadvantages of 403(b) Plans
There are distinct benefits and drawbacks of holding a 403(b) plan. We’ve highlighted some of the most common ones below.
Advantages
Earnings and returns on amounts in a regular 403(b) plan are tax-deferred until they are withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions.
Certain 403(b) plans are not required to meet the onerous oversight rules of the Employee Retirement Income Security Act (ERISA). As such, these plans tend to come with lower administrative costs, which puts more money back into the employee’s pocket.
Many 403(b) plans vest funds over a shorter period than 401(k)s, and some even allow immediate vesting of funds, which 401(k)s rarely do.
If an employee has 15 or more years of service with certain nonprofits or government agencies, they may be able to make additional catch-up contributions to a 403(b) plan. Under this provision, you can contribute an additional $3,000 a year, up to a lifetime limit of $15,000. And unlike the usual retirement plan catch-up provisions, you don’t have to be 50 or older to take advantage of this as long as you worked for the same eligible employer for the whole 15 years.
Employers aren’t allowed to contribute to the non-ERISA 403(b) plans of their employees.
Disadvantages
Funds withdrawn from a 403(b) plan before age 59½ are subject to a 10% tax penalty, although you may avoid the penalty under certain circumstances, such as separating from an employer at age 55 or older, needing to pay a qualified medical expense, or becoming disabled.
A 403(b) may offer a narrower choice of investments than other plans. Although these plans now offer mutual fund options inside variable annuity contracts. you can only choose between fixed and variable contracts, and mutual funds inside these plans—other securities, such as stocks and real estate investment trusts (REITs), are prohibited.
The presence of an investment option that 403(b)s favor is, at best, a mixed blessing. When the 403(b) was invented in 1958, it was known as a tax-sheltered annuity. While times have changed, and 403(b) plans can now offer mutual funds, as noted, many still emphasize annuities.
If you are at risk of creditors pursuing you, speak to a local attorney who understands the nuances of your state as the laws can be complex.
Another disadvantage of non-ERISA 403(b)s is their exemption from nondiscrimination testing. Done annually, this testing is designed to prevent management-level or highly compensated employees from receiving a disproportionate amount of benefits from a given plan.
Pros
- Earnings and returns in regular 403(b) plans are tax-deferred until they are withdrawn
- Plans that aren’t subject to ERISA requirements come with lower administrative costs
- Many 403(b) plans vest funds over a shorter period and some allow immediate vesting
- Employees with 15 or more years of service may be eligible for increased catch-up contributions
Cons
- Withdrawals before age 59½ are subject to a 10% tax penalty
- Plans may offer a narrower choice of investments than other retirement options
- Accounts within a 403(b) may lack the same protection from creditors as plans with ERISA compliance
- Non-ERISA 403(b)s is exempt from nondiscrimination testing.
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Because tax considerations are an integral part of sound business and personal planning, be sure to consult your tax advisor. This information is a general overview of the tax treatment of disability premiums and benefits for informational purposes only and it is not to be construed as tax or legal advice.