If you work for a public school, charity or tax-exempt organization, you might be eligible for a 403(b) plan, which allows you to set aside tax-deferred savings for retirement. The 403(b) plan was designed with the nonprofit and public school sectors in mind and has similarities to other retirement accounts such as a 401(k) and IRA. A 403(b) plan “offers a way for participants to take a systematic and regular amount from their pay each month to save for their long-term goals,” says Brad Griffith, a certified public accountant and financial planner for Buckingham Advisors in Westerville, Ohio.
A 403(b) plan:
— Offers tax breaks on retirement savings.
— May be offered by employers in the nonprofit sector.
— Typically includes different options for investments.
— Takes contributions directly from a paycheck.
Following is a look at how a 403(b) plan works, the advantages and disadvantages of a 403(b) and how a 403(b) compares to 401(k)s and IRAs.
What Is a 403(b)?
Not-for-profit organizations such as public schools, colleges, hospitals, churches and charities can offer 403(b) accounts to their employees. If you sign up for the plan, you will have a certain amount of money taken out of each paycheck and placed into the account. You can defer paying tax on up to $19,500 of your earnings that you contribute to a 403(b) in 2021. If you are 50 or older, you are eligible to make additional catch-up contributions of up to $6,500.
Some employers offer to match your contributions to the 403(b) up to a certain amount. For instance, your organization might opt to match up to 3% of your salary. In this case, if you earn $1,000 during a pay period and put $30 in the 403(b), your employer will add another 3%, or $30, to your account. The total amount that can be contributed to the plan, including your employer’s contributions and your own, is $58,000 for 2021.
How to Use a 403(b) Plan
If you work in the nonprofit sector and want to save for retirement, a 403(b) plan might be a good fit. “You will have to select from a set list of investment choices when electing how to invest your contribution,” says Heather Comella, lead financial planner at Origin in San Francisco. Your investment options might include stocks, bonds, mutual funds or annuities. If you are just starting out in your career, you may decide to buy investments such as stock funds. Over time, as retirement draws near, you might opt to move some of your money into more conservative investments such as bond funds.
Once you retire, you could keep the account or rollover the funds to an IRA. “As long as they stay in that ‘retirement account shell’ this type of transfer would be a nontaxable event,” Comella says.
The Advantages of a 403(b)
The amount you put into the 403(b) will be deducted from your income, and you can defer paying tax on it. If you put in $30 during a pay period in which you earned $1,000, your taxable income will only be $970. You won’t have to pay taxes on the $30 contributed to the account when you put it in. Distributions from the 403(b) will be considered income and taxed as such when you withdraw funds in retirement.
All employees who work more than 20 hours per week are offered eligibility for a 403(b) plan. “This is called the ‘universal availability’ rule,” says Richard Tatum, president of retirement services at Vestwell in New York. Employers may choose to put a waiting period on matching contributions.
The Disadvantages of a 403(b)
A 403(b) plan typically does not have as many investment choices as some other types of retirement accounts, such as an IRA. “There are also fees for participating in an employer sponsored retirement plan, so make sure you understand what fees your account will be subject to,” Comella says.
Since the plan functions as a retirement savings vehicle, you could face additional expenses if you take withdrawals early. “If you distribute funds from a 403(b) account before age 59 1/2 your funds may be subject to taxes and early withdrawal penalties,” Comella says.
A 403(b) Plan vs. a 401(k) Plan
The contribution limit for 403(b) plans and 401(k) plans is the same in 2021. However, an organization’s 403(b) plan may also include a special catch-up contribution for long-term employees with at least 15 years of service. In that case, contributions could be increased up to $3,000 per year, with a lifetime limit of $15,000. This makes it possible to save more in a 403(b) than a 401(k) near the end of your career.
For traditional 401(k)s and 403(b)s, the amount you put into the plan will be deducted from your income, and you can defer paying tax on it. The money contributed will grow tax-free until you take it out. Distributions will be considered income and taxed as such when you withdraw funds in retirement.
Both plans may also allow Roth contributions. With a Roth, the contributions made are considered taxable income, and will be subject to taxes during the year you put them in the plan. Funds in a Roth account grow tax-free, and withdrawals in retirement can be made tax-free.
A 403(b) Plan vs. an IRA
While a 403(b) plan is sponsored by an employer, an IRA must be opened and funded by an individual investor. Your employer can contribute to a 403(b) plan on your behalf, but it cannot make contributions to an IRA.
IRAs have different contribution limits than 401(k)s and 403(b)s. You can contribute up to $6,000 to an IRA in 2021. If you are 50 or older, you can put $7,000 in an IRA during 2021. This is significantly less than the contribution limit for a 403(b) plan.
You will find more investment options available through an IRA, but you might not receive as much information regarding how to manage your funds. “There are no income limits that apply when making a 403(b) contribution,” Comella says. “However, there are income limits to watch out for if you’re trying to make an IRA contribution.”
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Update 07/14/21: This story was published at an earlier date and has been updated with new information.