Do you work for a nonprofit or tax-exempt organization? In that case, you’re probably driven by your desire to help others. But, who’s going to take care of you when it’s time to retire?
Unlike your peers you’ve put in their time at a corporate gig, you probably don’t have access to a 401(k). Does that mean you have to self-fund your retirement? Not necessarily if your employer offers something known as a 403(b) retirement plan.
What is a 403(b) Retirement Plan and How Does it Work?
403(b)s are retirement plans offered by non-profit organizations and some tax-exempt employers, such as not-for-profits and some governmental organizations. A 403(b) plan is named after the section of the Internal Revenue Service (IRS) code for which they are designed.
As of 2018, about one in five U.S. employees had access to these accounts, according to the Investment Company Institute. In spite of this, they get far less attention than their private, for-profit counterparts, 401(k) plans. However, a 403(b) works very much like a 401(k) in that eligible employees can contribute to their retirement funds through payroll deductions (also called elective deferrals) based on a percentage of their salary or a personal budget.
As an additional benefit, employers can contribute to your accounts as well — aka matching contributions. When you are ready to invest in the 403(b), be sure to invest at least that percentage of your employer’s match
403(b) plans are generally divided into two types: traditional and Roth. Just note that employees may not have access to the Roth version in all workplaces.
As part of a traditional 403(b) plan, pretax money is deducted from each paycheck and placed into the employee’s personal retirement account. At the same time, the employee has saved some money for the future and reduced his or her gross income and tax liability. And. taxes are due on those funds only when the employee withdraws them.
When a Roth 403(b) is established, after-tax money must be contributed to the retirement account. It does not provide immediate tax benefits. However, when the money is withdrawn, the employee won’t have to pay any more taxes on that money or on the profit it accrues.
Who is Eligible for a 403(b) Retirement Plan?
It’s important to note that 401(b) plans are not open to everyone. Participants must be employed by certain organizations and institutions for tax reasons.
Those who are eligible to participate in a 403(b) plan include:
- People who work for tax-exempt 501(c)(3) organizations
- Employees of public schools, state colleges, and universities
- Public school employees of Indian tribal governments
- Those who work for cooperative hospital service organizations
- Members of the faculty and staff of the Uniformed Services University of the Health Sciences
- Ministers employed by 501(c)(3) organizations
- A minister or chaplain who is employed by a non-501(c)(3) organization, but who functions as a minister in their daily professional responsibilities
- Ministers who are self-employed
In accordance with the IRS, employers can exclude employees who work less than 20 hours a week from participation in a 403(b) plan.
403(b) Plans Versus 401(k) Plans
In many ways, a 403(b) plan is similar to a 401(k). They are both offered by employers, and your employer can contribute to both accounts. The key difference, though, is that 401(k) plans are offered by for-profit companies whereas 403(b) plans are offered by religious organizations, government, and nonprofits.
Another difference? A 403(b) plan also allows workers who have served for at least 15 years with the same nonprofit or government entity to contribute an additional $3,000 a year to their accounts. And, the maximum lifetime contribution is $15,000.
As a final note, 403(b) plans are typically handled by insurance companies, while most 401(k) plans are handled by mutual fund companies. As a result, 403(b) plans tend to feature annuities more often than 401(k) plans.
How to Invest in a 403(b) Retirement Plan
As compared to other tax-advantaged retirement plans, 403(b) plans have fewer investment options. Most commonly, you’re limited to mutual funds and annuities. And, in contrast to 401(k)s, you cannot typically invest in individual stocks, exchange-traded funds (ETFs), or real estate investment trusts (REITs).
Nevertheless, many 403(b) plans offer low-cost bond and stock index funds for retirement investments. As a general rule of thumb, you should pick a stock fund/bond fund mix that reflects your time left before retirement, as well as your risk tolerance. As you get older, you’ll typically have more bond funds and fewer stock funds.
A target-date fund can simplify your investment strategy greatly if it’s offered by your 403(b) plan. How so? By automatically adjusting your holdings based on your retirement target date.
As an alternative, you may invest all or part of your retirement savings in an annuity through your 403(b). Before you invest in annuities, consult with a financial advisor. While annuities can provide a guaranteed lifetime income, they can also be complex and expensive.
An IRA can also serve as a supplement to a 403(b) plan if it does not provide the options you want. However, investing in an IRA should only be done if your employer will match your 403(b) contributions.
403(b) Retirement Plan Contribution Limits, Distributions, and Penalties
403(b) plans have contribution limits, early withdrawal penalties, and tax implications, just like other employer-sponsored plans. The maximum employee contribution to a 403(b) plan is $20,500 in 2022. The total contribution limit for retirees over 50 years of age in 2022 will increase to $27,000 when they make catch-up contributions of $6,500.
A 10% early withdrawal penalty applies if you withdraw from your 403(b) before you are 59 ½. You would also lose the growth potential of those dollars. That means you could be depriving yourself of thousands of dollars down the road.
What about distribution? This is when you withdraw money from your 403(b) plan without being penalized. The reason? You’re either 59 ½ or you’re transferring the money from one qualified plan to another.
If you are a member of the reserves, you are exempt from the early withdrawal penalty. The IRS doesn’t apply a 10% penalty to qualified reservist distributions if you’re called to active duty for more than 179 days (thank you for your service!). However, distributions are still taxable in this case. But, unless you need this money for an emergency, you should leave it alone so that it can continue to compound and grow.
