What Is a 403(b) Plan? And How Do They Work?

Written by Samantha CatheyUpdated: 30th Aug 2021
Share this article

Disclaimer: This post contains references to products from one or more of our advertisers. We may receive compensation (at no cost to you) when you click on links to those products. Read our Disclaimer Policy for more information.

Think about where we’d be without our doctors and teachers. Pretty bleak, right? Such important people in society deserve the best, especially in the form of their retirement accounts.

After years of hard work and helping people, they’ll need a good nest egg to fall back on. Introducing the 403(b) employer-sponsored retirement account.

You’ve probably heard of its close relative to the 401(k) plan, and they do have a lot of similarities. The following is a look at 403(b) accounts and how they work.

What Is a 403(b) Plan?

A 403(b) is a retirement plan offered by certain nonprofits, tax-exempt organizations, and public schools. Eligible workers include teachers, professors, school administrators, government employees, doctors, nurses, and librarians.

Clergy have their own special type of retirement plan called a 403(b)(9). Officially named a tax-sheltered annuity (or TSA) by the IRS, there are two 403(b) accounts types: traditional and Roth. Since the latter isn’t as common, know that we’re referring to a traditional 403(b) unless specified.

How Do 403(b) Plans Work?

In traditional 403(b) accounts, contributions are deducted from an employee’s paycheck, and investment earnings and returns are tax-deferred until they are withdrawn in retirement.

Sometimes employers match contributions up to a certain percent, and we always recommend maxing out on however much they’re willing to contribute.

After all, it’s free money! All Roth accounts—Roth 401(k), Roth IRA, Roth 403(b)—are funded with money that’s already been taxed. Therefore, distributions and earnings are tax-free, no matter how much an account has grown.

403(b) Contribution Limits

The IRS sets yearly contribution limits on certain types of retirement accounts. This year workers can deposit up to $19,500, and the same was for 2020.

Employees who are age 50 or older can contribute an additional $6,500 a year in the form of “catch-up contributions.”

Certain government agencies and nonprofits allow employees with 15 or more years of service to make additional catch-up contributions of $3,000 a year for a lifetime limit of $15,000. There is no age restriction to take advantage of this bonus.

Though not as common, employers may also fund their workers’ 403(b) retirement accounts. For 2021, the limit for these combined employer/employee contributions is $58,000 or 100% of an employee’s most recent yearly salary, whichever is less.

How to Invest in a 403(b)

Investment options in a 403(b) are limited, and a plan can offer mutual funds and fixed and variable annuities.

No individual stocks are permitted here. Luckily, most 403(b) will offer stock and bond index funds to support the growth needed for retirement.

Finally, since annuities are such complex financial instruments (like, too tricky to go over here), it’s really important to check with your financial advisor before entering a contract. Need help finding an advisor?

403(b) Withdrawal Rules and Regulations

As long as individuals are 59 ½ years old, standard withdrawals are taxed as regular income. Remember that’s because employees deferred part of their salary before their employer removed taxes.

That is unless we’re talking about a Roth account, in which case distributions from Roth 403(b)s are tax-free. However, Roth accounts must have been open for at least five years before withdrawals can occur.

In general, retirement plans and accounts were created to encourage people to save for later in life.

Thus, an early withdrawal of funds is subjected to a 10% early withdrawal penalty in addition to taxes, unless employees have one of these reasons:

  • Reach age 59 ½
  • Become permanently disabled
  • Encounter a financial hardship (conditions apply)

People can also avoid a penalty if they separate from their employer at age 55 or older.

Note: When investors turn age 72, the IRS requires them to withdraw a required minimum distribution or RMD.

Employer-sponsored accounts like the 403(b) and 401(k), as well as traditional IRAs, are subject to RMDs. The penalties for not taking the required distribution can be costly.

What Are the Advantages of a 403(b) Plan?

The benefits of having a 403(b) are plenty! For example, the account contribution limits previously discussed are much higher than those allotted to individual retirement accounts.

