The focus of this article is what is a 403(b) plan (also known as a TSA or tax-sheltered annuity plan).
Most people are familiar with a 401(k) account, which is an employer sponsored retirement plan, and a 403(b) isn’t too different. Nevertheless, we’re going to walk you through some of the key things to be aware of when thinking about the two, and what the advantages and disadvantages are of the 403(b).
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What is a 403(b)?
A 403(b) plan is a retirement plan sponsored by the government or a non-profit for its employees. Similar to a 401(k), the intention of offering the account is to encourage employees to save for retirement through tax advantaged means. This allows those employees to contribute to their account pre-tax. Once that money is in the account, it can then be invested, with the idea that those investments will grow until the account-holder needs them for retirement. In a 403(b) account, these investments can be annuities (fixed rate of return from an insurance company policy) or mutual funds.
403(b) vs 401(k) – What are the Differences?
A 403(b) is only available to specific government and non-profit employees, unlike a 401(k), which any for-profit company can offer to its employees. Some organizations offer both a 401(k) and a 403(b), in which case employees are able to contribute to both. Following are some of the key differences to be aware of between the two accounts.
Employer Match
One of the great appeals of a 401(k) account is that the employer sponsoring the plan will often match employee contributions up to a certain level to incentivize use of the plan. This is generally thought of as “free money” for the employee, and is a nice perk.
When it comes to 403(b) accounts, though, this is a rarer feature. The underlying reason for this is a legal one. 403(b) accounts are not subject to Employee Retirement Income Security Act (“ERISA”) reporting requirements, assuming they do not fund any contributions to the accounts. This status is seen as desirable enough that the norm is no matching provision on 403(b) accounts.
Expense Ratios
Because of the avoidance of ERISA reporting, 403(b) accounts are generally able to function at lower expense ratios. If you are unfamiliar with expense ratios just know that the lower the better. Preferably you want an expense ratio under 0.75% and check out Investopedia’s definition for more information.
Vesting Period
A 401(k) sometimes has a vesting period, whereby your employer’s matching contributions vest over a set number of years. As such, if you leave the company and some amounts haven’t vested, your balance will be reduced by that amount upon your departure. Because 403(b) plans tend not to have matching contributions, there is no vesting period to consider when switching employers.
Catch-up Contributions
Although 403(b) accounts fall behind 401(k) accounts in terms of their matching, after a 15 years of service with the same organization (or in related churches, for ministers), 403(b) account holders can make catch-up contributions beyond the annual maximum. These are still subject to certain limitations, and they must be funded by the employee. But they do enable the account holder to add more dollars to their 403(b) than a 401(k) holder would be able to.
Investment Options
Because of the history of the 403(b) account, which started life as a Tax Sheltered Annuity plan, these accounts tend to be administered by insurance companies. As a result, annuity investments are more heavily featured as 403(b) investment options, with mutual funds sometimes limited.
401(k) plans, generally administered by mutual fund companies, tend to favor mutual fund investments. Regulation changes mean that 401(k) plans are able to offer annuity investments more easily now. But 403(b) accounts still skew towards annuities.
Can I have a Roth 403(b)?
A Roth retirement account is one that you fund with after-tax dollars. Then you do not pay tax when you withdraw the money. If you’re young and can afford to, it is generally very favorable to use a Roth account. Check out our tax demonstration in our Investing 101 Part 1: Retirement Investing guide to see why. However, not all employers will offer a Roth option for either a 401(k) or 403(b). Although offering a Roth option is becoming more common.
Can I roll my 403(b) into an IRA if I leave my employer?
Yes! Thankfully, there are no issues with rolling your 403(b) account into an IRA if you part ways with your employer, or they stop offering the plan. Indeed, this will likely provide more investment flexibility than the 403(b) offered. Don’t worry about losing the money you’ve contributed. It’s still your money.
Note that the size of your balance may dictate how quickly you have to roll over your employer sponsored account. The larger your balance the more likely you won’t be forced to rollover your account immediately. There are instances where a provider may cash out your balance and send you the funds. This could cause adverse tax consequences if you do not handle the funds correctly. Thus when leaving an employer, call your 403(b) or 401(k) provider and ask them directly to understand your options and avoid any unexpected tax consequences.
How Much Should You Contribute to Your 403(b)?
Contributions to your 403(b) are typically based on a percentage of your paycheck. But the question is how much should you contribute? Well first remember that if you have a traditional 403(b) and not a Roth 403(b) then your contributions happen before tax. If you contribute $100 pre-tax that means that the amount your paycheck is reduced is actually less than $100. That is the power of contributing before taxes.
To see an example check out the retirement investing guide or if you prefer playing with numbers check out this 403(b) calculator. We also encourage you, no matter where you start, to sign up for the Acquire Then Retire savings challenge on Ostrich. This challenge will enable you to find the ideal contribution percentage.
403(b) 2021 Max Contribution
The limit for elective deferrals by an individual to a 403(b) account for 2021 is $19,500 – the same as for a 401(k). You can find more detail on whether you qualify for catch-up contributions on the IRS website.
403(b) Withdrawals
Withdrawing money early from your 403(b) is not advised if you can avoid it. You’ll be taxed and may be charged a penalty on the amount you withdraw. To avoid early withdrawal penalties you must wait until either you are 59 ½ if you are still working or 55 if you are retired. Now let’s say you desperately need the money there are some exceptions and alternative options.
For example, during the COVID-19 pandemic, congress passed exceptions to waive penalties for early withdrawals from retirement accounts including 403(b) accounts. Now those are only temporary, but there are other exceptions such as becoming disabled and encountering a financial hardship.
Another option to access funds early is through a 403(b) loan. These loans are available in most 403(b) plans and allow you to borrow up to $50,000 or 50% of your 403(b) balance. You are required to pay back the loan within 5 years or if you leave your employer to pay the balance off in full. Otherwise, the outstanding balance will be taxed as regular income in the tax year you leave your employer.
Conclusion
There are many similarities between 401(k) and 403(b) retirement plans. Ultimately it is a good idea for you to set aside money for retirement using your employer offered 403(b) plan. That being said, the nuances with your employer matching, catch-up contributions and investment options are particularly important to recognize and understand. Start contributing to your 403(b) today and future you will be thankful.
