It's important to save for retirement, but it's hard to do it all on your own. There are many tools you can use to boost your independent retirement savings, such as a regular investment account or tax-favored IRAs. But many workers are fortunate enough to get some help from the companies they work for, and employer-sponsored retirement plans often have attractive features that demonstrate your employer's commitment to helping you retire in comfort.
Employer-sponsored retirement plans can be complicated because of the highly technical tax laws that govern them, so experts refer to them by the section of the Internal Revenue Code that authorizes their use. 403(b) retirement plans are just one example. Despite their somewhat cryptic name, 403(b)s can be extremely useful in helping eligible workers save for their retirement needs. Below, you'll learn everything you need to know about 403(b) plans and how you can use them to retire confidently and securely.
What's a 403(b) plan?
403(b) retirement plans are governed by Section 403(b) of the Internal Revenue Code, which lays out all of the guidelines, requirements, features, and limitations of the plans. Also known as tax-sheltered annuity plans, 403(b) plans allow participants to set money aside in a special account and invest it for their retirement. Participants are offered a fixed menu of investment options.
In addition to letting employees save part of their wages in a 403(b) account, many employers also make extra contributions to their workers' retirement savings. These employer contributions can take the form of either discretionary deposits into all workers' accounts or matches on the contributions that employees make on their own behalf. Like the employee's own contributions, these employer contributions are invested and grow over time, eventually becoming available to withdraw in retirement.
What's the difference between a 403(b) and a 401(k) plan?
403(b) plans are similar to the 401(k) retirement plans that most people are familiar with. They have many things in common, including their limits on annual contributions. For 2019, savers can put aside $19,000 in either a 401(k) or a 403(b) plan account if they're younger than 50, or $25,000 if they're 50 or older. Both allow employers to match employees' contributions or make discretionary contributions, and both share the favorable tax features you'll read more about below.
However, 403(b) plans differ from 401(k) plans in several key ways. First, only certain employers are allowed to offer a 403(b) plan. In order to sponsor a 403(b) plan, an employer must be a public school system, a qualified nonprofit organization, or a religious institution such as a church. That means that if your employer offers a 401(k) plan, it's likely not allowed to offer a 403(b) plan and vice versa.
In addition, the investments that 403(b) plans typically offer are different from what you'll find in many 401(k) plans. Historically, 403(b) plans were required to invest in annuity contracts from insurance companies. Over time, the laws governing these plans allowed a wider range of investments, including stock mutual funds. However, because of the historical bias -- as well as the original name, which emphasized the tax-sheltered annuity origins of the accounts -- you'll find annuity products much more frequently in 403(b) plans than in 401(k) plans.
Finally, 403(b) plans have a special rule that allows additional contributions by some employees who have had at least 15 years of service with their employers. Such employees can put an additional $3,000 into their 403(b) plan accounts for up to five years, subject to reduction if their average annual contribution to that point exceeds $5,000.
Am I eligible to participate in a 403(b) plan?
In general, those who work for an eligible employer will qualify to participate in its 403(b) plan, including the following workers:
- Employees of public school systems who are involved in the day-to-day operations of a school.
- Employees of tax-exempt organizations established under Section 501(c)(3) of the Internal Revenue Code, which encompasses most charitable organizations.
- Employees of cooperative hospital service organizations.
- Employees of public school systems organized by Native American tribal governments.
- Civilian faculty and staff members of the Uniformed Services University of the Health Sciences.
- Ministers who are employed by charitable organizations, who are self-employed, or who function as ministers in their day-to-day professional responsibilities with their employers.
Employers are generally required to make their 403(b) plans universally available. In other words, any employee should be allowed to make contributions to a 403(b) plan if it's in place, so if your employer offers a 403(b) plan, you should get information about it soon after you start your job there.
How do I contribute to a 403(b) plan?
In order to contribute to a 403(b) plan that your employer offers, you'll need to fill out some paperwork from your company's payroll person or human resources department. To fill it out correctly, you'll need to consider the following things.
