403(b) plan is a retirement plan for specific employees of public schools, tax-exempt organizations and certain ministers. These plans can invest in either annuities or mutual funds. A 403(b) plan is also another name for a tax-sheltered annuity plan, and the features of a 403(b) plan are comparable to those found in a 401(k) plan.
Employees may make salary deferral contributions, but they are bound by regulatory limits. Individual accounts in a 403(b) plan include an annuity contract, bought through an insurance company or a custodial account, which invests in mutual funds or a retirement income account established for church workers.
Employees of tax-exempt organizations are eligible to participate in the plan. Participants include teachers, school administrators, professors, government employees, nurses, doctors and librarians. A TSA is another funding source for retirement in addition to a retirement plan or pension that helps employees meet their retirement goals. Many plans vest funds over a shorter period than 401(k) plans or may allow immediate vesting of funds.
Benefits of a 403(b) Retirement Plan
Earnings and returns on amounts in a 403(b) plan are tax-deferred until withdrawn. Earnings and returns on amounts in a Roth 403(b) are tax-deferred if the withdrawals are qualified distributions. Employees age 50 or over can make catch-up contributions to both plan types, and employees may be eligible for matching contributions, which varies by employer.
For example, an employer matches funds at 50 percent of any employee contribution up to 6 percent of his or her salary. If an employee earns $75,000 and contributes 6 percent per year, the employer contributes $2,250 per year, which is essentially free money toward the employee’s retirement. This helps employees exceed the annual maximum contribution limits, receive tax deductions and accelerate their retirement goals.
How to Contribute to a 403(b) Plan
Different types of contributions fund TSAs, such as after-tax contributions, nonelective contributions and elective deferrals. After-tax contributions are voluntary contributions that a participant must include as income when filing taxes. Non-elective contributions are mandatory employer contributions, such as discretionary contributions that include end-of-plan-year contributions or profit-sharing contributions. Elective deferrals are voluntary contributions set up by the employee that allows an employer to withhold money from the employee’s paycheck to be paid directly into his or her TSA. These contributions are a percentage of the employee’s salary. Another funding option is using a combination of elective, non-elective and after-tax contributions.
All employee contributions are limited to $18,500 per year, as of 2018. The combination of employee and employer contributions are limited to the lesser of $55,000 per year, as of 2018, or 100 percent of the employee’s most recent yearly salary.
Disadvantages of a 403(b) Plan
A 403(b) plan withdrawal before age 59 1/2 is subject to a 10 percent tax penalty. A participant may avoid the penalty under certain circumstances, such as separating from an employer when a person reaches age 55, a qualified medical expense, death of the employee or disability. Withdrawals are subject to 20 percent federal income tax withholding unless the total amount is transferred to another qualified retirement plan or individual retirement account. However, if a participant wants to dissolve an annuity investment, the participant must pay a surrender charge of up to 8 percent of the investment.
Where the Money Goes
Employers that want to establish 403(b) plans create them to accommodate a few different types of assets in which their employees can invest through their accounts. These are:
- Tax Deferred Annuities or Tax-Sheltered Annuities. These are a type of annuity contract provided by insurance companies through a 403(b) investment to provide income later in life.
- A custodial account at an appropriate financial institution such as a brokerage firm that holds the securities of registered investment companies such as mutual funds. This version is probably the most commonly understood type of 403(b) retirement plan.
- A retirement income account such as a Roth IRA that lists either type of investment option as a choice for the owners of the 403(b) accounts; that is, they can invest in either mutual funds or eligible annuities.
403(b) Contribution Limits
The government provides fairly high 403(b) contribution limits for those who want to plan for retirement. The maximum potential 403(b) contribution is $55,000 per year for fiscal year 2018 if you meet certain conditions.
The following is a breakdown of the potential 403(b) contributions that can be made:
- Basic salary deferral (the maximum payroll amount an employee can contribute to their 403(b) plan by having money taken out of their check) is $18,500 for fiscal year 2018.
- Employees 50 years and older can add $6,000 per year in special 403(b) contributions called “catch-up” 403(b) contributions. This is in addition to the $18,500 they can put aside as a regular employee.