The Advantages and Disadvantages of a 403(b) Retirement Plan
A 403(b) plan comes with distinct benefits and drawbacks. Listed below are a few of the most common.
- Tax advantages. A 403(b) account carries the same tax advantages as a 401(k) or IRA account. You may also have a reduced tax bill this year, depending on if you choose a Roth 403(b), instead of paying taxes on retirement distributions. But your retirement withdrawals will be tax-free if you pay taxes on your contributions.
- High contribution limits. The 403(b) contribution limit is the same as what can be contributed to a 401(k) but is much higher than an IRA contribution limit.
- Employer matching. A company offering a 403(b) plan might match some of its employees’ contributions, similar to a company offering a 401(k). At the same time, companies have different rules when, how, and if they will match employees’ contributions.
- Additional catch-up contributions. The employee may be eligible to contribute more to a 403(b) plan if they have worked for certain nonprofits or government agencies for 15 or more years. You can contribute an additional $3,000 a year under this provision, with a lifetime contribution cap of $15,000. Unlike most retirement plans, this one does not require you to be older than 50 to take full advantage of it.
- Shorter vesting schedules. When you have access to your employer-matched funds depends on your vesting schedule. 401(k) vesting schedules tend to be longer, while 403(b) vesting schedules are generally shorter. There are even some 403(b) plans that offer immediate vesting, which means that you can keep all employer-match
Another perk worth mentioning? If you enroll in a 403(b) retirement plan through work, your employer will handle the bulk of the paperwork.
- Investing options are limited. The only annuities offered by 403(b)s were variable annuities until recently. While this is no longer true, these types of accounts offer fewer investment options than 401(k) accounts or IRAs.
- There are high fees. While this is not true of all 403(b) plans, there are some that charge higher fees that can reduce your profits. For maximum profits, look into the plan’s administrative costs and any fees associated with your investments. The lower these are, the better your returns will be.
- Early withdrawal penalties. Taking money out of your tax-deferred 403(b) before age 59 ½ is subject to a 10% early withdrawal penalty. Although you can waive the penalty if you have a qualifying reason, such as a large medical expense. However, this is also the case with 401(k)s and IRAs.
- ERISA is not always applicable. To protect employees, the Employee Retirement Income Security Act (ERISA) establishes minimum standards for retirement plans, including reporting and fiduciary standards. However, many 403(b)s aren’t covered by ERISA. As such, you should do more research to determine if it’s the right place to invest your money before you commit.
And, finally, for 403(b) plans, fewer employers match contributions than for 401(k) plans.
403(b) Retirement Plan FAQs
1. When was the 403(b) retirement plan established?
401(b) plans were introduced in 1958. Participants could initially invest only in annuities, primarily a tax-sheltered annuity. Paragraph 7 of the plan was added in 1974, enabling mutual fund investments through a 403(b)(7) custodial account. Despite this, most 403(b) plans still favor annuities.
2. When can an employee join a 403(b) plan?
An employee’s eligibility to enroll in a 403(b) plan is determined by the plan’s terms. Generally speaking, a 403(b) plan must make all eligible employees eligible for the plan as soon as they begin working due to the universal availability rule.
It is the employee’s responsibility to determine how to enroll in the plan with their employer.
3. Can a 403(b) plan automatically enroll employees in the plan?
Short answer? Yes.
If a 403(b) plan allows employees to contribute, they can be automatically enrolled. The plan’s provisions contain a provision for automatic contributions, and employees are not permitted to opt-out.
4. Can you make early withdrawals?
If you withdraw funds from your 403(b) account before you reach the age of 59 ½ there will be a 10% penalty added to the tax on the money not already taxed. But, you can avoid the early withdrawal penalties in a few cases, including;
- The Rule of 55. Withdrawals from a 403(b) plan are penalty-free when you leave your employer at age 55 or later. However, any money in an IRA or previous employer retirement account will be penalized as usual
- Substantially equal periodic payments (SEPPs). You can avoid the 10% penalty for early withdrawals by sticking to a payment schedule under a rule known as 72(t). These distributions must be taken for at least five years or until you reach the age of 59 1/2, whichever occurs later. If you need help calculating your SEPP withdrawals, speak to a financial advisor.
- Medical emergency. You can take an early withdrawal to cover unreimbursed medical expenses greater than 7.5% of your adjusted gross income without paying a penalty if those expenses exceed 7.5%.
Consider your situation carefully before taking an early withdrawal under section 403(b). And, always take a look at whether early 403(b) funds are worth paying for if you can’t avoid it.
5. What regulations protect consumers with 403(b) plans?
The Internal Revenue Service (IRS) regulates all 403(b) plans. In addition to defining who may participate in the plan, the IRS specifies which investment options are permitted. The IRS also requires 403(b) plans to include a document that describes the eligibility, restrictions, and benefits of the plan.
The Employee Retirement Income Security Act (ERISA), the same federal pension law when it comes to 401(k) plans, may apply to 403(b) plans offered by charitable organizations or private schools and universities, depending on the level of employer involvement.
All state-run retirement plans are exempt from ERISA, including 403(b) plans offered by public schools and universities. Also, state and federal securities laws provide protection to consumers in non-ERISA arrangements. In addition, state insurance departments regulate and protect life insurance consumers and companies that offer 403(b) plan annuities.
The Securities and Exchange Commission regulates variable annuities, along with state laws and regulations. In order to sell variable annuities, one must be a registered representative of a broker-dealer that belongs to the Financial Industry Regulatory Authority. Furthermore, the representative must be licensed by the state in which the annuity is being sold.