403(b) Accounts Explained: What They Are and How They Differ From a 401(k)
A 403(b) retirement plan is an employer-sponsored plan for employees of public schools and certain 501(c)(3) tax-exempt organizations. Also known as a tax-sheltered annuity plan, a 403(b) is similar to a 401(k) in that it allows employees to save for retirement by contributing pre-tax income to their individual accounts. Employers can also contribute to employees’ accounts.
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When comparing 403(b) versus 401(k) plans, you’ll find that these tax-deferred retirement plans offer benefits not available to people working for for-profit entities; however, they also feature certain disadvantages.
How Does a 403(b) Retirement Plan Work?
Specific types of workers in nonprofit organizations have the option of deferring a percentage of their salary into a 403(b) retirement account. The contributions are tax-deferred, so contributors make these initial contributions with pretax dollars. Account holders will not pay taxes on contributions or gains within the account until after they make withdrawals.
Contribution Limits
For tax year 2022, employees could contribute up to $20,500 into a 403(b). That limit increases to $22,500 for tax year 2023.
Employees who are age 50 or older at the end of the calendar year may contribute an additional $6,500 in 2022 and $7,500 in 2023. The IRS refers to these as “catch-up contributions.”
Making Contributions
In many cases, an employer will automatically enroll employees in its retirement plan. Automatic enrollment forces employees who are not interested to opt out manually.
Once the employee is in the plan and has elected to defer a certain percentage of their pay, the employer withholds that percentage of wages and places the money in a 403(b) account. The employer can also contribute to the employee’s account. Plans that have employers match a portion of an employee’s contributions fall into this category.
Vesting
Still, receiving those funds depends on a schedule for vesting, or ownership, of the plan. All contributions made by an employee become vested instantly. Employer matching contributions, however, usually vest on a schedule determined by the employer.
Vesting can happen immediately, or the employer can choose to vest a certain percentage of contributions for each year of service offered. Vesting at 100% becomes automatic when an employee reaches retirement age or upon termination of the plan.
Related: Not All of the Money in Your 401(k) Is Really Yours
How Much Should I Contribute to My 403(b)?
Fidelity recommends saving at least 15% of your pre-tax income, including employer contributions, from ages 25 through 67, with the goal of building enough savings to make up 45% of your income in retirement.
Younger workers can benefit from the gift of time. Workers who wait until age 40 to begin saving will have to contribute more than three times as much as those who begin at age 25 to build the same amount of savings. For workers who are behind, catch-up contributions can help you meet your goal.
Whatever your financial limitations, you should always try to take advantage of any employer match that’s offered. For example, an employer might match 50% of the employee’s contribution on up to 3% of their income. Whatever the amount, the employer match is free money that will help your savings grow faster.
The maximum combined contribution you can receive into your account is 100% of your most-recent-year’s compensation, up to $61,000 in 2022 and $66,000 in 2023.
Choosing Investments for Your 403(b)
Investment choices are more limited with a 403(b) than with a 401(k), usually including only mutual funds and perhaps annuities, as mandated by the IRS.
If you’re not sure which of the available investments to select, considering working with a certified financial planner to develop the best strategy for your retirement goals.
Can I Withdraw From a 403(b) Plan?
Early withdrawal, which is before age 59 1/2, incurs a 10% penalty unless the the employee has an exception, such as for an IRS-approved hardship or severance from employment at or after age 55. In either case, the employee must pay income tax on the withdrawal.
If the plan allows it, an employee can take a loan against their 403(b). Although there’s no penalty, removing the money will result in lost gains.
Differences Between a 403(b) Plan and a 401(k) Plan
Is a 403(b) better than a 401(k)? Both plans take a portion of your paycheck to invest in retirement funds. They also offer the same tax-exempt growth while funds remain in their respective plans. Annual contribution limits for the 401(k) and the 403(b) are also the same — $20,500 in 2022 and $22,500 in 2023, plus catch-up contributions for employees age 50 or older. Additionally, employees can begin penalty-free withdrawals at age 59 1/2 in both plans.
What Are the Disadvantages of a 403(b) Plan?
The most obvious difference when comparing 403(b) versus 401(k) plans is that 403(b) participants must work for a school, government entity or a specific type of nonprofit organization. For one, organizations that offer a 403(b) do not earn profits — the plans cannot participate in profit sharing.
Also, funds in a 403(b) plan may not be protected from creditors.
What Are the Advantages of a 403(b) Plan?
Even so, 403(b) plans offer some advantages. On average, they come with lower fees. Moreover, 15 or more years of participation allows employees to contribute an additional $3,000 per year to their plans.
A 403(b) can also give employees more flexibility with contributions, loans and hardship distributions.
Comparison
The following table outlines the basic similarities and differences:
403(b) Plan | 401(k) Plan | |
|---|---|---|
Eligibility | Work for a nonprofit or government entity | Work for any private employer |
Contribution Limits | $22,500 per year in 2023, plus an additional $3,000 per year after 15 years in the plan; additional $7,500 if 50 or older | $22,500 per year in 2023; additional $7,500 if 50 or older |
Investment Options | Plan-selected mutual funds, variable annuities, retirement income account for church employees | Plan-selected options |
Penalty-Free Withdrawals | Reach age 59 1/2 or separate from service at 55 (50 for certain public safety employees); more options for hardship withdrawals | Reach age 59 1/2 or separate from service at 55 (50 for certain public safety employees); limited options for hardship withdrawals |
ERISA Protections | Optional | Required |
Is a 403(b) a Good Retirement Plan?
A 403(b) can be a good retirement plan, if you qualify and take full advantage of your employer’s matching. Once you know your plan options, you also need to find the discipline and the strategies to place savings in these accounts — especially when your employer offers matching funds.
Once you have funded the account, consider seeking financial advice to find the investments that will suit your needs and risk tolerances well.
Daria Uhlig contributed to the reporting for this article.
Information is accurate as of Feb. 22, 2023, and is subject to change.
This article originally appeared on GOBankingRates.com: 403(b) Accounts Explained: What They Are and How They Differ From a 401(k)