First, you'll need to decide how much money to contribute. Most employers allow you to defer either a percentage of your pay or a fixed dollar amount toward your retirement savings each pay period. Your employer will then withhold the specified amount and make sure the money goes to the financial institution that manages and invests the 403(b) accounts owned by you and your coworkers. In addition, if your employer matches 403(b) plan contributions or adds additional employer contributions of its own, then that money will also be deposited into your account.
When determining your contribution amount, keep in mind that the limits mentioned above -- $19,000 for those younger than 50 and $25,000 for those 50 or older in 2019 -- apply to total annual contributions. Even if you set a percentage that would cause you to exceed those amounts, your employer should stop withholding money from your paycheck once you hit the maximum.
Next, you'll need to specify which investments you want your 403(b) money to go into. It's up to your employer to offer a menu of investments, and the exact type of 403(b) plan your employer chooses will determine in part what those investments are likely to be. Some employers offer individual annuity contracts through insurance companies, which typically let you choose among fixed annuities that pay out income at set interest rates and variable annuities that are tied to various investment asset classes, such as stocks and bonds. If your employer offers what's known as a custodial 403(b) account, then you'll have access to mutual funds as well. Retirement income 403(b) accounts, which are available to church employees, can invest in either annuities or mutual funds.
To be smart about your 403(b) plan account's investments, you'll need to balance a couple of needs that sometimes conflict. First, it's generally smart to have a diversified portfolio to invest for retirement, with a range of asset classes that include both growth-oriented investments such as stocks and income-generating investments such as bonds, which typically pay you interest once or twice per year. However, the fees and costs of investing in 403(b) plan account investments can vary widely even within the same plan, so focusing on the lowest-cost options ensures that you'll hang on to more of the returns that those particular investments generate. Ideally, you can put together a 403(b) retirement account portfolio that fulfills both of those needs, but not all employers are able to offer a large number of investment options that are attractive from a cost standpoint.
How can I get money out of my 403(b) plan?
Like most employer-sponsored retirement plans, 403(b) plans are primarily designed to let participants withdraw money after they retire. Most 403(b) accounts offer multiple options when it comes time to start accessing their retirement funds, including one-time withdrawals on demand, as well as a host of different periodic withdrawal schedules that you can tailor to your cash flow needs. In many cases, you can arrange to have fixed amounts withdrawn every month, three months, six months, or year. If you hold annuities within your 403(b) plan account, then those products may offer some payout options of their own that can give you additional flexibility.
The other choice you have after you retire is to roll over your 403(b) account balance to an IRA. In cases in which the 403(b) plan's investments aren't ideal, rolling money over to an IRA lets you reinvest the money in a wider array of more desirable investments without any immediate tax consequences. However, in some cases, rolling over a 403(b) can cause you to miss out on attractive investment options that employers have access to but aren't available to ordinary investors.
Meanwhile, if you need to withdraw money before you retire, you may face early-withdrawal penalties. Those who take money out before turning 59 1/2 will have to pay a 10% penalty on the amount withdrawn. That's on top of the other tax consequences of all 403(b) plan withdrawals, which we'll discuss below. Avoiding early distributions is usually smart, though there are a few limited situations in which you can take money before 59 1/2 without paying a penalty. For instance, withdrawals that go toward higher-education expenses, medical bills, or the purchase of your first primary residence may be exempt from the early-withdrawal penalty.
At the same time, there's an age at which you have to start taking withdrawals from your 403(b), lest you face an even steeper penalty. Once you reach age 70 1/2, IRS rules force you to take required minimum distributions (RMDs) from your 403(b) each year. These amounts are based on the value of your account each year and your life expectancy, the idea being that you'll take proportionally similar withdrawals for the rest of your life. If you don't take your RMD in full and on time, you'll be assessed a penalty of 50% of the amount you failed to withdraw.
