Unless you’re a teacher or you work for a nonprofit, you may not be familiar with a 403(b) plan. This employer-sponsored retirement plan has been around for a long time, but it’s less popular than a 401(k).
A 403(b) is offered by public schools and tax-exempt organizations. Like a 401(k), you can contribute money from your paycheck every month, and your employer has the option to match your contributions.
Let’s look more closely at what a 403(b) plan is and what you should know before signing up.
What Is a 403(b)?
A 403(b) is an employer-sponsored retirement account offered by public schools and 501(c)(3) tax-exempt organizations. When you take out a 403(b), you can contribute some of your salary toward your retirement savings. Your employer may contribute to the plan as well.
Like a 401(k), there are two different types of 403(b) plans you can choose from. The main difference between the two plans is in how they are taxed:
- Traditional 403(b): A traditional 403(b) plan is funded with pre-tax dollars, and your money grows on a tax-deferred basis. So instead of paying taxes now, you’ll be taxed on your withdrawals during retirement.
- Roth 403(b): A Roth 403(b) plan is funded with after-tax dollars, so any money you contribute will grow tax-free. That means you won’t pay any taxes on withdrawals you take out during retirement, and that's why so many people believe utilizing the Roth, whether it's an IRA or in a 403(b), is such a great deal. However, this only applies to the contributions you make—if your employer matches your contribution, that money is tax-deferred. That means you’ll have to pay taxes on the money your employer contributes when you're in retirement.
How Does a 403(b) Work?
When you take out a 403(b) plan through your employer, you’ll contribute a certain amount from your salary. These contributions are subject to the annual limits set by the IRS.
The benefit to taking out a 403(b) is that your employer can match these contributions. If your employer offers a match, you should take advantage of this option since it’s free money.
403(b) Contribution Limits
The IRS sets annual contribution limits on how much money you can contribute to your 403(b) plan. However, these contribution limits are subject to change.
In 2021, employees can contribute up to $19,500 annually, but these limits will increase to $20,500 in 2022. The IRS does allow catch-up contributions for individuals over the age of 50. The catch-up contribution limit will remain at $6,500 for 2022, so if you're 50+, your 403(b) employee contribution limit will be $27,000 in 2022.
If you've worked for your employer for at least 15 years and your annual contributions are less than $5,000, you can make a lifetime catch-up contribution of $15,000. You can make this payment in yearly $3,000 increments.
Who Is Eligible for a 403(b)?
According to the IRS, the following employees are eligible for a 403(b) plan:
- Eligible employees who work for a 501(c)(3) tax-exempt organization
- Eligible employees who work for a public school, state college, or university
- Eligible employees who work for a church
- Employees who work for a public school organized by an Indian tribal government
- Ministers who work for 501(c)(3) organizations
- Self-employed ministers who are treated as employed by a qualifying organization
- Ministers who meet both of the following requirements: 1) They’re employed by organizations that are not 501(c)(3) organizations, and 2) They work as a minister in their daily professional obligations
How to Open a 403(b)
Here are the steps you’ll take to open a 403(b) plan:
- Decide What You’ll Invest In: The first step is to decide what you want to invest in. 403(b) plans come with multiple investment options, including mutual funds, fixed annuities, and variable annuities.
- Choose How Much to Withhold: Next, you need to decide how much money you want to withhold from your salary. This could be a dollar amount or a percentage of your paycheck.
- Determine If Your Employer Matches Your Contributions: You should find out if your employer offers a match for your monthly contributions. If so, this is free money you’ll be earning toward your retirement savings.
- Make Catch-Up Contributions: If you’re over the age of 50, you can make additional catch-up contributions.
Pros and Cons of 403(b) Plans
There are advantages and disadvantages to participating in a 403(b) plan. Here are a few things you should consider before investing.
- High Contribution Limits: If you take out a traditional 403(b) plan, the contribution limits are much higher than the IRA contribution limits (you can only contribute $6,000 into a traditional IRA in 2022).
- Employer Matching: Some employers will be willing to match your contributions. You should check with your employer to see what the company is willing to contribute.
- Catch-Up Contributions: Employees 50 or older can make the standard catch-up contribution of $6,500 per year for a total of $27,000 in 2022. But if you’ve been with your employer for at least 15 years, you can make a lifetime catch-up contribution of $15,000.
- High Fees: Some 403(b) plans come with high fees, though this isn’t true of every plan. You should try to keep the fees as low as possible to maximize your profits.
- Early Withdrawal Penalties: If you withdraw funds from the plan before the age of 59½, you’ll pay a 10% early withdrawal fee in addition to the applicable taxes you owe.
403(b) Distributions and Withdrawals
You need to be at least 59½ to begin making withdrawals from your 403(b) plan without penalty. Assuming you have the traditional plan, the amount you withdraw (and its growth) will be taxed at the standard income tax rate. You won't pay any taxes if you have a Roth 403(b) plan since the account was funded with after-tax income.
Once you reach the age of 72, you must begin taking the required minimum distributions (RMDs). RMDs are calculated based on your account balance at the end of the previous year and the IRS life expectancy tables.
How Is a 403(b) Different from 401(k) and 457(b) Accounts?
A 401(k) is typically offered by larger organizations, but owning an individual 401(k) and having a 403(b) could cause some problems because there's is a unique rule if you have a 403(b) AND a 401(k) that prevents many doctors who use a 403(b) at their main job from maxing out an individual 401(k) on the side, at least if they own 50% or more of the company for which they have an individual 401(k).
A 457(b) is usually provided by state and local governments. However, a 457(b) plan doesn’t come with any age restrictions. You’re free to begin withdrawing money from the plan once you stop working.
All three plans come with the same annual contribution limits.
Do You Pay Taxes on a 403(b)?
Yes. If you take money out of a traditional 403(b), you won’t pay any taxes until you begin withdrawing money in retirement. With a Roth 403(b), you make contributions with after-tax dollars so that you won’t pay any taxes in retirement. Either way, you are getting taxed.
What Happens to My 403(b) If I Change Jobs?
If you leave your job, there are a few options for what you can do with your 403(b) plan. You may be able to roll over your 403(b) into your new employer’s retirement plan. However, you’ll need to contact your new employer to ensure this is an option. You can also roll it over into your own IRA, or you can roll it into a solo 401(k) if you have self-employment income.
You can also cash out the plan, but this isn’t ideal. You'll miss out on tax-advantaged growth, and you’ll also pay income taxes on anything you withdraw. And if you’re under the age of 59½, you may face an additional 10% penalty from the IRS.
And finally, your former employer may let you leave the money in the plan. You can check with the human resources department to find out what your options are.
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