The federal government gives Americans a variety of ways to get tax breaks for putting money aside for retirement, among them, the 403(b) plan. These are commonly offered by employers in the educational, medical, and nonprofit world as a way of offer their employees a better tool for retirement saving.
One of the biggest benefits of a 403(b) plan -- also known as a tax-sheltered annuity -- is the high annual contribution limit. Workers can put aside up to $18,000 in 2017 if they're younger than 50, or $24,000 if they're 50 or older. Below, we'll take a closer look at what 403(b) plans are, and why they're a good option for those who have access to them.
How 403(b) plans work
Section 403(b) of the Internal Revenue Code defines what these plans are, along with their requirements and benefits. In most ways, a 403(b) plan is similar to the more common 401(k) employer retirement plans you'll find throughout much of the private sector. However, 403(b) plans can be offered only by tax-exempt organizations -- either public schools, charities or other nonprofits. Most people who are eligible for 403(b) plans work for employers like public educational facilities, nonprofit hospitals and healthcare providers, churches, and other public charities.
In part because the employers that offer 403(b) plans aren't for-profit entities, many of them aren't as generous as their 401(k)-providing counterparts. For instance, it's somewhat rarer for 403(b) plans to offer an employer match than it is for 401(k) plans.
In addition, some 403(b) plans suffer from investment options that aren't ideal for most retirement savers. One reason for this goes back to the creation of the 403(b) plan. Initially, employers were required to purchase tax-deferred annuities in order to qualify for favorable tax treatment. Such annuities often come with more expensive annual fees, as well as features that aren't always well-suited to retirement saving. In the decades since, the rules for 403(b) plans have undergone revisions that allow them to hold mutual funds and exchange-traded funds as well. Even so, not all employers offer such options, and that can impose hardships on workers looking to minimize their costs and maximize the amount of retirement savings they get to keep.
2 types of 403(b) plans
All that said, 403(b) plans can be extremely valuable for workers, because they offer tax benefits that you'll have trouble matching anywhere else. Two types of 403(b) plans are available, and employers can choose to offer one or both.
A traditional 403(b) allows workers to save money on a tax-deferred basis, excluding it from their current taxable income. For instance, if you earn $50,000 and decide to contribute $5,000 to your 403(b) plan, then when you file your tax return, that will reduce the taxable income from your salary to $45,000. Moreover, you won't have to pay taxes on any interest, dividends, capital gains, or other income the investments in the fund generate, as long as the money remains in the 403(b) account. Once you retire, you'll have to include any amount withdrawn as taxable income in the year you take it out, but you'll generally have considerable flexibility in choosing when to take withdrawals.
Meanwhile, a Roth 403(b) offers a different type of tax savings. Roth 403(b) contributions don't reduce your current gross income for tax purposes -- you still pay taxes on the money you stash in the account for the year you earned it. However, the trade-off for paying tax now is that Roth 403(b) contributions get to grow on a tax-free basis. When you withdraw the money in retirement, you won't have to pay taxes on any of it -- even though a substantial portion of the account balance by then will usually represent income and gains on the initial contribution.
The biggest benefit of the 403(b)
If you have access to a 403(b) plan, the high maximum contributions give you more flexibility than most other tax-advantaged retirement plan options. For instance, you can always use an IRA instead of a 403(b), but the annual contribution limits on IRAs are much lower -- currently $5,500 for those under 50 or $6,500 for those 50 or older.
Even though they aren't as well-known as 401(k) plans, a 403(b) gives you the same high contribution limits. If your employer does a good job structuring the plan's investment options, a 403(b) plan can be an ideal place to build up a healthy retirement nest egg.