Lastly, different rules apply when it comes to money that your employer has contributed to your account, either through a match or as part of a one-time contribution. Most employers' 403(b) contributions are subject to vesting requirements, which means you have to work for a certain amount of time before you're entitled to keep that free money. Some common provisions for vesting schedules include a three-year waiting period before all of your employer contributions become available to you, or a graded schedule whereby a portion of the contributions become vested each year until you eventually reach 100%. If you don't work long enough to meet the vesting requirements, then you'll have to leave that money with your employer, which can then use it to defray the expenses of the 403(b) plan.
One alternative to withdrawals that some 403(b) plans offer is the ability to take out a 403(b) loan. Specific requirements for such loans vary from employer to employer, but the plan document will give details on exactly how much you're allowed to take, what the repayment terms are, and what documentation is required. Keep in mind that with 403(b) plan loans, there can be substantial penalties if you fail to repay the loan, and if you leave your job, any outstanding 403(b) loan gets accelerated, and you'll have to repay it in full within a short period of time -- typically 60 days.
What are the tax benefits of using a 403(b) plan?
The reason why 403(b) plans are so popular is that they offer substantial tax benefits. The biggest benefit that 403(b) plans offer is that you're allowed to make contributions on a pre-tax basis. Therefore, any money you contribute isn't counted in your taxable income for the year, so your tax bill will be lower by the amount of tax that you would have paid on the contributed amount.
In addition, some 403(b) plans offer what's known as Roth options. Roth 403(b)s do not give you the tax benefit above: Instead, you'll contribute after-tax money to the plan. However, in exchange for giving up the immediate tax benefit, you can make withdrawals from the Roth 403(b) account in retirement tax-free. However, not every employer offers a Roth option, so you'll want to check with your HR department to find out whether you're eligible.
Once you've put money into your 403(b) plan account, the other big benefit is that it grows on a tax-deferred basis. Over the years, your investments inside your 403(b) will typically make payments in the form of interest, dividends, or other types of investment income. In an ordinary account, you'd often have to pay taxes on that income in the year in which you received it. However, because the investments are inside a 403(b) account, you don't have to pay those taxes along the way.
In addition, the tax deferral qualities of 403(b) accounts also apply when you sell a winning investment. In a typical investment account, you'd owe capital gains taxes at the time you sold. With a 403(b) plan account, you once again don't have to pay taxes on those capital gains immediately.
It's true that for regular 403(b) plans, you eventually have to pay the tax man. Taxes come due when you start making withdrawals from your 403(b) plan account, with the amount withdrawn getting added to your taxable income for the year. Often, that's still a net benefit, because most people end up in lower tax brackets after they retire than they were in during their working years.
What downsides do 403(b) plans have?
403(b) plans are extremely useful, but they aren't perfect. One downside to using 403(b) plans is that you have to pay taxes at your ordinary income tax rate on withdrawals in retirement. That's not entirely unfair, given that you avoided paying ordinary income taxes on the money you initially contributed. However, even if much of your account's value comes from long-term capital gains -- which are subject to preferential tax rates when investments are sold outside a retirement account -- you'll still have to pay ordinary income taxes on your withdrawal.
The greatest hazard of 403(b) plans is the investment fees that certain financial institutions charge. Some institutions try to make it easy for employers -- especially small ones -- to create a 403(b) plan for their employees, offering services at inexpensive rates. For school systems and nonprofit organizations, that's an appealing proposition. However, these financial institutions often have the ulterior motive of offering a limited menu of investment options, all of which have relatively high fees. In other words, in a bad plan, you might end up paying for the cut-rate offer that your employer got to open the plan in the first place.
Use 403(b) plans to your advantage
Even with these downsides, however, 403(b) plans are an extremely useful and versatile tool that eligible employees can use to save for retirement. With generous maximum contribution limits, favorable tax treatment, and a structure that's relatively easy for both employers and employees to understand, 403(b) plans are definitely worth a closer look as part of your overall retirement plan.