- Some people are eligible for an additional 403(b) contribution known as a 403(b) Lifetime Catch-up. This special type of 403(b) contribution is only available to employees who have worked for a qualified organization for 15 years or longer. Often, this special 403(b) contribution is referred to as the “15-year rule” from IRS Publication 571.
- These 403(b) contributions, combined with any matching funds provided by the employer, cannot exceed 100 percent of compensation or $55,000 for the fiscal year 2018. Thus, the only people who will be able to take advantage of the total maximum 403(b) contribution are those who work for a company that has extraordinarily rich benefits.
- The government allows these 403(b) contribution limits to increase for inflation by releasing the cost of living adjustment figures each year.
- When you reach the age of 59.5 years old, you can begin taking regular 403(b) withdrawals without penalties – you will simply pay regular income taxes on the money you take out of the account.
- If you are younger than that age, however, you will be subject to a special 10 percent tax penalty on top of the income tax unless you meet one of a handful of special situations.
403(b) Required Minimum Distributions
As part of your participation in a 403(b) plan, the IRS will require you to begin taking the required minimum distributions by April 1st of the year following the calendar year in which you turn 70.5 years old. The only exception is if the 403(b) plan allows, an employee who still works can defer the required minimum distributions until the year after they have retired. This option is not available to those employees who own more than 5 percent of the company.
The purpose of a 403(b) account is for you to save for retirement. The Government doesn’t want investors to sock away large amounts of capital without paying taxes on the gains. This is one of the reasons that it is often advisable to have a Roth IRA in addition to a 403(b) account. The Roth IRA will never be subject to taxes in case you find the next Microsoft or Berkshire Hathaway; every penny stays in your family.
You must begin taking required minimum distribution 403(b) withdrawals in an amount calculated so that the entire balance of your assets within the retirement plan will be distributed to you by the end of your life expectancy.
An accountant can help you break out the actuarial tables and calculate when you are likely to pass away, using the number of years of life left as a guide to coming up with a precise figure the IRS is likely to support. In some cases, you can use the life expectancy of the designated beneficiary of the 403(b) plan, as well, which could be longer in the case of a married couple where one spouse is substantially younger than the other. If you do not take your required minimum distribution 403(b) withdrawals, the IRS will penalize you with a 50 percent excess accumulation tax.
How Much Should I Contribute to a 403(b)?
The average goal for most people is to save around 15% of their income for retirement each year. Worth noting: Your employer match counts towards that total. You should always take full advantage of your employer match if you have one since it’s basically free money, earmarked for your retirement. When you are investing for retirement, a good plan of action is to invest in your 403(b) the full amount that your employer matches, then max out your IRA contributions. Then, if you still have funds you’d like to invest in your retirement, return to your 403(b) until you’ve reached the 15% goal.
Other tips to invest in your 403(b) effectively:
- Start by contributing up to your employer match (if you have one).
- Each time you get a raise, increase the amount of your contribution.
- If you are paying off debt, decrease your contributions until the debt is paid off, but don’t stop contributing altogether. Then, once you’ve completed your debt payoff plan, increase your contributions.
Should I Choose High Risk or Conservative Investments for My 403(b)?
When you are in your 20s, it makes more sense to choose higher risk investments.
The rate of return on these investments is higher than the conservative investments. When you are young, you can afford to ride out the market. This means you will have a chance to recover if the market drops.
However, as you near retirement age, you should begin transferring your funds to more conservative investments.
You can re-balance your 403(b) portfolio by talking to a human resources representative at your company. You may also choose to seek the advice of a financial advisor. It is important not to panic if your portfolio drops due to a market dip. This is common, and if you are several years away from retirement, your portfolio should have time to recover.
Other Tips on How to Invest in yYour 403(b):
- Think about how much you are willing to risk and how long until you retire.
- Monitor your account, but try not to panic if the market dips.
- Be sure to adjust your portfolio as you get closer to retirement age.
- Can I Choose Between a 403(b) or a 401(k)?
- Your employer will determine the type of plan that it offers you. This means you will not have an option to choose a 403(b) or a 401(k).
Yet, the rules for the plans are basically the same. You can contribute the same amount to each plan each year. You have the same rollover rules, and similar rules when it comes to being vested in the plan. The withdrawal penalties are also the same.You also may consider a traditional IRA or a Roth IRA as a means of additionally padding your retirement fund.