Speaking of contributions, remember that 403(b)s permit bonus catch-up contributions to those with certain employment of 15 or more years. Other advantages include:

Tax Advantages

By contributing to a retirement plan, investors can reduce their taxable income in the now. Most people will be in a lower tax bracket in retirement, so it’s better to pay Uncle Sam later.

Shorter Vesting Periods

A vesting schedule refers to the time period before both employer contributions are 100% owned by the worker in a retirement plan.

Some plans vest funds immediately, others over a short period of time, but all are much quicker than 401(k)s typically.

ERISA Guidelines

If it isn’t receiving employer contributions, a 403(b) plan is not required to meet the demands of the Employee Retirement Income Security Act (ERISA), which implements regulations that protect the retirement assets of American workers by preventing plan fiduciaries from abusing plan assets.

This attributes to lower administrative fees when compared to other retirement plans.

What Are the Disadvantages of a 403(b) Plan?

That being said, accounts without ERISA protection also have disadvantages. Accounts may lack protection from creditors, bankruptcy, and lawsuits. Non-ERISA plans plus IRAs may not be protected depending on the state.

These laws are sophisticated. Unfortunately, these non-ERISA plans are exempt from nondiscrimination testing, which is designed to keep management or other highly compensated employees from receiving excessive benefits.

The lack of investment options is also a drawback to 403(b)s, and annuities often charge higher fees. Stocks, ETFs, and real estate investment trusts (REITs) are prohibited in accounts, but fortunately, this trend is changing.

401(k) vs. 403(b): The Differences that Matter

We’ve mentioned a few of the similarities between 403(b)s and 401(k)s. They follow the same rules regarding contribution limits and withdrawal conditions. Both offer a Roth option and allow employers to match contributions.

They are also taxed the same way, and some include loan options. The main difference between the two plans are the types of employees who are eligible to participate.

A 401(k) is for private sector businesses, and a 403(b) is for nonprofits and government organizations. A few other key distinctions:

  • Different Vesting Periods: As mentioned, funds in 401(k)s take longer to vest than in 403(b)s. Employers do this to encourage longevity in their workers. An average vesting period is five years.
  • Plan administration and Investment Election: 401(k)s are usually administered by mutual fund companies, whereas 403(b)s are typically administered by insurance companies. Therefore, the former offers better investment choices than the latter.
  • Bonus Contributions: Some 403(b)s allow bonus contributions for those with 15+ years of service with the same employer, up to a $15,000 lifetime limit.
  • ERISA Exemptions: Companies offering 401(k)s must follow certain ERISA rules that employers offering 403(b)s don’t have to. This difference can be good and bad for both types of accounts.

>> More: Differences Between 401(k) and 403(b) Plans

Can You Lose Money in a 403 (b)?

The short answer is yes. All retirement investments are subject to risk and can lose value, but leading up to retirement, employees will very likely be making positive returns.

For example, the average annualized return from 2011-2020 was 13.9%. An individual may lose money in their 403(b) if invested in an annuity.

These investment vehicles often levy surrender charges if money is transferred out before a predetermined period, usually several years.

Additionally, fixed annuities can lose money since they offer a payout based on the performance of underlying investments.

Bottom Line: What Is a 403(b) Plan?

If you’re someone with a 403(b) retirement plan, thank you for serving your community. If you’re someone who isn’t enrolled but can be, don’t wait any longer.

The magnitude of saving for retirement cannot be emphasized enough. And with a 403(b), you’ve got a few perks no other retirement plan can give you.

Keep Reading:

Samantha Cathey
Samantha Cathey

Samantha Cathey is a Senior Personal Finance Writer & Product Analyst with years of financial training and industry knowledge. She is a former banker, loan officer and investment advisor before dedicating her energy to helping individuals more creatively, through her writing. Samantha studied at the University of Idaho where she majored in Journalism and Writing. Her areas of expertise are mortgages, credit cards, loans, and investing.