Should I Save for More than Just Retirement?
If you want to build wealth, you will need to save more than just the money you put toward retirement each year. You should have regular savings goals that you set for yourself. These goals should include an emergency fund, a down payment for a home, and money for your children’s education in the future.
After those goals are met, you may want to save up for larger projects around your home, or maybe even your dream vacation. You may also choose to invest in real estate or to put additional money in the stock market. However, keep in mind that real estate is a risky investment.
Other Tips on How to Grow your Net Worth:
- Make retirement savings a priority.
- If you plan on retiring early, you will need to build investments that you can draw on before you reach retirement age.
- Consider talking to a financial adviser to set up a plan that will allow you to reach your goals on your timeline.
What Happens If I Change Jobs?
Once you are vested in your 403(b) plan, you can take the money with you when you change jobs. You will likely need to roll it over in an IRA account. If you are not vested, you will lose your employer’s contributions, but you will keep the money that you have put into your retirement plan yourself.
Some employers will require you to roll over the account, others will allow you to stay with the current plan as long as you have a specific amount in the account. If you have any questions, your human resources representative should be able to answer your questions or connect you with someone who can.
401 k vs 403(b)
The 401(k) is a retirement plan offered mostly by for-profit companies to assist employees in saving for retirement. Decades ago companies offered their employees a pension but in 1978, Congress passed the Revenue Act of 1978.That when Section 401(k) of the tax code was born. By 1983, nearly half of all large companies offered a 401(k) and today, there is more than $4.8 trillion invested into 401(k) plans.
- A 401(k) is what is called a qualified plan in IRS lingo. Your company gets a tax benefit for contributing money to the account on your behalf and you can contribute part of your paycheck to the plan before the IRS taxes the funds.
- But let’s not forget the rules. Qualified plans allow contributions of up to $18,500 in 2018, you can’t withdrawal money out of most 401(k) plans until you reach age 59 ½ or meet certain IRS conditions, and you have to begin taking withdrawals by age 70 ½. (Roth 401(k) plans have different rules.)
- 401(k) and other company-sponsored retirement plans also limit the amount of investing choices you have. Unlike an IRA where you can choose between most types of traditional investing products, a 401(k) may only have 20-25 choices.
The big killer of retirement plan balances is fund fees. Depending on the quality of the plan, you may be stuck with less than ideal options from a fee perspective.
You’re not going to believe this but from the perspective of the average employee, there are next to no differences between a 401(k) and a 403(b). Generally, non-profits including schools, hospitals, and religious groups offer their employees 403(b) retirement accounts instead of 401(k) although the 401(k) is available to any company regardless of type. Does that mean that for-profit companies can offer a 403(b)? No. You can’t be a for-profit company and offer a 403(b).
Just like a 401(k), the 403(b) allows you to make tax deferred deposits, have the same contribution limits, and come with all of the same withdrawal rules as the 401(k). One difference that applies to a small subset of employees—if you have 15 years of service and your company is considered a “qualified organization,” you may be eligible to contribute an extra $3,000 to a 401(k). This is not available in a 403(b).
Another difference between a 401(k) and a 403(b) is the investment choices. Although most 401(k) plans offer different types of mutual funds as their investing choices, 401(k) plans have the option to offer other choices. 403(b) plans may only offer mutual funds and annuities. Technically, 403(b)s are more limited on investing options than 401(k)s but in practice, there’s not much difference.
Finally, because 403(b)s are more limited in the amount of companies they can serve, and non-profits tend to be smaller and have less resources than larger for-profit companies, 403(b)s have gained the reputation of having higher fees than 401(k) but recent trends have seen 403(b) plans emerge with lower fees.
Which is Better?
There are some other benefits to non-profits that might make a 403(b) more attractive but to the vast majority of employees, the type of plan doesn’t matter. One isn’t better than the other. Instead of evaluating a 403(b) vs. a 401(k), evaluate the investment options inside the plan. Generally, the larger the company, the lower the plan fees because there are more people participating, which brings the costs down.
If you work for a small company, you can find lower cost index funds as investment options instead of placing money in the higher-priced actively managed funds. Either way, if your company is matching your deposits, participate in the plan up to the maximum amount they’ll match. After that, open an IRA if the plan’s fees are high.